The AUSTRIAN Theory of the Trade Cycle - · PDF fileGottfried Haberler Murray N. Rothbard ......

The

AUSTRIANTheory of the

Trade Cycleand 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 Böhm-Bawerk. Mises showed that an artificially lowrate of interest, maintained by credit expansion,misallocates capital, making the production process too

ROGER W. GARRISON

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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).


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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

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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.


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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

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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."3Drawing 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.


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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.

ROGER W. GARRISON

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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."


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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.

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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.


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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.

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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.


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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.

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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 CycleÉconomique," in the Bulletin of the Sociéte Belge d'Etudes et d'Expansion(1936): 459-64. It was translated from the French by David O'Mahoney and J.Huston McCulloch.


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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.

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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, Böhm-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, Führer 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.]


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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

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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


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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

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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

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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).


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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.

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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.


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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.

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(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.


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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

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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.


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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.

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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."

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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


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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

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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


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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

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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


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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.

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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


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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

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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


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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

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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


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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.

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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


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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.

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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.

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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.

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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 the late Britisheconomist, John Maynard Keynes, who created theKeynesian, or the "New," Economics in his book, TheGeneral Theory of Employment, Interest, and Money,published in 1936. Beneath their diagrams, mathematics,and inchoate jargon, the attitude of Keynesians towardbooms and bust is simplicity, even naivete, itself. If there isinflation, then the cause is supposed to be "excessivespending" on the part of the public; the alleged cure is forthe government, the self-appointed stabilizer and regulatorof the nation's economy, to step in and force people tospend less, "sopping up their excess purchasing power"through increased taxation. If there is a recession, on theother hand, this has been caused by insufficient private


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spending, and the cure now is for the government toincrease its own spending, preferably through deficits,thereby adding to the nation's aggregate spending stream.

The idea that increased government spending or easymoney is "good for business" and that budget cuts or hardermoney is "bad" permeates even the most conservativenewspapers and magazines. These journals will also takefor granted that it is the sacred task of the federalgovernment to steer the economic system on the narrowroad between the abysses of depression on the one handand inflation on the other, for the free-market economy issupposed to be ever liable to succumb to one of these evils.

All current schools of economists have the sameattitude. Note, for example, the viewpoint of Dr. Paul W.McCracken, the incoming chairman of President Nixon'sCouncil of Economic Advisers. In an interview with theNew York Times shortly after taking office [January 24,1969], Dr. McCracken asserted that one of the majoreconomic problems facing the new Administration is "howyou cool down this inflationary economy without at thesame time tripping off unacceptably high levels ofunemployment. In other words, if the only thing we want todo is cool off the inflation, it could be done. But our socialtolerances on unemployment are narrow." And again: "Ithink we have to feel our way along here. We don't reallyhave much experience in trying to cool an economy inorderly fashion. We slammed on the brakes in 1957, but, ofcourse, we got substantial slack in the economy."

Note the fundamental attitude of Dr. McCracken towardthe economy-remarkable only in that it is shared by almost

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all economists of the present day. The economy is treatedas a potentially workable, but always troublesome andrecalcitrant patient, with a continual tendency to hive offinto greater inflation or unemployment. The function of thegovernment is to be the wise old manager and physician,ever watchful, ever tinkering to keep the economic patientin good working order. In any case, here the economicpatient is clearly supposed to be the subject, and thegovernment as "physician" the master.

It was not so long ago that this kind of attitude andpolicy was called "socialism"; but we live in a world ofeuphemism, and now we call it by far less harsh labels,such as "moderation" or "enlightened free enterprise." Welive and learn.

What, then, are the causes of periodic depressions? Mustwe always remain agnostic about the causes of booms andbusts? Is it really true that business cycles are rooted deepwithin the free-market economy, and that therefore someform of government planning is needed if we wish to keepthe economy within some kind of stable bounds? Do boomsand then busts just simply happen, or does one phase of thecycle flow logically from the other?

The currently fashionable attitude toward the businesscycle stems, actually, from Karl Marx. Marx saw that,before the Industrial Revolution in approximately the lateeighteenth century, there were no regularly recurringbooms and depressions. There would be a sudden economiccrisis whenever some king made war or confiscated theproperty of his subject; but there was no sign of thepeculiarly modern phenomena of general and fairly regular


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swings in business fortunes, of expansions andcontractions. Since these cycles also appeared on the sceneat about the same time as modern industry, Marx concludedthat business cycles were an inherent feature of thecapitalist market economy. All the various current schoolsof economic thought, regardless of their other differencesand the different causes that they attribute to the cycle,agree on this vital point: That these business cyclesoriginate somewhere deep within the free-market economy.The market economy is to blame. Karl Marx believed thatthe periodic depressions would get worse and worse, untilthe masses would be moved to revolt and destroy thesystem, while the modern economists believe that thegovernment can successfully stabilize depressions and thecycle. But all parties agree that the fault lies deep within themarket economy and that if anything can save the day, itmust be some form of massive government intervention.

There are, however, some critical problems in theassumption that the market economy is the culprit. For"general economic theory" teaches us that supply anddemand always tend to be in equilibrium in the market andthat therefore prices of products as well as of the factorsthat contribute to production are always tending towardsome equilibrium point. Even though changes of data,which are always taking place, prevent equilibrium fromever being reached, there is nothing in the general theory ofthe market system that would account for regular andrecurring boom-and-bust phases of the business cycle.Modern economists "solve" this problem by simplykeeping their general price and market theory and theirbusiness cycle theory in separate, tightly-sealedcompartments, with never the twain meeting, much less

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integrated with each other. Economists, unfortunately, haveforgotten that there is only one economy and therefore onlyone integrated economic theory. Neither economic life northe structure of theory can or should be in watertightcompartments; our knowledge of the economy is either oneintegrated whole or it is nothing. Yet most economists arecontent to apply totally separate and, indeed, mutuallyexclusive, theories for general price analysis and forbusiness cycles. They cannot be genuine economicscientists so long as they are content to keep operating inthis primitive way.

But there are still graver problems with the currentlyfashionable approach. Economists also do not see oneparticularly critical problem because they do not bother tosquare their business cycle and general price theories: thepeculiar breakdown of the entrepreneurial function at timesof economic crisis and depression. In the market economy,one of the most vital functions of the businessman is to bean "entrepreneur," a man who invests in productivemethods, who buys equipment and hires labor to producesomething which he is not sure will reap him any return. Inshort, the entrepreneurial function is the function offorecasting the uncertain future. Before embarking on anyinvestment or line of production, the entrepreneur, or"enterpriser," must estimate present and future costs andfuture revenues and therefore estimate whether and howmuch profits he will earn from the investment. If heforecasts well and significantly better than his businesscompetitors, he will reap profits from his investment. Thebetter his forecasting, the higher the profits he will earn. If,on the other hand, he is a poor forecaster and overestimates


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the demand for his product, he will suffer losses and prettysoon be forced out of the business.

The market economy, then, is a profit-and-losseconomy, in which the acumen and ability of businessentrepreneurs is gauged by the profits and losses they reap.The market economy, moreover, contains a built-inmechanism, a kind of natural selection, that ensures thesurvival and the flourishing of the superior forecaster andthe weeding-out of the inferior ones. For the more profitsreaped by the better forecasters, the greater become theirbusiness responsibilities, and the more they will haveavailable to invest in the productive system. On the otherhand, a few years of making losses will drive the poorerforecasters and entrepreneurs out of business altogether andpush them into the ranks of salaried employees.

If, then, the market economy has a built-in naturalselection mechanism for good entrepreneurs, this meansthat, generally, we would expect not many business firmsto be making losses. And, in fact, if we look around at theeconomy on an average day or year, we will find that lossesare not very widespread. But, in that case, the odd fact thatneeds explaining is this: How is it that, periodically, intimes of the onset of recessions and especially in steepdepressions, the business world suddenly experiences amassive cluster of severe losses? A moment arrives whenbusiness firms, previously highly astute entrepreneurs intheir ability to make profits and avoid losses, suddenly anddismayingly find themselves, almost all of them, sufferingsevere and unaccountable losses? How come? Here is amomentous fact that any theory of depressions mustexplain. An explanation such as "underconsumption"-a

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drop in total consumer spending-is not sufficient, for onething, because what needs to be explained is whybusinessmen, able to forecast all manner of previouseconomic changes and developments, proved themselvestotally and catastrophically unable to forecast this allegeddrop in consumer demand. Why this sudden failure inforecasting ability?

An adequate theory of depressions, then, must accountfor the tendency of the economy to move throughsuccessive booms and busts, showing no sign of settlinginto any sort of smoothly moving, or quietly progressive,approximation of an equilibrium situation. In particular, atheory of depression must account for the mammoth clusterof errors which appears swiftly and suddenly at a momentof economic crisis, and lingers through the depressionperiod until recovery. And there is a third universal factthat a theory of the cycle must account for. Invariably, thebooms and busts are much more intense and severe in the"capital goods industries"-the industries making machinesand equipment, the ones producing industrial raw materialsor constructing industrial plants-than in the industriesmaking consumers' goods. Here is another fact of businesscycle life that must be explained-and obviously can't beexplained by such theories of depression as the popularunderconsumption doctrine: That consumers aren'tspending enough on consumer goods. For if insufficientspending is the culprit, then how is it that retail sales are thelast and the least to fall in any depression, and thatdepression really hits such industries as machine tools,capital equipment, construction, and raw materials?Conversely, it is these industries that really take off in theinflationary boom phases of the business cycle, and not


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those businesses serving the consumer. An adequate theoryof the business cycle, then, must also explain the far greaterintensity of booms and busts in the non-consumer goods, or"producers' goods," industries.

Fortunately, a correct theory of depression and of thebusiness cycle does exist, even though it is universallyneglected in present-day economics. It, too, has a longtradition in economic thought. This theory began with theeighteenth century Scottish philosopher and economistDavid Hume, and with the eminent early nineteenth centuryEnglish classical economist David Ricardo. Essentially,these theorists saw that another crucial institution haddeveloped in the mid-eighteenth century, alongside theindustrial system. This was the institution of banking, withits capacity to expand credit and the money supply (first, inthe form of paper money, or bank notes, and later in theform of demand deposits, or checking accounts, that areinstantly redeemable in cash at the banks). It was theoperations of these commercial banks which, theseeconomists saw, held the key to the mysterious recurrentcycles of expansion and contraction, of boom and bust, thathad puzzled observers since the mid-eighteenth century.

The Ricardian analysis of the business cycle wentsomething as follows: The natural moneys emerging assuch on the world free market are useful commodities,generally gold and silver. If money were confined simply tothese commodities, then the economy would work in theaggregate as it does in particular markets: A smoothadjustment of supply and demand, and therefore no cyclesof boom and bust. But the injection of bank credit addsanother crucial and disruptive element. For the banks

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expand credit and therefore bank money in the form ofnotes or deposits which are theoretically redeemable ondemand in gold, but in practice clearly are not. Forexample, if a bank has 1000 ounces of gold in its vaults,and it issues instantly redeemable warehouse receipts for2500 ounces of gold, then it clearly has issued 1500 ouncesmore than it can possibly redeem. But so long as there is noconcerted "run" on the bank to cash in these receipts, itswarehouse-receipts function on the market as equivalent togold, and therefore the bank has been able to expand themoney supply of the country by 1500 gold ounces.

The banks, then, happily begin to expand credit, for themore they expand credit the greater will be their profits.This results in the expansion of the money supply within acountry, say England. As the supply of paper and bankmoney in England increases, the money incomes andexpenditures of Englishmen rise, and the increased moneybids up prices of English goods. The result is inflation anda boom within the country. But this inflationary boom,while it proceeds on its merry way, sows the seeds of itsown demise. For as English money supply and incomesincrease, Englishmen proceed to purchase more goods fromabroad. Furthermore, as English prices go up, Englishgoods begin to lose their competitiveness with the productsof other countries which have not inflated, or have beeninflating to a lesser degree. Englishmen begin to buy less athome and more abroad, while foreigners buy less inEngland and more at home; the result is a deficit in theEnglish balance of payments, with English exports fallingsharply behind imports. But if imports exceed exports, thismeans that money must flow out of England to foreigncountries. And what money will this be? Surely not English


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bank notes or deposits, for Frenchmen or Germans orItalians have little or no interest in keeping their fundslocked up in English banks. These foreigners will thereforetake their bank notes and deposits and present them to theEnglish banks for redemption in gold-and gold will be thetype of money that will tend to flow persistently out of thecountry as the English inflation proceeds on its way. Butthis means that English bank credit money will be, moreand more, pyramiding on top of a dwindling gold base inthe English bank vaults. As the boom proceeds, ourhypothetical bank will expand its warehouse receipts issuedfrom, say 2500 ounces to 4000 ounces, while its gold basedwindles to, say, 800. As this process intensifies, the bankswill eventually become frightened. For the banks, after all,are obligated to redeem their liabilities in cash, and theircash is flowing out rapidly as their liabilities pile up.Hence, the banks will eventually lose their nerve, stop theircredit expansion, and in order to save themselves, contracttheir bank loans outstanding. Often, this retreat isprecipitated by bankrupting runs on the banks touched offby the public, who had also been getting increasinglynervous about the ever more shaky condition of the nation'sbanks.

The bank contraction reverses the economic picture;contraction and bust follow boom. The banks pull in theirhorns, and businesses suffer as the pressure mounts for debtrepayment and contraction. The fall in the supply of bankmoney, in turn, leads to a general fall in English prices. Asmoney supply and incomes fall, and English pricescollapse, English goods become relatively more attractivein terms of foreign products, and the balance of paymentsreverses itself, with exports exceeding imports. As gold

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flows into the country, and as bank money contracts on topof an expanding gold base, the condition of the banksbecomes much sounder.

This, then, is the meaning of the depression phase of thebusiness cycle. Note that it is a phase that comes out of, andinevitably comes out of, the preceding expansionary boom.It is the preceding inflation that makes the depression phasenecessary. We can see, for example, that the depression isthe process by which the market economy adjusts, throwsoff the excesses and distortions of the previous inflationaryboom, and reestablishes a sound economic condition. Thedepression is the unpleasant but necessary reaction to thedistortions and excesses of the previous boom.

Why, then, does the next cycle begin? Why do businesscycles tend to be recurrent and continuous? Because whenthe banks have pretty well recovered, and are in a soundercondition, they are then in a confident position to proceedto their natural path of bank credit expansion, and the nextboom proceeds on its way, sowing the seeds for the nextinevitable bust.

But if banking is the cause of the business cycle, aren'tthe banks also a part of the private market economy, andcan't we therefore say that the free market is still theculprit, if only in the banking segment of that free market?The answer is No, for the banks, for one thing, would neverbe able to expand credit in concert were it not for theintervention and encouragement of government. For ifbanks were truly competitive, any expansion of credit byone bank would quickly pile up the debts of that bank in itscompetitors, and its competitors would quickly call upon


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the expanding bank for redemption in cash. In short, abank's rivals will call upon it for redemption in gold or cashin the same way as do foreigners, except that the process ismuch faster and would nip any incipient inflation in the budbefore it got started. Banks can only expand comfortably inunison when a Central Bank exists, essentially agovernmental bank, enjoying a monopoly of governmentbusiness, and a privileged position imposed by governmentover the entire banking system. It is only when centralbanking got established that the banks were able to expandfor any length of time and the familiar business cycle gotunderway in the modern world.

The central bank acquires its control over the bankingsystem by such governmental measures as: Making its ownliabilities legal tender for all debts and receivable in taxes;granting the central bank monopoly of the issue of banknotes, as contrasted to deposits (in England the Bank ofEngland, the governmentally established central bank, hada legal monopoly of bank notes in the London area); orthrough the outright forcing of banks to use the centralbank as their client for keeping their reserves of cash (as inthe United States and its Federal Reserve System). Not thatthe banks complain about this intervention; for it is theestablishment of central banking that makes long-term bankcredit expansion possible, since the expansion of CentralBank notes provides added cash reserves for the entirebanking system and permits all the commercial banks toexpand their credit together. Central banking works like acozy compulsory bank cartel to expand the banks'liabilities; and the banks are now able to expand on a largerbase of cash in the form of central bank notes as well asgold.

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So now we see, at last, that the business cycle is broughtabout, not by any mysterious failings of the free marketeconomy, but quite the opposite: By systematicintervention by government in the market process.Government intervention brings about bank expansion andinflation, and, when the inflation comes to an end, thesubsequent depression-adjustment comes into play.

The Ricardian theory of the business cycle grasped theessentials of a correct cycle theory: The recurrent nature ofthe phases of the cycle, depression as adjustmentintervention in the market rather than from the free-marketeconomy. But two problems were as yet unexplained: Whythe sudden cluster of business error, the sudden failure ofthe entrepreneurial function, and why the vastly greaterfluctuations in the producers' goods than in the consumers'goods industries? The Ricardian theory only explainedmovements in the price level, in general business; there wasno hint of explanation of the vastly different reactions inthe capital and consumers' goods industries.

The correct and fully developed theory of the businesscycle was finally discovered and set forth by the Austrianeconomist Ludwig von Mises, when he was a professor atthe University of Vienna. Mises developed hints of hissolution to the vital problem of the business cycle in hismonumental Theory of Money and Credit, published in1912, and still, nearly 60 years later, the best book on thetheory of money and banking. Mises developed his cycletheory during the 1920s, and it was brought to the English-speaking world by Mises's leading follower, Friedrich A.von Hayek, who came from Vienna to teach at the London


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School of Economics in the early 1930s, and whopublished, in German and in English, two books whichapplied and elaborated the Mises cycle theory: MonetaryTheory and the Trade Cycle, and Prices and Production.Since Mises and Hayek were Austrians, and also since theywere in the tradition of the great nineteenth-centuryAustrian economists, this theory has become known in theliterature as the "Austrian" (or the "monetary over-investment") theory of the business cycle.

Building on the Ricardians, on general "Austrian"theory, and on his own creative genius, Mises developedthe following theory of the business cycle:

Without bank credit expansion, supply and demand tendto be equilibrated through the free price system, and nocumulative booms or busts can then develop. But thengovernment through its central bank stimulates bank creditexpansion by expanding central bank liabilities andtherefore the cash reserves of all the nation's commercialbanks. The banks then proceed to expand credit and hencethe nation's money supply in the form of check deposits. Asthe Ricardians saw, this expansion of bank money drives upthe prices of goods and hence causes inflation. But, Misesshowed, it does something else, and something even moresinister. Bank credit expansion, by pouring new loan fundsinto the business world, artificially lowers the rate ofinterest in the economy below its free market level.

On the free and unhampered market, the interest rate isdetermined purely by the "time-preferences" of all theindividuals that make up the market economy. For theessence of a loan is that a "present good" (money which

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can be used at present) is being exchanged for a "futuregood" (an IOU which can only be used at some point in thefuture). Since people always prefer money right now to thepresent prospect of getting the same amount of moneysome time in the future, the present good always commandsa premium in the market over the future. This premium isthe interest rate, and its height will vary according to thedegree to which people prefer the present to the future, i.e.,the degree of their time-preferences.

People's time-preferences also determine the extent towhich people will save and invest, as compared to howmuch they will consume. If people's time-preferencesshould fall, i.e., if their degree of preference for presentover future falls, then people will tend to consume less nowand save and invest more; at the same time, and for thesame reason, the rate of interest, the rate of time-discount,will also fall. Economic growth comes about largely as theresult of falling rates of time-preference, which lead to anincrease in the proportion of saving and investment toconsumption, and also to a falling rate of interest.

But what happens when the rate of interest falls, notbecause of lower time-preferences and higher savings, butfrom government interference that promotes the expansionof bank credit? In other words, if the rate of interest fallsartificially, due to intervention, rather than naturally, as aresult of changes in the valuations and preferences of theconsuming public?

What happens is trouble. For businessmen, seeing therate of interest fall, react as they always would and must tosuch a change of market signals: They invest more in


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capital and producers' goods. Investments, particularly inlengthy and time-consuming projects, which previouslylooked unprofitable now seem profitable, because of thefall of the interest charge. In short, businessmen react asthey would react if savings had genuinely increased: Theyexpand their investment in durable equipment, in capitalgoods, in industrial raw material, in construction ascompared to their direct production of consumer goods.

Businesses, in short, happily borrow the newlyexpanded bank money that is coming to them at cheaperrates; they use the money to invest in capital goods, andeventually this money gets paid out in higher rents to land,and higher wages to workers in the capital goods industries.The increased business demand bids up labor costs, butbusinesses think they can pay these higher costs becausethey have been fooled by the government-and-bankintervention in the loan market and its decisively importanttampering with the interest-rate signal of the marketplace.

The problem comes as soon as the workers andlandlords-largely the former, since most gross businessincome is paid out in wages-begin to spend the new bankmoney that they have received in the form of higher wages.For the time-preferences of the public have not reallygotten lower; the public doesn't want to save more than ithas. So the workers set about to consume most of their newincome, in short to reestablish the old consumer/savingproportions. This means that they redirect the spendingback to the consumer goods industries, and they don't saveand invest enough to buy the newly-produced machines,capital equipment, industrial raw materials, etc. This allreveals itself as a sudden sharp and continuing depression

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in the producers' goods industries. Once the consumersreestablished their desired consumption/investmentproportions, it is thus revealed that business had investedtoo much in capital goods and had underinvested inconsumer goods. Business had been seduced by thegovernmental tampering and artificial lowering of the rateof interest, and acted as if more savings were available toinvest than were really there. As soon as the new bankmoney filtered through the system and the consumersreestablished their old proportions, it became clear thatthere were not enough savings to buy all the producers'goods, and that business had misinvested the limitedsavings available. Business had overinvested in capitalgoods and underinvested in consumer products.

The inflationary boom thus leads to distortions of thepricing and production system. Prices of labor and rawmaterials in the capital goods industries had been bid upduring the boom too high to be profitable once theconsumers reassert their old consumption/investmentpreferences. The "depression" is then seen as the necessaryand healthy phase by which the market economy sloughsoff and liquidates the unsound, uneconomic investments ofthe boom, and reestablishes those proportions betweenconsumption and investment that are truly desired by theconsumers. The depression is the painful but necessaryprocess by which the free market sloughs off the excessesand errors of the boom and reestablishes the marketeconomy in its function of efficient service to the mass ofconsumers. Since prices of factors of production have beenbid too high in the boom, this means that prices of laborand goods in these capital goods industries must be allowedto fall until proper market relations are resumed.


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Since the workers receive the increased money in theform of higher wages fairly rapidly, how is it that boomscan go on for years without having their unsoundinvestments revealed, their errors due to tampering withmarket signals become evident, and the depression-adjustment process begins its work? The answer is thatbooms would be very short lived if the bank creditexpansion and subsequent pushing of the rate of interestbelow the free market level were a one-shot affair. But thepoint is that the credit expansion is not one-shot; itproceeds on and on, never giving consumers the chance toreestablish their preferred proportions of consumption andsaving, never allowing the rise in costs in the capital goodsindustries to catch up to the inflationary rise in prices. Likethe repeated doping of a horse, the boom is kept on its wayand ahead of its inevitable comeuppance, by repeated dosesof the stimulant of bank credit. It is only when bank creditexpansion must finally stop, either because the banks aregetting into a shaky condition or because the public beginsto balk at the continuing inflation, that retribution finallycatches up with the boom. As soon as credit expansionstops, then the piper must be paid, and the inevitablereadjustments liquidate the unsound over-investments ofthe boom, with the reassertion of a greater proportionateemphasis on consumers' goods production.

Thus, the Misesian theory of the business cycle accountsfor all of our puzzles: The repeated and recurrent nature ofthe cycle, the massive cluster of entrepreneurial error, thefar greater intensity of the boom and bust in the producers'goods industries.

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Mises, then, pinpoints the blame for the cycle oninflationary bank credit expansion propelled by theintervention of government and its central bank. What doesMises say should be done, say by government, once thedepression arrives? What is the governmental role in thecure of depression? In the first place, government mustcease inflating as soon as possible. It is true that this will,inevitably, bring the inflationary boom abruptly to an end,and commence the inevitable recession or depression. Butthe longer the government waits for this, the worse thenecessary readjustments will have to be. The sooner thedepression-readjustment is gotten over with, the better.This means, also, that the government must never try toprop up unsound business situations; it must never bail outor lend money to business firms in trouble. Doing this willsimply prolong the agony and convert a sharp and quickdepression phase into a lingering and chronic disease. Thegovernment must never try to prop up wage rates or pricesof producers' goods; doing so will prolong and delayindefinitely the completion of the depression-adjustmentprocess; it will cause indefinite and prolonged depressionand mass unemployment in the vital capital goodsindustries. The government must not try to inflate again, inorder to get out of the depression. For even if thisreinflation succeeds, it will only sow greater trouble lateron. The government must do nothing to encourageconsumption, and it must not increase its own expenditures,for this will further increase the socialconsumption/investment ratio. In fact, cutting thegovernment budget will improve the ratio. What theeconomy needs is not more consumption spending butmore saving, in order to validate some of the excessiveinvestments of the boom.


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Thus, what the government should do, according to theMisesian analysis of the depression, is absolutely nothing.It should, from the point of view of economic health andending the depression as quickly as possible, maintain astrict hands off, "laissez-faire" policy. Anything it does willdelay and obstruct the adjustment process of the market;the less it does, the more rapidly will the market adjustmentprocess do its work, and sound economic recovery ensue.

The Misesian prescription is thus the exact opposite ofthe Keynesian: It is for the government to keep absolutehands off the economy and to confine itself to stopping itsown inflation and to cutting its own budget.

It has today been completely forgotten, even amongeconomists, that the Misesian explanation and analysis ofthe depression gained great headway precisely during theGreat Depression of the 1930s-the very depression that isalways held up to advocates of the free market economy asthe greatest single and catastrophic failure of laissez-fairecapitalism. It was no such thing. 1929 was made inevitableby the vast bank credit expansion throughout the Westernworld during the 1920s: A policy deliberately adopted bythe Western governments, and most importantly by theFederal Reserve System in the United States. It was madepossible by the failure of the Western world to return to agenuine gold standard after World War I, and thus allowingmore room for inflationary policies by government.Everyone now thinks of President Coolidge as a believer inlaissez-faire and an unhampered market economy; he wasnot, and tragically, nowhere less so than in the field ofmoney and credit. Unfortunately, the sins and errors of the

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Coolidge intervention were laid to the door of a non-existent free market economy.

If Coolidge made 1929 inevitable, it was PresidentHoover who prolonged and deepened the depression,transforming it from a typically sharp but swiftly-disappearing depression into a lingering and near-fatalmalady, a malady "cured" only by the holocaust of WorldWar II. Hoover, not Franklin Roosevelt, was the founder ofthe policy of the "New Deal": essentially the massive use ofthe State to do exactly what Misesian theory would mostwarn against-to prop up wage rates above their free-marketlevels, prop up prices, inflate credit, and lend money toshaky business positions. Roosevelt only advanced, to agreater degree, what Hoover had pioneered. The result forthe first time in American history, was a nearly perpetualdepression and nearly permanent mass unemployment. TheCoolidge crisis had become the unprecedentedly prolongedHoover-Roosevelt depression.

Ludwig von Mises had predicted the depression duringthe heyday of the great boom of the 1920s-a time, just liketoday, when economists and politicians, armed with a "neweconomics" of perpetual inflation, and with new "tools"provided by the Federal Reserve System, proclaimed aperpetual "New Era" of permanent prosperity guaranteedby our wise economic doctors in Washington. Ludwig vonMises, alone armed with a correct theory of the businesscycle, was one of the very few economists to predict theGreat Depression, and hence the economic world wasforced to listen to him with respect. F. A. Hayek spread theword in England, and the younger English economists wereall, in the early 1930s, beginning to adopt the Misesian


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cycle theory for their analysis of the depression-and also toadopt, of course, the strictly free-market policy prescriptionthat flowed with this theory. Unfortunately, economistshave now adopted the historical notion of Lord Keynes:That no "classical economists" had a theory of the businesscycle until Keynes came along in 1936. There was a theoryof the depression; it was the classical economic tradition;its prescription was strict hard money and laissez-faire; andit was rapidly being adopted, in England and even in theUnited States, as the accepted theory of the business cycle.(A particular irony is that the major "Austrian" proponentin the United States in the early and mid-1930s was noneother than Professor Alvin Hansen, very soon to make hismark as the outstanding Keynesian disciple in this country.)

What swamped the growing acceptance of Misesiancycle theory was simply the "Keynesian Revolution"-theamazing sweep that Keynesian theory made of theeconomic world shortly after the publication of the GeneralTheory in 1936. It is not that Misesian theory was refutedsuccessfully; it was just forgotten in the rush to climb onthe suddenly fashionable Keynesian bandwagon. Some ofthe leading adherents of the Mises theory-who clearly knewbetter-succumbed to the newly established winds ofdoctrine, and won leading American university posts as aconsequence.

But now the once arch-Keynesian London Economisthas recently proclaimed that "Keynes is Dead." After over adecade of facing trenchant theoretical critiques andrefutation by stubborn economic facts, the Keynesians arenow in general and massive retreat. Once again, the moneysupply and bank credit are being grudgingly acknowledged

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to play a leading role in the cycle. The time is ripe-for arediscovery, a renaissance, of the Mises theory of thebusiness cycle. It can come none too soon; if it ever does,the whole concept of a Council of Economic Advisorswould be swept away, and we would see a massive retreatof government from the economic sphere. But for all this tohappen, the world of economics, and the public at large,must be made aware of the existence of an explanation ofthe business cycle that has lain neglected on the shelf for alltoo many tragic years.

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Can We Still Avoid Inflation?∗∗

Friedrich A. HayekIn one sense the question asked in the title of this lecture

is purely rhetorical. I hope none of you has suspected me ofdoubting even for a moment that technically there is noproblem in stopping inflation. If the monetary authoritiesreally want to and are prepared to accept the consequences,they can always do so practically overnight. They fullycontrol the base of the pyramid of credit, and a credibleannouncement that they will not increase the quantity ofbank notes in circulation and bank deposits, and, ifnecessary, even decrease them, will do the trick. About thisthere is no doubt among economists. What I am concernedabout is not the technical but the political possibilities.Here, indeed, we face a task so difficult that more and morepeople, including highly competent people, have resignedthemselves to the inevitability of indefinitely continuedinflation. I know in fact of no serious attempt to show howwe can overcome these obstacles which lie not in themonetary but in the political field. And I cannot myselfclaim to have a patent medicine which I am sure isapplicable and effective in the prevailing conditions. But Ido not regard it as a task beyond the scope of humaningenuity once the urgency of the problem is generally

∗ This essay was originally given as a lecture before the Trustees and guests ofthe Foundation for Economic Education at Tarrytown, New York on May 18,1970, and was first published in the first edition of this book.

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understood. My main aim tonight is to bring out clearlywhy we must stop inflation if we are to preserve a viablesociety of free men. Once this urgent necessity is fullyunderstood, I hope people will also gather the courage tograsp the hot irons which must be tackled if the politicalobstacles are to be removed and we are to have a chance ofrestoring a functioning market economy.

In the elementary textbook accounts, and probably alsoin the public mind generally, only one harmful effect ofinflation is seriously considered, that on the relationsbetween debtors and creditors. Of course, an unforeseendepreciation of the value of money harms creditors andbenefits debtors. This is important but by no means themost important effect of inflation. And since it is thecreditors who are harmed and the debtors who benefit, mostpeople do not particularly mind, at least until they realizethat in modern society the most important and numerousclass of creditors are the wage and salary earners and thesmall savers, and the representative groups of debtors whoprofit in the first instance are the enterprises and creditinstitutions.

But I do not want to dwell too long on this most familiareffect of inflation which is also the one which most readilycorrects itself. Twenty years ago I still had some difficultyto make my students believe that if an annual rate of priceincrease of five per cent were generally expected, we wouldhave rates of interest of 9-10 per cent or more. There stillseem to be a few people who have not yet understood thatrates of this sort are bound to last so long as inflationcontinues. Yet, so long as this is the case, and the creditorsunderstand that only part of their gross return is net return,


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at least short term lenders have comparatively little groundfor complaint-even though long term creditors, such as theowners of government loans and other debentures, arepartly expropriated.

There is, however, another more devious aspect of thisprocess which I must at least briefly mention at this point.It is that it upsets the reliability of all accounting practicesand is bound to show spurious profits much in excess totrue gains. Of course, a wise manager could allow for thisalso, at least in a general way, and treat as profits only whatremains after he has taken into account the depreciation ofmoney as affecting the replacement costs of his capital. Butthe tax inspector will not permit him to do so and insist ontaxing all the pseudo-profits. Such taxation is simplyconfiscation of some of the substance of capital, and in thecase of a rapid inflation may become a very serious matter.

But all this is familiar ground-matters of which I merelywanted to remind you before turning to the lessconspicuous but, for that very reason, more dangerouseffects of inflation. The whole conventional analysisreproduced in most textbooks proceeds as if a rise inaverage prices meant that all prices rise at the same time bymore or less the same percentage, or that this at least wastrue of all prices determined currently on the market,leaving out only a few prices fixed by decree or long termcontracts, such as public utility rates, rents and variousconventional fees. But this is not true or even possible. Thecrucial point is that so long as the flow of moneyexpenditure continues to grow and prices of commoditiesand services are driven up, the different prices must rise,not at the same time but in succession, and that in

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consequence, so long as this process continues, the priceswhich rise first must all the time move ahead of the others.This distortion of the whole price structure will disappearonly sometime after the process of inflation has stopped.This is a fundamental point which the master of all of us,Ludwig von Mises, has never tired from emphasizing forthe past sixty years. It seems nevertheless necessary todwell upon it at some length since, as I recently discoveredwith some shock, it is not appreciated and even explicitlydenied by one of the most distinguished living economists.1

That the order in which a continued increase in themoney stream raises the different prices is crucial for anunderstanding of the effects of inflation was clearly seenmore than two hundred years ago by David Hume-andindeed before him by Richard Cantillon. It was in orderdeliberately to eliminate this effect that Hume assumed as afirst approximation that one morning every citizen of acountry woke up to find the stock of money in hispossession miraculously doubled. Even this would notreally lead to an immediate rise of all prices by the samepercentage. But it is not what ever really happens. Theinflux of the additional money into the system always takesplace at some particular point. There will always be somepeople who have more money to spend before the others.Who these people are will depend on the particular mannerin which the increase in the money stream is being broughtabout. It may be spent in the first instance by governmenton public works or increased salaries, or it may be firstspent by investors mobilizing cash balances or borrowing 1 [See Professor Hayek's criticism of Sir John Hicks in his article, "ThreeElucidations of the Ricardo Effect," Journal of Political Economy (March-April 1969): 274-ed.]


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for the purpose; it may be spent in the first instance onsecurities, on investment goods, on wages or on consumer'sgoods. It will then in turn be spent on something else by thefirst recipients of the additional expenditure, and so on. Theprocess will take very different forms according to theinitial source or sources of the additional money stream;and all its ramifications will soon be so complex thatnobody can trace them. But one thing all these differentforms of the process will have in common: that thedifferent prices will rise, not at the same time but insuccession, and that so long as the process continues someprices will always be ahead of the others and the wholestructure of relative prices therefore very different fromwhat the pure theorist describes as an equilibrium position.There will always exist what might be described as a pricesgradient in favor of those commodities and services whicheach increment of the money stream hits first and to thedisadvantage of the successive groups which it reaches onlylater-with the effect that what will rise as a whole will notbe a level but a sort of inclined plane-if we take as normalthe system of prices which existed before inflation startedand which will approximately restore itself sometime afterit has stopped.

To such a change in relative prices, if it has persisted forsome time and comes to be expected to continue, will ofcourse correspond a similar change in the allocation ofresources: relatively more will be produced of the goodsand services whose prices are now comparatively higherand relatively less of those whose prices are comparativelylower. This redistribution of the productive resources willevidently persist so long, but only so long, as inflationcontinues at a given rate. We shall see that this inducement

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to activities, or a volume of some activities, which can becontinued only if inflation is also continued, is one of theways in which even a contemporary inflation places us in aquandary because its discontinuance will necessarilydestroy some of the jobs it has created.

But before I turn to those consequences of an economyadjusting itself to a continuous process of inflation, I mustdeal with an argument that, though I do not know that it hasanywhere been clearly stated, seems to lie at the root of theview which represents inflation as relatively harmless. Itseems to be that, if future prices are correctly foreseen, anyset of prices expected in the future is compatible with anequilibrium position, because present prices will adjustthemselves to expected future prices. For this it would,however, clearly not be sufficient that the general level ofprices at the various future dates be correctly foreseen, andthese, as we have seen, will change in different degrees.The assumption that the future prices of particularcommodities can be correctly foreseen during a period ofinflation is probably an assumption which never can betrue: because, whatever future prices are foreseen, presentprices do not by themselves adapt themselves to theexpected higher prices of the future, but only through apresent increase in the quantity of money with all thechanges in the relative height of the different prices whichsuch changes in the quantity of money necessarily involve.

More important, however, is the fact that if future priceswere correctly foreseen, inflation would have none of thestimulating effects for which it is welcomed by so manypeople.


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Now the chief effect of inflation which makes it at firstgenerally welcome to business is precisely that prices ofproducts turn out to be higher in general than foreseen. It isthis which produces the general state of euphoria, a falsesense of wellbeing, in which everybody seems to prosper.Those who without inflation would have made high profitsmake still higher ones. Those who would have madenormal profits make unusually high ones. And not onlybusinesses which were near failure but even some whichought to fail are kept above water by the unexpected boom.There is a general excess of demand over supply-all issaleable and everybody can continue what he had beendoing. It is this seemingly blessed state in which there aremore jobs than applicants which Lord Beveridge defined asthe state of full employment-never understanding that theshrinking value of his pension of which he so bitterlycomplained in old age was the inevitable consequence ofhis own recommendations having been followed.

But, and this brings me to my next point, "fullemployment" in his sense requires not only continuedinflation but inflation at a growing rate. Because, as wehave seen, it will have its immediate beneficial effect onlyso long as it, or at least its magnitude, is not foreseen. Butonce it has continued for some time, its further continuancecomes to be expected. If prices have for some time beenrising at five percent per annum, it comes to be expectedthat they will do the same in the future. Present prices offactors are driven up by the expectation of the higher pricesfor the product-sometimes, where some of the costelements are fixed, the flexible costs may be driven up evenmore than the expected rise of the price of the product-upto the point where there will be only a normal profit.

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But if prices then do not rise more than expected, noextra profits will be made. Although prices continue to riseat the former rate, this will no longer have the miraculouseffect on sales and employment it had before. The artificialgains will disappear, there will again be losses, and somefirms will find that prices will not even cover costs. Tomaintain the effect inflation had earlier when its full extentwas not anticipated, it will have to be stronger than before.If at first an annual rate of price increase of five percent hadbeen sufficient, once five percent comes to be expectedsomething like seven percent or more will be necessary tohave the same stimulating effect which a five percent risehad before. And since, if inflation has already lasted forsome time, a great many activities will have becomedependent on its continuance at a progressive rate, we willhave a situation in which, in spite of rising prices, manyfirms will be making losses, and there may be substantialunemployment. Depression with rising prices is a typicalconsequence of a mere braking of the increase in the rate ofinflation once the economy has become geared to a certainrate of inflation.

All this means that, unless we are prepared to acceptconstantly increasing rates of inflation which in the endwould have to exceed any assignable limit, inflation canalways give only a temporary fillip to the economy, butmust not only cease to have stimulating effect but willalways leave us with a legacy of postponed adjustmentsand new maladjustments which make our problem moredifficult. Please note that I am not saying that once weembark on inflation we are bound to be drawn into agalloping hyper-inflation. I do not believe that this is true.


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All I am contending is that if we wanted to perpetuate thepeculiar prosperity-and-job-creating effects of inflation wewould have progressively to step it up and must never stopincreasing its rate. That this is so has been empiricallyconfirmed by the Great German inflation of the early1920s. So long as that increased at a geometrical rate therewas indeed (except towards the end) practically nounemployment. But till then every time merely the increaseof the rate of inflation slowed down, unemployment rapidlyassumed major proportions. I do not believe we shallfollow that path-at least not so long as tolerably responsiblepeople are at the helm-though I am not quite so sure that acontinuance of the monetary policies of the last decade maynot sooner or later create a position in which lessresponsible people will be put into command. But this isnot yet our problem. What we are experiencing is still onlywhat in Britain is known as the "stop-go" policy in whichfrom time to time the authorities get alarmed and try tobrake, but only with the result that even before the rise ofprices has been brought to a stop, unemployment begins toassume threatening proportions and the authorities feelforced to resume expansion. This sort of thing may go onfor quite some time, but I am not sure that the effectivenessof relatively minor doses of inflation in rekindling theboom is not rapidly decreasing. The one thing which, I willadmit, has surprised me about the boom of the last twentyyears is how long the effectiveness of resumed expansionin restarting the boom has lasted. My expectation was thatthis power of getting investment under way by a little morecredit expansion would much sooner exhaust itself-and itmay well be that we have now reached that point. But I amnot sure. We may well have another ten years of stop-gopolicy ahead of us, probably with decreasing effectiveness

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of the ordinary measures of monetary policy and longerintervals of recessions. Within the political framework andthe prevailing state of opinion the present chairman of theFederal Reserve Board will probably do as well as can beexpected by anybody. But the limitations imposed uponhim by circumstances beyond his control and to which Ishall have to turn in a moment may well greatly restrict hisability of doing what we would like to do.

On an earlier occasion on which several of you werepresent, I have compared the position of those responsiblefor monetary policy after a full employment policy hasbeen pursued for some time to "holding a tiger by the tail."It seems to me that these two positions have more incommon than is comfortable to contemplate. Not onlywould the tiger tend to run faster and faster and themovement bumpier and bumpier as one is dragged along,but also the prospective effects of letting go become moreand more frightening as the tiger becomes more enraged.That one is soon placed in such a position is the centralobjection against allowing inflation to run on for sometime. Another metaphor that has often been justly used inthis connection is the effects of drug-taking. The earlypleasant effects and the later necessity of a bitter choiceconstitute indeed a similar dilemma. Once placed in thisposition it is tempting to rely on palliatives and be contentwith overcoming short-term difficulties without ever facingthe basic trouble about which those solely responsible formonetary policy indeed can do little.

Before I proceed with this main point, however, I muststill say a few words about the alleged indispensability ofinflation as a condition of rapid growth. We shall see that


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modern developments of labor union policies in the highlyindustrialized countries may there indeed have created aposition in which both growth and a reasonably high andstable level of employment may, so long as those policiescontinue, make inflation the only effective means ofovercoming the obstacles created by them. But this doesnot mean that inflation is, in normal conditions, andespecially in less developed countries, required or evenfavorable for growth. None of the great industrial powers ofthe modern world has reached its position in periods ofdepreciating money. British prices in 1914 were, so far asmeaningful comparisons can be made over such longperiods, just about where they had been two hundred yearsbefore, and American prices in 1939 were also at about thesame level as at the earliest point of time for which we havedata, 1749. Though it is largely true that world history is ahistory of inflation, the few success stories we find are onthe whole the stories of countries and periods which havepreserved a stable currency; and in the past a deteriorationof the value of money has usually gone hand in hand witheconomic decay.

There is of course, no doubt that temporarily theproduction of capital goods can be increased by what iscalled "forced saving"-that is, credit expansion can be usedto direct a greater part of the current services of resourcesto the production of capital goods. At the end of such aperiod the physical quantity of capital goods existing willbe greater than it would otherwise have been. Some of thismay be a lasting gain-people may get houses in return forwhat they were not allowed to consume. But I am not sosure that such a forced growth of the stock of industrialequipment always makes a country richer, that is, that the

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value of its capital stock will afterwards be greater-or by itsassistance all-round productivity be increased more thanwould otherwise have been the case. If investment wasguided by the expectation of a higher rate of continuedinvestment (or a lower rate of interest, or a higher rate ofreal wages, which all come to the same thing) in the futurethan in fact will exist, this higher rate of investment mayhave done less to enhance overall productivity than a lowerrate of investment would have done if it had taken moreappropriate forms. This I regard as a particularly seriousdanger for underdeveloped countries that rely on inflationto step up the rate of investment. The regular effect of thisseems to me to be that a small fraction of the workers ofsuch countries is equipped with an amount of capital perhead much larger than it can hope within the foreseeablefuture to provide for all its workers, and that the investmentof the larger total in consequence does less to raise thegeneral standard of living than a smaller total more widelyand evenly spread would have done. Those who counselunderdeveloped countries to speed up the rate of growth byinflation seem to me wholly irresponsible to an almostcriminal degree. The one condition which, on Keynesianassumptions, makes inflation necessary to secure a fullutilization of resources, namely the rigidity of wage ratesdetermined by labor unions, is not present there. Andnothing I have seen of the effects of such policies, be it inSouth America, Africa, or Asia, can change my convictionthat in such countries inflation is entirely and exclusivelydamaging-producing a waste of resources and delaying thedevelopment of that spirit of rational calculation which isthe indispensable condition of the growth of an efficientmarket economy.


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The whole Keynesian argument for an expansionistcredit policy rests entirely and completely on the existenceof that union determined level of money wages which ischaracteristic of the industrially advanced countries of theWest but is absent in underdeveloped countries-and fordifferent reasons less marked in countries like Japan andGermany. It is only for those countries where, as it is said,money wages are "rigid downward" and are constantlypushed up by union pressure that a plausible case can bemade that a high level of employment can be maintainedonly by continuous inflation-and I have no doubt that wewill get this so long as those conditions persist. What hashappened here at the end of the last war has been thatprinciples of policy have been adopted, and often embodiedin the law, which in effect release unions of allresponsibility for the unemployment their wage policiesmay cause and place all responsibility for the preservationof full employment on the monetary and fiscal authorities.The latter are in effect required to provide enough moneyso that the supply of labor at the wages fixed by the unionscan be taken off the market. And since it cannot be deniedthat at least for a period of years the monetary authoritieshave the power by sufficient inflation to secure a high levelof employment, they will be forced by public opinion touse that instrument. This is the sole cause of theinflationary developments of the last twenty-five years, andit will continue to operate as long as we allow on the onehand the unions to drive up money wages to whatever levelthey can get employers to consent to-and these employersconsent to money wages with a present buying powerwhich they can accept only because they know themonetary authorities will partly undo the harm by lowering

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the purchasing power of money and thereby also the realequivalent of the agreed money wages.

This is the political fact which for the present makescontinued inflation inevitable and which can be altered notby any changes in monetary but only by changes in wagepolicy. Nobody should have any illusion about the fact thatso long as the present position on the labor market lasts weare bound to have continued inflation. Yet we cannot affordthis, not only because inflation becomes less and lesseffective even in preventing unemployment, but becauseafter it has lasted for some time and comes to operate at ahigh rate, it begins progressively to disorganize theeconomy and to create strong pressure for the imposition ofall kinds of controls. Open inflation is bad enough, butinflation repressed by controls is even worse: it is the realend of the market economy.

The hot iron which we must grasp if we are to preservethe enterprise system and the free market is, therefore, thepower of the unions over wages. Unless wages, andparticularly the relative wages in the different industries,are again subjected to the forces of the market and becometruly flexible, in particular groups downwards as well asupwards, there is no possibility for a non-inflationarypolicy. A very simple consideration shows that, if no wageis allowed to fall, all the changes in relative wages whichbecome necessary must be brought about by all the wagesexcept those who tend to fall relatively most being adjustedupwards. This means that practically all money wages mustrise if any change in the wage structure is to be broughtabout. Yet a labor union conceding a reduction of thewages of its members appears today to be an impossibility.


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Nobody, of course, gains from this situation, since the risein money wages must be offset by a depreciation of thevalue of money if no unemployment is to be caused. Itseems, however, a built-in necessity of that determinationof wages by collective bargaining by industrial or craftunions plus a full employment policy.

I believe that so long as this fundamental issue is notresolved, there is little to be hoped from any improvementof the machinery of monetary control. But this does notmean that the existing arrangements are satisfactory. Theyhave been designed precisely to make it easier to give in tothe necessities determined by the wage problem, i.e., tomake it easier for each country to inflate. The gold standardhas been destroyed chiefly because it was an obstacle toinflation. When in 1931 a few days after the suspension ofthe gold standard in Great Britain Lord Keynes wrote in aLondon newspaper that "there are few Englishmen who donot rejoice at the breaking of our gold fetters," and fifteenyears later could assure us that Bretton Woodsarrangements were "the opposite of the gold standard," allthis was directed against the very feature of the goldstandard by which it made impossible any prolongedinflationary policy of any one country. And though I amnot sure that the gold standard is the best conceivablearrangement for that purpose, it has been the only one thathas been fairly successful in doing so. It probably has manydefects, but the reason for which it has been destroyed wasnot one of them; and what has been put into its place is noimprovement. If, as I have recently heard it explained byone of the members of the original Bretton Woods group,their aim was to place the burden of adjustment ofinternational balances exclusively on the surplus countries,

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it seems to me the result of this must be continuedinternational inflation. But I only mention this inconclusion to show that if we are to avoid continued world-wide inflation, we need also a different internationalmonetary system. Yet the time when we can profitablythink about this will be only after the leading countrieshave solved their internal problems. Till then we probablyhave to be satisfied with makeshifts, and it seems to me thatat the present time, and so long as the fundamentaldifficulties I have considered continue to be present, thereis no chance of meeting the problem of internationalinflation by restoring an international gold standard, even ifthis were practical policy. The central problem which mustbe solved before we can hope for a satisfactory monetaryorder is the problem of wage determination.

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The Austrian Theory:A Summary∗∗

Roger W. GarrisonGrounded in the economic theory set out in Carl

Menger's Principles of Economics and built on the vision ofa capital-using production process developed in Eugen vonBöhm-Bawerk's Capital and Interest, the Austrian theoryof the business cycle remains sufficiently distinct to justifyits national identification. But even in its earliest renditionin Ludwig von Mises's Theory of Money and Credit and insubsequent exposition and extension in F. A. Hayek'sPrices and Production, the theory incorporated importantelements from Swedish and British economics. KnutWicksell's Interest and Prices, which showed how pricesrespond to a discrepancy between the bank rate and the realrate of interest, provided the basis for the Austrian accountof the misallocation of capital during the boom. The marketprocess that eventually reveals the intertemporalmisallocation and turns boom into bust resembles ananalogous process described by the British CurrencySchool, in which international misallocations induced bycredit expansion are subsequently eliminated by changes inthe terms of trade and hence in specie flow.

The Austrian theory of the business cycle emergesstraightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced

∗ This "Summary" is adapted from Roger W. Garrison, "The Austrian

Theory of the Business Cycle," in David Glasner, ed., Business Cycles andDepressions: An Encyclopedia (New York: Garland Publishing, 1996).

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boom, which is not. An increase in saving by individualsand a credit expansion orchestrated by the central bank setinto motion market processes whose initial allocationaleffects on the economy's capital structure are similar. Butthe ultimate consequences of the two processes stand instark contrast: Saving gets us genuine growth; creditexpansion gets us boom and bust.

The general thrust of the theory, though not the fullargument, can be stated in terms of the conventional macro-economic aggregates of saving and investment. The levelof investment is determined by the supply of and demandfor loanable funds, as shown in Figures 1a and 1b. Supplyreflects the willingness of individuals to save at variousrates of interest; demand reflects the willingness ofbusinesses to borrow and undertake investment projects.Each figure represents a state of equilibrium in the loanmarket: the market-clearing rate of interest is i, as shownon the vertical axis; the amount of income saved andborrowed for investment purposes is A, as shown on thehorizontal axis.

An increase in the supply of loanable funds, as shown inboth figures, has obvious initial effects on the interest rateand on the level of investment borrowing. But the marketprocess plays itself out differently depending upon whetherthe increased supply of loanable funds derives fromincreased saving by individuals or from increased creditcreation by the central bank.

Figure 1a shows the market's reaction to an increase inthe thriftiness of individuals, as represented by a shift of thesupply curve from S to<M> S'. People have become more


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future-oriented; they prefer to shift consumption from thepresent to the future. As a result of the increasedavailability of loanable funds, the rate of interest falls fromi to i', enticing businesses to undertake investment projectspreviously considered unprofitable. At the new lowermarket-clearing rate of interest, both saving and investmentincrease by the amount AB. This increase in the economy'sproductive capacity constitutes genuine growth.

Figure 1b shows the effect of an increase in creditcreation brought about by the central bank, as representedby a shift of the supply curve from S to S+delta M. Here itis assumed that people have not become more thrifty orfuture-oriented; the central bank has simply inflated thesupply of loanable funds by injecting new money intocredit markets. As the market-clearing rate of interest fallsfrom i to i', businesses are enticed to increase investment bythe amount AB, while genuine saving actually falls by theamount AC. Padding the supply of loanable funds withnewly created money holds the interest rate artificially lowand drives a wedge between saving and investment. Thelow bank rate of interest has stimulated growth in theabsence of any new saving. The credit-induced artificialboom is inherently unsustainable and is followed inevitablyby a bust, as investment falls back into line with saving.

Even in this simple loanable-funds framework, manyaspects of the Austrian theory of the business cycle areevident. The natural rate of interest is the rate that equatessaving and investment. The bank rate diverges from thenatural rate as a result of credit expansion. When newmoney is injected into credit markets, the injection effects,which the Austrian theorists emphasize over price-level

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effects, take the form of too much investment. And actualinvestment in excess of desired saving, -B, constitutes whatAustrian theorists call forced saving.

Other significant aspects of the Austrian theory of thebusiness cycle can be identified only after the simpleconcept of investment represented in Figures 1a and 1b isreplaced by the Austrian vision of a multistage, time-consuming production process. The rate of interest governsnot only the level of investment but also the allocation ofresources within the investment sector. The economy'sintertemporal structure of production consists of investmentsubaggregates, which are defined in terms of their temporalrelationship to the consumer goods they help to produce.Some stages of production, such as research anddevelopment and resource extraction, are temporally distantfrom the output of consumer goods. Other stages, such aswholesale and retail operations, are temporally close tofinal goods in the hands of consumers. As implied bystandard calculations of discounted factor values, interest-rate sensitivity increases with the temporal distance of theinvestment subaggregate, or stage of production, from finalconsumption.

The interest rate governs the intertemporal pattern ofresource allocation. For an economy to exhibit equilibratingtendencies over time, the intertemporal pattern of resourceallocation must adjust to changes in the intertemporalpattern of consumption preferences. An increase in the rateof saving implies a change in the preferred consumptionpattern such that planned consumption is shifted from thenear future to the remote future. A savings-induceddecrease in the rate of interest favors investment over


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current consumption, as shown in Figures 1a and 1b.Further-and more significant in Austrian theorizing-itfavors investment in more durable over less durable capitaland in capital suited for temporally more remote rather thanless remote stages of production. These are the kinds ofchanges within the capital structure that are necessary toshift output from the near future to the more remote futurein conformity with changing intertemporal consumptionpreferences.

The shift of capital away from final output-and hencethe shift of output towards the more remote future-can alsobe induced by credit creation. However, the credit-induceddecrease in the rate of interest engenders a disconformitybetween intertemporal resource usage and intertemporalconsumption preferences. Market mechanisms that allocateresources within the capital structure are imperfect enoughto permit substantial intertemporal disequilibria, but themarket process that shifts output from the near to the moreremote future when savings preferences have not changedis bound to be ill-fated. The spending pattern of incomeearners clashes with the production decisions that generatedtheir income. The intertemporal mismatch between earningand spending patterns eventually turns boom into bust.More specifically, the artificially low rate of interest thattriggered the boom eventually gives way to a high real rateof interest as overcommitted investors bid against oneanother for increasingly scarce resources. The bust, whichis simply the market's recognition of the unsustainability ofthe boom, is followed by liquidation and capitalrestructuring through which production activities arebrought back into conformity with consumptionpreferences.

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Mainstream macroeconomics bypasses all issuesinvolving intertemporal capital structure by positing asimple inverse relationship between aggregate (net)investment and the interest rate. The investment aggregateis typically taken to be interest-inelastic in the context ofshort-run macroeconomic theory and policy prescriptionand interest-elastic in the context of long-run growth.Further, the very simplicity of this formulation suggeststhat expectations-which are formulated in the light ofcurrent and anticipated policy prescriptions-can make orbreak policy effectiveness. The Austrian theory recognizesthat whatever the interest elasticity of the conventionallydefined investment aggregate, the impact of interest-ratemovements on the structure of capital is crucial to themaintenance of intertemporal equilibrium. Changes withinthe capital structure may be significant even when thechange in net investment is not. And those structuralchanges can be equilibrating or disequilibrating dependingon whether they are savings-induced or credit-induced, or-more generally-depending on whether they are preference-induced or policy-induced. Further, the very complexity ofthe interplay between preferences and policy within amultistage intertemporal capital structure suggests thatmarket participants cannot fully sort out and hedge againstthe effects of policy on product and factor prices.

In mainstream theory, a change in the conventionallydefined investment aggregate not accommodated by anincrease in saving, commonly identified as overinvestmentand represented as -B in Figure 1b, is often downplayed onboth theoretical and empirical grounds. In Austrian theory,the possibility of overinvestment is recognized, but the


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central concern is with the more complex and insidiousmalinvestment (not represented at all in Figure 1b) whichinvolves the intertemporal misallocation of resourceswithin the capital structure.

Conventionally, business cycles are marked by changesin employment and in total output. The Austrian theorysuggests that the boom and bust are more meaningfullyidentified with intertemporal misallocations of resourceswithin the economy's capital structure followed byliquidation and capital restructuring. Under extremeassumptions about labor mobility, an economy couldundergo policy-induced intertemporal misallocations andthe subsequent reallocation with no change in totalemployment. Actual market processes, however, involveadjustments in both capital and labor markets that translatecapital-market misallocations into labor-marketfluctuations. During the artificial boom, when workers arebid away from late stages of production into earlier stages,unemployment is low; when the boom ends, workers aresimply released from failing businesses, and theirabsorption into new or surviving firms is time-consuming.

Mainstream theory distinguishes between broadlyconceived structural unemployment (a mismatch of jobopenings and job applicants) and cyclical unemployment (adecrease in job openings). In the Austrian view, cyclicalunemployment is, at least initially, a particular kind ofstructural unemployment: the credit-induced restructuringof capital has created too many jobs in the early stages ofproduction. A relatively high level of unemploymentushered in by the bust involves workers whose subsequent

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employment prospects depend on reversing the credit-induced capital restructuring.

The Austrian theory allows for the possibility that whilemalinvested capital is being liquidated and reabsorbedelsewhere in the economy's intertemporal capital structure,unemployment can increase dramatically as reducedincomes and reduced spending feed upon one another. Theself-aggravating contraction of economic activity wasdesignated as a "secondary depression" by the Austrians todistinguish it from the structural maladjustment that, intheir view, is the primary problem. By contrast, mainstreamtheories, particularly Keynesianism, which ignore theintertemporal capital structure, deal exclusively with thedownward spiral.

Questions of policy and institutional reform areanswered differently by Austrian and mainstreameconomists because of the difference in focus as betweenintertemporal misallocations and downward spirals. TheAustrians, who see the intertemporal distortion of thecapital structure as the more fundamental problem,recommend monetary reform aimed at avoiding credit-induced booms. Hard money and decentralized banking arekey elements of the Austrian reform agenda. Mainstreammacroeconomists take structural problems (intertemporal orotherwise) to be completely separate from the generalproblem of demand deficiency and the periodic problem ofdownward spirals of demand and income. Their policyprescriptions, which include fiscal and monetary stimulantsaimed at maintaining economic expansion, are seen by theAustrians as the primary source of intertemporal distortionsof the capital structure.


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Although the purging in the 1930s of capital theory frommacroeconomics consigned the Austrian theory of thebusiness cycle to a minority view, a number of economistsworking within the Austrian tradition continue thedevelopment of capital-based macroeconomics.

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Further Reading

Bellante, Don and Roger W. Garrison. "Phillips Curvesand Hayekian Triangles: Two Perspectives on MonetaryDynamics," History of Political Economy 20, no. 2(Summer 1988): 207-34.

Butos, William N. "The Recession and AustrianBusiness Cycle Theory: An Empirical Perspective,"Critical Review7, nos. 2-3 (Spring-Winter 1993): 277-306.

Garrison, Roger W. "Austrian Capital Theory and theFuture of Macroeconomics," in Richard M. Ebeling, ed.Austrian Economics: Perspectives on the Past andProspects for the Future (Hillsdale, Mich.: HillsdaleCollege Press, 1991), pp. 303-24.

"The Austrian Theory of the Business Cycle in the Lightof Modern Macroeconomics," [PDF File] Review ofAustrian Economics 3 (1989): 3-29.

"The Hayekian Trade Cycle Theory: A Reappraisal,"Cato Journal 6, no. 2 (Fall 1986): 437-53.

"Time and Money: The Universals of MacroeconomicTheorizing," <i>Journal of Macroeconomics</i> 6, no. 2(Spring 1984): 197-213.

O'Driscoll, Gerald P., Jr. Economics as a CoordinationProblem: The Contribution of Friedrich A. Hayek (KansasCity: Sheed Andrews and McMeel, 1977).

Mises, Ludwig von, Human Action: A Treatise onEconomics. (Chicago: Henry Regnery Company) pp. 538.

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Rothbard, Murray N. The Case Against the Fed(Auburn, Ala.: Ludwig von Mises Institute, 1995).

Skousen, Mark. The Structure of Production (NewYork: New York University Press, 1990).

Wainhouse, Charles E. "Empirical Evidence for Hayek'sTheory of Economic Fluctuations," in Barry N. Siegel, ed.,Money in Crises: The Federal Reserve, the Economy, andMonetary Reform (Cambridge, Mass.: Ballinger Publishing,1984), pp. 37-66.

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About the Authors

Ludwig von Mises (1881-1973), leading proponent ofthe Austrian School in the 20th century, received hisdoctorate from the University of Vienna, where he taught.He was also economic advisor to the Austrian Chamber ofCommerce. Mises later taught at the Graduate Institute forInternational Studies in Geneva and New York University.His most important works include The Theory of Moneyand Credit, Socialism Theory and History, and HumanAction.

Gottfried Haberler (1900-1995) received his doctoratefrom the University of Vienna, and taught there as well asat Harvard University. A student of Mises's, he was alsoresident scholar at the American Enterprise Institute and adistinguished scholar of the Ludwig von Mises Institute.His most important works include The Sense of IndexNumbers, Theory of International Trade, Prosperity andDepression, and Economic Growth and Stability.

Murray N. Rothbard (1926-1995) received hisdoctorate from Columbia University. He also studied withMises at New York University. He taught at New YorkPolytechnic Institute and the University of Nevada, LasVegas, where he held the S.J. Hall Chair. He was alsoacademic vice president of the Ludwig von Mises Institutefrom its founding. His most important works include Man,Economy, and State, Power and Market, America's GreatDepression, and The History of Economic Thought.

On-Line links include: What Has Government Done toOur Money,

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Freedom, Inequality, Primitivism, and the Division ofLabor

"Economic Depression: Their Cause and Cure”.

Friedrich A. Hayek (1899-1992) received his doctoratefrom the University of Vienna, and taught there as well asat the London School of Economics, the University ofChicago, and the University of Freiburg. A student ofMises's and the recipient of the Nobel Prize in Economicsfor his work with Mises, Hayek was a distinguished scholarof the Ludwig von Mises Institute. His most importantworks include Prices and Production, Monetary Theoryand the Trade Cycle, Monetary Nationalism andInternational Stability, and The Pure Theory of Capital.

Roger W. Garrison received his doctorate from theUniversity of Virginia and is Professor of Economics atAuburn University. He lectures for the Ludwig von MisesInstitute and directs its Austrian Economics Workshop. Heis also the author of many important articles onmacroeconomics, and is considered a leading business-cycle theorist in the Austrian School. On-Line linksinclude:

In Defense of the Misesian Theory of Interest [PDFFile] Journal of Libertarian Studies 3:2 (Winter 1978):141-50;

West's "Cantillon and Adam Smith" : A Comment [PDFFile] Journal of Libertarian Studies 7:2 (Summer 1983):287-94;

http://www.libertarianstudies.org/journals/jls/pdfs/3_2/3_2_2.pdf



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The Austrian Theory of the Business Cycle in the Lightof Modern Macroeconomics [PDF File] The Review ofAustrian Economics 3:1;

New Classical and Old Austrian Economics:Equilibrium Business Cycle Theory in Perspective [PDF

File] The Review of Austrian Economics 5:1;

The Federal Reserve: Then and Now [PDF File] TheReview of Austrian Economics 8:1;

Keynes Was a Keynesian [PDF File] The Review ofAustrian Economics9:1;

Central Banking, Free Banking, and Financial Crises[PDF File] The Review of Austrian Economics 9:2;

The Intertemporal Adam Smith [PDF File] The Quarterly Journal Of Austrian

Economics > 1:1 (Spring 1998).

journals/rae/pdf/R3_1.pdf

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