8th Lecture: Money, Credit, and the Business Cycle

The beginning of money substitutes is very well known. People in Great Britain used to keep deposits of gold with the goldsmiths in London. Later they began to use the receipts from the goldsmiths as substitutes for money in transactions and cash holdings. The difference between a ticket entitling a person to a definite amount of money and a ticket entitling him to a certain amount of bread is that if he wants to get the bread he must cash the bread ticket, although he may use the money ticket itself to get the bread provided the baker considers the money ticket of value and wants to use it as cash holding.

Goldsmiths soon discovered that they could issue more money tickets, more money substitutes, than they had gold in reserve. This meant an addition to the nation’s quantity of money in the form of fiduciary media and money certificates, over and above the quantity of gold in reserves. A problem arises because fiduciary media may be created out of nothing; theoretically there is no limit—or so it appears.

The creation of fiduciary media represents a factor that brings about a rise in prices. if the fiduciary media appear on the loan market, as an additional supply of loan money, there is another effect also; the increased supply causes, immediately and temporarily, a reduction in the rate of interest. There cannot be any argument that the rate of interest is a real market phenomenon that arises out of the time preferences of individuals; it is not solely a monetary phenomenon. However, the rate of interest is affected by an increase in the amount of money appearing on the loan market. An increase in the amount of money appearing on the loan market brings about a drop in the monetary rate of interest. How does this readjustment take place? This is the problem of the trade cycle.

In dealing with money substitutes and fiduciary media, i.e., that amount of money substitutes in excess over the reserves of the bank, we must never forget that the position of the banker or of the bank issuing such fiduciary media is delicate. Only if the banker has the good will of the people can it be assumed that they will be willing to hold these excess money substitutes and not present them for redemption, which would push the bank into bankruptcy. It is even more important to realize in the first place that it is not very easy to make the people accept money substitutes as money. Originally money substitutes were looked on with suspicion; people were not very enthusiastic about accepting them in place of gold. It is difficult for our contemporaries to realize this, because money substitutes protected by the government have appeared in recent years and been forced on the people by the government. Moreover, today these money substitutes have been declared to be legal tender, so that if a debtor wants to repay a debt, the creditor is bound by law to accept the money substitutes as if they were real money.

Propagandists who wanted to make the government pre-eminent in the issuance of money substitutes have publicized many stories about private money substitutes. These tales were condensed by an anonymous American who is credited with the dictum “Free trade in banking is free trade in swindling.” Economists, however, think differently; they consider free trade in banking as the only protection against the government’s issuance of bad banknotes.

The main problem is that unfortunately all people, even in the age of liberalism and classical economists, consider the rate of interest as a monetary, not a market, phenomenon. The classical economists explained that prices and wages were market phenomena, but they were not so anxious to say that the rate of interest was also a market phenomenon. This is one of the weaknesses of Adam Smith’s The Wealth of Nations. He refuted the idea that a scarcity of money can make business bad. But he was not prepared to attack the age-old laws against high interest rates, the laws against “usury.” Jeremy Bentham, in his Defense of Usury [1787], which is still in use today, was the first to refute these old ideas of interest.

People considered high interest rates a barrier to economic trade and progress, and felt that anything that might lower the rate of interest a blessing. Consequently an increase in money substitutes was considered a blessing because with it came a lowering of the rate of interest. All other things remaining equal, if an additional offer of loans by the person making the money, by the bank of issue, is made, the would-be lender must drop the rate of interest to attract additional borrowers. This was considered advantageous and there was enthusiasm for it on the part of public opinion.

It is tragic and fateful that not all liberals realized that the rate of interest was an economic, not a monetary, phenomenon. These liberals not only failed to fight, but they even aided the foundation of additional government central banks with special privileges because they thought these banks would lower the rate of interest. The consequence was a lowering of the interest rate in the short run, a short-run boom—but later, inevitably, after some time, the appearance of an economic crisis, a depression. People began to consider periodical depressions and the trade cycle as inherent characteristics of capitalism. This has been one of the main arguments for socialism and one of the main causes of making people anti-capitalistic. The effect of the 1929 depression in this county is still evident in the erroneous interpretation of this experience by the people.

As a consequence of the belief in the advantages of low interest rates, credit expansion became very popular—at first in those countries where there was capitalism and a banking system. At the end of the eighteenth century, Great Britain was already suffering from the consequences of recurring economic crises. Later these crises began to affect other countries—at first the European countries that were more advanced in capitalism—the Netherlands, France, and the most advanced city-states of Germany, Hamburg, and Bremen. These periodical crises came to other countries only with the spread of capitalism. For instance, in the depression of 1857, Austria was still rather backward in the capitalistic development so that she was affected only very slightly. The Austrian government did something which was very spectacular for those days. For political reasons, Austria wanted to aid Hamburg. She shipped a full trainload of silver under heavy soldier guard to Hamburg to support Hamburg’s banking system. At that time, Austria was still out of the world. But in 1873, when the next depression came, Austria was so much involved that Vienna was the center of the crisis.

Economists began to raise the question as to what caused these crises. Say’s Law demonstrated only what could not be considered the cause—overproduction. A little later a group of English economists and bankers began to realize that the problem was the boom-bust trade cycle and that the cause of the bust, the depression, was the preceding boom. To eliminate the depression the preceding boom and credit expansion by the banks must be eliminated.

But this was not a complete explanation. It was an explanation of conditions in Great Britain and the few countries already equipped at that time with such a banking system. This was an explanation under the assumption that the rest of the world did not have such a credit expansion. For example, the Currency School argued that if there is credit expansion in England, which results in a boom and higher prices in Great Britain while conditions hold prices in other parts of the world stable, exports diminish and the balance of payment becomes such that gold bullion is shipped out of England to other parts of the world. The holders of the banknotes seek to redeem their notes. The reserve of the British banks drops so that the banks must restrict their issue of notes in order to protect their own solvency. This brings about the depression. This is correct as far as it goes, but it does not take into account the fact that all countries might expand their currency, so that then there would be no explanation for an outflow of money.

The Currency School’s theory made one great mistake—it failed to realize that it made no difference whether inflation was caused by banknotes or by checkbook money. Legislation in 1844, Peel’s Act, made it impossible to expand money by means of banknotes in England and other countries adopting similar legislation. But the legislation limiting banknotes said nothing about checkbook money. Consequently, this law of 1833 didn’t stop booms. Another boom, based on checkbook money, appeared already the next year, leading people to feel the whole theory was worthless.

This Currency School’s theory was the basis of the Banking School’s quantity theory of money. The British Banking School developed the theory that there is a certain demand by business for money. If the bank restricts its creation of bank money, checkbook money, and banknotes, to the “needs of business,” they say it can never bring about an inflation. Let us assume that the bank of issue discounts only bills of exchange which are the result of an actual business transaction. The cotton merchant sells a quantity of cotton to a cotton spinner, and the spinner needs money to pay for it. He draws the bill, which is discounted by the bank, which creates additional money. After three months when the raw cotton has been converted into cotton yarn and is sold, the loan is paid back and the money disappears. Under this system it was believed that the “needs of business” automatically produce the amount of money business needs.

This theory was as popular in the second part of the nineteenth century as it was false. The idea that the “needs of business” would automatically limit the creation of additional money is mistaken. When it has been applied in practice it has resulted periodically in inflationary booms. No one minded the booms. But the booms were succeeded by depressions which the people didn’t like.

For 50 years there was no progress at all in this study. Then, at the end of the nineteenth century there was published a book by the Swedish economist Knut Wicksell [1851–1926], Geldzins und Güterpreise [1898, English translation, Interest and Prices, 1936]. Wicksell pointed out that the amount of such business transactions is not independent of the behavior of the bank. If the banker reduces its rate of discount, the amount the purchaser must pay for his raw material is less, and the transaction seems more profitable than it would otherwise. Thus, banks may increase the “needs of business” by lowering the interest rate. And when the interest rate is lower, the banks expand, which is inflationary. Thus, the demolition of this theory was due to Wicksell. And then in 1912, my book, The Theory of Money and Credit, came out. The foundation of this theory can be traced to the originators of the theory of interest—W. Stanley Jevons and Böhm-Bawerk. This is the monetary theory, the circulation theory, or the Austrian theory, of the trade cycle.

Peel’s Act was in 1844. The next boom was in 1845 and 1846. The depression followed in 1847. In 1848 came the Communist Manifesto, which said that the capitalistic system leads to periodical crises. Each crisis, the Manifesto said, would be progressively worse until it would lead eventually to the breakdown of the capitalistic system. In 1857, 1866, 1873, and again in 1929, the Marxists were awaiting the day, “der Tag.” And today in Moscow, Stalin waits for the final crisis of the capitalistic system in the belief that it is just around the corner. What is worse is that so many economists think this way too. This is the philosophy of the League of Nations and of the many “disunited” peoples in the United Nations. They do not believe that the occurrence of depressions has anything to do with credit expansion; they believe that trade cycles are inherent in the capitalistic system, and that a special committee must be formed to fight the trade cycle.

At the beginning, the popularity of credit expansion was due to the idea that it is a blessing for every country and for the whole world to have a low interest rate. Credit expansion was considered a vehicle to lower the rate of interest. The politician wanted prosperity for his country, and for the people. Governments wanted to keep interest rates low; even Coolidge in 1924 wanted low interest rates. It seems to me astonishing that attempts have been made to raise and lower wages, to raise and lower prices, but you will never find an occasion when a government or politician was in favor of raising interest rates. I don’t mean to say I am in favor of a high interest rate—I am for the market rate.

When governments first fathered central banks, the aim was to create prosperity by lowering the interest rate. But later governments favored the central banks with special privileges because they wanted to borrow money themselves and they considered the central banks a source of cheap money. This was a wonderful discovery by the governments. First of all, the governments granted the central bank legal-tender status for their banknotes and freed them from the obligation of keeping their contracts to redeem their banknotes in gold or silver, banknotes which people had accepted voluntarily. (How different would have been Charles I’s fate—he was beheaded in 1649—if he had been able to finance his military ventures without worrying about Parliament and the taxpayers.)

Now I want to discuss the consequences of artificially cheap interest rates. It is agreed that the problem is the trade cycle, the credit expansion, that we must fear the boom which results in a depression. The League of Nations made a report, prepared by Professor Gottfried Haberler [1901–1995], on the trade cycle. On its first pages it is clearly stated that the boom which causes the following depression could not occur if the banks did not expand credit. Therefore, one would think the solution would be easy—we have only to prevent the banks from expanding credit or at least from adopting governmental institutions and policies which invite the bank to expand credit. But no—they began to look for another explanation of the cycle. Marxists recognize that one cannot do away with interest entirely by credit expansion, but they deny that lowering it artificially will have evil consequences. They ignore the fact that the rate of interest is the expression of the difference between the market valuation of present goods as against that of future goods.

What really takes place in a credit expansion? Why do we say that certain things may not be done because capital is lacking? Certain projects not feasible today could be effected by cutting down present consumption enough to permit more producers to build more durable investment goods. Everyone contributes a share to the determination of how much is to be consumed and how much is to be invested. The individual entrepreneur is aware of this fact because of the rate of interest. If people are more willing to save, the interest rate will drop. On the contrary, if they are ready to spend, the rate goes up. The entrepreneur in planning estimates anticipated costs and prices, takes into consideration costs of labor, material, and the rate of interest. If he decides a certain project cannot be done profitably, then it is not done. There are always projects which are not undertaken because the money is used for consumption.

The rate of interest is lowered artificially by credit expansion, so that a project which appeared unfeasible yesterday may today appear profitable. Therefore, the effect of credit expansion and of the lowering of the interest rate is that certain projects which would not have been undertaken are now started. If we think it over, we realize this is not good. There has been no increase in material goods. The only difference is that the bank has created out of nothing additional banknotes or additional checkbook money.

The consequence is that the businessman’s calculation is falsified. While before it reflected precisely the conditions of the available factors of production and demonstrated what could be done and what could not be done, it is now falsified, for there exists an additional amount of money substitutes and fiduciary media. The businessman is led, by artificially low interest rates, to embark on projects for which the available supply of capital goods is insufficient. (Suppose a man owns a limited amount of building materials. The contractor makes an error in estimating so that the foundation is too large for the material actually on hand. He should have realized before that the amount of material would not suffice. A crisis results for the master builder.)

It is more difficult in life. The additional demand for projects which would not have been undertaken earlier raises the prices asked for the materials. True, the rate of interest is lower. But prices are higher. The whole thing must stop if the bank’s credit expansion comes to an end. But bank credit is elastic, and the banks give more credit.

As wage rates go up, the demand for consumer goods goes up also. But because the boom seems general, the entrepreneur decides to go ahead with the project. Higher prices for the factors of production, including labor, result. And there is a further increase in consumption.

Also of importance is the fact that the banks, when faced with this increased demand, begin to raise their interest rates. In every crisis cautious people tell the bankers, “It is an over-expansion. The expansion should be cut down and you should not give credit at such easy terms.” But the bank says, “Look, we have higher interest rates and there is still an additional demand in spite of this higher rate. Therefore, you can’t say our cheap money policy is responsible for the boom.”

The relation between price movements and the rate of interest was contributed by Irving Fisher. In a period of rising prices the money lender can make a profit by not lending, by refraining from lending, and by buying goods and selling them himself. On the other hand, the borrower makes an additional profit because when he repays the loan the prices of the goods he made with the borrowed money are higher. Therefore, when there is a tendency for prices to go up, the interest rate is increased by more than the true interest rate. This additional increase in the interest rate is the “price premium.” Therefore, a rate which is considered mathematically higher in comparison with the prior rate is still too low for what it should be in consideration of both the interest rate plus the price premium. (In 1923 in Germany, the Reichsbank increased the discount rate to the unheard-of rate of 90 percent, but the price premium at that time was such that the discount rate should have been something like 10,000 percent.)

During a period of speculation stock market prices move up. Everyone becomes enthusiastic and people who know nothing about it enter the stock market. Credit is given to anybody. All these symptoms are well known. Also well known is how such a boom breaks and the consequences and features of such a boom. The problem is what is going on and what makes the whole situation unsound.

In 1929, there was credit expansion in this country and money was cheap. So loans were made to other countries causing the balance of trade to be active. There were more exports from the United States than imports because the other countries didn’t have to pay for them—they could pay with bonds. The “wicked” Mr. Schacht[1] was more aware of what was going on than the great Bank of New York. Anybody who wanted to borrow money could get it. (Money was so easy to get from the United States that one small town in Silesia, for instance, built a heated outdoor lake for tropical plants.)

It is said that the characteristic of a boom is general overinvestment. This is an impossibility. The amounts available for investment are (1) the savings of past years, and (2) that part of the previous year’s production equal to the equipment used up in the past years and available for replacement of worn-out tools. (The replacement of old machinery may be made by substituting better or different machines. In this way, many producers have completely changed their production.) Nothing else is available for investment, so there cannot be general overinvestment.

When the available past savings (1) and capital available for replacements (2) are invested according to a plan that overestimates the amount of investment goods available, the result for the whole national economy is malinvestment. Construction is started calling for more material than is available. It has been said that the 1857 crisis in Great Britain was due to the fact that they had built too many railroads. At that time those railroads were unprofitable and capital was lacking for other requirements. Too much circulating capital had been converted into fixed capital. In the crisis, goods for consumption are available at very low prices as there is a surplus of consumer goods.

An individual can overexpand. One can say, “My personal financial situation is very bad. I spent too much money in expanding my business, in building my new factory.” The overinvestment idea appeared when this situation, applicable to an individual, was transferred to a nation. But it cannot be true for the whole economic system because only those goods which are available for investment can be used for that purpose. Money can be invested in the wrong plans, and too many projects can be started so that some of them cannot be finished, or if finished they can be used only at a loss.

It is obvious what happens. The question is why the situation is suddenly discovered in only a few days, so that the crisis comes overnight. Where there was confidence and optimism, there is depression and despair. Of course, it is only the insight that comes overnight, not the real crisis, which has been building over time.

Because there was no uniformity in credit expansion in various countries in the past, the extent of the credit varied in the different countries. With the demand for foreign exchange and credits, there was a drain of money from some countries. Bankers became frightened. A government official announced, “Maybe we will be forced to restrict credit.” The businessmen became frightened: “We need credit. Let us, therefore, get credit as long as there is any possibility.” The demand for credit increased overnight and the banks then had to restrict it. If one bank started, all the others had to restrict it also. Once it started in one country, all other countries had to do the same, so that the restrictions spread all over the world.

If the banks did not restrict credit, could such prosperity be made to last forever? The fact is that in every period of prosperity businessmen have declared, “This is not a temporary boom—this is the final great prosperity of mankind. It will never be followed by a crisis.” But it is not possible to make the boom last forever because the boom is built upon paper, on banknotes and checkbook money. It is based on the assumption that there are more goods available than there really are. If the banks did not stop at the last minute, then the credit expansion would have proceeded more and more rapidly until the complete breakdown of the currency occurred, as it did in Germany in 1923. The inflationary movement must come to an end either by a complete breakdown or by voluntary restrictions on the part of the banks involved.

If people were not so optimistic, the crisis would not be so bad, for people would prepare for it. The reasons that make the boom collapse are individual historical facts. The problem when the boom comes to an end is decided by accidental factors. But it cannot be avoided. And the later the crisis comes, the more capital has been squandered, and the worse the consequences.

I want to say something about the relation between inflation and credit expansion. Both are very similar, in fact almost the same. The difference is this. In the case of credit expansion, the total additional amount of newly created money goes first into the loan market. It is not spent for consumption, but lent to business. Therefore, the first consequence of credit expansion is that an expansion of business is brought about. And all the other effects come from this stimulation of business. In the case of inflation, the additional money goes first into the hands of a spender—for instance, the government spending for arms or other reasons. Thus, the course of the inflation is different. In essence the two are the same, but their sequences are different, and the characters of the two booms are different. But sooner or later, the spending money from the inflation reaches the investment market also, just as the credit expansion money also finally reaches the spending market.

The idea of qualitative credit control has been popular. We want to give additional credit for good things, for additional industrial plants and for agriculture, but not for bad people and bad purposes, not for frivolous things. In the final analysis, it doesn’t matter where it starts. If the additional money goes first to farmers, the demand for credit among farmers drops and the amount that they would have absorbed without credit expansion is available for creating a boom somewhere else. A boom cannot be directed. No segment of the economy is separate.

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[1] [Hjalmar Horace Greeley Schacht (1877–1970), German financier who held a number of positions in German government, 1923–1943, including president of the Reichsbank and minister of economy.—Ed.]