Looking to the next few years, will America and the world continue to ride a wave of economic growth, improved living standards, and technological changes that raise the quality of life? Or will this turn out to be, at least partly, an artificial economic boom that ends in another economic bust?
Reading the economic tea leaves is never an easy task. But the Austrian theory of the business cycle offers clues of what may be in store. In 1928, the famous Austrian economist Ludwig von Mises published a monograph called Monetary Stabilization and Cyclical Policy. It was an extension of his earlier work, The Theory of Money and Credit (1912).
Many things have happened, of course, over the last nine decades—the Great Depression, the Second World War, the Cold War, the end of the Soviet Union, roller coasters of inflations and recessions, replacement of gold with paper monies, the dramatic expansion of the welfare state, and an era of government debt fed by deficit spending to cover the costs of political largesse.
Then, as today, many governments were busy manipulating the supply of money and credit.
Yet, the laws of economics have not been overturned. As a result, like causes still bring about like effects. Minimum wage laws still price some workers out of the labor market whose value added to the employer is less than what the government dictates he must be paid. Rent controls and restrictive zoning laws create housing shortages when government interferes with market-based pricing.
Mises’ Monetary and Business Cycle Analysis Still Relevant Today
This is no less the case in the area of money and banking. When Mises published Monetary Stabilization and Cyclical Policy in 1928, most of the major countries of the world where still on some version of the gold standard. But that world was still recovering from the political, economic, social, and monetary catastrophes of the First World War (1914-1918) and was on the verge of the Great Depression.
Then, as today, many governments were busy manipulating the supply of money and credit. The goals of governments and their central banks may have been somewhat different ninety years ago, but they followed the same logic as today: monetary central planning with the intent to manage the economy as a whole.
There were still ways governments could influence the monetary system and the value of money.
In Monetary Stabilization, Mises reminded readers that before 1914, the leading nations of the world, especially in Europe and North America, had monetary systems based on a gold standard. These were, indeed, government-managed gold standards through national central banks, but nonetheless, they limited the amount of currency these authorities could inject into their respective economies. To a noticeable degree, Mises emphasized, it had removed the government’s hand from the handle of the monetary printing press. There were still ways governments could influence the monetary system and the value of money, but the methods were more indirect and less open to manipulation.
In the wake of the monetary madness during and immediately following the First World War, when some countries suffered massive hyperinflation (such as Germany and Mises’ homeland of Austria), there had been halting and partial attempts to return to versions of the gold standard. (See my articles, “War, Big Government, and Lost Freedoms” and “Lessons from the Great Austrian Inflation”.)
Price Level Stabilization vs. the Changing Value of Money
In the 1920s, the goal of government monetary policy, especially in the United States, became price level stabilization. American economists, such as Irving Fisher, argued that central banks should manage the creation of money and credit to maintain stable prices. This would require injections of larger quantities of money into the economy when a general price index was measured as tending to decline and withdrawals of money from the economy when such a price index was tending to rise.
But money in the marketplace, unlike other goods, has no single price. It possesses as many prices as the goods against which it trades.
Mises’ critical response was two-pronged. First, he pointed out that all general price indices were statistical fictions that had no absolute scientific validity or precision. Money is the most widely used and generally accepted medium of exchange. It facilitates an easier and less costly exchange of goods and services between multitudes of market transactors.
But money has no single price or exchange ratio in the market, unlike other goods. In a money-using economy, it becomes the practice and pattern for everyone to first trade the good or service they specialize in offering on the market for a sum of money: two dollars for a box of breakfast cereal; twenty-five dollars for a restaurant meal; seventy-five dollars for a pair of blue jeans; four hundred dollars for prescription sunglasses, etc. Thus, every good offered on the market tends to, competitively, have one market price at any moment of time—its money price.
But money in the marketplace, unlike other goods, has no single price. It possesses as many prices as the goods against which it trades. Hence, money’s general value or purchasing power is represented in the set, or array, or structure of relative money prices.
The Fictions of a Price Index
For many decades in the 19th century, economic historians and statisticians had diligently worked to devise various ways to construct “index numbers” as an average measurement of the general value of money and changes in it. But Mises had become well known as a critic of such attempts. He pointed out the limits in the construction of a hypothetical “basket” of goods, the value or cost of which was to be tracked through time:
- There had to be a decision as to which goods were to be considered “representative” of the purchases of an average consumer and placed in this imaginary basket when in reality there are as many buying patterns for different goods and combinations of goods as there are individuals making choices in the market;
- There needed to be a decision concerning the “weight” assigned to each good in the imaginary basket; that is, a relative amount of each good presumed to be consumed per period of time for following the cost of buying the basket. In reality, these relative amounts can widely vary based upon each person’s preferences and ability to pay;
- It needed to be assumed that, in spite of constant real-world changes in market supplies and demands that might influence a person’s willingness or ability in buying different amounts or types of goods in this basket, this representative consumer’s buying patterns remained the same over time; and,
- It needed to be assumed that changes in the qualities and characteristics of the goods offered on the market did not influence this representative consumer’s judgment concerning the real relative worth of any of the goods that might otherwise affect this artificial buyer’s purchasing decisions.
Without some version of these assumptions, there is no common denominator—a given basket of particular goods unchanging in the relative amounts purchased due to no change in the artificial representative consumer’s buying patterns from either a change in taste or relative price or worth of the items bought—so to compare what the same basket of goods costs over extended periods of time. (And, thus, whether, the basket has become more or less costly to buy “tomorrow” compared to “today,” or perhaps simply costs the same.)
The details and construction of various price indices have become more sophisticated and complex since Mises wrote his original criticism of index number methods (for example, “chain-weighted” techniques meant to reduce the impact of any changes in the basket by averaging out these changes over periods of time). But the core criticisms remain the same because of the reality of the diversity and changeability in the buying patterns of individuals whose choices make up the market process. (See my article, “The Consumer Price Index, A False Indicator of Our Individual Costs-of-Living”)
The Complexity of Inflation and the Non-Neutrality of Money
Secondly, Mises emphasized that when focusing on the average change in a general “price level,” it is easy to assume that changes in the money supply impact prices more or less at the same time and to the same degree. Mises became well known for drawing attention to the fact that changes in the supply of money and credit, in fact, are “non-neutral” in their effects in the economy.
The impact and influence of any monetary changes reflect the “inject” point from which they are introduced.
That is, changes in the money supply are not like manna from heaven impacting everyone at the same time, to the same degree. The impact and influence of any monetary changes reflect the “inject” point from which they are introduced. Suppose there is an increase, say, in the gold supply due to the discovery and mining of new gold fields. The 19th-century classical economist John E. Cairnes insightfully traced the history of how the Australian gold discoveries in the 1840s and 1850s set in motion a worldwide monetary rippling effect.
It started in the Australian coastal cities and towns where gold prospectors and miners spent their newly-mined gold, raising the prices for the particular goods and services they demanded from Australian merchants. As the new gold supplies passed into the hands of Australian merchants, they demanded more goods for imports from European wholesalers and manufacturers, which slowly but surely pushed up prices in European markets. These European producers then spent their new gold money receipts on increasing their demands for resources and raw materials and other inputs, which they imported from Latin America, Asia, and Africa.
Prices around the world increased as a result of the increase in the quantity of gold money injected into the global market starting in Australia. But, as Cairnes emphasized, there was a temporal sequence, with prices rising in a distinct pattern over time reflecting who had the new money first, second, third, and so on, bringing about a rise in some prices. The final result, of course, was a decline in the purchasing power of money due to an increase in the supply of money relative to the demand for holding money for transactions and other purposes. But it was neither proportional nor simultaneous. (See, John E. Cairnes, Essays in Political Economy: Theoretical and Applied  pp. 1-165.)
Savings, Investment and the Rate of Interest
The other major theme in Monetary Stabilization was that the institutional manner in which governments attempt to influence the amount of money and credit within an economy carried with it the potential to set in motion the phases of the business cycle—that is, an inflationary boom followed by a recessionary bust.
Interest rates are meant to facilitate the transfer of and access to the use of resources and the employment of labor for desirable uses closer to the present.
Central banks inject additional “reserves” into the banking system which serve as the means for financial institutions to increase their lending to interested and willing borrowers. However, a primary means by which banks with new excess reserves can attract potential borrowers to take on additional lending is to reduce the cost of loans. This means lowering the rates of interest at which additional money loans may be had.
What is the purpose of market-based rates of interest? They are the intertemporal prices at which savers choose to set aside, for a period of time, portions of previously earned income in the form of savings which are made available to others who desire access to portions of the scarce means of production for, most frequently, investment purposes that their own incomes are not sufficient to undertake. Thus, interest rates are meant to facilitate the transfer of and access to the use of resources and the employment of labor for desirable uses closer to the present to those involving more time-consuming production processes.
Thus, market interest rates are meant to reflect the supply of and demand for real savings and to balance the two sides of the market so investment activities are limited to and undertaken for investment periods consistent with the willingness and decisions of other income-earners to forgo the use of that savings for equivalent periods of time. Thus, market-based interest rates coordinate savings and investment in consistent ways over time. Investment plans tend to be compatible with the demands of savers willing to forgo finished goods in the present in exchange for more and different consumer goods in the future.
Monetary Expansion and Interest Rates Manipulation
The heart of Ludwig von Mises’ “Austrian” theory of the business cycle is that by expanding the money supply through the banking system and, as a consequence, tending to lower rates of interest in the financial markets, like any price artificially pushed below its market-clearing or “equilibrium” level, it generates a quantity demanded in excess of quantity supplied. In any other market, if the government artificially manipulates a price below its market-clearing level, it tends to bring about a shortage, that is, a desire by people to buy more of a good than is available to be purchased from willing sellers.
Instead, the trading of goods and services is done through the use of money, the market’s medium of exchange.
But with monetary expansion, an illusion is created that there is, in fact, more real savings available to undertake more investments and more time-consuming investments that is actually the case. People do not trade saved goods and resources across time from the hands of savers into the hands of investment borrowers like might be the case in some hypothetical system of direct barter exchange.
Instead, the trading of goods and services is done through the use of money, the market’s medium of exchange. People forgo buying all the real goods and services they might have with the money income they have previously earned. They supply that money-savings to interested investment borrowers through the intermediation of banks into which those savers have deposited their savings. Those borrowers take up that savings through banks and use it to hire, purchase, and employ available factors of production that have been freed up for such uses.
But, now, the central bank has created an increased amount of the medium of exchange through the banking system. Borrowers are able to obtain larger loans, not representing real savings (in the form of money) set aside by actual savers, but with created bank credit.
With an increase in the amount of money available for spending and investment purposes in the economy as a whole, over time there will be (all other things given) a tendency for a general rise in prices—that is, a possible price inflation. But a central point in Mises’ analysis is to argue that prices do not rise simultaneously or to the same degree. The banking system serves as the “injection point” from which the inflationary process is set in motion.
In this inflationary process, some demands and prices necessarily rise before others.
First, the prices for those goods demanded by investment borrowers will tend to be nudged up. The money they spend is then passed on as additional revenues to those from whom they buy (or in the case of labor, those they hire) for the investment projects of different types and durations they now attempt to undertake. Those who have received these additional sums of created money as additional revenues increase their demands for the specific goods and services.
In this inflationary process, some demands and prices necessarily rise before others. This influences the relative profitability of different economic and investment activities, which, in turn, influences the allocation and use of resources, labor, and capital goods in different ways across sectors in the economy. The entire structure of the economy is skewed toward greater and more time-consuming investment projects that, in fact, the actual savings in the economy cannot sustain in the long-run.
Unsustainability of the Boom Phase of the Business Cycle
The inflation-induced distortions are not sustainable. The use of resources across time is out of balance with the desire and willingness of actual income-earners to consume and save. The “crisis” comes when these imbalances finally reach a breaking point, and it is discovered that the hoped-for investment profitability has been unmasked as serious mal-investments, many of which not only turn unprofitable but which cannot be brought to completion. The economy then goes through an adjustment period, a process of “rebalancing” of prices and costs, as well as reallocations of labor and resources between various sectors of the market that is labeled the “recession” or the “bust” or, when severe enough, the “depression” phase of the business cycle.
It was due to governments introducing regulations, controls, interventions, and tax burdens that hindered the market from successfully “rebalancing” the economy.
This “Austrian” analysis became the basis for Ludwig von Mises and his younger friend and protégé, Friedrich A. Hayek, to explain in the 1930s the causes and consequences of the Great Depression. The attempt to “stabilize” the general price level though central bank monetary manipulation, especially by the American Federal Reserve in the 1920s, created the appearance of a healthy, well-balanced, growing economy. In fact, beneath the surface of that relatively “stable” price level, central bank policy had generated unbalanced and distorted patterns of investment activities and resource uses that meant that the “good times” were coming to an end.
The severity and duration of the Great Depression, the Austrian Economists argued, was not due to any inherent flaws in the market economy, as John Maynard Keynes and the “Keynesians” who followed him insisted. It was due to governments, including the U.S. government under Herbert Hoover and Franklin D. Roosevelt, introducing regulations, controls, interventions, and tax burdens that hindered the market from successfully “rebalancing” the economy. (See my eBook Monetary Central Planning and the State, for a detailed analysis and comparison of the “Austrian” and Keynesian theories, and their respective interpretations of the causes and cures for the Great Depression.)
Relevancy of Mises’ Analysis to Today’s Monetary and Financial Situation
The financial and economic crisis of 2008-2009 can easily be analyzed within the “Austrian” framework: a large money expansion, artificially low interest rates, and reduced credit standards fostered unsustainable investment, housing, and consumer spending booms that finally ended with a major market crash.
If carefully read and reflected upon, Ludwig von Mises’ still has much to teach us about money and the central banking problems of our own time.
This was followed by a slow economic recovery with potentially new distortions due to even greater monetary expansion and interest rate manipulations since 2009 combined with a grab bag of Federal Reserve tricks to influence banks not to lend a good part of the money the Fed created in the banking system since 2009. (See my articles, “Low Interest Rates Cannot Save a House of Cards,” and “Austrian Monetary Theory vs. Federal Reserve Inflation Targeting” and “Ten Years On: Recession, Recovery and the Regulatory State”.)
If carefully read and reflected upon, Ludwig von Mises’ Monetary Stabilization and Cyclical Policy still has much to teach us about money and the central banking problems of our own time. This includes a section in which Mises argues that the only long-run, lasting solution to the periodic occurrence of the business cycle is the end to central banking and its replacement with private, competitive banking.