9th Lecture: The Business Cycle and Beyond

About the end of the nineteenth century, when people began to realize that there was something questionable about credit expansion, the defenders of this policy found a new excuse. They declared that credit expansion could work in an isolated country which did not connect with the rest of the world through the medium of the gold standard. By abolishing the gold standard and establishing a free-of-gold currency or fiat money system it would be possible to expand credit, lower the rate of interest, and make the country prosperous forever. This attitude was evident among the German Junkers who suffered in the 1880s and 1890s from the importation of American cereals. However, they ascribed their misfortune to the gold standard, not to their poor soil and the low yield per acre. They said if it were not for the gold standard they could enjoy a low rate of interest and prosperity.

The influence of these ideas was apparent when the Italian minister of finance declared that a conference of the banks was needed. Toward the end of World War II, these ideas led to the establishment of the International Monetary Fund (IMF). The British government suggested an international bank and in order to create favorable public opinion for an “International Clearing Union” published a pamphlet written by Lord Keynes. This pamphlet, distributed in this country by the British propaganda office, declared that credit expansion was most desirable. In Keynes’s own words, credit expansion had brought about the miracle of “converting stones into bread” within nations and it was now necessary to do this on an international scale. They wanted an international monetary unit. The Bretton Woods Conference produced a document and also an institute with members, a board, and so on. But it is very well known that otherwise they produced nothing. From the beginning, the Conference was abortive and useless.

Why can’t credit be expanded on an international basis? The failure of credit expansion is due not to the fact that it has been done on a national basis only, but to the fact that it is impossible to substitute paper for non-existing capital goods. It was not realized that what is needed for an economic expansion is more capital goods, more previous savings. It is true that in the past credit expansion of individual countries came to an end because the pace of the expansion was not the same in other countries. But it would have come to an end anyway.

The real reason why such an international bank cannot succeed is the impossibility of answering this question: “Who should profit from this credit expansion in the short run?” Suppose there was one central bank—let us assume that all political rivalries are forgotten. Such an international bank could increase the amount of credit available either by printing additional banknotes or by giving additional bank credits by checkbook money. But then the problem appears for which no solution is possible—to whom will the new credit, the “easy money,” be offered?

Let us assume that the whole additional amount is loaned to one country. This country will enjoy the first boom. Its people will have more money and will bid up the prices of the things they want to buy. Having more money at their disposal, they will be in the favorable position of being able to buy from other countries not yet adjusted to the credit expansion. This first country will be the winner, and the others will be the losers. The other countries will still sell at the old prices but they will have to buy at the new, higher prices.

The questions to be asked are: “Who will get the loans? How will the additional money be distributed?” Every group of countries will propose a system of distribution. The Far East will favor distribution according to population. The advanced countries, for instance, will suggest distribution according to the total amount of yearly production or according to national income. Therefore, such plans are more or less useless. The only value of the IMF, which has been one of the most conspicuous failures of world policies of the last twenty years, is that it occupies office space in Washington.

As all these things proved useless, the defenders of credit expansion, that is, those people who with Marx and the Banking School theorists do not believe that the source of a depression is the credit expansion that precedes it, have proposed elaborate countercyclical methods for minimizing depressions. Considering depressions unavoidable, they want to make them as smooth and as mild as possible by means of government interference. Their idea is that the cycle comes from business or from laissez faire, and the government should interfere with countercyclical programs to make it milder. But this is just the opposite of the case.

The idea of countercyclical measures is that when there is a crisis, business is bad and there are unemployed. The government then should step in with public works. The members of the League of Nations and United Nations committees believe they have discovered something new, but this is nothing new.

The boom comes to an end because the factors of production have been malinvested. The existence of unused capacity in times of depression is an indication of malinvestment, because errors in judgment were made in the past. The solution would be to let wages and prices drop until things started up again. But then someone suggests that the government step in with public works. But why should the government take the factors away from the private works where they are needed? The answer made is that the government should restrict government expenditures as long as there is a boom, and then, when the depression comes, embark on great projects. In a rather childish way these reports always say that there should be a number of projects “on the shelf,” already elaborated by the technologists. As soon as the crisis appears, the government should take them off the shelf and start work.

This idea is erroneous because it is based on comparing the individual’s situation to that of the whole nation. An individual is cautious; he saves for a rainy day; he may realize that he is prosperous now, but he remembers that his business may not always be successful. When the rainy day comes and he wants to consume, he must sell his savings to others who make use of them.

What should the government do with the taxes it collects if such a public works scheme is anticipated? Should it hoard the money in advance? Should it withdraw money from the system by taxation, thus neutralizing the credit expansion? Advocates of public works feel the government should abstain from spending during the expansion, hoard the money, and when the depression comes spend the money, thus making a new inflation. Perhaps, they reason, it will be possible in this way to prolong the boom for a few weeks. But it is also possible that the economic system won’t cooperate and the pump-priming will fail to work as it failed in the early New Deal.

The other suggestion is that the government hoard, not the money, but the means of production—the machines, tools, and raw materials. This would mean that during the boom the government would make the boom still more “boomy” by appearing on the market as a purchaser of machines, tools, and raw materials.

Sweden boasted that she had solved the problem of the depression by following countercyclical policies. In the 1930s her position was rather peculiar. Sweden exports precisely those things that Germany was consuming for her rearmament effort—iron, lumber, machinery, etc. Sweden’s situation in this rearmament boom was like that which Pittsburgh or the entertainment section of Broadway would have enjoyed if they had been independent countries during the war. They would have sold steel and provided amusement to soldiers and munitions works; they would have enjoyed the advantages and had none of the disadvantages of a boom. They would have been the most flourishing sections of the Western hemisphere. This was the situation in Sweden. To say that it was her wonderful policy is another thing. Then, when the war was over, her lead over the whole world was due to her neutrality. You know, it would have been a different story if Hitler had gone into Sweden. One of the Swedish economists was made head of the reconstruction of Europe, which has been a rather miserable experiment.

No boom is possible without credit expansion, and credit expansion must result in catastrophe. When the end of the boom comes and the depression begins, the psychology of the people may make the depression last longer than it would have. (The depression of 1929, for instance, lasted as long as it did because the unions would not accept any substantial lowering of wage rates. This important cost factor of the boom remained for many years and could be remedied only by a new inflation.) The boom is illusory; it is based on the assumption that we are richer than we really are. The boom started projects which could not be executed. The depression means the readjustment of conditions to the real state of affairs. In the depression, the main activity of business consists of salvaging what can be rescued from the boom. The depression lasts as long as necessary to accumulate, by new savings, the capital needed for the continuation of as many enterprises as possible that were started during the boom. The depression does not mean an impoverishment of the country. Actually it reflects a more accurate picture than the preceding boom. But due to psychological reasons and the political situation caused by the depression, by the drop in prices, and the decline in production, it may go much farther than necessary to re-establish the preceding conditions.

Literature on the trade cycle, especially the earlier material, took sadistic pleasure in describing in detail all the phenomena of the depression. Sometimes paradoxical phenomena appear. But we must not fail to realize that the depression is the return to reality and the attempt to make well, as far as possible, the deficiencies produced by the preceding boom.

During the nineteenth century there was an almost regular recurrence of booms and depressions. This is what has been called the “trade cycle.” As soon as conditions begin to be normal, the people and the government call for a new credit expansion and the boom begins again.

The people came to consider the trade cycle as an inevitable trade phenomenon, and they began to study the length of the cycle. All efforts to estimate the length of the trade cycle are more or less fantastic. Because some economists declared that the length of the cycle is eleven years, the idea arose that it is not caused by social and human events, but by cosmic events. The sunspot theory was developed. Such theories are merely guesswork. In the first place the cycle is not eleven years. Also, if true, why does business, which adjusts itself to nature, climate, fertility, and other conditions, never realize that and adjust its activities to the sunspots? There is not the slightest empirical proof that the cycles and sunspots coincide.

But a regularity of some kind was recognized. There is some feeling that the trade cycles are a new development which came with the banking and money system of modern times. But is the trade cycle inevitable? If capitalism continues, will this phenomenon prevail in the future as it has prevailed in the past? The science of human action should not be confused with the natural sciences. Trade cycles originate as the outcome of a human action—credit expansion. Will the trade cycle remain if this knowledge becomes general? Certainly not! If everybody realizes that the credit expansion is the cause of the following depression, governments and people will probably learn that credit expansion is not to their advantage and it will be discontinued.

On the other hand, let us assume that governments and public opinion, in spite of this insight, stubbornly cling to a policy of credit expansions from time to time. Would it not be probable that the reaction of the individual businessman to credit expansion would be different? Might not business itself, in spite of the governmental incentives, make adjustments so that business would be more stable? Suppose the government embarks on credit expansion and the businessmen feel it is questionable. Instead of expanding their operations because expansion was possible, they might become rather cautious and not expand to the extent possible. This is not such an impossible idea. Remember the New Deal pump-priming. The New Deal wanted a boom but no depression. They wanted to make only the initial movement and then stop expanding credit. But the businessmen realized that the government was planning to stop once the businessmen had started expanding and they did not fall into that trap.

This makes me think the trade cycles which have occurred in capitalistic countries from 1780 on may eventually disappear. It would be a mistake, therefore, to say that the trade cycle belongs to the market economy and will not disappear as long as there is a market economy. First of all, the trade cycle is not a market phenomenon but a phenomenon of the credit expansion which is inserted into the market economy because governments and public opinion believe that the normal operation of the market economy doesn’t produce enough bridges and wealth. They believe they have discovered the method for “converting stones into bread.” I would say the trade cycle may be only a passing phenomenon, one evidence of the difference between the science of human action and the natural sciences.

What is wrong in the boom may be described as disproportionality between the various branches of production, between the producer goods and consumer goods. Those who try to explain a general boom or general nationwide losses as due to this disproportionality in business production point out that there are durable consumer goods and producer goods. When a new invention, such as a refrigerator, comes on the market, everyone wants to buy. That particular industry booms and expands. But, it is asked, when everybody has bought a new refrigerator, how can the industry continue to expand? The same situation applies, they say, to other businesses—to the building trade, and so on. After everybody who wants these durable and producer goods has bought, the demand falls off and there is the depression. This idea is really fantastic because economic expansion doesn’t take place in this way.

The monetary theory of the trade cycle explains the disproportionality in this way. At first only a few buy the new gadget, and then more and more. When the last ones buy, those who bought the early production need replacements. Businessmen are not so stupid as to say that a business which was good yesterday will necessarily be good tomorrow also. A man embarking on a new business asks himself if there are already enough plants. People do not enter into business as morons. This explains the proportionate sizes of the various industries and the reason why the number of loaves of bread produced and sold on the market is more than the number of coffins. This is why the size of industries is adjusted to the life of their production. It isn’t necessary for the government to tell the people what would be surplus production. The calculations of an individual businessman may be erroneous and that man may go bankrupt. Perhaps he increased production in the motor car industry when he should have increased it in the refrigerator industry. He caused a surplus of automobiles and a deficiency of refrigerators. Every day there is loss to some business and gain to others. This means that some businesses will be overstaffed and some understaffed. But it doesn’t mean a general boom or a general nationwide loss. A general boom can only be brought about by the illusion which is inherent in the credit expansion.

All attempts to explain the crisis by referring to the mistakes and insufficiencies of businessmen are in error; they fail to take into consideration that such mistakes counteract one another. If one sector of business has made the mistake of overexpansion, there is necessarily underproduction and good business in other branches. Only by general credit expansion can a boom be caused.

The idea that what is wrong with business is that the businessman doesn’t see the whole field but only a small segment and, therefore, is bound to make mistakes is Marx’s idea of the anarchy of production. Adam Smith and others have answered this in their books. Marx failed to account for the fact that, even if no dictator tells men what to do, there is a tendency in the economic system to give every branch of industry precisely that amount of capital, labor, and products that the consumers demand. Those who guess right make profits; those who are wrong incur losses. The result is that eventually control of the factors of production gets into the hands of those who best satisfy the needs of consumers.

If government, by means of a tax on production, tries to eliminate the profits, to confiscate them, and, therefore, to prevent them from bringing about the consequences which would ensue without these taxes, the operation of the market is considerably weakened. The result is that economic progressiveness and the tendency toward improvement which are inherent in the capitalistic system are eliminated and rigidity enters into the system.

As an example, let us consider a department store developed years ago by an ambitious young man who started in business with “two shoelaces” [on a “shoestring”]. The market economy prevents the old department store from becoming rigid, conservative, and bureaucratic. If it does, and if the founder’s grandchildren operate the store inefficiently, other small shops around the corner will make profits, consume only a part of their profits, and invest the balance. In time the business of the old store will shrink until it may be absorbed by the newcomer, or perhaps sold to new management. Then one of the small shops will be the big department store.

But today things are different. Modern taxation prevents the newcomer from reinvesting the greater part of his funds. The government doesn’t legally and officially discriminate against the newcomer; if he makes $250,000 he is taxed the same as an old business making $250,000. But the future business capital is taxed away before the newcomer can build the big store. Therefore, the old department store is somewhat protected; it doesn’t need to compete so actively with the gifted newcomer, and it may become negligent. These conditions make it difficult for newcomers to challenge established businesses, the “vested interests.” People think the tax laws are extremely progressive, but in reality they are extremely conservative, favoring the existing structure against newcomers. Rigidity results. But this has nothing to do with our subject, credit expansion. However, if there is a credit expansion, the banks prefer to lend to the old rather than to the new firms. This also means that the existing structure tends to be petrified.

I want to say something about the banks and their connection with credit expansion. We must never confuse two very different things which have nothing in common except for the fact that the business is done by the same person, the banker. In one case, the banker may lend his own money; he who lends his own money is a money-lender. In this case, there is no question of credit expansion.

In the other case, the banker may lend other people’s money. The banker who receives deposits from customers and lends this money, other people’s money, is a savings bank, an intermediary. The banker may also create fiduciary media, banknotes, and lend them also, usually by crediting his customers’ checking accounts. As these two banking functions—lending the deposits of customers and lending fiduciary media—are generally connected in the same enterprises, the government, which controls the business of the fiduciary media, has gained control of the whole lending business. This has given tremendous powers to the government. If there had never been government interference with the banks, the whole problem would never have appeared.

The defenders of government interference with the issuance of banknotes and checkbook money justify this policy by declaring that “free trade in banking is free trade in swindling.” The poor, ignorant people must be protected, they say, against bad banknotes. But no one would be forced to take banknotes if they had not been declared legal tender by the government. The German literature of the mid-nineteenth century considered it really necessary to protect the poor people of Germany from the banks. But the German central bank, the Reichsbank, devalued from 1914, when one U.S. dollar equaled 4.20 marks, to 1923, when it took 4,200,000,000 marks to buy one dollar. The situation today in this country is not that bad, but it is bad enough. The interference of the government in money and banking has made government supreme in devaluing the money. The results today are fantastic compared with the promises and reasons for giving the government this power. Could anything be worse than to have the money in the people’s hands shrink from day to day?

Lord Keynes called the gold standard a “barbarous relic.” Many books say that the government had to step in because the gold standard failed. But the gold standard didn’t fail! The government abolished the gold standard by making it illegal to hold gold. But even today, all international trade is calculated in gold. It is not because gold is yellow and heavy, but because gold alone makes the determination of the purchasing power of the monetary unit independent of the changes in ideas of governments and political parties.

The essence of the market economy is that the economic actions of the individuals are not performed by order of the government but spontaneously by the individuals. This requires also that the money, the medium of exchange, be independent of political influence. If not, the coming years will be nothing but a series of failures of various governmental monetary and credit policies. To prevent this, it is necessary to make everybody realize that there are no Keynesian miracles possible, and that you cannot improve the situation of the people by credit expansion.

I thank you.

Miscellaneous References Cited During Discussions

1. Anderson, Benjamin McAlester. Economics and the Public Welfare: Financial and Economic History of the United States, 1914–1946. New York: D. Van Nostrand Co., 1949.

2. Cannan, Edwin. Money: Its Connexion with Rising and Falling Prices. London: P S. King & Son, Ltd., 1935. (Reprinted by Staples Press, Inc., New York, 1945)

3. Cortney, Phillip. The Economic Munich: The I.T.O. Charter, Inflation or Liberty, The 1929 Lesson. New York: The Philosophical Library, 1949.

4. Hume, David. Essays, Moral, Political and Literary. First published in 1741, many reprints.

5. Weber, Max. Gesammelte Aufsätze zur Religionssoziologie (Collected Essays on the Sociology of the Great Religions). The first study in this book has been translated into English under the title of The Protestant Ethic and the Spirit of Capitalism. London: George Allen Unwin Ltd., 1930. 2nd ed., 1948.

6. Wicksteed, Philip H. The Common Sense of Political Economy and Selected Papers and Reviews on Economic Theory. London: George Routledge & Sons, Ltd., 1935.

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