-
The
AUSTRIANTheory of theTrade Cycle
and other essays
Ludwig von MisesGottfried Haberler
Murray N. Rothbard Friedrich A. Hayek
Compiled by Richard M. EbelingWith an Introduction and Summary
by Roger W.
Garrison
MISESINSTITUTE
518 West Magnolia AvenueAuburn, Alabama 36832-4528
www.mises.org
http://www.mises.org
-
Dedicated to the memory of O.P. Alford,III,champion of liberty
and the Austrian School
-
Copyright 1996 by the Ludwig von Mises Institute.
Originally published by the Center for LibertarianStudies
(1978).
All rights reserved. Written permission must be securedfrom the
publisher to use or reproduce any part of thisbook, except for
brief quotations in critical reviews orarticles.
Published by the Ludwig von Mises Institute, Auburn,Alabama
36832-4528.
Library of Congress Catalog Card Number 96-075695.
ISBN: 0-945466-21-8
Online edition prepared by William Harshbarger for theLudwig von
Mises Institute.
-
Contents
Introduction: The Austrian Theory in Perspective Roger W.
Garrison 7
The Austrian Theory of the Trade Cycle Ludwig von Mises.. 25
Money and the Business Cycle Gottfried Haberler.. 37
Economic Depressions: Their Cause and Cure Murray N. Rothbard...
65
Can We Still Avoid Inflation? Friedrich A. Hayek. 93
The Austrian Theory: A Summary Roger W. Garrison. 111
Index... 123
About the Authors.. 127
-
7
Introduction:The Austrian Theory
in Perspective
Roger W. Garrison
The four essays in this volume, each written by a majorfigure in
the Austrian school of economics, set out andapply a distinctive
theory of the business cycle. The span ofyears (1932-1970) over
which they appeared saw adramatic waxing and then waning of the
prominence-bothinside and outside the economics profession-of the
Austriantheory. Gottfried Haberler wrote in his 1932 essay that
thetheory "is not so well known in this country as it deservesto
be" (pp. 44). Although Ludwig von Mises offered noassessment in
this regard in his essay, he remarked in 1943about the effect of
the theory's general acceptance on theactual course of the cycle.
Anticipating a key insight in themodern literature on "rational
expectations," Mises wrote,"The teachings of the monetary theory of
the trade cycleare today so well known even outside the circle
ofeconomists that the naive optimism which inspired
theentrepreneurs in the boom periods has given way to
greaterskepticism."1 Then, in 1969, Murray N. Rothbard
couldwrite-without serious overstatement-that "a correct theoryof
depressions and of the business cycle does exist, even
1 Ludwig von Mises, "Elastic Expectations and the Austrian
Theory of theTrade Cycle," Economica, ns. 10 (August 1943):
251.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
8
though it is universally neglected in present-dayeconomics" (p.
74).
What happened over the span of nearly forty years toaccount for
the rise and fall of this theory of boom andbust? The simple
answer, of course, is: the Keynesianrevolution. John Maynard
Keynes's General Theory ofEmployment, Interest, and Money, which
made itsappearance in 1936, produced a major change in the waythat
economists deal with macro-economic issues. A closelook at some
pre-Keynesian ideas can show why theAustrian theory was so easily
lost in the aftermath of theKeynesian revolution; a brief survey of
the alternativesoffered by modern macroeconomics will show why
there isa new-found interest in this old Austrian theory.
First introduced by Mises in his Theory of Money andCredit
(1912), the theory was originally billed as thecirculation credit
theory rather than as a uniquely Austriantheory. Mises was very
much aware of its multinationalroots. The notion that the market
process can besystematically affected by a divergence between the
bankrate of interest and the natural rate came from
Swedisheconomist Knut Wicksell; the understanding that theprocess
so affected would have a self-reversing quality to it(Mises used
the term "counter-movements" in his earliestexposition) came from
the British currency school, whoseanalysis featured international
gold flows. The uniquelyAustrian element in Mises's formulation is
the capitaltheory introduced by Carl Menger and developed by
Eugenvon Bhm-Bawerk. Mises showed that an artificially lowrate of
interest, maintained by credit expansion,misallocates capital,
making the production process too
-
ROGER W. GARRISON
9
time-consuming in relation to the temporal pattern ofconsumer
demand. As time eventually reveals thediscrepancy, markets for both
capital goods and consumergoods react to undo the misallocation.
The initialmisallocation and eventual reallocation constitute
themicroeconomic foundations that underlie the
observedmacroeconomic phenomenon of boom and bust. Mises'stheory
was superior to its Swedish forerunner in thatWicksell was
concerned almost exclusively with the effectof credit expansion on
the general level of prices. It wassuperior to its British
forerunner in that the currencyschool's theory applied only when
monetary expansion inone country outpaced that of its trading
partners. Mises'stheory was applicable even to a closed economy and
to aworld economy in which all countries are experiencing acredit
expansion.
The theory took on a more predominantly Austriancharacter in the
hands of F. A. Hayek. In the late 1920s andearly 1930s, Hayek gave
emphasis to the Austrian vision ofcapital that underlies the
business cycle theory byintroducing a simple graphical
representation of thestructure of production. He used right
triangles that changein shape to illustrate a change in the
economy's capitalstructure.2 Hayek focused the analysis clearly on
therelationship between the roundaboutness of the productionprocess
and the value of the corresponding output. TheHayekian triangles
keep track of both time and money asgoods-in-process make their way
through the temporallysequenced stages of production. His notion of
a linear
2 Friedrich A. Hayek, Prices and Production, 2nd ed. (New York:
Augustus M.Kelley, 1935).
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
10
production process is highly abstract and overly simple inthe
light of a fuller accounting of the fixed and circulatingcapital
that actually characterize a capital-using economy.However, these
triangles feature an essential but oftenneglected dimension-the
time dimension-in the account ofboom and bust. Alternative
theories, in which consumptionand investment appear as two
coexisting aggregates, can beseen as even more simplistic-to the
point of being whollyinadequate for analyzing the boom-bust
sequence.
Haberler concludes his essay with an expression ofconcern about
the complexity of the Austrian theory, whichhe saw as a "serious
disadvantage" (p. 64). But thecomplexity, in his judgment, is
inherent in the subjectmatter and hence is not a fault of the
theory. Complexity isevident in the two early essays (1936 and
1932) in theirorganization and style of argument. Both Mises
andHaberler defend the theory against its critics and deal
withvarious misunderstandings. Mises, for instance,
identifiesIrving Fisher's inflation premium, which attaches itself
tothe rate of interest as prices in general rise, only to say
thatthis is not what he is talking about. He is discussing,instead,
still another aspect of interest-rate dynamics. Thereal rate of
interest rises at the end of the boom to reflectthe increasing
scarcity of circulating capital, after excessiveamounts of capital
have been committed to the early stagesof production processes (p.
31). Haberler takes great painsto refocus the reader's attention
away from the general pricelevel and toward the relative prices
that govern the "verticalstructure of production" (p. 49). He
distinguishes between"absolute deflation" and "relative deflation,"
and between"primary and fundamental" phenomena that characterizethe
downturn and "secondary and accidental" phenomena
-
ROGER W. GARRISON
11
that may also be observed. All these complexities-plus
stillothers involving such notions as the natural rate of
interestand the corresponding degree of roundaboutness of
theproduction process-are unavoidable in a theory that featuresan
intertemporal capital structure. The theoretical richnessthat stems
from the attention to capital has as its negativecounterpart the
expositional difficulties and scope formisunderstanding.
Keynes offered the profession relief from all this
byarticulating- though cryptically- a capital- freemacroeconomics.
As Rothbard's discussion implies, all thethorny issues of capital
theory were simply swept aside. Analternative theory that featured
the playoff betweenincomes and expenditures left little or no room
for a capitalstructure. Investment was given special treatment
notbecause of its link to future consumption but becausespending on
investment goods is particularly unstable.Uncertainties, which are
perceived to be a deep-seatedfeature of market economies, dominate
decision making inthe business community and give play to
psychologicalexplanations of prosperity and depression. And the
notionthat depression may be attributable to pessimism on thepart
of the business community suggests a need for centraldirection and
policy activism. Prosperity seems to dependupon strong and
optimistic leadership in the political arena.Relief from the
complexities of capital theory together withpolicy implications
that were exceedingly attractive toelected officials gave
Keynesianism an advantage overAustrianism. An easy-to-follow recipe
for managing themacroeconomy won out over a difficult-to-follow
theorythat explains why such management is counterproductive.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
12
Tellingly, the two later essays (1969 and 1970) are asmuch about
Keynesianism as about Austrianism. Rothbardand Hayek are trying
anew to call attention to a theory thathad been buried for decades
under the Keynesianavalanche. Rothbard deals with the Phillips
curve, whichpurports to offer a choice to political leaders
betweeninflation and unemployment; Hayek deals with the wage-price
spiral, which had captured the attention of journalistsand textbook
authors for much of the postwar era. The needfor dealing critically
with Keynesianism-and withmonetarism-while at the same time
reintroducing the keyconsiderations from capital theory meant that
the Austriantheory of the business cycle was an even harder sell in
the1970s than it had been a half-century earlier.
The offering of these four separate and distinct essays onthe
Austrian theory carries the message that there is nosingle
canonical version of the theory. Our understandingof boom and bust
is not based upon some pat story to betold once and for all time.
Rather, the theory allows forvariations on a theme. The market
works; it tailorsproduction decisions to consumption preferences.
Butproduction takes time, and as the economy becomes morecapital
intensive, the time element takes on greatersignificance. The role
of the interest rate in allocatingresources over time becomes an
increasingly critical one.Still, if the interest rate is right,
that is, if the interplaybetween lenders and borrowers is allowed
to establish thenatural rate, then the market works right. However,
if theinterest rate is wrong, possibly because of central
bankpolicies aimed at "growing the economy," then the marketgoes
wrong. The particulars of just how it goes wrong, justwhen the
misallocations are eventually detected, and just
-
ROGER W. GARRISON
13
what complications the subsequent reallocation might entailare
all dependent on the underlying institutionalarrangements and on
the particular actions of policy makersand reactions of market
participants.
The essays leave much scope for solving puzzles, forrefining
both theory and exposition, and for applying thetheory in different
institutional and political environments.One enduring puzzle
emerges from the writings of severaleconomists, including Haberler,
who once embraced thetheory enthusiastically but subsequently
rejected it. The keyquestion underlying the recantations is easily
stated: Canthe intertemporal misallocation of capital that occurs
duringthe boom account for the length and depth of thedepression?
Haberler provides one of the best answers tothis question-one that
is most favorable to the Austriantheory-in his 1932 essay. The
"maladjustment of thevertical structure of production," to use
Haberler's ownterm, does not, by itself, account for the length and
depth ofthe depression. Rather, this policy-induced change in
theintertemporal structure of capital is the basis for the
claimthat a crisis and downturn are inevitable. The reallocationof
resources that follows the downturn, which largelymirrors-both
qualitatively and quantitatively-the earliermisallocation, involves
an abnormally high level of(structural) unemployment but need not
involve a deep andlengthy depression.
However, complications that may well accompany themarket's
adjustment to a policy-induced intertemporalmisallocation can cause
the depression to be much deeperand longer than it otherwise would
be. The same policymakers who orchestrated the artificial boom may
well
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
14
behave ineptly when they see that the ultimate consequenceof
their policy is a bust. Their failure to stem the
monetarycontraction together with interventions by the
legislaturethat prop up prices and wages and strengthen trade
barrierswill make a bad situation worse. All such
complications,which play themselves out as a
self-aggravatingcontraction, are correctly identified by Haberler
as"secondary phenomena." This term is not employed tosuggest that
these aspects of the depression are negligibleor second-order in
importance. "[I]t may very well be,"Haberler explains, "that this
secondary wave of depression,which is induced by the more
fundamental maladjustment,will grow to an overwhelming importance"
(p. 58). Thoughpossibly overwhelming, the effects of the
complications arestill secondary in the sense of temporal and
causal ordering.
The puzzle in all this emerges when we read Haberler's1976
recantation of the Austrian theory, which echoedLionel Robbins's
heartfelt recantation of a few years earlier.Mises refers to
Robbins's 1934 book, The GreatDepression, as "the best analysis of
the actual crisis" (p. 28n). In 1971 Robbins wrote in his
autobiography that this isa book "which [he] would willingly see
forgotten."3
Drawing on Robbins's recantation, Haberler offers theopinion
that the "real maladjustments, whatever theirnature, were
completely swamped by vast deflationaryforces.'" But rather than
suggest, as he had earlier, thatthese forces could easily have been
"induced by the morefundamental maladjustments," he simply
attributes them to
3 Lionel Robbins, An Autobiography of an Economist (London:
Macmillan,1971),p. 154.
-
ROGER W. GARRISON
15
"institutional weaknesses and policy mistakes."4 The
astutereader will see Haberler's 1932 discussion of
secondaryphenomena as an insightful and hard-hitting critique of
the1976 Haberler-and would see a similar relationshipbetween the
1934 Robbins and the 1971 Robbins.
In 1932, Haberler alluded to the "economic earthquakes"(p. 37)
that Western countries had experienced. He mighthave put the
earthquake metaphor to further use inaccounting for the
relationship between primary andsecondary issues. During the 1906
earthquake in SanFrancisco, for instance, fires broke out and
caused muchmore destruction than had been caused by the
actualquaking of the earth. Even so, the fire was a
secondaryphenomenon; the quake was the primary phenomenon. Thefact
that the length and depth of the Great Depression are tobe
accounted for largely in terms of secondary phenomena,then, does
not weigh against our understanding that theprimary phenomenon was
the quaking of the capitalstructure. What accounts, then, for the
recantation of theseAustrian theorists-and of several others,
including John R.Hicks, Nicholas Kaldor, and Abba P. Lerner? This
puzzleremains to be solved.
Expositional difficulties derive largely from the fact thatthe
capital-based macroeconomics of the Austrian schooland particularly
the Austrian theory of the business cycleare foreign to modern
economists whose training isexclusively in labor-based
macroeconomics. In today's
4 Gottfried Haberler, The World Economy, Money, and the Great
Depression1919-1939 (Washington, D.C.: American Enterprise
Institute, 1976), p. 26.Also see Haberler, "Reflections on Hayek's
Business Cycle Theory," CatoJournal 6, no 2 (Fall 1986):
421-35.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
16
profession, a given capital stock has become one of thedefining
assumptions underlying the conventionalmacroeconomic relationships.
To allow capital to be avariable rather than a parameter is to
change the subjectmatter-from macroeconomics to the economics of
growth.Further, modern economists tend to think of
capitalholistically in terms of stocks and flows, which
precludesany consideration of changes-to say nothing
ofunsustainable changes-in the capital structure. GordonTullock's
bafflement at the Austrian theory is illuminatingin this regard.
Tullock takes Rothbard's essay as canonicaland explains "Why the
Austrians Are Wrong aboutDepressions." This article, together with
a comment byJoseph T. Salerno and reply by Tullock, merit
carefulstudy.5 According to Tullock's understanding of theAustrian
theory, the boom is a period during which theflow of consumer goods
is sacrificed so that the capitalstock can be enlarged. At the end
of the boom, then, thecapital stock would actually be larger, and
the subsequentflow of consumer goods would be correspondingly
greater.Therefore, the period identified by the Austrians as
adepression would, instead, be a period marked by
increasedemployment (labor is complementary to capital) and ahigher
standard of living. The stock-flow construction thatunderlies this
line of reasoning does not allow for thestructural unemployment
that characterizes the crisis-muchless for the complications in the
form of the secondary
5 Gordon Tullock, "Why the Austrians Are Wrong About
Depressions" Reviewof Austrian Economics 2 (1987): 73-78; Joseph T.
Salerno, Comment onTullock's "Why Austrians Are Wrong About
Depressions" Review of AustrianEconomics 3 (1989): 141-45; and
Tullock, "Reply to Comment by Joseph T.Salerno" Review of Austrian
Economics 3 (1989): 147-49.
/journals/rae/pdf/R2_4.pdf/journals/rae/pdf/R3_11.pdf/journals/rae/pdf/R3_12.pdf/journals/rae/pdf/R3_12.pdf
-
ROGER W. GARRISON
17
depression.6 This exchange between Tullock and Salernogives the
modern student of Austrianism a good feel for thechallenge involved
in the exposition of Austrian theory inan academic environment
unreceptive to a capital-basedmacroeconomics.
Capital-based macroeconomics is simplymacroeconomics that
incorporates the time element into thebasic construction of the
theory. Investment now is aimedat consumption later. The interval
of time that separates thisemployment of means and the eventual
achievement ofends is as fundamental a variable as are the
moreconventional ones of land and labor. The Austrian
theoryfeatures the time element by showing what happens whenthe
economy's production time, the degree ofroundaboutness, is thrown
out of equilibrium by policiesthat override the market process.
Beyond this generalunderstanding, as already suggested, the focus
of particularexpositions vary in accordance with the historical
andinstitutional setting. The fact that each of the essays in
thisvolume reflects its own time and setting does not imply amyopia
on the part of its author. Rather, it suggests theversatility of
the theory.
Writing in the early 1930s, for instance, Mises calledattention
to the "flight into real values" (p. 30) thatcharacterizes a
hyperinflation, such as the one experienced 6 Tullock on the basis
of a peculiar judgment about the relative size of theeconomy's
producer goods sector, makes a minor concession to the
Austriantheory: It applies to "those factories and machine tools
that were less than 40percent completed [at the end of the boom]."
But, "the producer goodsindustries are always a fairly small part
of the economy. In that small part,however, undeniably a Rothbard,
Austrian type of depression would cause acutback in production and
laying off of personnel."
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
18
in Germany in 1923. The lesson, though, transcends theinsights
into that particular historical experience. If, over aperiod of
years, capital has been misallocated by anaccelerating credit
expansion, there is no policy that avoidsa crisis. In the modern
vernacular, there is no possibility ofa "soft landing."7
Decelerating the expansion will causereal interest rates to rise
dramatically as credit becomesincreasingly scarce; bankruptcies
would follow. Furtheraccelerating the expansion will cause
hyperinflation and acollapse of the monetary system. Mises is
telling us, ineffect, that the central bank can print itself into
trouble, butit cannot print itself out of trouble. Writing in 1970,
Hayekrefers to the central bank's dilemma by suggesting that onthe
eve of the crisis the policy makers find themselves"holding a tiger
by the tail." He gives play to the politicaland economic forces
that were then dominant by relatingthem to the commonly perceived
wage-price spiral thataccompanies a prolonged expansion. The final
throes of theboom take the form of a duel between labor unions,
whichhave the political power to force wage rates higher, and
thecentral bank, which can bring them back down (in realterms) by
accelerating the rate of inflation. AlthoughHayek, above all
others, is to be credited with shifting thefocus of business cycle
theory from labor markets to capitalmarkets, he offers few clues in
this essay aboutdisequilibrium in the intertemporal structure of
production.Instead, he recognizes that the political and
economicdynamics of the period have given special relevance to
theproblem-he even calls it the "central problem" (p. 110)-ofwage
determination.
7 This is not to deny the difference between a hard landing with
nocomplications and a crash, in which the complications
dominate.
-
ROGER W. GARRISON
19
The application of the Austrian theory of the businesscycle in
today's economy would give little play to the fearof hyperinflation
or to the problem of a wage-price spiral.The central problem today
is chronic and dramatic fiscalimbalance. Budget deficits rather
than credit expansion arebound to be the focus in any plausible
account of the effectof the government's macroeconomic policy on
theeconomy's performance. Still, the central bank
figuresimportantly into the story. The very potential formonetizing
the Treasury's debt eliminates the risk ofdefault, and thereby puts
the Treasury on a much longerleash than it would otherwise enjoy.
The problem of anartificially low rate of interest in earlier
episodes isovershadowed by the problem of an artificially low
riskpremium on government debt. Although risk-free to theholders of
Treasury securities, this black cloud of debtoverhangs the market
for private securities, distorting theeconomy's capital structure
and degrading its performancegenerally. There are some modern
applications of theAustrian theory that take these considerations
into account,but much remains to be done.8
A stocktaking of the modern alternatives to the Austriantheory
suggests that capital-based macroeconomics may bedue for a
comeback. Conventional Keynesianism, whetherin the guise of the
principles-level Keynesian cross, theintermediate IS-LM, or the
advanced AS/AD is formulatedat a level of aggregation too high to
bring the cyclical
8 Roger W. Garrison, "Hayekian Triangles and Beyond," in Jack
Birner andRudy van Zijp, eds., Hayek, Coordination and Evolution
(London: Routledge,1994), pp.109-25; and Roger W. Garrison, "The
Federal Reserve: Then andNow" Review of Austrian Economics 8, no. 1
(1994): 3-19.
/journals/rae/pdf/R81_1.pdf/journals/rae/pdf/R81_1.pdf
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
20
quality of boom and bust into full view. Worse, thedevelopment
of these tools of analysis in the hands of themodern textbook
industry has involved a serious sacrificeof substance in favor of
pedagogy. Students are taughtabout the supply and demand curves
that represent themarket for a particular good or service, such as
hamburgersor haircuts. Then they are led into the
macroeconomicissues by the application of similar-looking supply
anddemand curves to the economy as a whole. The transitionto
aggregate supply and aggregate demand, which is madeto look
deceptively simple, hides all the fundamentaldifferences between
microeconomic issues andmacroeconomic issues. While these
macroeconomicaggregates continue to be presented to
collegeundergraduates, they have fallen into disrepute outside
theclassroom. One recent reconsideration of themacroeconomic
stories told to students identifiesfundamental inconsistencies in
AS/AD analysis.9
Conventional monetarism employs a level ofaggregation as high
as, if not higher than, that employed byKeynesianism. While Milton
Friedman is to be creditedwith having persuaded the economics
profession-and muchof the general citizenry-of the strong
relationship betweenthe supply of money and the general level of
prices, hismonetarism adds little to our understanding of
therelationship between boom and bust. The monetarists
haveeffectively countered the Keynesians on many fronts, butthey
share with them the belief that macroeconomics and
9 David Colander, "The Stories We Tell: A Reconsideration of
AS/AD
Analysis," Journal of Economic Perspectives 9, no. 3 (Summer
1995): 169-88.
-
ROGER W. GARRISON
21
even business cycle theory can safely ignore allconsiderations
of a capital structure. Modern spin-offs ofmonetarism, which
incorporate the ideas of rationalexpectations and instantaneous
market clearing, havebrought the time element back into play.
Overlapping-generations models and particularly the
time-to-buildmodels seem to have some relationship to Austrian
ideas.But the emphasis on the development of modelingtechniques
over the application of the theory to actualepisodes of boom and
bust has greatly diminished therelevance of this strand of
macroeconomic thought.10
In recent years, there has been an increasinglywidespread
recognition that modern macroeconomics is indisarray. Today's
textbooks and professional journals arereplete with models that,
while impressive in their displayof technique, are profoundly
implausible and whollyinapplicable to the world as we know it. The
inadequaciesof modern macroeconomics have caused someacademicians
to wonder (if only facetiously): How far backdo we have to go
before we can start all over? The essaysin this volume provide a
substantive answer to thatquestion. We have to go back about sixty
years to a timewhen capital theory was an integral part
ofmacroeconomics. We have to go back to the Austrianschool. A
modernized capital-based macroeconomics cancompare favorably with
any of the present-day rivals.
10 On the relationship between new classical theory and Austrian
theory, seeKevin Hoover, "An Austrian Revival?" in Hoover, The New
ClassicalMacroeconomics: A Skeptical Inquiry (Cambridge: Basil
Blackwell, 1988), pp.231-57; and Roger W. Garrison, "New Classical
and Old Austrian Economics:Equilibrium Business Cycle Theory in
Perspective" Review of AustrianEconomics 5, no. 1 (1991):
91-103.
/journals/rae/pdf/R51_4.pdf/journals/rae/pdf/R51_4.pdf
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
22
Murray Rothbard's essay ends with an anticipation of theAustrian
revival-which actually began, with his help, in1974. This volume is
offered in the spirit of Rothbard andin the hope that the Austrians
will have an increasinginfluence in the years ahead on the
development ofbusiness cycle theory.
-
23
The Austrian Theoryof the Trade Cycle
Ludwig von Mises
Nowadays it is usual in economics to talk about theAustrian
theory of the trade cycle. This description isextremely flattering
for us Austrian economists, and wegreatly appreciate the honor
thereby given us. Like all otherscientific contributions, however,
the modern theory ofeconomic crises is not the work of one nation.
As with theother elements of our present economic knowledge,
thisapproach is the result of the mutual collaboration of
theeconomists of all countries.
The monetary explanation of the trade cycle is notentirely new.
The English "Currency School" has alreadytried to explain the boom
by the extension of creditresulting from the issue of bank notes
without metallicbacking. Nevertheless, this school did not see that
bankaccounts which could be drawn upon at any time by meansof
checks, that is to say, current accounts, play exactly the
This essay was originally published as "La Theorie dite
Autrichienne de Cycleconomique," in the Bulletin of the Socite
Belge d'Etudes et d'Expansion(1936): 459-64. It was translated from
the French by David O'Mahoney and J.Huston McCulloch.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
24
same role in the extension of credit as bank notes.Consequently
the expansion of credit can result not onlyfrom the excessive issue
of bank notes but also from theopening of excessive current
accounts. It is because itmisunderstood this truth that the
Currency School believedthat it would suffice, in order to prevent
the recurrence ofeconomic crises, to enact legislation restricting
the issue ofbank notes without metallic backing, while leaving
theexpansion of credit by means of current accountsunregulated.
Peel's Bank Act of 1844, and similar laws inother countries, did
not accomplish their intended effect.From this it was wrongly
concluded that the EnglishSchool's attempt to explain the trade
cycle in monetaryterms had been refuted by the facts.
The Currency School's second defect is that its analysisof the
credit expansion mechanism and the resulting crisiswas restricted
to the case where credit is expanded in onlyone country while the
banking policy of all the othersremains conservative. The reaction
which is produced inthis case results from foreign trade effects.
The internal risein prices encourages imports and paralyses
exports.Metallic money drains away to foreign countries. As aresult
the banks face increased demands for repayment ofthe instruments
they have put into circulation (such asunbacked notes and current
accounts), until such time asthey find they have to restrict
credit. Ultimately the outflowof specie checks the rise in prices.
The Currency Schoolanalyzed only this particular case; it did not
consider creditexpansion on an international scale by all the
capitalistcountries simultaneously.
-
LUDWIG VON MISES
25
In the second half of the 19th century, this theory of thetrade
cycle fell into discredit, and the notion that the tradecycle had
nothing to do with money and credit gainedacceptance. The attempt
of Wicksell (1898)1 to rehabilitatethe Currency School was
short-lived.
The founders of the Austrian School of Economics-CarlMenger,
Bhm-Bawerk, and Wieser-were not interested inthe problem of the
trade cycle. The analysis of this problemwas to be the task of the
second generation of Austrianeconomists.2
In issuing fiduciary media, by which I mean bank noteswithout
gold backing or current accounts which are notentirely backed by
gold reserves, the banks are in a positionto expand credit
considerably. The creation of theseadditional fiduciary media
permits them to extend credit
1 Knut Wicksell, Interest and Prices , R.F. Kahn, trans. (New
York:Augustus M. Kelley, 1965)-Tr.
2 The principal Austrian works concerning the theory of the
economic cycle [asof 1936] are: Mises, The Theory of Money and
Credit (New York: Foundationfor Economic Education, 1971;
translation of the 2nd German edition, 1924;originally published in
1912); Mises, Monetary Stabilization and CyclicalPolicy (1928)
reprinted in On the Manipulation of Money and Credit, Percy
L.Greaves, ed., Bettina Bien Greaves, trans. (Dobbs Ferry, N.Y.:
Free MarketBooks, 1978; originally published as a monograph in
German); Friedrich A.von Hayek, Monetary Theory and the Trade Cycle
(New York: Augustus M.Kelley, 1966; reprint of 1933 English
edition, originally published in Germanin 1929); Hayek, Prices and
Production (New York: Augustus M. Kelley,1967; reprint of 1935 2nd
revised edition, originally published in 1931); FritzMachlup, Fhrer
durch die Krisenpolitik (1934); Richard von Strigl, Capitaland
Production, Margaret Rudelich Hoppe and Hans-Hermann Hoppe,
trans.(Auburn, Al: Ludwig von Mises Institute, 1995; translation of
the 1934edition); the best analysis of the actual crisis was made
by Sir Lionel Robbins,The Great Depression (Freeport, R.I.: Books
for Libraries Press, 1971; reprintof 1934 edition).-[Note:
citations have been updated in this new edition.]
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
26
well beyond the limit set by their own assets and by thefunds
entrusted to them by their clients. They intervene onthe market in
this case as "suppliers" of additional credit,created by
themselves, and they thus produce a lowering ofthe rate of
interest, which falls below the level at which itwould have been
without their intervention. The loweringof the rate of interest
stimulates economic activity. Projectswhich would not have been
thought "profitable" if the rateof interest had not been influenced
by the manipulations ofthe banks, and which, therefore, would not
have beenundertaken, are nevertheless found "profitable" and can
beinitiated. The more active state of business leads toincreased
demand for production materials and for labor.The prices of the
means of production and the wages oflabor rise, and the increase in
wages leads, in turn, to anincrease in prices of consumption goods.
If the banks wereto refrain from any further extension of credit
and limitedthemselves to what they had already done, the boom
wouldrapidly halt. But the banks do not deflect from their courseof
action; they continue to expand credit on a larger andlarger scale,
and prices and wages correspondinglycontinue to rise.
This upward movement could not, however, continueindefinitely.
The material means of production and thelabor available have not
increased; all that has increased isthe quantity of the fiduciary
media which can play the samerole as money in the circulation of
goods. The means ofproduction and labor which have been diverted to
the newenterprises have had to be taken away from otherenterprises.
Society is not sufficiently rich to permit thecreation of new
enterprises without taking anything awayfrom other enterprises. As
long as the expansion of credit is
-
LUDWIG VON MISES
27
continued this will not be noticed, but this extension cannotbe
pushed indefinitely. For if an attempt were made toprevent the
sudden halt of the upward movement (and thecollapse of prices which
would result) by creating more andmore credit, a continuous and
even more rapid increase ofprices would result. But the inflation
and the boom cancontinue smoothly only as long as the public thinks
that theupward movement of prices will stop in the near future.
Assoon as public opinion becomes aware that there is noreason to
expect an end to the inflation, and that prices willcontinue to
rise, panic sets in. No one wants to keep hismoney, because its
possession implies greater and greaterlosses from one day to the
next; everyone rushes toexchange money for goods, people buy things
they have noconsiderable use for without even considering the
price,just in order to get rid of the money. Such is thephenomenon
that occurred in Germany and in othercountries that followed a
policy of prolonged inflation andthat was known as the "flight into
real values." Commodityprices rise enormously as do foreign
exchange rates, whilethe price of the domestic money falls almost
to zero. Thevalue of the currency collapses, as was the case in
Germanyin 1923.
If, on the contrary, the banks decided to halt theexpansion of
credit in time to prevent the collapse of thecurrency and if a
brake is thus put on the boom, it willquickly be seen that the
false impression of "profitability"created by the credit expansion
has led to unjustifiedinvestments. Many enterprises or business
endeavors whichhad been launched thanks to the artificial lowering
of theinterest rate, and which had been sustained thanks to
theequally artificial increase of prices, no longer appear
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
28
profitable. Some enterprises cut back their scale ofoperation,
others close down or fail. Prices collapse; crisisand depression
follow the boom. The crisis and the ensuingperiod of depression are
the culmination of the period ofunjustified investment brought
about by the extension ofcredit. The projects which owe their
existence to the factthat they once appeared "profitable" in the
artificialconditions created on the market by the extension of
creditand the increase in prices which resulted from it, haveceased
to be "profitable." The capital invested in theseenterprises is
lost to the extent that it is locked in. Theeconomy must adapt
itself to these losses and to thesituation that they bring about.
In this case the thing to do,first of all, is to curtail
consumption and, by economizing,to build up new capital funds in
order to make theproductive apparatus conform to the actual wants
and not toartificial wants which could never be manifested
andconsidered as real except as a consequence of the
falsecalculation of "profitability" based on the extension
ofcredit.
The artificial "boom" had been brought on by theextension of
credit and by lowering of the rate of interestconsequent on the
intervention of the banks. During theperiod of credit extension, it
is true that the banksprogressively raised the rate of interest;
from a purelyarithmetical point of view it ends up higher than it
had beenat the beginning of the boom. This raising of the rate
ofinterest is nevertheless insufficient to reestablishequilibrium
on the market and put a stop to the unhealthyboom. For in a market
where the prices are risingcontinually, gross interest must include
in addition tointerest on capital in the strict sense-i.e., the net
rate of
-
LUDWIG VON MISES
29
interest-still another element representing a compensationfor
the rise in prices arising during the period of the loan. Ifthe
prices rise in a continuous manner and if the borroweras a result
gains a supplementary profit from the sale of themerchandise which
he bought with the borrowed money, hewill be disposed to pay a
higher rate of interest than hewould have paid in a period of
stable prices; the capitalist,on the other hand, will not be
disposed to lend under theseconditions, unless the interest
includes a compensation forthe losses which the diminution in the
purchasing power ofmoney entails for creditors. If the banks do not
takeaccount of these conditions in setting the gross interest
ratethey demand, their rate ought to be considered as
beingmaintained artificially at too low a level, even if from
apurely arithmetical point of view it appears much higherthan that
which prevailed under "normal" conditions. Thusin Germany an
interest rate of several hundred per centcould be considered too
low in the autumn of 1923 becauseof the accelerated depreciation of
the mark.
Once the reversal of the trade cycle sets in following thechange
in banking policy, it becomes very difficult toobtain loans because
of the general restriction of credit. Therate of interest
consequently rises very rapidly as a result ofa sudden panic.
Presently, it will fall again. It is a well-known phenomenon,
indeed, that in a period of depressionsa very low rate of
interest-considered from the arithmeticalpoint of view-does not
succeed in stimulating economicactivity. The cash reserves of
individuals and of banksgrow, liquid funds accumulate, yet the
depressioncontinues. In the present [1936] crisis, the accumulation
ofthese "inactive" gold reserves has for a particular reason,taken
on inordinate proportions. As is natural, capitalists
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
30
wish to avoid the risk of losses from the
devaluationscontemplated by various governments. Given that
theconsiderable monetary risks which the possession of bondsor of
other interest-bearing securities entail are notcompensated by a
corresponding increase of the rate ofinterest, capitalists prefer
to hold their funds in a form thatpermits them, in such a case, to
protect their money fromthe losses inherent in an eventual
devaluation by a rapidconversion to a currency not immediately
menaced by theprospect of devaluation. This is the very simple
reason whycapitalists today are reluctant to tie themselves,
throughpermanent investments, to a particular currency. This iswhy
they allow their bank accounts to grow even thoughthey return only
very little interest, and hoard gold, whichnot only pays no
interest, but also involves storageexpenses.
Another factor which is helping to prolong the presentperiod of
depression is the rigidity of wages. Wagesincrease in periods of
expansion. In periods of contractionthey ought to fall, not only in
money terms, but in realterms as well. By successfully preventing
the lowering ofwages during a period of depression, the policy of
the tradeunions makes unemployment a massive and
persistentphenomenon. Moreover, this policy postpones the
recoveryindefinitely. A normal situation cannot return until
pricesand wages adapt themselves to the quantity of money
incirculation.
Public opinion is perfectly right to see the end of theboom and
the crisis as a consequence of the policy of thebanks. The banks
could undoubtedly have delayed theunfavorable developments for some
further time. They
-
LUDWIG VON MISES
31
could have continued their policy of credit expansion for
awhile. But-as we have already seen-they could not havepersisted in
it indefinitely without risking the completecollapse of the
monetary system. The boom brought aboutby the banks' policy of
extending credit must necessarilyend sooner or later. Unless they
are willing to let theirpolicy completely destroy the monetary and
credit system,the banks themselves must cut it short before
thecatastrophe occurs. The longer the period of creditexpansion and
the longer the banks delay in changing theirpolicy, the worse will
be the consequences of themalinvestments and of the inordinate
speculationcharacterizing the boom; and as a result the longer will
bethe period of depression and the more uncertain the date
ofrecovery and return to normal economic activity.
It has often been suggested to "stimulate" economicactivity and
to "prime the pump" by recourse to a newextension of credit which
would allow the depression to beended and bring about a recovery or
at least a return tonormal conditions; the advocates of this method
forget,however, that even though it might overcome thedifficulties
of the moment, it will certainly produce a worsesituation in a not
too distant future.
Finally, it will be necessary to understand that theattempts to
artificially lower the rate of interest whicharises on the market,
through an expansion of credit, canonly produce temporary results,
and that the initial recoverywill be followed by a deeper decline
which will manifestitself as a complete stagnation of commercial
and industrialactivity. The economy will not be able to
developharmoniously and smoothly unless all artificial measures
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
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).
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
34
movement. The fundamental appearance of the businesscycle is a
wavelike movement of business activity-if I maybe allowed to use
for the moment this rather vagueexpression. The development of our
modern economic lifeis not an even and continuous growth; it is
interrupted, notonly by external disturbances like wars and
similarcatastrophes, but shows an inherent discontinuity; periodsof
rapid progress are followed by periods of stagnation.
The attention of the economists was first caught bythose
secondary and accidental phenomena-glaringbreakdowns and financial
panics. They tried to explainthem in terms of individual accidents,
mistakes, andmisguided speculations of the leaders of those banks
andbusiness firms which were primarily involved. But theregular
recurrence of these accidents during the nineteenthcentury brought
home to the economists that they had notisolated accidents before
them but symptoms of a severedisease, which affects the whole
economic body.
During the second half of the nineteenth century therewas a
marked tendency for these disturbances to becomemilder. Especially
those conspicuous events, breakdowns,bankruptcies, and panics
became less numerous, and therewere even business cycles from which
they were entirelyabsent. Before the war, it was the general belief
ofeconomists that this tendency would persist and that suchdramatic
breakdowns and panics as the nineteenth centuryhad witnessed
belonged definitely to the past.
Now, the present depression shows that we rejoiced toohastily,
that we have not yet got rid of this scourge of thecapitalistic
system.
-
GOTTFRIED HABERLER
35
But, nevertheless, so much can be and must be learnedfrom the
experience of the past: if we want a deeper insightinto the inner
mechanism of our capitalistic system whichmakes for its cyclical
movements, we must try to explainthe fundamental phenomenon,
abstracting from theseaccidental events, which might be absent or
present.
If we disregard these secondary phenomena, thebusiness cycle
presents itself as a periodic up and down ofgeneral business
activity, or, to put it now in a more preciseform, of the volume of
production. The secular growth ofproduction does not show a
continuous, uninterrupted trendupward but a wavelike movement
around its averageannual increase. It does not make a great
differencewhether the downward swings of these business waves
arecharacterized by an absolute fall of the volume ofproduction or
just by a decrease of the rate of growth.
In this lecture I am not concerned with the ingenuousdevices
which statisticians have invented to isolate thecyclical movements
from other periodic or erraticmovements on which they are
superimposed, or which aresuperimposed on them. I assume, first,
that we have such athing as a business cycle, which is not
identical withseasonal movements within the year and erratic
irregulardisturbances caused by wars, periods of
governmentinflation, and the like; it is necessary to state this,
becauseeven the existence of the phenomenon under considerationhas
been doubted. Secondly, I assume that we have beenable to isolate
this movement statistically.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
36
Our chief concern will be with the explanation of thismovement
and especially with the role of money in thewidest sense of the
term, including credit and bank money.
II
There is hardly any explanation of the business cycle-Ihesitate
a little to say "theory of the business cycle,"because many people
have developed a certain prejudiceagainst this term-in which the
monetary factor does notplay a very decisive role. The following
considerationshows that this must necessarily be so: Still
abstractingfrom the previously mentioned accessory phenomena, oneof
the most outstanding external symptoms of the businesscycle is the
rise of prices during prosperity and the fall ofprices during
depression. On the other hand, there is anincrease of the volume of
production during the upwardand a decrease during the downward
swing. But not onlymore commodities are produced and sold but also
in otherbranches of the economy there is an increase
oftransactions-e.g., on the stock exchange. Therefore, we cansafely
say there is a considerable increase of the volume ofpayments
during the upward swing of the cycle and adistinct decrease of this
volume during depression.
Now, it is clear that, in order to handle this increasedvolume
of payments, an augmentation of the means ofpayment is
necessary-means of payment in the widest senseof the term. One of
the following things must happen:
(a) An increase of gold and legal tender money.(b) An increase
of banknotes.
-
GOTTFRIED HABERLER
37
(c) An increase of bank deposits and bank credits.(d) An
increase in the circulation of checks, bills, and
other means of payment which are regularly or
occasionallysubstituted forordinary money.
(e) An increase of the velocity of circulation of one orall of
these means of payments.
I do not claim that this enumeration is exhaustive orquite
systematic. It is largely a matter of terminologicalconvenience, as
one likes to express oneself. One writerprefers to call bank
deposits, on which checks may bedrawn, money, bank money, credit
money. Other writersrestrict the term "money" to legal-tender money
and speakthen of bank deposits as means to save money or to make
itmore efficient in making payments by increasing itsvelocity of
circulation. Still others have an aversion againstthe term
"velocity of circulation" and prefer to speak ofchanges in the
requirement for money and means ofpayment.
Without going more deeply into these technical details,it is, I
hope, clear that there must occur in one way oranother during the
upward swing of the cycle an expansionof the means of payment and
during the downward swing acorresponding contraction.
No serious theory, no explanation of the cycle, canafford to
overlook, disregard, or deny this fact. Differencescan arise only
(a) in respect to the particular way in whichthe expansion takes
place-whether it is primarily anincrease in the quantity of credit
money or legal-tendermoney or gold or just of the velocity of
circulation of oneof these-and (b) as to the causal sequence.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
38
As to the causal relation, broadly speaking, twopossibilities
seem to be open:
1. One might assume that the impulse comes from theside of
money, that the circulation is expanded by adeliberate action of
the banks or other monetary authority,and that this sets the whole
chain of events going, or 2. Onemay hold the opinion that the
monetary authorities take apassive role; that the initiative comes
from the commodityside, that changes of demand for certain
commodities,changes in the structure of production, inventions
andimprovements, large crops, or psychological forces, a waveof
optimism and pessimism-that one of these phenomenaand its
repercussions makes for an increase or decrease ofthe volume of
production, and that this, in turn, draws intocirculation a greater
amount of means of payment. Thegreater flow of goods induces a
larger flow of money.
The theories of the first group, which maintain that theactive
cause of the cycle lies on the side of money, may becalled
"monetary theories" of the business cycle. In a widersense,
however, we may include in the group of monetarytheorists also all
those who admit that the impulse mightalso come from the commodity
side, but hold that anappropriate policy of the monetary
authorities, an effectiveand elastic regulation of the volume of
the circulatingmedium, can forestall every serious disturbance.
As you all know, the most frequently recommendedcriterion for
such a policy is the "stabilization of the pricelevel" in the one
or other of the many meanings of thisambiguous term. You all will
agree that it is impossible to
-
GOTTFRIED HABERLER
39
discuss this problem exhaustively in one hour. So I shallconfine
myself to pointing out the insufficiencies of thistype of monetary
theory and of its recommendations for theremedy of the business
cycle, which center around changesin the price level. I shall try,
then, to indicate a morerefined monetary theory of the cycle, which
has beendeveloped in the last few years, although it is not so
wellknown in this country as it deserves to be. This refinedtheory
seems to explain some features of the cycle,especially of the last
one, which are not entirely compatiblewith the cruder form of the
monetary approach, whichidentifies monetary influences with changes
in the generalprice level.
III
The traditional monetary theory, which is represented bysuch
well-known writers as the Swedish economistProfessor Cassel and Mr.
Hawtrey of the English treasury,regards the upward and the downward
swing of thebusiness cycle as a replica of a simple government
inflationor deflation. To be sure, it is-as a rule-a much milder
formof inflation or deflation, but at the root it is exactly
thesame. Mr. Hawtrey states this quite uncompromisingly inhis
famous dictum: "The trade cycle is a purely monetaryphenomenon" and
is, in principle, the same as the inflationduring the war and the
deflation, that is to say, thereduction of the amount of
circulating medium, which wasdeliberately undertaken by certain
governments to approachor to restore the post-war parity of their
currencies.
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
40
Hawtrey recognizes and stresses, of course, thedifference in
degree between the two types of inflation anddeflation, namely,
that the expansion and contraction in thecourse of the business
cycle is chiefly produced bymaladjustment of the discount rate,
which is not the way inwhich a government inflation is brought
about. It is todayan almost generally accepted doctrine, that a
lowering ofthe discount rate by the banking system, especially by
thecentral banks, induces people to borrow more, so that theamount
of the circulating medium increases and prices rise.A raising of
the discount rate has the opposite effect-ittends to depress prices
or, if they were rising, to put a brakeon the upward movement. I
know, of course, that this barestatement needs some qualifications,
I trust, however, thatbefore so competent an audience it will
suffice to say thatthis is literally true only if the influence of
the change in thediscount rate is not compensated by any other
force whichchanges the willingness of businessmen to borrow.
But,given all these other circumstances, that is to say,
ceterisparibus, a change in the discount rate will have
theindicated effect on prices. In any given situation there isone
rate which keeps the price level constant. If the rate isforced
below this equilibrium rate, prices have a tendencyto rise; if the
rate is raised above the equilibrium rate,prices tend to fall.
Now, according to Mr. Hawtrey, there is a tendency inour banking
system to keep the interest rate too low duringthe upward swing of
the cycle; then prices rise, we get acredit inflation, and sooner
or later the banks are forced totake steps to protect their
reserves-they increase the rateand bring about the crisis and the
depression.
-
GOTTFRIED HABERLER
41
There is no time here to go into details, to discuss
theingenious explanation which Mr. Hawtrey offers for thefact that
banks always go too far, that they swing like apendulum from one
extreme to the other and do not stop atthe equilibrium rate. The
reason which Mr. Hawtrey givesfor this is different from the one
which Professor IrvingFisher and other writers of this group have
to offer. Whatthey all have in common is that the disturbing
factors actthrough changes of the price level. It is through
changes ofthe price level that expansion and contraction of credit
andmoney act upon the economic system, and they all believethat
stability of the price level is the sufficient criterion of
arational regulation of credit. If it were possible to keep
theprice level stable, prosperity would never be followed
bydepression. If the price level is allowed to rise and
theinevitable reaction to come, it would be possible to end
thedepression and to restore equilibrium, if one could stop thefall
of prices.
Let me now indicate briefly why this explanation seemsto me
insufficient. Or, to put it in other words, I shall try toshow that
(a) the price level is frequently a misleadingguide to monetary
policy and that its stability is nosufficient safeguard against
crises and depressions, because(b) a credit expansion has a much
deeper and morefundamental influence on the whole economy,
especiallyon the structure of production, than that expressed in
themere change of the price level.
The principal defect of those theories is that they do
notdistinguish between a fall of prices which is due to anactual
contraction of the circulating medium and a fall ofprices which is
caused by lowering of cost as a
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
42
consequence of inventions and technologicalimprovements. (I
must, however, mention that thisparticular criticism does not apply
to Mr. Hawtrey, who, bya peculiar interpretation of the term "price
level,"recognizes this distinction, although he does not seem
todraw the necessary conclusions.)
It is true, if there is an absolute decrease of the quantityof
money, demand will fall off, prices will have to godown, and a
serious depression will be the result. Normalconditions will return
only after all prices have beenlowered, including the prices of the
factors of production,especially wages. This may be a long and
painful process,because some prices, e.g., wages, are rigid and
some pricesand debts are definitely fixed for a long time and
cannot bealtered at all.
From this, however, it does not follow that the same istrue if
prices fall because of a lowering of costs. It is nowgenerally
accepted that the period preceding the presentdepression was
characterized by the fact that manytechnological improvements,
especially in the productionof raw materials and agricultural
products, but also in thefield of manufacture, took place on a
large scale.
The natural thing in such a situation would be for pricesto fall
gradually, and apparently such a fall of prices cannothave the same
bad consequence as a fall of prices broughtabout by a decrease of
the amount of money. We couldspeak, perhaps, of a "relative
deflation" of the quantity ofmoney, relative in respect to the flow
of goods, inopposition to an "absolute deflation."
-
GOTTFRIED HABERLER
43
Especially, those writers who stress the scarcity of goldas a
cause for the present depression are guilty ofoverlooking the
radical difference between an absolute anda relative deflation. A
scarcity of gold could result only in arelative deflation, which
could never have such disastrousresults as the present depression.
Of a more indirect way inwhich the "smallness" of the annual output
of gold hasperhaps to do with-I do not venture to say "is the cause
of"-the acuteness of the present depression and the vehemenceof the
price fall, I shall say more later.
Now, as I said already, during the years 1924-27 and1928 we
experienced an unprecedented growth of thevolume of production.
Commodity prices, on the otherhand, as measured by the wholesale
price index, were fairlystable, as everybody knows. From this it
follows, and directstatistical investigations have verified it,
that the volume ofthe circulating medium had been increased. We
could say,there was a "relative inflation," that is, an expansion
ofmeans of payment, which did not result in an increase ofcommodity
prices, because it was just large enough tocompensate for the
effect of a parallel increase of thevolume of production.
There is now an obvious presumption that it wasprecisely this
relative inflation which brought about all thetrouble. If this were
so-and it seems to me that it is veryprobable-it would be plain
that the price level is amisleading guide for monetary policy and
that there aremonetary influences at work on the economic system
thatdo not find an adequate expression in a change of the
pricelevel, at least as measured by the wholesale price index.And,
in fact, there are such very far-reaching influences of
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
44
certain monetary changes on the economic system-theymay express
themselves in a change of the price level ornot-which have been
wholly overlooked by the traditionalmonetary explanation, although
the external symptoms ofthis influence have been well recognized
(but differentlyinterpreted) by certain non-monetary theories
anddescriptive studies of the business cycle.
IV
These changes which I have in mind and shall now try toanalyze
are changes of what I shall call the verticalstructure of
production, brought about by changes in thesupply of credit for
productive purposes. If we have toanalyze an economic system, we
can make a horizontal orvertical cross-section through it. A
horizontal cross-sectionwould exhibit different branches or lines
of industry asdifferentiated by the consumption goods, which are
thefinal result of these different branches: there, we have thefood
industry, including agriculture, the clothing industry,the show
industry, etc. Industries which produce producer'sgoods-say, the
iron and steel industry-belongsimultaneously to different branches
in this horizontalsense, because iron and steel are used in the
production ofmany or of all consumer's goods. The old statement
that ageneral overproduction is unthinkable, that we can neverhave
too much of all goods, because human wants areinsatiable, but that
serious disproportionalities mightdevelop in consequence of a
partial overproduction-thisstatement relates principally to the
horizontal structure ofproduction. Disproportionality in this sense
means that, forone reason or another, the appropriate proportion
of
-
GOTTFRIED HABERLER
45
productive resources devoted to different branches ofindustry
has been disturbed-that, e.g., the automobileindustry is
overdeveloped, that more capital and labor hasbeen invested in this
industry than is justified by thecomparative demand for the product
of this industry and forother industrial products. I hope it is now
pretty clear whatI mean by horizontal structure and
horizontaldisproportionalities of production.
We make, on the other hand, a vertical cross-sectionthrough an
economic system, if we follow every finishedgood, ready for
consumption, up through the differentphases of production and note
how many stages a particulargood has to pass through before it
reaches the finalconsumer. Take, e.g., a pair of shoes and trace
its economicfamily tree. Our path leads us from the retailer via
thewholesale merchant to the shoe factory; and, taking up oneof the
different threads which come together at this point,say, a sewing
machine used for the fabrication of shoes, weare led to the machine
industry, the steel plant, andeventually to the coal and iron mine.
If we follow anotherstrand, it leads us to the farm which bred the
cattle fromwhich the leather was taken. And besides, there are
manyintermediate stages interpolated between these majorphases of
the productive process, namely, the varioustransportation services.
Every good has to pass throughmany successive stages of preparation
before the finishingtouches are applied and it eventually reaches
the finalconsumer. It takes a considerable length of time to
followone particular piece through this whole process, from
thesource of this stream to the mouth where it flows out
anddisappears in the bottomless sea of consumption. But, whenthe
whole process is once completed and every one of the
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
46
successive stages is properly equipped with fixed andcirculating
capital, we may expect a continuous flow ofconsumer's goods.
Now, in the equipment of these successive stages ofproduction,
the capital stock of a country, which has beenaccumulated during
centuries, is embodied. The amount ofaccumulated capital is a
measure of the length of thestream. In a rich country the stream is
very long, and goodshave to pass through many stages before they
reach theconsumer. In a poor country this stream is much
shorter,and the volume of output correspondingly smaller.
If, during a time of economic progress, capital isaccumulated
and invested, new stages of production areadded, or, in technical
economic parlance, the process ofproduction is lengthened, it
becomes more roundabout. Ifyou compare the way in which we produce
today with themethods of our fathers, or the productive process of
a richcountry with the one of a poor country, innumerableexamples
can be found.
But what has this to do with the business cycle? Now,when I
spoke of the vertical structure of production and theinfluence of
monetary forces upon it, I thought of alengthening and shortening
of the productive process.Obviously, just as there must be a
certain proportionbetween the different horizontal branches of
industry, theremust also be a certain relation of the productive
resources-labor and capital-which are devoted to the upper and
lowerstages of production respectively, to the current productionof
consumer's goods by means of the existing productive
-
GOTTFRIED HABERLER
47
apparatus, and to the increase of this apparatus for
theincreased future production of consumer's goods.
If, e.g., too much labor is used for lengthening theprocess and
too small an amount for current consumption,we shall get a
maladjustment of the vertical structure ofproduction. And it can be
shown that certain monetaryinfluences, concretely, a credit
expansion by the bankswhich lowers the rate of interest below that
rate whichwould prevail if only those sums which are
deliberatelysaved by the public from their current income came on
thecapital-market-it can be shown that such an artificialdecrease
of the rate of interest will induce the businessleaders to indulge
in an excessive lengthening of theprocess of production, in other
words, in overinvestments.As the finishing of a productive process
takes aconsiderable period of time, it turns out only too late
thatthese newly initiated processes are too long. A reaction
isinevitably produced-how, we shall see at once-which raisesthe
rate of interest again to its natural level or even higher.Then
these new investments are no longer profitable, and itbecomes
impossible to finish the new roundabout ways ofproduction. They
have to be abandoned, and productiveresources are returned to the
older, shorter methods ofproduction. This process of adjustment of
the verticalstructure of production, which necessarily implies the
lossof large amounts of fixed capital which is invested in
thoselonger processes and cannot be shifted, takes place during,and
constitutes the essence of, the period of depression.
Unfortunately, it is impossible to discuss here all thesteps of
this process and to compare them with thecorresponding phases of
the business cycle of which they
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
48
are the picture and explanation. I hope it will be possible
togive you a clear idea of what happens in our
capitalisticsocieties during the business cycle by means of
acomparison with a corresponding event in a communisticeconomy.
What the Russians are doing now, or trying to do-thefive-year
plan-is nothing else but an attempt to increase bya desperate
effort the roundaboutness of production and, bymeans of this, to
increase in the future the production ofconsumer's goods. Instead
of producing consumer's goods,with the existing primitive methods,
they have curtailedproduction for immediate consumption purposes to
theindispensable minimum. Instead of shoes and houses theyproduce
power plants, steel works, try to improve thetransportation system,
in a word, build up a productiveapparatus which will turn out
consumption goods only aftera considerable period of time.
Now, suppose that it becomes impossible to carrythrough this
ambitious plan. Assume the government comesto the conclusion that
the population cannot stand theenormous strain, or that a
revolution threatens to break out,or that by a popular vote it is
decided to change the policy.In any such case, if they are forced
to give up the newlyinitiated roundabout ways of production and to
produceconsumer's goods as quickly as possible, they will have
tostop the building of their power plants and steel works
andtractor factories and, instead of that, try to producehurriedly
simple implements and tools to increase theoutput of food and shoes
and houses. That would mean anenormous loss of capital, sunk in
those now abandonedworks.
-
GOTTFRIED HABERLER
49
Now, what in a communistic society is done upon adecision of the
supreme economic council is in ourindividualistic society brought
about by the collective butindependent action of the individuals
and carried out by theprice mechanism. If many people, individuals
orcorporations, decide to save, to restrict, for some time,
theirconsumption, the demand for and production of consumer'sgoods
declines, productive resources are shifted to theupper stages of
production, and the process of production isbeing lengthened.
If we rely on voluntary saving we can assume thatduring every
year approximately the same proportion of thenational income will
be saved-although not always by thesame individuals. Then we have a
steady flow of savings,and the adjustment of production does not
take place interms of actual shifts of invested productive
resources butin terms of a lasting deflection of the flow of
productiveresources into other channels.
There is no reason why this should not go on smoothlyand
continuously. Violent fluctuations are introduced bythe influence
of the banks in this process. The effect of thevoluntary decision
of the public to save, i.e., to divertproductive resources from the
current production ofconsumption goods to the lengthening of the
process, canbe produced also by the banking system. If the banks
createcredit and place it at the disposal of certain business
menwho wish to use it for productive purposes, that part of
themoney stream, which is directed to the upper stages
ofproduction, is increased. More productive resources will
bediverted from the current production of consumer's goods
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
50
to the lengthening of the process than corresponds to
thevoluntary decision of the members of the economiccommunity. This
is what economists speak of as forcedsaving. First everything goes
all right. But very soon pricesbegin to rise, because those firms
who have got the newmoney use it to bid away factors of
production-labor andworking capital-from those concerns which were
engagedin producing consumption goods. Wages and prices go up,and a
restriction of consumption is imposed on those whoare not able to
increase their money income. If throughprevious investment of
voluntary savings there is already atendency for the price level to
fall, the new credit instead ofresulting in an absolute rise of
prices may simply offset theprice fall which would otherwise take
place.
But, after some time, a reaction sets in, which tends torestore
the old arrangement that has been distorted by theinjection of
money. The new money becomes income in thehands of the factors
which have been hired away from thelower stages of production, and
the receivers of thisadditional income will probably adhere to
their habitualproportion of saving and spending, that is, they will
try toincrease their consumption again.
If they do this, the previous proportion of the moneystreams
directed to the purchase of consumer's goods andof producer's goods
will be restored. For some time it mightbe possible to overcome
this countertendency and tocontinue the policy of expansion by
making new injectionsof credit. But this attempt would lead to a
progressive riseof prices and must be given up sooner or later.
Then the oldproportion of demand for consumer's goods and
producer'sgoods will be definitely restored. The consequence is
that
-
GOTTFRIED HABERLER
51
those firms in the lower stages of production, which hadbeen
forced to curtail their production somewhat, becausefactors have
been hired away, will in turn be able to drawaway productive
resources from the higher stages. The newroundabout ways of
production, which have beenundertaken under the artificial stimulus
of a creditexpansion, or at least a part of them, become
unprofitable.They will be discontinued, and the crisis and
depression hasits start. It could be otherwise only if the new
processeswere already finished when the additional money hasbecome
income and comes onto the market for consumer'sgoods. In this case,
the additional demand would findadditional supply; to the increased
flow of money wouldcorrespond an increased flow of goods. This is,
however,almost impossible, because, as Mr. Robertson has shown,the
period of production is much longer than the period ofcirculation
of money. The new money is bound to come onthe market for
consumption goods much earlier than thenew processes are completed
and turn out goods ready forconsumption.
V
This explanation of the slump, of which I have been ableto
indicate here only the bare outline, could, of course, beelaborated
and has been elaborated. (Compare especiallyHayek, Prices and
Production [New York: Augustus M.Kelley, 1967]). If this
interpretation of the crisis and of thebreakdown of a large part of
the structure of production iscorrect, it seems then comparatively
easy to explain thefurther events in more familiar terms. Such an
initialbreakdown must have very serious repercussions. In our
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
52
highly complicated credit economy where every part of thesystem
is connected with every other, directly or indirectly,by
contractual bonds, every disturbance at one pointspreads at once to
others. If some banks-those nerve centerswhere innumerable strands
of credit relations cometogether-are involved and become bankrupt,
a wave ofpessimism is bound to come: as a secondary phenomenon
acredit deflation is likely to be the consequence of thegeneral
distrust and nervousness. All these things, uponwhich the
traditional monetary doctrine builds its entireexplanation, will
make things even worse than they are, andit may very well be that
this secondary wave of depression,which is induced by the more
fundamental maladjustment,will grow to an overwhelming importance.
This depends,however, largely upon the concrete circumstances of
thecase in hand, upon the peculiar features of the
creditorganization, on psychological factors, and need not bear
adefinite proportion of the magnitude of the "real"dislocation of
the structure of production.
This is the place to say a few words about an indirectconnection
between the alleged insufficient supply of goldand the present
depression. It is undoubtedly true that sincebefore the war the
quantity of gold has not increased somuch as the volume of
payments. To maintain a price level,roughly 50 percent higher than
before the war, was possibleonly by building a comparatively much
larger creditstructure on the existing stock of gold. After the
process ofinflation has once been completed, this should not
causetroubles-in normal times. In times of acute financial
crisis,when confidence vanishes, and when runs and panics maketheir
appearance, such a system becomes, however,extremely dangerous. If
the means of payment consist
-
GOTTFRIED HABERLER
53
principally of gold and gold-covered notes and
certificates,there is no danger that suddenly a large part of
thecirculating medium may be annihilated. A world-system
ofpayments, however, which relies to a large proportion oncredit
money, is subject to rapid deflation, if this airy creditstructure
is once shaken and crushed down.
For example, the adoption of a gold-exchange standardby many
countries amounts to erecting a daring creditsuperstructure on the
existing gold stock of the world; thisstructure may easily break
down, if these countries abandonthe gold-exchange standard and
re-adopt an old-fashionedgold standard.
It would be, however, entirely wrong to conclude fromthis that
we have to blame the niggardliness of nature, thatthe situation
would necessarily be quite different, if bychance, gold production
had been much larger during thelast twenty years. Other factors are
responsible, principallythe inflation during and after the war. By
means of such amonetary policy it is always possible to drive any
stock ofgold, however large it may be, out of the country.
Thenatural thing is then to substitute later a
gold-exchangestandard for the abandoned gold standard, which means,
asI have said already, the erection of a credit structure on
theexisting stock of gold.
Therefore, if the annual output of gold had been largerthan it
actually was, the difference would have been onlythis: the credit
structure too would have become larger, andwe would have started in
for the last boom from a higherprice level. If this is a correct
guess of what would havehappened-and it seems to me very
probable-the economic
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
54
consequences of the last period of credit expansion, 1927-29,
and the present deflation would have been exactly thesame.
It is of vital importance to distinguish between
theseadditional, secondary, and accidental disturbances and
theprimary "real" maladjustment of the process of production.If it
were only a wave of pessimism and absolute deflationwhich caused
the trouble, it should be possible to get rid ofit very quickly.
After all, a deflation, however strong it maybe, and by whatever
circumstances it may have been madepossible and aggravated, can be
stopped by drasticinflationary methods within a comparatively short
period oftime.
If we have, however, once realized that at the bottom ofthese
surface phenomena lies a far-reaching dislocation ofproductive
resources, we must lose confidence in all theeconomic and monetary
quacks who are going around thesedays preaching inflationary
measures which would bringalmost instant relief.
If we accept the proposition that the productiveapparatus is out
of gear, that great shifts of labor and capitalare necessary to
restore equilibrium, then it is emphaticallynot true that the
business cycle is a purely monetaryphenomenon, as Mr. Hawtrey would
have it; this is nottrue, although monetary forces have brought
about thewhole trouble. Such a dislocation of real physical
capital,as distinguished from purely monetary changes, can in
nocase be cured in a very short time.
-
GOTTFRIED HABERLER
55
I do not deny that we can and must combat thesecondary
phenomenon-an exaggerated pessimism and anunjustified deflation. I
cannot go into this matter here, Ionly wish to say that we should
not expect too much of amore or less symptomatic treatment, and, on
the other hand,we must be careful not to produce again that
artificialdisproportion of the money streams, directed
towardconsumption and production goods, which led tooverinvestment
and produced the whole trouble. The worstthing we could do is a
one-sided strengthening of thepurchasing power of the consumer,
because it was preciselythis disproportional increase of demand for
consumer'sgoods which precipitated the crisis.
It is a great advantage of this more refined monetaryexplanation
of the business cycle, over the traditional one,to have cleared up
these non-monetary, "real" changes dueto monetary forces. In doing
so, it has bridged the gapbetween the monetary and non-monetary
explanation; it hastaken out the elements of truth contained in
each of themand combined them into one coherent system. It takes
careof the well-established fact that every boom period
ischaracterized by an extension of investments of fixedcapital. It
is primarily the construction of fixed capital andof the principal
materials used for this-iron and steel-wherethe largest changes
occur, the greatest expansion during theboom and the most violent
contractions in the depression.
This fact, which has been stressed by all descriptivestudies of
the business cycle, has not been used by thetraditional monetary
explanations, which run in terms ofchanges in the price level and
look at real dislocations ofthe structure of production, if they
regard it at all, as an
-
THE AUSTRIAN THEORY OF THE TRADE CYCLE AND OTHER ESSAYS
56
unimportant accidental matter. The explanation, which Ihave
indicated, not only describes this fact as does the so-called
non-monetary explanation of the cycle, but explainsit. If the rate
of interest is lowered, all kinds of investmentscome into the reach
of practical consideration. May I beallowed to quote an example
given by Mr. Keynes in alecture before the Harris Foundation
Institute last year. "Noone believes that it will pay to electrify
the railway systemof Great Britain on the basis of borrowing at 5
percent. . . .At 3 1/2 percent it is impossible to dispute that it
will beworthwhile. So it must be with endless other
technicalprojects."1 It is clear that especially those branches
ofindustry are favored by a reduction of the rate of interestwhich
employ a large amount of fixed capital, as, forexample, railroads,
power plants, etc. In their cost-account,interest charges play an
important role. But there is anindisputable general tendency to
replace labor bymachinery, if capital becomes cheap. That is to
say, morelabor and working capital is used to produce
machines,railroads, power plants-comparatively less for
currentproduction of consumption goods. In technical
economicparlance: the roundaboutness of production is increased.The
crucial point and also the point of deviation from Mr.Keynes's
analysis is to understand well that a reaction mustinevitably set
in, if this productive expansion is notfinanced by real, voluntary
saving of individuals orcorporations but by ad hoc created credit.
And it ispractically very important-the last boom should
havebrought this home to us-that a stable commodity price levelis
not a sufficient safeguard against such an artificial
1 Unemployment as a World Problem (Chicago, 1931), p. 39.
-
GOTTFRIED HABERLER
57
stimulation of an expansion of production. In other words,that a
relative credit inflation, in the above-definedmeaning of the term,
will induce the same counter-movements as an absolute
inflation.
I hope that I have been able to give you a tolerably clearidea
of this improved monetary explanation of the businesscycle. Once
more I must ask you not to take as a completeexposition what can be
only a brief indication. Asufficiently detailed discussion of the
case could be onlyundertaken in a big volume. Therefore, I beg you
tosuspend your final judgment until the case has been morefully
presented to you. Only one objection I should like toanticipate. It
is true this theory suffers from a seriousdisadvantage: it is so
much more complicated than thetraditional monetary explanation. But
I venture to say thatthis is not the fault of this theory, but due
to the malice ofthe object. Unfortunately, facts are not always so
simple asmany people would like to have them.
-
58
Economic Depressions:Their Cause and Cure
Murray N. Rothbard
We live in a world of euphemism. Undertakers havebecome
"morticians," press agents are now "publicrelations counsellors"
and janitors have all beentransformed into "superintendents." In
every walk of life,plain facts have been wrapped in cloudy
camouflage.
No less has this been true of economics. In the old days,we used
to suffer nearly periodic economic crises, thesudden onset of which
was called a "panic," and thelingering trough period after the
panic was called"depression."
The most famous depression in modern times, of course,was the
one that began in a typical financial panic in 1929and lasted until
the advent of World War II. After thedisaster of 1929, economists
and politicians resolved thatthis must never happen again. The
easiest way ofsucceeding at this resolve was, simply to
define"depressions" out of existence. From that point on,
America
This essay was originally published as a minibook by the
ConstitutionalAlliance of Lansing, Michigan, 1969.
-
MURRAY N. ROTHBARD
59
was to suffer no further depressions. For when the nextsharp
depression came along, in 1937-38, the economistssimply refused to
use the dread name, and came up with anew, much softer-sounding
word: "recession." From thatpoint on, we have been through quite a
few recessions, butnot a single depression.
But pretty soon the word "recession" also became tooharsh for
the delicate sensibilities of the American public. Itnow seems that
we had our last recession in 1957-58. Forsince then, we have only
had "downturns," or, even better,"slowdowns," or "sidewise
movements." So be of goodcheer; from now on, depressions and even
recessions havebeen outlawed by the semantic fiat of economists;
fromnow on, the worst that can possibly happen to us
are"slowdowns." Such are the wonders of the "NewEconomics."
For 30 years, our nation's economists have adopted theview of
the business cycle held by th