America's Great Depression (11 page)

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America’s Great Depression

holding out for a higher real wage than the free market can provide, stupidly settle for a lower real wage if it is camouflaged in the form of a rise in the cost of living. As for idle capital goods, these may have been totally and hopelessly malinvested in a previous boom (or at some other time) and hopelessly lost to profitable production for a long time or forever. A credit expansion may appear to render submarginal capital profitable once more, but this too will be
malinvestment
, and the now greater error will be exposed when this boom is over. Thus, credit expansion generates the business cycle regardless of the existence of unemployed factors.

Credit expansion in the midst of unemployment will create more distortions and malinvestments, delay recovery from the preceding boom, and make a more grueling recovery necessary in the future.

While it is true that the unemployed factors are not now diverted from more valuable uses as employed factors would be (since they were speculatively idle or malinvested instead of employed), the other complementary factors will be diverted into working with them, and these factors will be malinvested and wasted. Moreover, all the other distorting effects of credit expansion will still follow, and a depression will be necessary to correct the new distortion.31

“Overinvestment” or Malinvestment?

The second misconception, given currency by Haberler in his famous
Prosperity and Depression
, calls the Misesian picture of the boom an “overinvestment” theory.32 Mises has brilliantly shown the error of this label. As Mises points out:

[A]dditional investment is only possible to the extent that there is an additional supply of capital goods available. . . . The boom itself does not result in a restriction but rather in an increase in consumption, it does not 31See Mises,
Human Action,
pp. 576–78. Professor Hayek, in his well-known (and excellent) exposition of the Austrian theory, had early shown how the theory fully applies to credit expansion amidst unemployed factors. Hayek,
Prices and
Production,
pp. 96–99.

32Haberler,
Prosperity and Depression,
chap. 3.

The Positive Theory of the Cycle

31

procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment

. . . on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. . . . The unavoidable end of the credit expansion makes the faults committed visible. There are plants which cannot be utilized because the plants needed for the production of the complementary factors of production are lacking; plants the products of which cannot be sold because the consumers are more intent upon purchasing other goods which, however, are not produced in sufficient quantities.

The observer notices only the malinvestments which are visible and fails to recognize that these establishments are malinvestments only because of the fact that other plants—those required for the production of the complementary factors of productions and those required for the production of consumers’ goods more urgently demanded by the public—are lacking. . . . The whole entrepreneurial class is, as it were, in the position of a master-builder [who] . . . overestimates the quantity of the available supply [of materials] . . . oversizes the groundwork . . . and only discovers later . . . that he lacks the material needed for the completion of the structure.

It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate [investment].33

Some critics have insisted that if the boom goes on long enough, these processes might finally be “completed.” But this takes the metaphor too literally. The point is that credit expansion distorts investment by directing too much of the available capital into the higher orders of production, leaving too little for lower 33Mises,
Human Action,
pp. 556–57. Mises also refutes the old notion that the boom is characterized by an undue conversion of “circulating capital” into “fixed capital.” If that were true, then the crisis would reveal a shortage of circulating capital, and would greatly drive up the prices of, e.g., industrial raw materials. Yet, these materials are precisely among the ones revealed by the crisis to be over-abundant, i.e., resources were malinvested in “circulating” as well as in “fixed” capital in the higher stages of production.

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America’s Great Depression

orders. The unhampered market assures that a complementary structure of capital is harmoniously developed; bank credit expansion hobbles the market and destroys the processes that bring about a balanced structure.34 The longer the boom goes on, the greater the extent of the distortions and malinvestments.

Banks: Active or Passive?

During the early 1930s, there was a great deal of interest, in the United States and Great Britain, in Mises’s theory of the trade cycle, an interest unfortunately nipped in the bud by the excite-ment surrounding the “Keynesian Revolution.” The adherents had split on an important question: Mises asserting that the cycle is always generated by the interventionary banking system and his followers claiming that often banks might only err in being passive and not raising their interest charges quickly enough.35 The followers held that for one reason or another the “natural rate” of interest might rise, and that the banks, which after all are not omniscient, may inadvertently cause the cycle by merely maintaining their old interest rate, now below the free-market rate.

In defense of the Mises “anti-bank” position, we must first point out that the natural interest rate or “profit rate” does not suddenly increase because of vague improvements in “investment opportunities.” The natural rate increases because time preferences increase.36 But how can banks force market interest rates 34For a stimulating discussion of some of these processes, see Ludwig M.

Lachmann,
Capital and Its Structure
(London: London School of Economics, 1956).

35For the “pro-bank” position on this issue, see F.A. Hayek,
Monetary Theory
and the Trade Cycle
(New York: Harcourt, Brace, 1933), pp. 144–48; Fritz Machlup,
Stock Market, Credit, and Capital Formation
(New York: Macmillan, 1940), pp. 247–48; Haberler,
Prosperity and Depression,
pp. 64–67. On the other side, see the brief comments of Mises,
Human Action,
pp. 570, 789n.; and Phillips et al.,
Banking and the Business Cycle,
pp. 139ff.

36The error of the followers stems from their failure to adopt the pure time-preference theory of interest of Fetter and Mises, and their clinging to eclectic

“productivity” elements in their explanation of interest. See the references mentioned in footnote 5 above.

The Positive Theory of the Cycle

33

below the free-market rates? Only by
expanding their credit!
To avoid the business cycle, then, it is not necessary for the banks to be omniscient; they need only refrain from credit expansion. If they do so, their loans made out of their own capital will not expand the money supply but will simply take their place with other savings as one of the determinants of the free-market interest rate.37

Hayek believes that Mises’s theory is somehow deficient because it is exogenous—because it holds that the generation of business cycles stems from interventionary acts rather than from acts of the market itself. This argument is difficult to fathom.

Processes are either analyzed correctly or incorrectly; the only test of any analysis is its truth, not whether it is exogenous or endogenous. If the process is
really
exogenous, then the analysis should reveal this fact; the same holds true for endogenous processes. No particular virtue attaches to a theory because it is one or the other.

Recurrence of Cycles

Another common criticism asserts that Mises’s theory may explain any
one
prosperity–depression cycle, but it fails to explain another familiar phenomenon of business cycles—their perpetual recurrence. Why does one cycle begin as the previous one ends?

Yet Mises’s theory
does
explain recurrence, and without requiring us to adopt the familiar but unproven hypothesis that cycles are

“self-generating,”—that some mysterious processes within a cycle lead to another cycle without tending toward an equilibrium condition. The self-generating assumption violates the general law of the tendency of the economy toward an equilibrium, while, on the other hand, the Mises theory for the first time succeeds in integrating the theory of the business cycle into the whole structural design of economic theory. Recurrence stems from the fact that 37Mises points out (
Human Action,
p. 789n.) that if the banks simply lowered the interest charges on their loans without expanding their credit, they would be granting gifts to debtors, and would not be generating a business cycle.

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America’s Great Depression

banks will always try to inflate credit if they can, and government will almost always back them up and spur them on. Bank profits derive mainly from credit expansion, so they will tend to inflate credit as much as they can until they are checked.38 Government, too, is inherently inflationary. Banks are forced to halt their credit expansion because of the combined force of external and internal drains, and, during a deflation, the drains, and their fears of bankruptcy, force them to contract credit. When the storm has run its course and recovery has arrived, the banks and the government are free to inflate again, and they proceed to do so. Hence the continual recurrence of business cycles.

Gold Changes and the Cycle

On one important point of business cycle theory this writer is reluctantly forced to part company with Mises. In his
Human
Action
, Mises first investigated the laws of a free-market economy and then analyzed various forms of coercive intervention in the free market. He admits that he had considered relegating trade-cycle theory to the section on intervention, but then retained the discussion in the free market part of the volume. He did so because he believed that a boom–bust cycle could also be generated by an increase in gold money, provided that the gold entered the loan market before all its price-raising effects had been completed. The potential range of such cyclical effects in practice, of course, is severely limited: the gold supply is limited by the fortunes of gold mining, and only a fraction of new gold enters the loan market before influencing prices and wage rates. Still, an important theoretical 38Walker,
The Science of Wealth,
pp. 145ff.; also see p. 159.

[B]anks must be constantly desirous of increasing their loans, by issuing their own credit in the shape of circulation and deposits. The more they can get out, the larger the income. This is the
motive power
that ensures the constant expansion of a mixed [fractional reserve] currency to its highest possible limit. The banks will always increase their indebtedness when they can, and only contract it when they must.

The Positive Theory of the Cycle

35

problem remains: can a boom–depression cycle of any degree be generated in a 100 percent gold economy? Can a purely free market suffer from business cycles, however limited in extent? One crucial distinction between a credit expansion and entry of new gold onto the loan market is that bank credit expansion
distorts
the market’s reflection of the pattern of voluntary time preferences; the gold inflow
embodies changes
in the structure of voluntary time preferences. Setting aside any permanent shifts in income distribution caused by gold changes, time preferences may temporarily fall during the transition period before the effect of increased gold on the price system is completed. (On the other hand, time preferences may temporarily rise.) The fall will cause a temporary increase in saved funds, an increase that will disappear once the effects of the new money on prices are completed. This is the case noted by Mises.

Here is an instance in which savings may be expected to increase first and then decline. There may certainly be other cases in which time preferences will change suddenly on the free market, first falling, then increasing. The latter change will undoubtedly cause a “crisis” and temporary readjustment to malinvestments, but these would be better termed irregular
fluctuations
than regular processes of the business cycle. Furthermore, entrepreneurs are trained to estimate changes and avoid error. They can handle irregular fluctuations, and certainly they should be able to cope with the results of an inflow of gold, results which are roughly predictable. They could not forecast the results of a credit expansion, because the credit expansion tampered with all their moorings, distorted interest rates and calculations of capital. No such tampering takes place when gold flows into the economy, and the normal forecasting ability of entrepreneurs is allowed full sway. We must, therefore, conclude that we cannot apply the “business cycle” label to any processes of the free market. Irregular fluctuations, in response to changing consumer tastes, resources, etc. will certainly occur, and sometimes there will be aggregate losses as a result. But the regular, systematic distortion that invariably ends in a cluster of business errors and depression—characteristic phenomena of
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America’s Great Depression

the “business cycle”—can only flow from intervention of the banking system in the market.39

39For a somewhat similar analysis of international gold flows, see F.A. Hayek,
Monetary Nationalism and International Stability
(New York: Longmans, Green, 1937), pp. 24f. Also see Walker,
The Science of Wealth,
p. 160.

2

Keynesian Criticisms of the Theory
1

There are two standard Keynesian criticisms of the Mises cycle theory. One charge takes the followers of Mises to task for identifying
saving
and
investment
. Saving and investment, the Keynesians charge, are two entirely separate processes, performed by two sets of people with little or no link between them; the “classical” identification of saving and investment is therefore illegitimate. Savings “leak” out of the consumption-spending stream; investments pour in from some other phase 1F.A. Hayek subjected J.M. Keynes’s early
Treatise on Money
(now relatively forgotten amid the glow of his later
General Theory
) to a sound and searching critique, much of which applies to the later volume. Thus, Hayek pointed out that Keynes simply assumed that zero aggregate profit was just sufficient to maintain capital, whereas profits in the lower stages combined with equal losses in the higher stages would reduce the capital structure; Keynes ignored the various stages of production; ignored changes in capital value and neglected the identity between entrepreneurs and capitalists; took replacement of the capital structure for granted; neglected price differentials in the stages of production as the source of interest; and did not realize that, ultimately, the question faced by businessmen is not whether to invest in consumer goods or capital goods, but whether to invest in capital goods that will yield consumer goods at a
nearer or later
date. In general, Hayek found Keynes ignorant of capital theory and real-interest theory, particularly that of Böhm-Bawerk, a criticism borne out in Keynes’s remarks on Mises’s theory of interest. See John Maynard Keynes,
The General Theory of
Employment, Interest, and Money
(New York: Harcourt, Brace, 1936), pp. 192–93; F.A. Hayek, “Reflections on the Pure Theory of Money of Mr. J.M. Keynes,”
Economica
(August, 1931): 270–95; and idem, “A Rejoinder to Mr. Keynes,”
Economica
(November, 1931): 400–02.