The Causes of the Economic Crisis

The Prophet of the Great Depression
By Frank Shostak

The Causes of the Economic Crisis is a collection of articles on the business cycle, money, and exchange rates by Ludwig von Mises that appeared between 1919 and 1946. Here we have the evidence that the master economist foresaw and warned against the breakdown of the German mark, as well as the market crash of 1929 and the depression that followed.

Mises presents his business cycle theory in its most elaborate form, applies it to the prevailing conditions, and discusses the policies that governments undertake that make recessions worse (even before Keynes's General Theory appeared!). He recommends a path for monetary reform that would eliminate business cycles as we have known them and provide the basis for a sustainable prosperity.

In foreseeing the interwar economic breakdown, Mises was nearly alone among his contemporaries — which is particularly interesting because Mises made no claim to possessing clairvoyant powers. To him, economics is a qualitative discipline. But among those who say that economics must be quantitative with the goal of accurate prediction, neither the pre-monetarists of the Fisher school nor the Keynesians foresaw the economic damage that would result from central bank policies that manipulate the supply of money and credit.

Why is this? Most economists were looking at the price level and growth rates as indicators of economic health. Mises's theoretical insights led him to look more deeply, and to elucidate the impact of credit expansion on the entire structure of the capitalistic production process.
The essays were well known to contemporary German-speaking audiences. They had not come to the attention of English audiences until 1978, four years after F.A. Hayek was awarded the Nobel Prize for, in particular, "his theory of business cycles and his conception of the effects of monetary and credit policies." In tribute to Hayek's excellent contributions, the Austrian theory of the business cycle has long been called a Hayekian theory.

But it might be more justly called the Misesian theory, for it was Mises who first presented it in his 1912 bookand elaborated it so fully in the essays presented in this new book from the Mises Institute.

Although the articles address issues that were debated many years ago, the analysis presented by Mises are as relevant today as they were in his time. Mises reached his conclusions regarding events of the day by means of a coherent theory, as applied to current events, rather than attempting to derive a theory from data alone, as many of his contemporaries did. This is what gave his writings their predictive power then, and it is what makes his writings fresh and relevant today. A proper economic theory such as Mises presents here applies in all times and places.

As in the past, most economists today believe that sophisticated mathematical and statistical methods can torture the data enough to reveal some causal link between events and yield a theory of inflation and the business cycle. But this is a senseless exercise. It is no more fruitful than a purely descriptive account and it has no more predictive value than a simple data extrapolation.

These essays have been buried in obscurity for far too long. How fortunate we are to have them in a form that can reach a mass audience. Reading the writings of this great master economist might convince some economists and policy makers that there is no substitute for sound thinking. Economics is far too important a subject to be left in the hands of the trend extrapolators, data torturers, and monetary central planners who rely on them.

Do we need ever more money?

In his articles from 1919 to 1923. Mises addressed the factors that were responsible for German hyperinflation. For Mises, inflation is defined as money creation, the act of which tends to manifest itself through the fall in the purchasing power of money (PPM). Thus for a given demand for money, an increase in its supply lowers the PPM.

Whenever monetary authorities allow the rate of monetary pumping to proceed at an accelerating pace, the purchasing power of money tends to fall by a much larger percentage than the rate of increase in money supply. Mises attributed this to increases in inflationary expectations. Peoples' expectation that the future PPM is likely to fall causes them to lower the present demand for money. This sets in motion a mechanism that, if allowed to continue unabated, can ultimately break the monetary system.

Inflationary expectations lead the suppliers of goods to ask for prices that are above what the holders of money can pay. Potential buyers don't have the money to purchase the goods. The emerging shortage of money, according to Mises, is an indication that the inflationary process has gained pace and cannot be "fixed" by raising the supply of money. On the contrary, policies that accommodate this shortage can only make things much worse. Ultimately, the sellers demand astronomical prices, transactions with inflated money become impossible, and the monetary system falls apart.

Mises argued that without an impenetrable link to gold, it is not possible to eradicate inflation. Gold cannot be printed, and it thereby evades the politicians' desires and wishes and keeps the economy healthy. For Mises, the real purpose of paper money is to give politicians control over the supply of money. In response to the view that there is not enough gold to support growing trade, Mises argued that any given amount of gold can fulfill all that money is required to do: provide the services of a medium of exchange. Additional quantities of gold cannot improve on the economic function of money.

It was also Mises's view that the international exchange rate of the domestic money tends to follow inflationary trends, all other things being equal. For Mises, a currency rate of exchange is determined by the relative purchasing power of respective monies. Any rate of exchange that deviates from the relative purchasing power of money makes it profitable to sell commodities for overvalued money and buy commodities with undervalued money. This brings the rate of exchange of a currency in line with the relative purchasing power of respective monies. This opinion clashes with popular thinking both then and today that the currency rate of exchange is set by the state of the balance of payments.

Do we need policies aimed at stabilizing prices?

Having established that the purchasing power of money is set by the relative supply and demand for money, Mises ridiculed the view that the PPM can or should be "stable." The notion of stability is compatible only with the imaginary conditions of economic equilibrium — a state of no change. Money is of little use in the state of equilibrium; it is only of use in the state of change.

What's more, once we accept stability as a policy goal, it would appear that having a money paper standard is a policy solution. Only a central bank should manipulate the money supply to bring about price stability and economic equilibrium. In this view, the existence of the gold standard is the major obstacle for attaining the goal of price stability, since the supply of gold is not under the control of the stabilizers, i.e., the central bankers.

There is a problem here, however. Even if we were to agree that the stable purchasing power of money leads to better economic conditions, we need to be able to quantify the PPM to provide a benchmark. But there are no means to determine scientifically the total purchasing power of money (PPM). The various price indexes that were suggested by the American economist Irving Fisher to calculate the PPM were just exercises in wishful thinking. For instance, there is no way to determine what type of average one should select in establishing the average price, and there are no objective criteria to prefer a geometrical average over an arithmetical average.
Mises raises the issue of weighing the importance of various goods in the index. In the world of change such weighting — i.e., the importance people attach to various goods and services — is constantly in flux. So even if one ignores various mathematical problems associated with the construction of price indexes, they can at best only describe frozen human beings, or automatons.

Mises concludes that policies of stabilizing the price level must only lead to more instability. Why? Because policies of stabilizing the PPM are in fact tampering with the prices of goods, which by implication must be a destabilizing act. Also, these policies generate a redistribution of wealth from the late receivers of the newly injected money to the early receivers of money. Some individuals derive benefit at the expense of other individuals.

Economic Business Cycles And Their Causes

In the slump of a cycle, businesses that were thriving come to experience difficulties or go under. They do so not because of firm-specific entrepreneurial errors but rather in tandem with whole sectors of the economy. People who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs.
Businessmen themselves are confused as to why. They cannot make sense of why certain business practices that were profitable yesterday are losing money today. Bad business conditions emerge when least expected — just when all businesses are holding the view that a new age of steady and rapid progress has emerged.

In his writings, Mises argued against the prevailing explanation of the business cycle by overproduction and under-consumption theories, and he critically addressed various theories that depended on vague notions of mass psychology and irregular shocks. In the psychological explanation, an increase in people's confidence regarding future business conditions gives rise to an economic boom. Conversely, a sudden fall in confidence sets in motion business stagnation. Now, there can be no doubt that during a recession people are less confident about the future than during good times. But to observe this is not to explain it. Likewise theories that view various shocks and disruptions as the central cause behind boom-bust cycles do not advance our knowledge regarding the boom-bust cycle phenomenon.

Neither explains how the boom and bust come about, nor why they are of a recurrent nature. To arrive at a correct explanation, we need to trace the change in business conditions back to a previously established and identified phenomena, and that is precisely what these theories do not do. Hence Mises concluded that all these theories do not provide an explanation but rather describe the phenomenon in a different way. That is to say, it does not help us to understand rain to define it as something that makes the ground wet.

Mises also held that various statistical and mathematical methods are others ways of describing but not explaining events. Statistical methods make it possible to generate charts of data fluctuations but they do not improve on our knowledge of what causes the fluctuations.

The Circulation Credit Theory of Business Cycles

Mises made a distinction between credit that is backed by savings, and credit that does not have any backing. The first type of credit he labeled commodity credit. The second he labeled circulation credit. It is circulation credit that plays the key role in setting the boom-bust cycle process.

Consider a producer of consumer goods who consumes part of his produce while saving the rest. In the market economy, our producer could exchange the saved goods for money. The money that he receives can be seen as a receipt as it were for the goods produced and saved. The receipt is his claim on the goods. He can then make a decision to lend the money to another producer through the mediation of a bank. By lending the money of the original saver, the lender transfers his claims on real savings to the borrower. The borrower can now use the money — i.e., the claims — and secure consumer goods that will support him while he is engaged in the production of other goods (say, tools and machinery).

The credit in this case is fully backed by savings and permits the expansion of tools and machinery. With better infrastructure, it is now possible to produce not only more goods but goods of a better quality. The expansion of real wealth is now possible. Once a lender lends his money, he relinquishes his claims on real goods for the duration of the loan.

In an unhampered market economy, borrowers are users of savings who make sure that savings are employed in the most efficient way: generating profits. This means that real savings are employed in accordance with consumers' most important priorities. We can thus see here that as long as banks facilitate commodity credit, they should be seen as agents of wealth generation.

In contrast, whenever banks embark on the lending of circulation credit they in fact become agents of real wealth destruction. As opposed to commodity credit, circulation credit is not supported by any real saving. This type of credit is just an empty claim created by banks. In the case of commodity credit, the borrower secures goods that were produced and saved for him. This is, however, not the case with respect to the circulation credit. No goods were produced and saved here. Once the borrower uses the unbacked claims, it is at the expense of the holders of fully backed claims. In this way, circulation credit undermines the true wealth generators.

Now, as a result of an increase in the supply of circulation credit money, market interest rates fall below the natural rate, that is, the rate that would be established by supply and demand if real goods were loaned directly in barter without the use of money. (In his later articles, Mises referred to the natural rate as the rate that would be established in a free market.)

As a result of the artificial lowering of interest rates, businesses undertake various new capital projects to expand and lengthen the production structure. Prior to the lowering of interest rates, these capital projects didn't appear to be profitable. Now, however, as money market rates are kept below the natural rate, economic activity zooms ahead and an economic boom emerges.
Such a situation cannot last. Mises here explains the important role played by the subsistence fund. The expansion of the production structure is always constrained by the availability of the means of sustenance (saved consumer goods) to maintain workers during the period of the expansion and the enhancement of the production structure.

The forced lowering of interest rates bring into being production processes that would not otherwise be undertaken. A production structure is now created that produces goods and services that consumers in fact cannot afford. Instead of using the limited pool of the means of sustenance to make tools and machinery that will generate consumer goods on the highest individual priority list, the means of sustenance are wasted on capital goods that are geared towards the production of low-priority consumer goods. At some point, the producers of such goods will discover that they cannot make a profit or even complete their plans. What we have here is not over-investment but misdirected investment or malinvestment.

The expansion of the production structure takes time and the limited subsistence fund may not be sufficient to support the expansion of the capital structure. If the new flow of the production of consumer goods does not emerge quickly enough to replace the currently consumed consumer goods, the subsistence fund comes under pressure.

At some point in time, banks discover that they don't have the savings to back their loans and that marginal businesses are starting to under-perform. All this causes them to curtail the expansion of circulation credit, which in turn raises interest rates. This undermines business funding, and can often be the precipitating event that leads to an economic bust.

Mises wrote that the bust phase of the business cycle process could be precipitated by other events. The expansion in the money supply enriches the early receivers of money. Those individuals who have now become wealthier as a result of receiving the money may alter their pattern of consumption. This may force businesses to adjust to this new setup. Once the rate of expansion in money slows down or comes to a halt, the new pattern of consumption cannot be supported and the new capital structure that was erected becomes unprofitable and must be abandoned.

It is not surprising that Mises was strongly opposed to the idea that central banks should impose "low" interest rates during a recession in order to keep the economy going. Instead, he believed that the policy makers should not engage in the artificial lowering of interest rates but rather refrain from any attempts to manage the economy via monetary policy. By curtailing its interference with businesses, the central bank provides breathing space to wealth generators and thereby lays the foundation for a durable economic recovery.

In the shelves of books on the business cycle, this one stands out for its theoretical clarity and also its historical prescience. May its appearance earn for Mises his rightful place in history as an economist who dared to break with the pack, think for himself, and provide a clear explanation while everyone else was in panic.