[Ludwig Von Mises, Murray N. Rothbard, Gottfried H(BookZZ.org)

The

AUSTRIANTheory of theTrade Cycle

and other essays

Ludwig von MisesGottfried Haberler

Murray N. Rothbard Friedrich A. Hayek

Compiled by Richard M. EbelingWith an Introduction and Summary by Roger W.

Garrison

MISESINSTITUTE

518 West Magnolia AvenueAuburn, Alabama 36832-4528

www.mises.org

http://www.mises.org

Dedicated to the memory of O.P. Alford,III,champion of liberty and the Austrian School

Copyright 1996 by the Ludwig von Mises Institute.

Originally published by the Center for LibertarianStudies (1978).

All rights reserved. Written permission must be securedfrom the publisher to use or reproduce any part of thisbook, except for brief quotations in critical reviews orarticles.

Published by the Ludwig von Mises Institute, Auburn,Alabama 36832-4528.

Library of Congress Catalog Card Number 96-075695.

ISBN: 0-945466-21-8

Online edition prepared by William Harshbarger for theLudwig von Mises Institute.

Contents

Introduction: The Austrian Theory in Perspective Roger W. Garrison 7

The Austrian Theory of the Trade Cycle Ludwig von Mises.. 25

Money and the Business Cycle Gottfried Haberler.. 37

Economic Depressions: Their Cause and Cure Murray N. Rothbard... 65

Can We Still Avoid Inflation? Friedrich A. Hayek. 93

The Austrian Theory: A Summary Roger W. Garrison. 111

Index... 123

About the Authors.. 127

7

Introduction:The Austrian Theory

in Perspective

Roger W. Garrison

The four essays in this volume, each written by a majorfigure in the Austrian school of economics, set out andapply a distinctive theory of the business cycle. The span ofyears (1932-1970) over which they appeared saw adramatic waxing and then waning of the prominence-bothinside and outside the economics profession-of the Austriantheory. Gottfried Haberler wrote in his 1932 essay that thetheory "is not so well known in this country as it deservesto be" (pp. 44). Although Ludwig von Mises offered noassessment in this regard in his essay, he remarked in 1943about the effect of the theory's general acceptance on theactual course of the cycle. Anticipating a key insight in themodern literature on "rational expectations," Mises wrote,"The teachings of the monetary theory of the trade cycleare today so well known even outside the circle ofeconomists that the naive optimism which inspired theentrepreneurs in the boom periods has given way to greaterskepticism."1 Then, in 1969, Murray N. Rothbard couldwrite-without serious overstatement-that "a correct theoryof depressions and of the business cycle does exist, even

1 Ludwig von Mises, "Elastic Expectations and the Austrian Theory of theTrade Cycle," Economica, ns. 10 (August 1943): 251.

THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS

8

though it is universally neglected in present-dayeconomics" (p. 74).

What happened over the span of nearly forty years toaccount for the rise and fall of this theory of boom andbust? The simple answer, of course, is: the Keynesianrevolution. John Maynard Keynes's General Theory ofEmployment, Interest, and Money, which made itsappearance in 1936, produced a major change in the waythat economists deal with macro-economic issues. A closelook at some pre-Keynesian ideas can show why theAustrian theory was so easily lost in the aftermath of theKeynesian revolution; a brief survey of the alternativesoffered by modern macroeconomics will show why there isa new-found interest in this old Austrian theory.

First introduced by Mises in his Theory of Money andCredit (1912), the theory was originally billed as thecirculation credit theory rather than as a uniquely Austriantheory. Mises was very much aware of its multinationalroots. The notion that the market process can besystematically affected by a divergence between the bankrate of interest and the natural rate came from Swedisheconomist Knut Wicksell; the understanding that theprocess so affected would have a self-reversing quality to it(Mises used the term "counter-movements" in his earliestexposition) came from the British currency school, whoseanalysis featured international gold flows. The uniquelyAustrian element in Mises's formulation is the capitaltheory introduced by Carl Menger and developed by Eugenvon Bhm-Bawerk. Mises showed that an artificially lowrate of interest, maintained by credit expansion,misallocates capital, making the production process too

ROGER W. GARRISON

9

time-consuming in relation to the temporal pattern ofconsumer demand. As time eventually reveals thediscrepancy, markets for both capital goods and consumergoods react to undo the misallocation. The initialmisallocation and eventual reallocation constitute themicroeconomic foundations that underlie the observedmacroeconomic phenomenon of boom and bust. Mises'stheory was superior to its Swedish forerunner in thatWicksell was concerned almost exclusively with the effectof credit expansion on the general level of prices. It wassuperior to its British forerunner in that the currencyschool's theory applied only when monetary expansion inone country outpaced that of its trading partners. Mises'stheory was applicable even to a closed economy and to aworld economy in which all countries are experiencing acredit expansion.

The theory took on a more predominantly Austriancharacter in the hands of F. A. Hayek. In the late 1920s andearly 1930s, Hayek gave emphasis to the Austrian vision ofcapital that underlies the business cycle theory byintroducing a simple graphical representation of thestructure of production. He used right triangles that changein shape to illustrate a change in the economy's capitalstructure.2 Hayek focused the analysis clearly on therelationship between the roundaboutness of the productionprocess and the value of the corresponding output. TheHayekian triangles keep track of both time and money asgoods-in-process make their way through the temporallysequenced stages of production. His notion of a linear

2 Friedrich A. Hayek, Prices and Production, 2nd ed. (New York: Augustus M.Kelley, 1935).


10

production process is highly abstract and overly simple inthe light of a fuller accounting of the fixed and circulatingcapital that actually characterize a capital-using economy.However, these triangles feature an essential but oftenneglected dimension-the time dimension-in the account ofboom and bust. Alternative theories, in which consumptionand investment appear as two coexisting aggregates, can beseen as even more simplistic-to the point of being whollyinadequate for analyzing the boom-bust sequence.

Haberler concludes his essay with an expression ofconcern about the complexity of the Austrian theory, whichhe saw as a "serious disadvantage" (p. 64). But thecomplexity, in his judgment, is inherent in the subjectmatter and hence is not a fault of the theory. Complexity isevident in the two early essays (1936 and 1932) in theirorganization and style of argument. Both Mises andHaberler defend the theory against its critics and deal withvarious misunderstandings. Mises, for instance, identifiesIrving Fisher's inflation premium, which attaches itself tothe rate of interest as prices in general rise, only to say thatthis is not what he is talking about. He is discussing,instead, still another aspect of interest-rate dynamics. Thereal rate of interest rises at the end of the boom to reflectthe increasing scarcity of circulating capital, after excessiveamounts of capital have been committed to the early stagesof production processes (p. 31). Haberler takes great painsto refocus the reader's attention away from the general pricelevel and toward the relative prices that govern the "verticalstructure of production" (p. 49). He distinguishes between"absolute deflation" and "relative deflation," and between"primary and fundamental" phenomena that characterizethe downturn and "secondary and accidental" phenomena

ROGER W. GARRISON

11

that may also be observed. All these complexities-plus stillothers involving such notions as the natural rate of interestand the corresponding degree of roundaboutness of theproduction process-are unavoidable in a theory that featuresan intertemporal capital structure. The theoretical richnessthat stems from the attention to capital has as its negativecounterpart the expositional difficulties and scope formisunderstanding.

Keynes offered the profession relief from all this byarticulating- though cryptically- a capital- freemacroeconomics. As Rothbard's discussion implies, all thethorny issues of capital theory were simply swept aside. Analternative theory that featured the playoff betweenincomes and expenditures left little or no room for a capitalstructure. Investment was given special treatment notbecause of its link to future consumption but becausespending on investment goods is particularly unstable.Uncertainties, which are perceived to be a deep-seatedfeature of market economies, dominate decision making inthe business community and give play to psychologicalexplanations of prosperity and depression. And the notionthat depression may be attributable to pessimism on thepart of the business community suggests a need for centraldirection and policy activism. Prosperity seems to dependupon strong and optimistic leadership in the political arena.Relief from the complexities of capital theory together withpolicy implications that were exceedingly attractive toelected officials gave Keynesianism an advantage overAustrianism. An easy-to-follow recipe for managing themacroeconomy won out over a difficult-to-follow theorythat explains why such management is counterproductive.


12

Tellingly, the two later essays (1969 and 1970) are asmuch about Keynesianism as about Austrianism. Rothbardand Hayek are trying anew to call attention to a theory thathad been buried for decades under the Keynesianavalanche. Rothbard deals with the Phillips curve, whichpurports to offer a choice to political leaders betweeninflation and unemployment; Hayek deals with the wage-price spiral, which had captured the attention of journalistsand textbook authors for much of the postwar era. The needfor dealing critically with Keynesianism-and withmonetarism-while at the same time reintroducing the keyconsiderations from capital theory meant that the Austriantheory of the business cycle was an even harder sell in the1970s than it had been a half-century earlier.

The offering of these four separate and distinct essays onthe Austrian theory carries the message that there is nosingle canonical version of the theory. Our understandingof boom and bust is not based upon some pat story to betold once and for all time. Rather, the theory allows forvariations on a theme. The market works; it tailorsproduction decisions to consumption preferences. Butproduction takes time, and as the economy becomes morecapital intensive, the time element takes on greatersignificance. The role of the interest rate in allocatingresources over time becomes an increasingly critical one.Still, if the interest rate is right, that is, if the interplaybetween lenders and borrowers is allowed to establish thenatural rate, then the market works right. However, if theinterest rate is wrong, possibly because of central bankpolicies aimed at "growing the economy," then the marketgoes wrong. The particulars of just how it goes wrong, justwhen the misallocations are eventually detected, and just

ROGER W. GARRISON

13

what complications the subsequent reallocation might entailare all dependent on the underlying institutionalarrangements and on the particular actions of policy makersand reactions of market participants.

The essays leave much scope for solving puzzles, forrefining both theory and exposition, and for applying thetheory in different institutional and political environments.One enduring puzzle emerges from the writings of severaleconomists, including Haberler, who once embraced thetheory enthusiastically but subsequently rejected it. The keyquestion underlying the recantations is easily stated: Canthe intertemporal misallocation of capital that occurs duringthe boom account for the length and depth of thedepression? Haberler provides one of the best answers tothis question-one that is most favorable to the Austriantheory-in his 1932 essay. The "maladjustment of thevertical structure of production," to use Haberler's ownterm, does not, by itself, account for the length and depth ofthe depression. Rather, this policy-induced change in theintertemporal structure of capital is the basis for the claimthat a crisis and downturn are inevitable. The reallocationof resources that follows the downturn, which largelymirrors-both qualitatively and quantitatively-the earliermisallocation, involves an abnormally high level of(structural) unemployment but need not involve a deep andlengthy depression.

However, complications that may well accompany themarket's adjustment to a policy-induced intertemporalmisallocation can cause the depression to be much deeperand longer than it otherwise would be. The same policymakers who orchestrated the artificial boom may well


14

behave ineptly when they see that the ultimate consequenceof their policy is a bust. Their failure to stem the monetarycontraction together with interventions by the legislaturethat prop up prices and wages and strengthen trade barrierswill make a bad situation worse. All such complications,which play themselves out as a self-aggravatingcontraction, are correctly identified by Haberler as"secondary phenomena." This term is not employed tosuggest that these aspects of the depression are negligibleor second-order in importance. "[I]t may very well be,"Haberler explains, "that this secondary wave of depression,which is induced by the more fundamental maladjustment,will grow to an overwhelming importance" (p. 58). Thoughpossibly overwhelming, the effects of the complications arestill secondary in the sense of temporal and causal ordering.

The puzzle in all this emerges when we read Haberler's1976 recantation of the Austrian theory, which echoedLionel Robbins's heartfelt recantation of a few years earlier.Mises refers to Robbins's 1934 book, The GreatDepression, as "the best analysis of the actual crisis" (p. 28n). In 1971 Robbins wrote in his autobiography that this isa book "which [he] would willingly see forgotten."3

Drawing on Robbins's recantation, Haberler offers theopinion that the "real maladjustments, whatever theirnature, were completely swamped by vast deflationaryforces.'" But rather than suggest, as he had earlier, thatthese forces could easily have been "induced by the morefundamental maladjustments," he simply attributes them to

3 Lionel Robbins, An Autobiography of an Economist (London: Macmillan,1971),p. 154.

ROGER W. GARRISON

15

"institutional weaknesses and policy mistakes."4 The astutereader will see Haberler's 1932 discussion of secondaryphenomena as an insightful and hard-hitting critique of the1976 Haberler-and would see a similar relationshipbetween the 1934 Robbins and the 1971 Robbins.

In 1932, Haberler alluded to the "economic earthquakes"(p. 37) that Western countries had experienced. He mighthave put the earthquake metaphor to further use inaccounting for the relationship between primary andsecondary issues. During the 1906 earthquake in SanFrancisco, for instance, fires broke out and caused muchmore destruction than had been caused by the actualquaking of the earth. Even so, the fire was a secondaryphenomenon; the quake was the primary phenomenon. Thefact that the length and depth of the Great Depression are tobe accounted for largely in terms of secondary phenomena,then, does not weigh against our understanding that theprimary phenomenon was the quaking of the capitalstructure. What accounts, then, for the recantation of theseAustrian theorists-and of several others, including John R.Hicks, Nicholas Kaldor, and Abba P. Lerner? This puzzleremains to be solved.

Expositional difficulties derive largely from the fact thatthe capital-based macroeconomics of the Austrian schooland particularly the Austrian theory of the business cycleare foreign to modern economists whose training isexclusively in labor-based macroeconomics. In today's

4 Gottfried Haberler, The World Economy, Money, and the Great Depression1919-1939 (Washington, D.C.: American Enterprise Institute, 1976), p. 26.Also see Haberler, "Reflections on Hayek's Business Cycle Theory," CatoJournal 6, no 2 (Fall 1986): 421-35.


16

profession, a given capital stock has become one of thedefining assumptions underlying the conventionalmacroeconomic relationships. To allow capital to be avariable rather than a parameter is to change the subjectmatter-from macroeconomics to the economics of growth.Further, modern economists tend to think of capitalholistically in terms of stocks and flows, which precludesany consideration of changes-to say nothing ofunsustainable changes-in the capital structure. GordonTullock's bafflement at the Austrian theory is illuminatingin this regard. Tullock takes Rothbard's essay as canonicaland explains "Why the Austrians Are Wrong aboutDepressions." This article, together with a comment byJoseph T. Salerno and reply by Tullock, merit carefulstudy.5 According to Tullock's understanding of theAustrian theory, the boom is a period during which theflow of consumer goods is sacrificed so that the capitalstock can be enlarged. At the end of the boom, then, thecapital stock would actually be larger, and the subsequentflow of consumer goods would be correspondingly greater.Therefore, the period identified by the Austrians as adepression would, instead, be a period marked by increasedemployment (labor is complementary to capital) and ahigher standard of living. The stock-flow construction thatunderlies this line of reasoning does not allow for thestructural unemployment that characterizes the crisis-muchless for the complications in the form of the secondary

5 Gordon Tullock, "Why the Austrians Are Wrong About Depressions" Reviewof Austrian Economics 2 (1987): 73-78; Joseph T. Salerno, Comment onTullock's "Why Austrians Are Wrong About Depressions" Review of AustrianEconomics 3 (1989): 141-45; and Tullock, "Reply to Comment by Joseph T.Salerno" Review of Austrian Economics 3 (1989): 147-49.

/journals/rae/pdf/R2_4.pdf/journals/rae/pdf/R3_11.pdf/journals/rae/pdf/R3_12.pdf/journals/rae/pdf/R3_12.pdf

ROGER W. GARRISON

17

depression.6 This exchange between Tullock and Salernogives the modern student of Austrianism a good feel for thechallenge involved in the exposition of Austrian theory inan academic environment unreceptive to a capital-basedmacroeconomics.

Capital-based macroeconomics is simplymacroeconomics that incorporates the time element into thebasic construction of the theory. Investment now is aimedat consumption later. The interval of time that separates thisemployment of means and the eventual achievement ofends is as fundamental a variable as are the moreconventional ones of land and labor. The Austrian theoryfeatures the time element by showing what happens whenthe economy's production time, the degree ofroundaboutness, is thrown out of equilibrium by policiesthat override the market process. Beyond this generalunderstanding, as already suggested, the focus of particularexpositions vary in accordance with the historical andinstitutional setting. The fact that each of the essays in thisvolume reflects its own time and setting does not imply amyopia on the part of its author. Rather, it suggests theversatility of the theory.

Writing in the early 1930s, for instance, Mises calledattention to the "flight into real values" (p. 30) thatcharacterizes a hyperinflation, such as the one experienced 6 Tullock on the basis of a peculiar judgment about the relative size of theeconomy's producer goods sector, makes a minor concession to the Austriantheory: It applies to "those factories and machine tools that were less than 40percent completed [at the end of the boom]." But, "the producer goodsindustries are always a fairly small part of the economy. In that small part,however, undeniably a Rothbard, Austrian type of depression would cause acutback in production and laying off of personnel."


18

in Germany in 1923. The lesson, though, transcends theinsights into that particular historical experience. If, over aperiod of years, capital has been misallocated by anaccelerating credit expansion, there is no policy that avoidsa crisis. In the modern vernacular, there is no possibility ofa "soft landing."7 Decelerating the expansion will causereal interest rates to rise dramatically as credit becomesincreasingly scarce; bankruptcies would follow. Furtheraccelerating the expansion will cause hyperinflation and acollapse of the monetary system. Mises is telling us, ineffect, that the central bank can print itself into trouble, butit cannot print itself out of trouble. Writing in 1970, Hayekrefers to the central bank's dilemma by suggesting that onthe eve of the crisis the policy makers find themselves"holding a tiger by the tail." He gives play to the politicaland economic forces that were then dominant by relatingthem to the commonly perceived wage-price spiral thataccompanies a prolonged expansion. The final throes of theboom take the form of a duel between labor unions, whichhave the political power to force wage rates higher, and thecentral bank, which can bring them back down (in realterms) by accelerating the rate of inflation. AlthoughHayek, above all others, is to be credited with shifting thefocus of business cycle theory from labor markets to capitalmarkets, he offers few clues in this essay aboutdisequilibrium in the intertemporal structure of production.Instead, he recognizes that the political and economicdynamics of the period have given special relevance to theproblem-he even calls it the "central problem" (p. 110)-ofwage determination.

7 This is not to deny the difference between a hard landing with nocomplications and a crash, in which the complications dominate.

ROGER W. GARRISON

19

The application of the Austrian theory of the businesscycle in today's economy would give little play to the fearof hyperinflation or to the problem of a wage-price spiral.The central problem today is chronic and dramatic fiscalimbalance. Budget deficits rather than credit expansion arebound to be the focus in any plausible account of the effectof the government's macroeconomic policy on theeconomy's performance. Still, the central bank figuresimportantly into the story. The very potential formonetizing the Treasury's debt eliminates the risk ofdefault, and thereby puts the Treasury on a much longerleash than it would otherwise enjoy. The problem of anartificially low rate of interest in earlier episodes isovershadowed by the problem of an artificially low riskpremium on government debt. Although risk-free to theholders of Treasury securities, this black cloud of debtoverhangs the market for private securities, distorting theeconomy's capital structure and degrading its performancegenerally. There are some modern applications of theAustrian theory that take these considerations into account,but much remains to be done.8

A stocktaking of the modern alternatives to the Austriantheory suggests that capital-based macroeconomics may bedue for a comeback. Conventional Keynesianism, whetherin the guise of the principles-level Keynesian cross, theintermediate IS-LM, or the advanced AS/AD is formulatedat a level of aggregation too high to bring the cyclical

8 Roger W. Garrison, "Hayekian Triangles and Beyond," in Jack Birner andRudy van Zijp, eds., Hayek, Coordination and Evolution (London: Routledge,1994), pp.109-25; and Roger W. Garrison, "The Federal Reserve: Then andNow" Review of Austrian Economics 8, no. 1 (1994): 3-19.

/journals/rae/pdf/R81_1.pdf/journals/rae/pdf/R81_1.pdf


20

quality of boom and bust into full view. Worse, thedevelopment of these tools of analysis in the hands of themodern textbook industry has involved a serious sacrificeof substance in favor of pedagogy. Students are taughtabout the supply and demand curves that represent themarket for a particular good or service, such as hamburgersor haircuts. Then they are led into the macroeconomicissues by the application of similar-looking supply anddemand curves to the economy as a whole. The transitionto aggregate supply and aggregate demand, which is madeto look deceptively simple, hides all the fundamentaldifferences between microeconomic issues andmacroeconomic issues. While these macroeconomicaggregates continue to be presented to collegeundergraduates, they have fallen into disrepute outside theclassroom. One recent reconsideration of themacroeconomic stories told to students identifiesfundamental inconsistencies in AS/AD analysis.9

Conventional monetarism employs a level ofaggregation as high as, if not higher than, that employed byKeynesianism. While Milton Friedman is to be creditedwith having persuaded the economics profession-and muchof the general citizenry-of the strong relationship betweenthe supply of money and the general level of prices, hismonetarism adds little to our understanding of therelationship between boom and bust. The monetarists haveeffectively countered the Keynesians on many fronts, butthey share with them the belief that macroeconomics and

9 David Colander, "The Stories We Tell: A Reconsideration of AS/AD

Analysis," Journal of Economic Perspectives 9, no. 3 (Summer 1995): 169-88.

ROGER W. GARRISON

21

even business cycle theory can safely ignore allconsiderations of a capital structure. Modern spin-offs ofmonetarism, which incorporate the ideas of rationalexpectations and instantaneous market clearing, havebrought the time element back into play. Overlapping-generations models and particularly the time-to-buildmodels seem to have some relationship to Austrian ideas.But the emphasis on the development of modelingtechniques over the application of the theory to actualepisodes of boom and bust has greatly diminished therelevance of this strand of macroeconomic thought.10

In recent years, there has been an increasinglywidespread recognition that modern macroeconomics is indisarray. Today's textbooks and professional journals arereplete with models that, while impressive in their displayof technique, are profoundly implausible and whollyinapplicable to the world as we know it. The inadequaciesof modern macroeconomics have caused someacademicians to wonder (if only facetiously): How far backdo we have to go before we can start all over? The essaysin this volume provide a substantive answer to thatquestion. We have to go back about sixty years to a timewhen capital theory was an integral part ofmacroeconomics. We have to go back to the Austrianschool. A modernized capital-based macroeconomics cancompare favorably with any of the present-day rivals.

10 On the relationship between new classical theory and Austrian theory, seeKevin Hoover, "An Austrian Revival?" in Hoover, The New ClassicalMacroeconomics: A Skeptical Inquiry (Cambridge: Basil Blackwell, 1988), pp.231-57; and Roger W. Garrison, "New Classical and Old Austrian Economics:Equilibrium Business Cycle Theory in Perspective" Review of AustrianEconomics 5, no. 1 (1991): 91-103.

/journals/rae/pdf/R51_4.pdf/journals/rae/pdf/R51_4.pdf


22

Murray Rothbard's essay ends with an anticipation of theAustrian revival-which actually began, with his help, in1974. This volume is offered in the spirit of Rothbard andin the hope that the Austrians will have an increasinginfluence in the years ahead on the development ofbusiness cycle theory.

23

The Austrian Theoryof the Trade Cycle

Ludwig von Mises

Nowadays it is usual in economics to talk about theAustrian theory of the trade cycle. This description isextremely flattering for us Austrian economists, and wegreatly appreciate the honor thereby given us. Like all otherscientific contributions, however, the modern theory ofeconomic crises is not the work of one nation. As with theother elements of our present economic knowledge, thisapproach is the result of the mutual collaboration of theeconomists of all countries.

The monetary explanation of the trade cycle is notentirely new. The English "Currency School" has alreadytried to explain the boom by the extension of creditresulting from the issue of bank notes without metallicbacking. Nevertheless, this school did not see that bankaccounts which could be drawn upon at any time by meansof checks, that is to say, current accounts, play exactly the

This essay was originally published as "La Theorie dite Autrichienne de Cycleconomique," in the Bulletin of the Socite Belge d'Etudes et d'Expansion(1936): 459-64. It was translated from the French by David O'Mahoney and J.Huston McCulloch.


24

same role in the extension of credit as bank notes.Consequently the expansion of credit can result not onlyfrom the excessive issue of bank notes but also from theopening of excessive current accounts. It is because itmisunderstood this truth that the Currency School believedthat it would suffice, in order to prevent the recurrence ofeconomic crises, to enact legislation restricting the issue ofbank notes without metallic backing, while leaving theexpansion of credit by means of current accountsunregulated. Peel's Bank Act of 1844, and similar laws inother countries, did not accomplish their intended effect.From this it was wrongly concluded that the EnglishSchool's attempt to explain the trade cycle in monetaryterms had been refuted by the facts.

The Currency School's second defect is that its analysisof the credit expansion mechanism and the resulting crisiswas restricted to the case where credit is expanded in onlyone country while the banking policy of all the othersremains conservative. The reaction which is produced inthis case results from foreign trade effects. The internal risein prices encourages imports and paralyses exports.Metallic money drains away to foreign countries. As aresult the banks face increased demands for repayment ofthe instruments they have put into circulation (such asunbacked notes and current accounts), until such time asthey find they have to restrict credit. Ultimately the outflowof specie checks the rise in prices. The Currency Schoolanalyzed only this particular case; it did not consider creditexpansion on an international scale by all the capitalistcountries simultaneously.

LUDWIG VON MISES

25

In the second half of the 19th century, this theory of thetrade cycle fell into discredit, and the notion that the tradecycle had nothing to do with money and credit gainedacceptance. The attempt of Wicksell (1898)1 to rehabilitatethe Currency School was short-lived.

The founders of the Austrian School of Economics-CarlMenger, Bhm-Bawerk, and Wieser-were not interested inthe problem of the trade cycle. The analysis of this problemwas to be the task of the second generation of Austrianeconomists.2

In issuing fiduciary media, by which I mean bank noteswithout gold backing or current accounts which are notentirely backed by gold reserves, the banks are in a positionto expand credit considerably. The creation of theseadditional fiduciary media permits them to extend credit

1 Knut Wicksell, Interest and Prices , R.F. Kahn, trans. (New York:Augustus M. Kelley, 1965)-Tr.

2 The principal Austrian works concerning the theory of the economic cycle [asof 1936] are: Mises, The Theory of Money and Credit (New York: Foundationfor Economic Education, 1971; translation of the 2nd German edition, 1924;originally published in 1912); Mises, Monetary Stabilization and CyclicalPolicy (1928) reprinted in On the Manipulation of Money and Credit, Percy L.Greaves, ed., Bettina Bien Greaves, trans. (Dobbs Ferry, N.Y.: Free MarketBooks, 1978; originally published as a monograph in German); Friedrich A.von Hayek, Monetary Theory and the Trade Cycle (New York: Augustus M.Kelley, 1966; reprint of 1933 English edition, originally published in Germanin 1929); Hayek, Prices and Production (New York: Augustus M. Kelley,1967; reprint of 1935 2nd revised edition, originally published in 1931); FritzMachlup, Fhrer durch die Krisenpolitik (1934); Richard von Strigl, Capitaland Production, Margaret Rudelich Hoppe and Hans-Hermann Hoppe, trans.(Auburn, Al: Ludwig von Mises Institute, 1995; translation of the 1934edition); the best analysis of the actual crisis was made by Sir Lionel Robbins,The Great Depression (Freeport, R.I.: Books for Libraries Press, 1971; reprintof 1934 edition).-[Note: citations have been updated in this new edition.]


26

well beyond the limit set by their own assets and by thefunds entrusted to them by their clients. They intervene onthe market in this case as "suppliers" of additional credit,created by themselves, and they thus produce a lowering ofthe rate of interest, which falls below the level at which itwould have been without their intervention. The loweringof the rate of interest stimulates economic activity. Projectswhich would not have been thought "profitable" if the rateof interest had not been influenced by the manipulations ofthe banks, and which, therefore, would not have beenundertaken, are nevertheless found "profitable" and can beinitiated. The more active state of business leads toincreased demand for production materials and for labor.The prices of the means of production and the wages oflabor rise, and the increase in wages leads, in turn, to anincrease in prices of consumption goods. If the banks wereto refrain from any further extension of credit and limitedthemselves to what they had already done, the boom wouldrapidly halt. But the banks do not deflect from their courseof action; they continue to expand credit on a larger andlarger scale, and prices and wages correspondinglycontinue to rise.

This upward movement could not, however, continueindefinitely. The material means of production and thelabor available have not increased; all that has increased isthe quantity of the fiduciary media which can play the samerole as money in the circulation of goods. The means ofproduction and labor which have been diverted to the newenterprises have had to be taken away from otherenterprises. Society is not sufficiently rich to permit thecreation of new enterprises without taking anything awayfrom other enterprises. As long as the expansion of credit is

LUDWIG VON MISES

27

continued this will not be noticed, but this extension cannotbe pushed indefinitely. For if an attempt were made toprevent the sudden halt of the upward movement (and thecollapse of prices which would result) by creating more andmore credit, a continuous and even more rapid increase ofprices would result. But the inflation and the boom cancontinue smoothly only as long as the public thinks that theupward movement of prices will stop in the near future. Assoon as public opinion becomes aware that there is noreason to expect an end to the inflation, and that prices willcontinue to rise, panic sets in. No one wants to keep hismoney, because its possession implies greater and greaterlosses from one day to the next; everyone rushes toexchange money for goods, people buy things they have noconsiderable use for without even considering the price,just in order to get rid of the money. Such is thephenomenon that occurred in Germany and in othercountries that followed a policy of prolonged inflation andthat was known as the "flight into real values." Commodityprices rise enormously as do foreign exchange rates, whilethe price of the domestic money falls almost to zero. Thevalue of the currency collapses, as was the case in Germanyin 1923.

If, on the contrary, the banks decided to halt theexpansion of credit in time to prevent the collapse of thecurrency and if a brake is thus put on the boom, it willquickly be seen that the false impression of "profitability"created by the credit expansion has led to unjustifiedinvestments. Many enterprises or business endeavors whichhad been launched thanks to the artificial lowering of theinterest rate, and which had been sustained thanks to theequally artificial increase of prices, no longer appear


28

profitable. Some enterprises cut back their scale ofoperation, others close down or fail. Prices collapse; crisisand depression follow the boom. The crisis and the ensuingperiod of depression are the culmination of the period ofunjustified investment brought about by the extension ofcredit. The projects which owe their existence to the factthat they once appeared "profitable" in the artificialconditions created on the market by the extension of creditand the increase in prices which resulted from it, haveceased to be "profitable." The capital invested in theseenterprises is lost to the extent that it is locked in. Theeconomy must adapt itself to these losses and to thesituation that they bring about. In this case the thing to do,first of all, is to curtail consumption and, by economizing,to build up new capital funds in order to make theproductive apparatus conform to the actual wants and not toartificial wants which could never be manifested andconsidered as real except as a consequence of the falsecalculation of "profitability" based on the extension ofcredit.

The artificial "boom" had been brought on by theextension of credit and by lowering of the rate of interestconsequent on the intervention of the banks. During theperiod of credit extension, it is true that the banksprogressively raised the rate of interest; from a purelyarithmetical point of view it ends up higher than it had beenat the beginning of the boom. This raising of the rate ofinterest is nevertheless insufficient to reestablishequilibrium on the market and put a stop to the unhealthyboom. For in a market where the prices are risingcontinually, gross interest must include in addition tointerest on capital in the strict sense-i.e., the net rate of

LUDWIG VON MISES

29

interest-still another element representing a compensationfor the rise in prices arising during the period of the loan. Ifthe prices rise in a continuous manner and if the borroweras a result gains a supplementary profit from the sale of themerchandise which he bought with the borrowed money, hewill be disposed to pay a higher rate of interest than hewould have paid in a period of stable prices; the capitalist,on the other hand, will not be disposed to lend under theseconditions, unless the interest includes a compensation forthe losses which the diminution in the purchasing power ofmoney entails for creditors. If the banks do not takeaccount of these conditions in setting the gross interest ratethey demand, their rate ought to be considered as beingmaintained artificially at too low a level, even if from apurely arithmetical point of view it appears much higherthan that which prevailed under "normal" conditions. Thusin Germany an interest rate of several hundred per centcould be considered too low in the autumn of 1923 becauseof the accelerated depreciation of the mark.

Once the reversal of the trade cycle sets in following thechange in banking policy, it becomes very difficult toobtain loans because of the general restriction of credit. Therate of interest consequently rises very rapidly as a result ofa sudden panic. Presently, it will fall again. It is a well-known phenomenon, indeed, that in a period of depressionsa very low rate of interest-considered from the arithmeticalpoint of view-does not succeed in stimulating economicactivity. The cash reserves of individuals and of banksgrow, liquid funds accumulate, yet the depressioncontinues. In the present [1936] crisis, the accumulation ofthese "inactive" gold reserves has for a particular reason,taken on inordinate proportions. As is natural, capitalists


30

wish to avoid the risk of losses from the devaluationscontemplated by various governments. Given that theconsiderable monetary risks which the possession of bondsor of other interest-bearing securities entail are notcompensated by a corresponding increase of the rate ofinterest, capitalists prefer to hold their funds in a form thatpermits them, in such a case, to protect their money fromthe losses inherent in an eventual devaluation by a rapidconversion to a currency not immediately menaced by theprospect of devaluation. This is the very simple reason whycapitalists today are reluctant to tie themselves, throughpermanent investments, to a particular currency. This iswhy they allow their bank accounts to grow even thoughthey return only very little interest, and hoard gold, whichnot only pays no interest, but also involves storageexpenses.

Another factor which is helping to prolong the presentperiod of depression is the rigidity of wages. Wagesincrease in periods of expansion. In periods of contractionthey ought to fall, not only in money terms, but in realterms as well. By successfully preventing the lowering ofwages during a period of depression, the policy of the tradeunions makes unemployment a massive and persistentphenomenon. Moreover, this policy postpones the recoveryindefinitely. A normal situation cannot return until pricesand wages adapt themselves to the quantity of money incirculation.

Public opinion is perfectly right to see the end of theboom and the crisis as a consequence of the policy of thebanks. The banks could undoubtedly have delayed theunfavorable developments for some further time. They

LUDWIG VON MISES

31

could have continued their policy of credit expansion for awhile. But-as we have already seen-they could not havepersisted in it indefinitely without risking the completecollapse of the monetary system. The boom brought aboutby the banks' policy of extending credit must necessarilyend sooner or later. Unless they are willing to let theirpolicy completely destroy the monetary and credit system,the banks themselves must cut it short before thecatastrophe occurs. The longer the period of creditexpansion and the longer the banks delay in changing theirpolicy, the worse will be the consequences of themalinvestments and of the inordinate speculationcharacterizing the boom; and as a result the longer will bethe period of depression and the more uncertain the date ofrecovery and return to normal economic activity.

It has often been suggested to "stimulate" economicactivity and to "prime the pump" by recourse to a newextension of credit which would allow the depression to beended and bring about a recovery or at least a return tonormal conditions; the advocates of this method forget,however, that even though it might overcome thedifficulties of the moment, it will certainly produce a worsesituation in a not too distant future.

Finally, it will be necessary to understand that theattempts to artificially lower the rate of interest whicharises on the market, through an expansion of credit, canonly produce temporary results, and that the initial recoverywill be followed by a deeper decline which will manifestitself as a complete stagnation of commercial and industrialactivity. The economy will not be able to developharmoniously and smoothly unless all artificial measures


32

that interfere with the level of prices, wages, and interestrates, as determined by the free play of economic forces,are renounced once and for all.

It is not the task of the banks to remedy theconsequences of the scarcity of capital or the effects ofwrong economic policy by extension of credit. It iscertainly unfortunate that the return to a normal economicsituation today is delayed by the pernicious policy ofshackling commerce, by armaments and by the only toojustified fear of war, not to mention the rigidity of wages.But it is not by banking measures and credit expansion thatthis situation will be corrected.

In the preceding pages I have given only a brief andnecessarily insufficient sketch of the monetary theory ofeconomic crises. It is unfortunately impossible for me inthe limits set by this article to enter into greater detail;those who are interested in the subject will be able to findmore in the various publications I have mentioned.

33

Money and theBusiness Cycle

Gottfried Haberler

I

If I speak of the business cycle during this lecture I donot think only or primarily of such financial and economicearthquakes as we have experienced during the last fewyears all over the world. It would perhaps be moreinteresting to talk about these dramatic events-ofspeculation, brokers' loans, collapse of the stock exchange,wholesale bankruptcies, panics, acute financial crises of anexternal or internal sort, gold drains, and the economic andpolitical repercussions of all this. I shall, however, resist thetemptation to make what I have to say dramatic and shalltry instead to get down to the more fundamental economicmovements which underlie those conspicuous phenomenawhich I have indicated.

For a complete understanding of the business cycle it isabsolutely indispensable to distinguish between a primaryand fundamental and a secondary and accidental

This essay was originally published in Gold and Monetary Stabilization(Lectures on the Harris Foundation), Quincy Wright, ed. (Chicago: Universityof Chicago Press, 1932).


34

movement. The fundamental appearance of the businesscycle is a wavelike movement of business activity-if I maybe allowed to use for the moment this rather vagueexpression. The development of our modern economic lifeis not an even and continuous growth; it is interrupted, notonly by external disturbances like wars and similarcatastrophes, but shows an inherent discontinuity; periodsof rapid progress are followed by periods of stagnation.

The attention of the economists was first caught bythose secondary and accidental phenomena-glaringbreakdowns and financial panics. They tried to explainthem in terms of individual accidents, mistakes, andmisguided speculations of the leaders of those banks andbusiness firms which were primarily involved. But theregular recurrence of these accidents during the nineteenthcentury brought home to the economists that they had notisolated accidents before them but symptoms of a severedisease, which affects the whole economic body.

During the second half of the nineteenth century therewas a marked tendency for these disturbances to becomemilder. Especially those conspicuous events, breakdowns,bankruptcies, and panics became less numerous, and therewere even business cycles from which they were entirelyabsent. Before the war, it was the general belief ofeconomists that this tendency would persist and that suchdramatic breakdowns and panics as the nineteenth centuryhad witnessed belonged definitely to the past.

Now, the present depression shows that we rejoiced toohastily, that we have not yet got rid of this scourge of thecapitalistic system.

GOTTFRIED HABERLER

35

But, nevertheless, so much can be and must be learnedfrom the experience of the past: if we want a deeper insightinto the inner mechanism of our capitalistic system whichmakes for its cyclical movements, we must try to explainthe fundamental phenomenon, abstracting from theseaccidental events, which might be absent or present.

If we disregard these secondary phenomena, thebusiness cycle presents itself as a periodic up and down ofgeneral business activity, or, to put it now in a more preciseform, of the volume of production. The secular growth ofproduction does not show a continuous, uninterrupted trendupward but a wavelike movement around its averageannual increase. It does not make a great differencewhether the downward swings of these business waves arecharacterized by an absolute fall of the volume ofproduction or just by a decrease of the rate of growth.

In this lecture I am not concerned with the ingenuousdevices which statisticians have invented to isolate thecyclical movements from other periodic or erraticmovements on which they are superimposed, or which aresuperimposed on them. I assume, first, that we have such athing as a business cycle, which is not identical withseasonal movements within the year and erratic irregulardisturbances caused by wars, periods of governmentinflation, and the like; it is necessary to state this, becauseeven the existence of the phenomenon under considerationhas been doubted. Secondly, I assume that we have beenable to isolate this movement statistically.


36

Our chief concern will be with the explanation of thismovement and especially with the role of money in thewidest sense of the term, including credit and bank money.

II

There is hardly any explanation of the business cycle-Ihesitate a little to say "theory of the business cycle,"because many people have developed a certain prejudiceagainst this term-in which the monetary factor does notplay a very decisive role. The following considerationshows that this must necessarily be so: Still abstractingfrom the previously mentioned accessory phenomena, oneof the most outstanding external symptoms of the businesscycle is the rise of prices during prosperity and the fall ofprices during depression. On the other hand, there is anincrease of the volume of production during the upwardand a decrease during the downward swing. But not onlymore commodities are produced and sold but also in otherbranches of the economy there is an increase oftransactions-e.g., on the stock exchange. Therefore, we cansafely say there is a considerable increase of the volume ofpayments during the upward swing of the cycle and adistinct decrease of this volume during depression.

Now, it is clear that, in order to handle this increasedvolume of payments, an augmentation of the means ofpayment is necessary-means of payment in the widest senseof the term. One of the following things must happen:

(a) An increase of gold and legal tender money.(b) An increase of banknotes.

GOTTFRIED HABERLER

37

(c) An increase of bank deposits and bank credits.(d) An increase in the circulation of checks, bills, and

other means of payment which are regularly or occasionallysubstituted forordinary money.

(e) An increase of the velocity of circulation of one orall of these means of payments.

I do not claim that this enumeration is exhaustive orquite systematic. It is largely a matter of terminologicalconvenience, as one likes to express oneself. One writerprefers to call bank deposits, on which checks may bedrawn, money, bank money, credit money. Other writersrestrict the term "money" to legal-tender money and speakthen of bank deposits as means to save money or to make itmore efficient in making payments by increasing itsvelocity of circulation. Still others have an aversion againstthe term "velocity of circulation" and prefer to speak ofchanges in the requirement for money and means ofpayment.

Without going more deeply into these technical details,it is, I hope, clear that there must occur in one way oranother during the upward swing of the cycle an expansionof the means of payment and during the downward swing acorresponding contraction.

No serious theory, no explanation of the cycle, canafford to overlook, disregard, or deny this fact. Differencescan arise only (a) in respect to the particular way in whichthe expansion takes place-whether it is primarily anincrease in the quantity of credit money or legal-tendermoney or gold or just of the velocity of circulation of oneof these-and (b) as to the causal sequence.


38

As to the causal relation, broadly speaking, twopossibilities seem to be open:

1. One might assume that the impulse comes from theside of money, that the circulation is expanded by adeliberate action of the banks or other monetary authority,and that this sets the whole chain of events going, or 2. Onemay hold the opinion that the monetary authorities take apassive role; that the initiative comes from the commodityside, that changes of demand for certain commodities,changes in the structure of production, inventions andimprovements, large crops, or psychological forces, a waveof optimism and pessimism-that one of these phenomenaand its repercussions makes for an increase or decrease ofthe volume of production, and that this, in turn, draws intocirculation a greater amount of means of payment. Thegreater flow of goods induces a larger flow of money.

The theories of the first group, which maintain that theactive cause of the cycle lies on the side of money, may becalled "monetary theories" of the business cycle. In a widersense, however, we may include in the group of monetarytheorists also all those who admit that the impulse mightalso come from the commodity side, but hold that anappropriate policy of the monetary authorities, an effectiveand elastic regulation of the volume of the circulatingmedium, can forestall every serious disturbance.

As you all know, the most frequently recommendedcriterion for such a policy is the "stabilization of the pricelevel" in the one or other of the many meanings of thisambiguous term. You all will agree that it is impossible to

GOTTFRIED HABERLER

39

discuss this problem exhaustively in one hour. So I shallconfine myself to pointing out the insufficiencies of thistype of monetary theory and of its recommendations for theremedy of the business cycle, which center around changesin the price level. I shall try, then, to indicate a morerefined monetary theory of the cycle, which has beendeveloped in the last few years, although it is not so wellknown in this country as it deserves to be. This refinedtheory seems to explain some features of the cycle,especially of the last one, which are not entirely compatiblewith the cruder form of the monetary approach, whichidentifies monetary influences with changes in the generalprice level.

III

The traditional monetary theory, which is represented bysuch well-known writers as the Swedish economistProfessor Cassel and Mr. Hawtrey of the English treasury,regards the upward and the downward swing of thebusiness cycle as a replica of a simple government inflationor deflation. To be sure, it is-as a rule-a much milder formof inflation or deflation, but at the root it is exactly thesame. Mr. Hawtrey states this quite uncompromisingly inhis famous dictum: "The trade cycle is a purely monetaryphenomenon" and is, in principle, the same as the inflationduring the war and the deflation, that is to say, thereduction of the amount of circulating medium, which wasdeliberately undertaken by certain governments to approachor to restore the post-war parity of their currencies.


40

Hawtrey recognizes and stresses, of course, thedifference in degree between the two types of inflation anddeflation, namely, that the expansion and contraction in thecourse of the business cycle is chiefly produced bymaladjustment of the discount rate, which is not the way inwhich a government inflation is brought about. It is todayan almost generally accepted doctrine, that a lowering ofthe discount rate by the banking system, especially by thecentral banks, induces people to borrow more, so that theamount of the circulating medium increases and prices rise.A raising of the discount rate has the opposite effect-ittends to depress prices or, if they were rising, to put a brakeon the upward movement. I know, of course, that this barestatement needs some qualifications, I trust, however, thatbefore so competent an audience it will suffice to say thatthis is literally true only if the influence of the change in thediscount rate is not compensated by any other force whichchanges the willingness of businessmen to borrow. But,given all these other circumstances, that is to say, ceterisparibus, a change in the discount rate will have theindicated effect on prices. In any given situation there isone rate which keeps the price level constant. If the rate isforced below this equilibrium rate, prices have a tendencyto rise; if the rate is raised above the equilibrium rate,prices tend to fall.

Now, according to Mr. Hawtrey, there is a tendency inour banking system to keep the interest rate too low duringthe upward swing of the cycle; then prices rise, we get acredit inflation, and sooner or later the banks are forced totake steps to protect their reserves-they increase the rateand bring about the crisis and the depression.

GOTTFRIED HABERLER

41

There is no time here to go into details, to discuss theingenious explanation which Mr. Hawtrey offers for thefact that banks always go too far, that they swing like apendulum from one extreme to the other and do not stop atthe equilibrium rate. The reason which Mr. Hawtrey givesfor this is different from the one which Professor IrvingFisher and other writers of this group have to offer. Whatthey all have in common is that the disturbing factors actthrough changes of the price level. It is through changes ofthe price level that expansion and contraction of credit andmoney act upon the economic system, and they all believethat stability of the price level is the sufficient criterion of arational regulation of credit. If it were possible to keep theprice level stable, prosperity would never be followed bydepression. If the price level is allowed to rise and theinevitable reaction to come, it would be possible to end thedepression and to restore equilibrium, if one could stop thefall of prices.

Let me now indicate briefly why this explanation seemsto me insufficient. Or, to put it in other words, I shall try toshow that (a) the price level is frequently a misleadingguide to monetary policy and that its stability is nosufficient safeguard against crises and depressions, because(b) a credit expansion has a much deeper and morefundamental influence on the whole economy, especiallyon the structure of production, than that expressed in themere change of the price level.

The principal defect of those theories is that they do notdistinguish between a fall of prices which is due to anactual contraction of the circulating medium and a fall ofprices which is caused by lowering of cost as a


42

consequence of inventions and technologicalimprovements. (I must, however, mention that thisparticular criticism does not apply to Mr. Hawtrey, who, bya peculiar interpretation of the term "price level,"recognizes this distinction, although he does not seem todraw the necessary conclusions.)

It is true, if there is an absolute decrease of the quantityof money, demand will fall off, prices will have to godown, and a serious depression will be the result. Normalconditions will return only after all prices have beenlowered, including the prices of the factors of production,especially wages. This may be a long and painful process,because some prices, e.g., wages, are rigid and some pricesand debts are definitely fixed for a long time and cannot bealtered at all.

From this, however, it does not follow that the same istrue if prices fall because of a lowering of costs. It is nowgenerally accepted that the period preceding the presentdepression was characterized by the fact that manytechnological improvements, especially in the productionof raw materials and agricultural products, but also in thefield of manufacture, took place on a large scale.

The natural thing in such a situation would be for pricesto fall gradually, and apparently such a fall of prices cannothave the same bad consequence as a fall of prices broughtabout by a decrease of the amount of money. We couldspeak, perhaps, of a "relative deflation" of the quantity ofmoney, relative in respect to the flow of goods, inopposition to an "absolute deflation."

GOTTFRIED HABERLER

43

Especially, those writers who stress the scarcity of goldas a cause for the present depression are guilty ofoverlooking the radical difference between an absolute anda relative deflation. A scarcity of gold could result only in arelative deflation, which could never have such disastrousresults as the present depression. Of a more indirect way inwhich the "smallness" of the annual output of gold hasperhaps to do with-I do not venture to say "is the cause of"-the acuteness of the present depression and the vehemenceof the price fall, I shall say more later.

Now, as I said already, during the years 1924-27 and1928 we experienced an unprecedented growth of thevolume of production. Commodity prices, on the otherhand, as measured by the wholesale price index, were fairlystable, as everybody knows. From this it follows, and directstatistical investigations have verified it, that the volume ofthe circulating medium had been increased. We could say,there was a "relative inflation," that is, an expansion ofmeans of payment, which did not result in an increase ofcommodity prices, because it was just large enough tocompensate for the effect of a parallel increase of thevolume of production.

There is now an obvious presumption that it wasprecisely this relative inflation which brought about all thetrouble. If this were so-and it seems to me that it is veryprobable-it would be plain that the price level is amisleading guide for monetary policy and that there aremonetary influences at work on the economic system thatdo not find an adequate expression in a change of the pricelevel, at least as measured by the wholesale price index.And, in fact, there are such very far-reaching influences of


44

certain monetary changes on the economic system-theymay express themselves in a change of the price level ornot-which have been wholly overlooked by the traditionalmonetary explanation, although the external symptoms ofthis influence have been well recognized (but differentlyinterpreted) by certain non-monetary theories anddescriptive studies of the business cycle.

IV

These changes which I have in mind and shall now try toanalyze are changes of what I shall call the verticalstructure of production, brought about by changes in thesupply of credit for productive purposes. If we have toanalyze an economic system, we can make a horizontal orvertical cross-section through it. A horizontal cross-sectionwould exhibit different branches or lines of industry asdifferentiated by the consumption goods, which are thefinal result of these different branches: there, we have thefood industry, including agriculture, the clothing industry,the show industry, etc. Industries which produce producer'sgoods-say, the iron and steel industry-belongsimultaneously to different branches in this horizontalsense, because iron and steel are used in the production ofmany or of all consumer's goods. The old statement that ageneral overproduction is unthinkable, that we can neverhave too much of all goods, because human wants areinsatiable, but that serious disproportionalities mightdevelop in consequence of a partial overproduction-thisstatement relates principally to the horizontal structure ofproduction. Disproportionality in this sense means that, forone reason or another, the appropriate proportion of

GOTTFRIED HABERLER

45

productive resources devoted to different branches ofindustry has been disturbed-that, e.g., the automobileindustry is overdeveloped, that more capital and labor hasbeen invested in this industry than is justified by thecomparative demand for the product of this industry and forother industrial products. I hope it is now pretty clear whatI mean by horizontal structure and horizontaldisproportionalities of production.

We make, on the other hand, a vertical cross-sectionthrough an economic system, if we follow every finishedgood, ready for consumption, up through the differentphases of production and note how many stages a particulargood has to pass through before it reaches the finalconsumer. Take, e.g., a pair of shoes and trace its economicfamily tree. Our path leads us from the retailer via thewholesale merchant to the shoe factory; and, taking up oneof the different threads which come together at this point,say, a sewing machine used for the fabrication of shoes, weare led to the machine industry, the steel plant, andeventually to the coal and iron mine. If we follow anotherstrand, it leads us to the farm which bred the cattle fromwhich the leather was taken. And besides, there are manyintermediate stages interpolated between these majorphases of the productive process, namely, the varioustransportation services. Every good has to pass throughmany successive stages of preparation before the finishingtouches are applied and it eventually reaches the finalconsumer. It takes a considerable length of time to followone particular piece through this whole process, from thesource of this stream to the mouth where it flows out anddisappears in the bottomless sea of consumption. But, whenthe whole process is once completed and every one of the


46

successive stages is properly equipped with fixed andcirculating capital, we may expect a continuous flow ofconsumer's goods.

Now, in the equipment of these successive stages ofproduction, the capital stock of a country, which has beenaccumulated during centuries, is embodied. The amount ofaccumulated capital is a measure of the length of thestream. In a rich country the stream is very long, and goodshave to pass through many stages before they reach theconsumer. In a poor country this stream is much shorter,and the volume of output correspondingly smaller.

If, during a time of economic progress, capital isaccumulated and invested, new stages of production areadded, or, in technical economic parlance, the process ofproduction is lengthened, it becomes more roundabout. Ifyou compare the way in which we produce today with themethods of our fathers, or the productive process of a richcountry with the one of a poor country, innumerableexamples can be found.

But what has this to do with the business cycle? Now,when I spoke of the vertical structure of production and theinfluence of monetary forces upon it, I thought of alengthening and shortening of the productive process.Obviously, just as there must be a certain proportionbetween the different horizontal branches of industry, theremust also be a certain relation of the productive resources-labor and capital-which are devoted to the upper and lowerstages of production respectively, to the current productionof consumer's goods by means of the existing productive

GOTTFRIED HABERLER

47

apparatus, and to the increase of this apparatus for theincreased future production of consumer's goods.

If, e.g., too much labor is used for lengthening theprocess and too small an amount for current consumption,we shall get a maladjustment of the vertical structure ofproduction. And it can be shown that certain monetaryinfluences, concretely, a credit expansion by the bankswhich lowers the rate of interest below that rate whichwould prevail if only those sums which are deliberatelysaved by the public from their current income came on thecapital-market-it can be shown that such an artificialdecrease of the rate of interest will induce the businessleaders to indulge in an excessive lengthening of theprocess of production, in other words, in overinvestments.As the finishing of a productive process takes aconsiderable period of time, it turns out only too late thatthese newly initiated processes are too long. A reaction isinevitably produced-how, we shall see at once-which raisesthe rate of interest again to its natural level or even higher.Then these new investments are no longer profitable, and itbecomes impossible to finish the new roundabout ways ofproduction. They have to be abandoned, and productiveresources are returned to the older, shorter methods ofproduction. This process of adjustment of the verticalstructure of production, which necessarily implies the lossof large amounts of fixed capital which is invested in thoselonger processes and cannot be shifted, takes place during,and constitutes the essence of, the period of depression.

Unfortunately, it is impossible to discuss here all thesteps of this process and to compare them with thecorresponding phases of the business cycle of which they


48

are the picture and explanation. I hope it will be possible togive you a clear idea of what happens in our capitalisticsocieties during the business cycle by means of acomparison with a corresponding event in a communisticeconomy.

What the Russians are doing now, or trying to do-thefive-year plan-is nothing else but an attempt to increase bya desperate effort the roundaboutness of production and, bymeans of this, to increase in the future the production ofconsumer's goods. Instead of producing consumer's goods,with the existing primitive methods, they have curtailedproduction for immediate consumption purposes to theindispensable minimum. Instead of shoes and houses theyproduce power plants, steel works, try to improve thetransportation system, in a word, build up a productiveapparatus which will turn out consumption goods only aftera considerable period of time.

Now, suppose that it becomes impossible to carrythrough this ambitious plan. Assume the government comesto the conclusion that the population cannot stand theenormous strain, or that a revolution threatens to break out,or that by a popular vote it is decided to change the policy.In any such case, if they are forced to give up the newlyinitiated roundabout ways of production and to produceconsumer's goods as quickly as possible, they will have tostop the building of their power plants and steel works andtractor factories and, instead of that, try to producehurriedly simple implements and tools to increase theoutput of food and shoes and houses. That would mean anenormous loss of capital, sunk in those now abandonedworks.

GOTTFRIED HABERLER

49

Now, what in a communistic society is done upon adecision of the supreme economic council is in ourindividualistic society brought about by the collective butindependent action of the individuals and carried out by theprice mechanism. If many people, individuals orcorporations, decide to save, to restrict, for some time, theirconsumption, the demand for and production of consumer'sgoods declines, productive resources are shifted to theupper stages of production, and the process of production isbeing lengthened.

If we rely on voluntary saving we can assume thatduring every year approximately the same proportion of thenational income will be saved-although not always by thesame individuals. Then we have a steady flow of savings,and the adjustment of production does not take place interms of actual shifts of invested productive resources butin terms of a lasting deflection of the flow of productiveresources into other channels.

There is no reason why this should not go on smoothlyand continuously. Violent fluctuations are introduced bythe influence of the banks in this process. The effect of thevoluntary decision of the public to save, i.e., to divertproductive resources from the current production ofconsumption goods to the lengthening of the process, canbe produced also by the banking system. If the banks createcredit and place it at the disposal of certain business menwho wish to use it for productive purposes, that part of themoney stream, which is directed to the upper stages ofproduction, is increased. More productive resources will bediverted from the current production of consumer's goods


50

to the lengthening of the process than corresponds to thevoluntary decision of the members of the economiccommunity. This is what economists speak of as forcedsaving. First everything goes all right. But very soon pricesbegin to rise, because those firms who have got the newmoney use it to bid away factors of production-labor andworking capital-from those concerns which were engagedin producing consumption goods. Wages and prices go up,and a restriction of consumption is imposed on those whoare not able to increase their money income. If throughprevious investment of voluntary savings there is already atendency for the price level to fall, the new credit instead ofresulting in an absolute rise of prices may simply offset theprice fall which would otherwise take place.

But, after some time, a reaction sets in, which tends torestore the old arrangement that has been distorted by theinjection of money. The new money becomes income in thehands of the factors which have been hired away from thelower stages of production, and the receivers of thisadditional income will probably adhere to their habitualproportion of saving and spending, that is, they will try toincrease their consumption again.

If they do this, the previous proportion of the moneystreams directed to the purchase of consumer's goods andof producer's goods will be restored. For some time it mightbe possible to overcome this countertendency and tocontinue the policy of expansion by making new injectionsof credit. But this attempt would lead to a progressive riseof prices and must be given up sooner or later. Then the oldproportion of demand for consumer's goods and producer'sgoods will be definitely restored. The consequence is that

GOTTFRIED HABERLER

51

those firms in the lower stages of production, which hadbeen forced to curtail their production somewhat, becausefactors have been hired away, will in turn be able to drawaway productive resources from the higher stages. The newroundabout ways of production, which have beenundertaken under the artificial stimulus of a creditexpansion, or at least a part of them, become unprofitable.They will be discontinued, and the crisis and depression hasits start. It could be otherwise only if the new processeswere already finished when the additional money hasbecome income and comes onto the market for consumer'sgoods. In this case, the additional demand would findadditional supply; to the increased flow of money wouldcorrespond an increased flow of goods. This is, however,almost impossible, because, as Mr. Robertson has shown,the period of production is much longer than the period ofcirculation of money. The new money is bound to come onthe market for consumption goods much earlier than thenew processes are completed and turn out goods ready forconsumption.

V

This explanation of the slump, of which I have been ableto indicate here only the bare outline, could, of course, beelaborated and has been elaborated. (Compare especiallyHayek, Prices and Production [New York: Augustus M.Kelley, 1967]). If this interpretation of the crisis and of thebreakdown of a large part of the structure of production iscorrect, it seems then comparatively easy to explain thefurther events in more familiar terms. Such an initialbreakdown must have very serious repercussions. In our


52

highly complicated credit economy where every part of thesystem is connected with every other, directly or indirectly,by contractual bonds, every disturbance at one pointspreads at once to others. If some banks-those nerve centerswhere innumerable strands of credit relations cometogether-are involved and become bankrupt, a wave ofpessimism is bound to come: as a secondary phenomenon acredit deflation is likely to be the consequence of thegeneral distrust and nervousness. All these things, uponwhich the traditional monetary doctrine builds its entireexplanation, will make things even worse than they are, andit may very well be that this secondary wave of depression,which is induced by the more fundamental maladjustment,will grow to an overwhelming importance. This depends,however, largely upon the concrete circumstances of thecase in hand, upon the peculiar features of the creditorganization, on psychological factors, and need not bear adefinite proportion of the magnitude of the "real"dislocation of the structure of production.

This is the place to say a few words about an indirectconnection between the alleged insufficient supply of goldand the present depression. It is undoubtedly true that sincebefore the war the quantity of gold has not increased somuch as the volume of payments. To maintain a price level,roughly 50 percent higher than before the war, was possibleonly by building a comparatively much larger creditstructure on the existing stock of gold. After the process ofinflation has once been completed, this should not causetroubles-in normal times. In times of acute financial crisis,when confidence vanishes, and when runs and panics maketheir appearance, such a system becomes, however,extremely dangerous. If the means of payment consist

GOTTFRIED HABERLER

53

principally of gold and gold-covered notes and certificates,there is no danger that suddenly a large part of thecirculating medium may be annihilated. A world-system ofpayments, however, which relies to a large proportion oncredit money, is subject to rapid deflation, if this airy creditstructure is once shaken and crushed down.

For example, the adoption of a gold-exchange standardby many countries amounts to erecting a daring creditsuperstructure on the existing gold stock of the world; thisstructure may easily break down, if these countries abandonthe gold-exchange standard and re-adopt an old-fashionedgold standard.

It would be, however, entirely wrong to conclude fromthis that we have to blame the niggardliness of nature, thatthe situation would necessarily be quite different, if bychance, gold production had been much larger during thelast twenty years. Other factors are responsible, principallythe inflation during and after the war. By means of such amonetary policy it is always possible to drive any stock ofgold, however large it may be, out of the country. Thenatural thing is then to substitute later a gold-exchangestandard for the abandoned gold standard, which means, asI have said already, the erection of a credit structure on theexisting stock of gold.

Therefore, if the annual output of gold had been largerthan it actually was, the difference would have been onlythis: the credit structure too would have become larger, andwe would have started in for the last boom from a higherprice level. If this is a correct guess of what would havehappened-and it seems to me very probable-the economic


54

consequences of the last period of credit expansion, 1927-29, and the present deflation would have been exactly thesame.

It is of vital importance to distinguish between theseadditional, secondary, and accidental disturbances and theprimary "real" maladjustment of the process of production.If it were only a wave of pessimism and absolute deflationwhich caused the trouble, it should be possible to get rid ofit very quickly. After all, a deflation, however strong it maybe, and by whatever circumstances it may have been madepossible and aggravated, can be stopped by drasticinflationary methods within a comparatively short period oftime.

If we have, however, once realized that at the bottom ofthese surface phenomena lies a far-reaching dislocation ofproductive resources, we must lose confidence in all theeconomic and monetary quacks who are going around thesedays preaching inflationary measures which would bringalmost instant relief.

If we accept the proposition that the productiveapparatus is out of gear, that great shifts of labor and capitalare necessary to restore equilibrium, then it is emphaticallynot true that the business cycle is a purely monetaryphenomenon, as Mr. Hawtrey would have it; this is nottrue, although monetary forces have brought about thewhole trouble. Such a dislocation of real physical capital,as distinguished from purely monetary changes, can in nocase be cured in a very short time.

GOTTFRIED HABERLER

55

I do not deny that we can and must combat thesecondary phenomenon-an exaggerated pessimism and anunjustified deflation. I cannot go into this matter here, Ionly wish to say that we should not expect too much of amore or less symptomatic treatment, and, on the other hand,we must be careful not to produce again that artificialdisproportion of the money streams, directed towardconsumption and production goods, which led tooverinvestment and produced the whole trouble. The worstthing we could do is a one-sided strengthening of thepurchasing power of the consumer, because it was preciselythis disproportional increase of demand for consumer'sgoods which precipitated the crisis.

It is a great advantage of this more refined monetaryexplanation of the business cycle, over the traditional one,to have cleared up these non-monetary, "real" changes dueto monetary forces. In doing so, it has bridged the gapbetween the monetary and non-monetary explanation; it hastaken out the elements of truth contained in each of themand combined them into one coherent system. It takes careof the well-established fact that every boom period ischaracterized by an extension of investments of fixedcapital. It is primarily the construction of fixed capital andof the principal materials used for this-iron and steel-wherethe largest changes occur, the greatest expansion during theboom and the most violent contractions in the depression.

This fact, which has been stressed by all descriptivestudies of the business cycle, has not been used by thetraditional monetary explanations, which run in terms ofchanges in the price level and look at real dislocations ofthe structure of production, if they regard it at all, as an


56

unimportant accidental matter. The explanation, which Ihave indicated, not only describes this fact as does the so-called non-monetary explanation of the cycle, but explainsit. If the rate of interest is lowered, all kinds of investmentscome into the reach of practical consideration. May I beallowed to quote an example given by Mr. Keynes in alecture before the Harris Foundation Institute last year. "Noone believes that it will pay to electrify the railway systemof Great Britain on the basis of borrowing at 5 percent. . . .At 3 1/2 percent it is impossible to dispute that it will beworthwhile. So it must be with endless other technicalprojects."1 It is clear that especially those branches ofindustry are favored by a reduction of the rate of interestwhich employ a large amount of fixed capital, as, forexample, railroads, power plants, etc. In their cost-account,interest charges play an important role. But there is anindisputable general tendency to replace labor bymachinery, if capital becomes cheap. That is to say, morelabor and working capital is used to produce machines,railroads, power plants-comparatively less for currentproduction of consumption goods. In technical economicparlance: the roundaboutness of production is increased.The crucial point and also the point of deviation from Mr.Keynes's analysis is to understand well that a reaction mustinevitably set in, if this productive expansion is notfinanced by real, voluntary saving of individuals orcorporations but by ad hoc created credit. And it ispractically very important-the last boom should havebrought this home to us-that a stable commodity price levelis not a sufficient safeguard against such an artificial

1 Unemployment as a World Problem (Chicago, 1931), p. 39.

GOTTFRIED HABERLER

57

stimulation of an expansion of production. In other words,that a relative credit inflation, in the above-definedmeaning of the term, will induce the same counter-movements as an absolute inflation.

I hope that I have been able to give you a tolerably clearidea of this improved monetary explanation of the businesscycle. Once more I must ask you not to take as a completeexposition what can be only a brief indication. Asufficiently detailed discussion of the case could be onlyundertaken in a big volume. Therefore, I beg you tosuspend your final judgment until the case has been morefully presented to you. Only one objection I should like toanticipate. It is true this theory suffers from a seriousdisadvantage: it is so much more complicated than thetraditional monetary explanation. But I venture to say thatthis is not the fault of this theory, but due to the malice ofthe object. Unfortunately, facts are not always so simple asmany people would like to have them.

58

Economic Depressions:Their Cause and Cure

Murray N. Rothbard

We live in a world of euphemism. Undertakers havebecome "morticians," press agents are now "publicrelations counsellors" and janitors have all beentransformed into "superintendents." In every walk of life,plain facts have been wrapped in cloudy camouflage.

No less has this been true of economics. In the old days,we used to suffer nearly periodic economic crises, thesudden onset of which was called a "panic," and thelingering trough period after the panic was called"depression."

The most famous depression in modern times, of course,was the one that began in a typical financial panic in 1929and lasted until the advent of World War II. After thedisaster of 1929, economists and politicians resolved thatthis must never happen again. The easiest way ofsucceeding at this resolve was, simply to define"depressions" out of existence. From that point on, America

This essay was originally published as a minibook by the ConstitutionalAlliance of Lansing, Michigan, 1969.

MURRAY N. ROTHBARD

59

was to suffer no further depressions. For when the nextsharp depression came along, in 1937-38, the economistssimply refused to use the dread name, and came up with anew, much softer-sounding word: "recession." From thatpoint on, we have been through quite a few recessions, butnot a single depression.

But pretty soon the word "recession" also became tooharsh for the delicate sensibilities of the American public. Itnow seems that we had our last recession in 1957-58. Forsince then, we have only had "downturns," or, even better,"slowdowns," or "sidewise movements." So be of goodcheer; from now on, depressions and even recessions havebeen outlawed by the semantic fiat of economists; fromnow on, the worst that can possibly happen to us are"slowdowns." Such are the wonders of the "NewEconomics."

For 30 years, our nation's economists have adopted theview of the business cycle held by th

Documents

[Ludwig Von Mises, Murray N. Rothbard, Gottfried H(BookZZ.org)