Gary North is a member of the Economists’ National Committee on Monetary Policy. He teaches at the University of California at Riverside while working on a doctorate in Economic History.
Those who wish to preserve freedom should recognize, however, that inflation is probably the most important single factor in that vicious circle wherein one kind of government action makes more and more government control necessary.
F. A. HAYEK¹
Depression is the bugaboo of most Americans, far more so than inflation. Our history textbooks from grade school through college drum the message into the heads of the readers: the depression of the 1930′s was the worst disaster in American economic history. The depression proved, we are told, that laissez-faire capitalism is unworkable in practice. President Roosevelt’s New Deal "saved American capitalism from itself." His administration brought into existence a whole new complex of governmental agencies that will supposedly be able to prevent another depression on such a scale. By expanding their interference into the free market, the government and the quasi-governmental central banking system are able to "smooth out" the trade cycle.
Ironically, many of the optimistic statements coming out of Washington in regard to the possibility of depressions are remarkably similar to the pronouncements of statesmen and economists in the late 1920′s. In 1931, Viking Press published a delightful little book, Oh Yeah?, which was a compilation of scores of such reassurances. In retrospect, such confidence is amusing; nevertheless, the typical graduate student in economics today is as confident of the ability of the State to prevent a crisis as the graduate student was in 1928. So are his professors.
This kind of thinking is dangerous. During prosperity, it convinces men to look with favor on policies that will result in disaster. Then when a crisis comes, unsound analyses lead to erroneous solutions that will compound the problems. A failure to diagnose the true cause of depressions will generally lead to the establishment of more restrictive state controls over the economy, as bureaucrats prescribe the only cure they understand: more bureaucracy. Mises is correct when he argues that the statist "wants to think of the whole world as inhabited only by officials."2 The majority of contemporary economists refuse to acknowledge that the modern business cycle is almost invariably the product of inflationary policies that have been permitted and/or actively pursued by the State and the State’s licensed agencies of inflation, the fractional reserve banks.³ The problem is initiated by the State in the first place; nevertheless, the vast majority of today’s professional economists believe that the cure for depression is further inflation.
Profit and Loss
The basic outline of the cause of the business cycle was sketched by Ludwig von Mises in 1912, and it has been amplified by F. A. Hayek and others since then.4 The explanation hinges on three factors: the nature of free market production; the role of the rate of interest; and the inflationary policies of the State and the banking system, especially the latter. While no short summary can do justice to the intricacy of some of the issues involved, it may at least present thought for further study.
Profit is the heart of the free market’s production process. Profits arise when capitalist entrepreneurs accurately forecast the state of the market at some future point in time. Entrepreneurs must organize production to meet the demand registered in the market at that point; they must also see to it that total expenditures do not exceed total revenue derived from sales. In other words, if all producers had perfect foreknowledge, profits and losses could never arise. There would be perfect competition based upon perfect foreknowledge.5 This situation can never arise in the real world, but it is the ultimate goal toward which capitalist competition aims, since in a perfect world of this sort, there could be no waste of scarce economic resources (given a prevailing level of technology).
It has been Mises’ life work to demonstrate that the operation of the free market economy is the most efficient means of allocating scarce resources in an imperfect world. Those entrepreneurs who forecast and plan incorrectly will suffer losses; if their errors persist, they will be driven out of business. In this way, less efficient producers lose command over the scarce factors of production, thus releasing such resources for use by more efficient planners. The consumers in the economy are sovereign; their demands are best met by an economic system which permits the efficient producers to benefit and the inefficient to fail.
The whole structure rests upon a system of rational economic calculation. Profits and losses must be measured against capital expenses and other costs. The heart of the competitive capitalist system is the flexible price mechanism. It is this which provides entrepreneurs with the data concerning the existing state of supply and demand. Only in this fashion can they compute the level of success or failure of their firms’ activities.
The Rate of Interest
Economic costs are varied; they include outlays for labor, raw materials, capital equipment, rent, taxes, and interest payments. The interest factor is really a payment for time: lenders are willing to forego the use of their funds for a period of time; in return, they are to be paid back their principal plus an additional amount of money which compensates them for the consumer goods they cannot purchase now. A little thought should reveal why this is necessary. The economic actor always discounts future goods. Assuming for the moment that economic conditions will remain relatively stable, a person will take a new automobile now rather than in the future if he is offered the choice of delivery dates and the price is the same in both cases. The present good is worth more simply because it can be used immediately. Since capitalist production takes time, the capitalist must pay interest in order to obtain the funds to be used for production. The interest payments therefore represent a cost of production: the capitalist is buying time. Time, in this perspective, is a scarce resource; therefore, it commands a price.
The actual rate of interest at any point in time is a product of many forces. Economists do not agree on all of the specific relationships involved, and the serious student would do well to consult Hayek’s The Pure Theory of Capital (1941) for an introduction to the complexities of the issues. Nevertheless, there are some things that we can say. First, the rate of interest reflects the demand for money in relation to the supply of money. This is why inflationary policies or deflationary policies have an effect on the rate of interest: by changing the supply of money, its price is altered. Second, the rate of interest reflects the time preferences of the lenders, since it establishes just how much compensation must be provided to induce savers to part with their funds for a period of time. This is the supply side of the equation. The demand side is the demand for capital investment. Entrepreneurs need the funds to begin the production process or to continue projects already begun; how much they will be willing to pay will depend upon their expectations for future profit. In an economy where the money supply is relatively constant, the rate of interest will be primarily a reflection of the demand for capital versus the time preferences of potential lenders. Neither aspect of the rate of interest should be ignored: it reflects both the demand for and supply of money and the demand for and supply of capital goods.
Another factor is also present in the interest rate, the risk factor. There are no certain investments in this world of change. Christ’s warning against excessive reliance on treasure which rusts or is subject to theft is an apt one (Matthew 6:19). High risk ventures will generally command a higher rate of interest on the market, for obvious reasons. Finally, there is the price premium paid in expectation of mass inflation, or a negative pressure on the interest rate in expectation of serious deflation. It is the inflationary price premium which we are witnessing in the United States at present. Mises’ comments in this regard are important:
It is necessary to realize that the price premium is the outgrowth of speculations having regard for anticipated changes in the money relation. What induces it, in the case of the expectation that an inflationary trend will keep on going, is already the first sign of that phenomenon which later, when it becomes general, is called "flight into real values" and finally produces the crack-up boom and the crash of the monetary system concerned.6
The Inflationary Boom
In the real world, money is never neutral (and even if it were, the economists who explain money certainly never are). The money supply is never perfectly constant: money is hoarded, or lost; new gold and silver come into circulation; the State’s unbacked money is produced; deposits in banks expand or contract. These alterations affect the so-called "real" factors of the economy; the distribution of income, capital goods, and other factors of production are all influenced. Even more important, these changes affect people’s expectations of the future. It is with this aspect of inflation that Mises’ theory of the trade cycle is concerned.
The function of the rate of interest is to allocate goods and services between those lines of production which serve immediate consumer demand and those which serve consumer demand in the future. When people save, they forego present consumption, thus releasing goods and labor for use in the expansion of production. These goods are used to elongate the structure of production: new techniques and more complex methods of production are added by entrepreneurs. This permits greater physical productivity at the end of the process, but it requires more capital or more time-consuming processes of production, or both extra time and added capital. These processes, once begun, require further inputs of materials and labor to bring the production process to completion. The rate of interest is supposed to act as an equilibrating device. Entrepreneurs can count the cost of adding new processes to the structure of production, comparing this cost with expected profit. The allocation of capital among competing uses is accomplished in a rational manner only in an economy which permits a flexible rate of interest to do its work.
Inflation upsets the equilibrium produced by the rate of interest. The new funds are injected into the economy at certain points. Gold mining companies sell their product, which in turn can be used for money; those closest to the mines get the use of the gold first, before prices rise. But gold is not a serious problem, especially in today’s world of credit. Its increase is relatively slow, due to the difficulty of mining, and the increase can be more readily predicted; hence, its influence on the price structure is not so radical. This cannot be said, as a general rule, for paper money and credit. Unlike gold or silver, paper is not in a highly limited supply. It is here that Mises argues that the business cycle is initiated. Here—meaning the money supply—is the one central economic factor which can account for a simultaneous collapse of so many of the various sectors of the economy. It is the only factor common to all branches of production.
Creation of Fiat Money
The economic boom begins when the State or the central bank initiates the creation of new money. (For the Western world in this century, the establishment of this policy can generally be dated: 1914, the outbreak of the First World War.) The central bank, or the fractional reserve banking system as a whole, can now supply credit to potential borrowers who would not have borrowed before. Had the fiat creation of new money not occurred, borrowers would have had to pay a higher rate of interest in order to obtain the additional funds. Now, however, the new funds can be loaned out at the prevailing rate, or possibly even a lower rate. Additional demand for money can therefore be met without an increase in the price of money.
This elasticity of the money supply makes money unique among scarce economic goods. It tempts both government officials and bankers to make decisions profitable to their institutions in the short run, but disastrous for the economy as a whole in the longer run. Governments can expand expenditures by printing the money directly, or by obtaining cheap loans from the central bank, and thereby avoid the embarrassment of raising visible taxes. Banks can create money which will earn interest and increase profits. Mises has shown that these policies must result either in depression or mass inflation. There is no middle ground in the long run.
As we saw earlier, the interest rate reflects both the supply of and demand for money and the supply of and demand for capital goods. Inflation causes this dualism to manifest itself in the distortion of the production process. Capitalists find that they can obtain the funds they want at a price lower than they had expected. The new funds keep the interest rate from going higher, and it may even drop lower, but only temporarily, i.e., during the boom period. In fact, one of the signals that the boom is ending is an increase in the rate of interest.
Capitalists misinterpret this low rate of interest: what is really merely an increase in the availability of money is seen as an increase in the availability of capital goods and labor services. In reality, savers have not provided the new funds by restricting their consumption, thereby releasing capital goods that had previously been used to satisfy consumer demand more directly, i.e., more rapidly. Their patterns of time preference have not been altered; they still value present goods at a higher level than the rate of interest indicates.
Capitalists purchase goods and services with their new funds. The price of these goods and services will therefore rise in relation to the price of goods and services in the lower stages of production—those closer to the immediate production of consumer products. Labor and capital then move out of the lower stages of production (e.g., a local restaurant or a car wash) and into the higher stages of production (e.g., a steel mill’s newly built branch). The process of production is elongated; as a result, it becomes more capital-intensive. The new money puts those who have immediate access to it at a competitive advantage: they can purchase goods with today’s new money at yesterday’s lower prices; or, once the prices of producers’ goods begin to rise, they can afford to purchase these goods, while their competitors must restrict their purchases because their incomes have not risen proportionately. Capital goods and labor are redistributed "upward," toward the new money. This is the phenomenon of "forced saving." Those capitalists at the lower stages of production are forced to forfeit their use of capital goods to those in the higher stages of production. The saving is not voluntary: it is the result of the inflation.
The result is an economic boom. More factors of production are employed than before, as capitalists with the new funds scramble to purchase them. Wages go up, especially wages in the capital goods industries. More people are hired. The incumbent political party can take credit for the "good times." Everybody seems to be prospering from the stimulating effects of the inflation. Profits appear to be easy, since capital goods seem to be more readily available than before. More capitalists therefore go to the banks for loans, and the banks are tempted to permit a new round of fiat credit expansion in order to avoid raising the interest rate and stifling the boom.
Sooner or later, however, capitalists realize that something is wrong. The costs of factors of production are rising faster than had been anticipated. The competition from the lower stages of production had slackened only temporarily. Now they compete once more, since consumer demand for present goods has risen. Higher wages are being paid and more people are receiving them. Their old time-preference patterns reassert themselves; they really did not want to restrict their consumption in order to save. They want their demands met now, not at some future date. Long-range projects which had seemed profitable before (due to a supposedly larger supply of capital goods released by savers for long-run investment) now are producing losses as their costs of maintenance are increasing. As consumers spend more, capitalists in the lower stages of production can now outbid the higher stages for factors of production. The production structure therefore shifts back toward the earlier, less capital-intensive patterns of consumer preference. As always, consumer sovereignty reigns on the free market. If no new inflation occurs, many of the projects in the higher stages of production must be abandoned. This is the phenomenon known as depression. It results from the shift back to earlier patterns of consumer timepreference.7
The injection of new money into the economy invariably creates a fundamental disequilibrium. It misleads entrepreneurs by distorting the rate of interest. It need not raise the nation’s aggregate price level, either: the inflation distorts relative prices primarily, and the cost of living index and similar guides are far less relevant.8 The depression is the market’s response to this disequilibrium. It restores the balance of true consumer preference with regard to the time preferences of people for present goods in relation to future goods. In doing so, the market makes unprofitable many of those incompleted projects which were begun during the boom.
What is the result? Men in the higher stages of production are thrown out of work, and not all are immediately rehired at lower stages, especially if these workers demand wages equivalent to those received during the inflationary boom. Yet they do tend to demand such wages, and if governmentally protected labor union monopolies are permitted to maintain high wage levels, those who are not in the unions will be forced to work at even lower pay scales, or not at all. Relative prices shift back toward their old relationships. The demand for loans drops, and with it goes much of the banks’ profit. The political party in power must take responsibility for the "hard times." Savers may even make runs on banks to retrieve their funds, and overextended banks will fail. This reduces the deposits in the economy, and results in a deflationary spiral, since the deposits function as money; the inverted pyramid of credit on the small base of specie reserves topples. Money gets "tight."
The depression is an absolutely inevitable result of a prior inflation.¹º At first, the new money kept the interest rate low; it forced up costs in certain sectors of the economy relative to others; the structure of production was elongated; those employed by the higher stages then began to spend their money on consumer goods; and the shift back to a shortened production process was the result. Everyone liked the boom (except those on fixed incomes); no one likes the depression (except those on fixed incomes, if the incomes keep coming in).
There is a cry for the State to do something. Banks want to have a moratorium on all withdrawals; unions want to fix wages; businessmen want to fix prices; everyone wants more inflation. "Bring back the boom!" It can only be done now as before, with fiat money. The call for inflation ignores the fact that new maladjustments will be created. The short-run perspective dominates. If the cries are heeded, the price mechanism is again sacrificed, and with it goes the system of rational calculation which makes possible the efficiency of the free market. Mises warned a half century ago against this policy of "repressed depression" through inflation. Most governments since 1914 have ignored the warning, except during the late 1920′s and early 1930′s; the depression which resulted was "cured" by repressed depression, and that cure is now leading to the point predicted by Mises:
The "beneficial effects" on trade of the depreciated money only last so long as the depreciation has not affected all commodities and services. Once the adjustment is completed, then these "beneficial effects" disappear. If it is desired to retain them permanently, continual resort must be had to fresh diminutions of the purchasing power of money. It is not enough to reduce the purchasing power of money by one set of measures only, as is erroneously supposed by numerous inflationist writers; only the progressive diminution of the value of money could permanently achieve the aims which they have in view.”12
Here is the inescapable choice for twentieth century Western civilization: will it be depression —the readjustment of the economy from the State-sponsored disequilibrium of supply and demand —or will it be mass inflation? The only way to escape the depression is for the inflation to continue at an ever-increasing rate.”- The result is assured: "Continued inflation must finally end in the crackup boom, the complete breakdown of the currency system."13 The economy will go through a period of total economic irrationality, just as the German economy did in the early 1920′s.¹4 The German catastrophe was mitigated by support in the form of loans from other nations; the German traditions of discipline and thrift also played a large part. But what will be the result if the monetary systems of the industrial nations are all destroyed by their policies of repressed depression? What will happen to the international trading community and its prevailing division of labor and high productivity if the foundations of that community—trustworthy monetary systems—are destroyed?¹5 It is questions like these that have led Jacques Rueff to conclude that the future of Western civilization hangs in the balance.16
Ours is not an age of principle. Governments would prefer to avoid both depression and mass inflation, and so we see the spectacle of the tightrope walk: tight money causing recession, which is followed by easy money policies that produce inflation and gold crises. But the trend is clear; inflation is the rule. Hayek says that it is a question of true recovery versus the inflationary spiral.17 Until we face this issue squarely, we will not find a solution.
Men, in short, must think clearly and act courageously. They must face the logic of economic reasoning, and admit that their own policies of inflation have brought on the specter of depression. They must then make amoral decision to stop the inflation. The price system must be restored; the forced redistribution of wealth involved in all inflation must end. If men refuse to think clearly and to act with moral courage, then we face disaster.
1 F. A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960), p. 338.
2 Ludwig von Mises, Socialism (New Haven, Conn.: Yale University Press, [19221 1951), pp. 208-09.
3 On this myopia of the economists, see Gottfried Haberler, Prosperity and Depression (New York: Atheneum, 1962), ch. 13. Haberler no longer blames all depressions on monetary factors, and he does favor policies of repressed depression.
4 Ludwig von Mises, The Theory of Money and Credit (New Haven. Conn.: Yale University Press, 1953); cf. Haberler, pp. 33-67.
5 Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 286-97.
6 Ibid., p. 541.
7 Hayek, Prices and Production (2nd ed.; London: Routledge & Kegan Paul, 1935), chs. 2, 3.
8 Ibid., p. 28; Hayek, Monetary Theory and the Trade Cycle (New York: Kelley Reprints,  1967), p. 117n.•
9 I owe this phrase to Rev. R. J. Rushdoony.
11 Hayek, Monetary Theory, pp. 126, 146, 179.
11 Mises, Theory of Money and Credit, p. 224.
¹² Hayek, Prices and Production, PP. 148-51.
13 Mises, Human Action, p. 468.
14 On the German inflation, see Constantino Bresciani-Turroni, The Economics of Inflation (London: Allen & Unwin, 1937).
15 Cf. Gary North, "Domestic Inflation versus International Solvency," THE FREEMAN (Feb., 1967).
16 Jacques Rueff, The Age of Inflation (Chicago: Regnery, 1964), pp. vii-xiv.
17 Hayek, Prices and Production, pp. 88-89.