Money, Interest, and the Business Cycle
There are two purely theoretical problems which have had serious influences and serious consequences that cannot be exaggerated.
The first of these two problems relates to the taking of interest. This leads us back to Aristotle and his famous dictum, “Money cannot beget money.” Aristotle found interest a very difficult problem. He was responsible for the error that interest was paid for the use of money. For many centuries, for two thousand years, this was the theoretical basis of the legal prohibition of interest-taking on loans. People saw only the interest on loans; they didn’t see that interest stemmed from a general category of human action, that it arose out of the fact that all people by necessity, without any exception, valued present goods higher than future goods. Therefore, this meant that the discounted values and discounted prices of future goods as against present goods could not be eliminated simply by a government fiat, rule, or command. When the Roman Empire’s “capitalism” broke down and the highly developed Roman economic system was supplanted by the economy of the invading tribes—an economy that was purely agricultural and based on the self-sufficiency of every householder’s farm—the general prohibition against the taking of interest was increasingly enforced.
In many parts of Europe there was a struggle against the taking of interest. At the head of this struggle was the Church. For a thousand years, the councils of the Church repeated the unconditional prohibition of interest. But in order to find a theoretical basis for this prohibition they could not use the Gospels and the New Testament—they had to go back to the law of Moses. There they found a passage referring to the taking of interest on loans lent to Jews and not to Gentiles. Later at the beginning of the twelfth century the theologians found a passage in the Gospels which could also be interpreted as being against interest taking. This, however, did not refer specifically to interest taking; it said, “lend, hoping for nothing again.” I think that translation is correct. This raised a problem which we needn’t go into, but which was contested by theologians and historians of law.
There was on the one hand the prohibition of the Church—the Canon Law—which the Church was very eager to enforce—but there was on the other hand reality, the practice of the people. Loans were needed. In the countries under the power of the Church, both religious and secular, modern banking was slowly developing. Theologians began to study the question of interest to determine whether or not there were reasons to justify the taking of interest. These studies were the beginning of economic law versus canonistic doctrine. They discussed many issues, and at least eliminated the erroneous belief that the lender extracts something unjust from the borrower by earning interest on money that is lent. Nevertheless that idea is still found in many American textbooks.
There was, however, another question and that question was this: If you increase the supply of money that is available for lending, then you bring about on the money market (the market for short-term loans) a tendency toward a drop in the rate of interest. If interest is not the reward for giving a man the use of a certain sum of money but in fact depends on the discount of present goods against future goods (and is independent of whether the supply of money is greater or smaller), how, then, and why does the initial drop in the rate of interest, caused by an increase in the supply of money, get reversed? In other words, notwithstanding this increased supply of money, what is the process that re-establishes a rate of interest that reflects people’s evaluations concerning the discount of future against present goods? Some people denied the existence of this phenomenon. Some people simply declared that if you increase the amount of money or money substitutes you can bring about a progressive tendency toward a further and further drop in the rate of interest until interest finally disappears completely. There are actually socialist authors who believe this is the right way to bring about abundance, to create plenty for all, and make everybody rich.
We must draw a sharp distinction between two types of bank transactions. The classical old definition of a banker, the businessman’s and economist’s definition, was that a banker was a man who loaned other people’s money. (A man who lends only his own money is a money-lender.) The banker is a person who gets deposits from people, who takes other people’s money, and lends this money to still other people. His business gains are derived from a difference in the rate of interest he pays to his depositors and the rate of interest he gets from those to whom he lends money. This is the genuine business of banking, of a banker.
The situation that came about in the nineteenth century with the development of modern methods of banking, with the issue of banknotes and of deposits subject to check, led to two serious problems: fiduciary media and credit expansion.
It was a historical evolution that took place first in Great Britain, and then also in other countries. People deposited money for safekeeping with persons whom they later called bankers—earlier these persons were the goldsmiths of London. From these goldsmiths the depositors got receipts for their money which they used in making payments. Today, we would call these receipts “banknotes.” When the goldsmith concerned enjoyed favorable good will, there was no reason for another person not to accept such a receipt in payment of money due him. The goldsmiths and the early bankers very soon discovered that it was not necessary to keep as reserves in their vaults funds amounting to the total amount of the receipts they issued—they could issue more receipts, more banknotes, than they really had ready in their cash holdings. They discovered that they could lend a part of their reserves, that it was possible to give more credit by means of banking operations than the amount of money actually deposited with them would have permitted. Thus they discovered what we would call “fiduciary media.”
The second very questionable business consists of the institution of credit expansion, which may be called the most important economic problem of our age. This means that the banker lends more money to people than he receives from his depositors. This surplus of banknotes issued by the banker, or of deposits subject to check which he opens for his customers, is credit expansion. The question is, “What are the consequences of such operations?” At the beginning, credit expansion of this type was not very critical, not very dangerous, because it was done by individual bankers who had a good standing in the city and their notes could be taken by people, or they could be refused. You could go to the banker and receive from him a loan made up completely of additional banknotes, fiduciary media, made up completely of credit expansion. But then the question was, would your customers and your creditors really be ready to accept as payment the banknotes issued by this banker? We may assume that a creditor who has a questionable deal would answer, “It is better to take these notes than to wait any longer for payment.” But then, he would have gone immediately to the banker who issued the notes and would have redeemed them, thus reducing the number of surplus banknotes outstanding. Therefore, the dangers of credit expansion were not very great as long as the credit expansion was the business of private banks and private businesses subject to commercial laws. As long as the surplus banknotes could be returned to the bank of issue for redemption, there was a check on credit expansion, and there couldn’t be credit expansion of any considerable extent.
But very soon governments invaded this field of action. They invaded it under the erroneous idea that by issuing circulation credit, additional credit, fiduciary media, by issuing more money than they had received from the public, the banks were in a position, precisely on account of this credit expansion, to reduce the height of the rate of interest.
I pointed out before that a great mistake concerning interest was inherited from earlier ages. It was a correct description of the conditions in ancient times to say that the wealthy were the creditors and the poor were the debtors. And as a result of this, the idea prevailed that a high interest rate was bad. People were not prepared to accept the rate of interest as a market phenomenon that could not be influenced by the government. They considered the interest rate merely as an obstacle to economic development and progress. Many even believed that the rate of interest was something produced by the greed of selfish money-lenders and that it was the duty of the government to fight against it. The development of modern capitalism was due to the fact that governments, after centuries and centuries of making mistakes, finally abandoned the idea that they should interfere with market prices, wage rates, and so on. Capitalism wouldn’t have developed if government interference with prices and wages had not been abandoned in the eighteenth century. This development laid the way for the economic improvements of our age. However, it did not succeed completely with regard to the rate of interest.
It is true that the older government decrees fixing maximum rates of interest were abolished in the age of liberalism and capitalism. But they were abolished only because governments thought they had discovered a new means of making credit cheaper, i.e., through credit expansion by the banks. In the process, private bankers disappeared completely from this business. Governments gave privileges to governmental banks that had the monopoly of the issuance of fiduciary media. It was not easy for them to do this, because there was some resistance. Twice in the United States, the efforts to establish a United States bank of issue were thwarted by the majority of the population.
What the governments did was to introduce a very weak “middle of the road” procedure for dealing with the problem. A consistent supporter of this system of credit expansion would have said, “If you can reduce the interest rate by credit expansion, why should you not finally abolish it altogether and make the rate of interest disappear and give everybody loans without charging them any rate of interest at all? This would be a solution to the social problem of poverty—you could give to everybody. Why not?” But the governments did not believe they could abolish the rates of interest altogether.
There was a famous exchange of letters between the French socialist Pierre-Joseph Proudhon [1809–1865] and Frédéric Bastiat. Proudhon was an opponent of Bastiat. Proudhon maintained that if we established such credit-issuing banks, then we could make the rate of interest disappear completely. Bastiat disagreed, but he didn’t find precisely the correct position; he endorsed a “middle of the road” solution, namely that interest rates should be allowed to go up to certain points but that they should not be “too high.” This middle-of-the-road position became later the generally accepted doctrine of the world. Those who still maintained that it was possible to create riches for all by credit measures aimed at lowering or eliminating interest rates altogether were called “monetary cranks.” There was no reason to call them monetary cranks; they were only more consistent than those who advocated the official middle-of-the-road policy. Some of the advocates of lowering interest rates drastically were very eminent men, eminent in other fields. There was Ernest Solvay [1838–1922], a Belgian who was successful as a businessman and as a chemist, but who believed that it was possible to make all people happy by establishing comptabilisme social [compatibilism]. In Canada, there was the Alberta Experiment, the program of an Englishman, Major Clifford H. Douglas [1879–1952]. Douglas called it “social credit.”
How could people be so mistaken as to assume that there were no consequences from this credit expansion? A special doctrine was developed for this purpose. It was said that within the economic system there is a natural limit to credit expansion. The amount of money required for business transactions, they said, was determined by the “needs of business,” and if the banks did not expand credit more than called for by these “needs of business,” then no harm can be done. Their idea was this: The producer of raw materials sells raw materials to a manufacturer and issues a bill of exchange to him; the businessman who buys the raw materials takes the bill of exchange to the bank; the bank discounts it and gives him credit to pay for these raw materials; after three months the manufacturer has produced a finished product out of these raw materials; he sells the product and pays back the loan granted to him. Therefore, the proponents of this system say, there is no danger if the bank merely provides credit enabling the businessman to buy these raw materials. If the bank limits itself to granting credit to such business already transacted, they say, then the amount of credit asked from the bank for such purposes is limited by the “needs of business”—by the exact and real amount of business transacted in the country. Therefore, it doesn’t mean an increase in the supply of credit, because the increase in the supply of credit corresponds exactly to the increase in the demand for credit transactions based on real transactions on the part of business.
But what this doctrine did not see was that these “needs of business” depend on the amount of credit given by the bank. And the amount of credit it gives out depends on the interest rate it asks from borrowers. The higher the interest rate, the fewer borrowers will want loans; the lower the interest rate, the more borrowers will ask for credit.
Every businessman calculates the expected outgo and income of his projects. If his calculations show that the transaction, given the costs, including, of course, the cost of interest, will not pay, then the project is not undertaken. But if the bank of issue appears on the scene and creates additional circulation credit to give out for such purposes, thereby lowering the rate of interest below what it would have been in the absence of this new credit, even if only by a quarter or a fifth of one percent, a number of projects which would not have been undertaken at the higher rate of interest would now be done. The credit expansion of the bank creates its own demand; it gives the impression that more savings, more capital goods, are available than actually is the case. In fact what has been increased is only the amount of credit.
If the bank does not expand credit, if it does not give out new circulation credit for this purpose, that is, if it lends only money from someone’s savings, the consequence would be that the bank would have to charge a higher rate of interest than if it did create new credit. Then many transactions would not be conducted, precisely on account of the fact that the rate of interest was a little bit higher. However, if the bank gives out new credit, additional money, it must reduce the interest rate to attract new borrowers, as all available funds were already loaned out at the prevailing market rate of interest.
The banks very often expand credit for political reasons. There is an old saying that if prices are rising, if business is booming, the party in power has a better chance to succeed in an election campaign than it would otherwise. Thus the decision to expand credit is very often influenced by the government that wants to have “prosperity.” Therefore, governments all over the world are in favor of such a credit-expansion policy.
On the market, credit expansion creates the impression that more capital and savings are available than actually are, and that projects which yesterday were not practical because of the higher interest rate are feasible today because conditions have changed. Businessmen assume that the lower interest rate signals the availability of sufficient capital goods. This means that credit expansion falsifies the businessman’s economic calculations; it gives the impression to him, to the nation, and to the world, that there are more capital goods than there really are. By credit expansion, you can increase the accounting concept of “capital”; what you cannot do is create more real capital goods. As production is necessarily always limited by the amount of capital goods available, the result of credit expansion is to make businessmen believe that projects are feasible which actually cannot be executed on account of the existing scarcity of capital goods. Thus credit expansion misleads businessmen, results in distorting production and causes economic “malinvestment.” When the credit expansion causes businessmen to undertake such projects, the result is called a “boom.”
We must not overlook the fact that all during the nineteenth and twentieth centuries there was always an obsession, unfortunately not against credit expansion, but at least against giving the government too much power in matters of credit expansion. The main object was to limit the government’s influence with regard to the central banks.
In the course of history, governments have used the central banks again and again for borrowing money. The government can borrow money from the public. For instance, a person who has saved one hundred dollars could hold them as dollars or invest them. But instead of doing either of these things he can buy a new government bond; this purchase doesn’t change the amount of money in existence; the money he pays for the bond passes from his hands to those of the government. But if the government goes to the central bank to borrow the money, the bank can buy government bonds and lend money to the government simply by expanding credit, in effect creating new money. Governments have a lot of good ideas as to how to carry out this borrowing.
There has always been a struggle between parliaments and the executive concerning the government’s influence on the central banks. Most of the European legislatures said very clearly that their central banks must be separate from the government, that they must be independent. And in this country, you know there is a continual conflict between the Federal Reserve Board and the U.S. Treasury. This is a natural situation caused by economic laws and government legislation. Some governments have found it very easy to violate the legislation without violating the letter of the law. The German government, for instance, borrowed from the public during World War I because the Reichsbank had promised to give it loans. Private individuals who bought German government bonds needed to pay out only 17 percent of the amount of the bond, and this 17 percent gave them a yield of 6 or 7 percent. Hence, 83 percent of the price of the bond was supplied by the Bank. This meant that when the government borrowed from the public, it was actually borrowing indirectly from the German Reichsbank. The result was that in Germany the U.S. dollar went from 4.20 Marks pre-World War I, to 4.2 billion Marks by the end of 1923.
There has always been resistance to giving power to the central banks, but in the last decades this resistance has been by and large completely defeated in all countries of the world. The U.S. government has used the power of the central bank, the Federal Reserve, to borrow from it to obtain a considerable part of the money it needs to fund its expenditures. The consequences have been inflation and a tendency for prices and wage rates to rise.
There is no doubt that the credit expansion brings about a drop in the rate of interest. Why then does this not mean that the rate of interest can always remain low and that interest could really disappear completely? If it is true that the rate of interest is not a monetary phenomenon but a general phenomenon of the market, which reflects the fact that future goods are traded at a discount as compared with present goods, we must ask ourselves, “What is the nature of the process which, after the initial drop of the interest rate due to credit expansion, finally brings about step by step a return of the rate of interest to that level which reflects market conditions and the general state of affairs?” That is, if the rate of interest is a general category of human action, and yet if an increased supply of money and bank credit can bring about a temporary drop in the rate of interest, how does the interest rate return once more to the rate that reflects the discount of future goods over present goods?
In answering this question, we are also answering a question that has occupied people for decades, even centuries in some countries that have had central banks and a system of credit expansion. This is the problem of the trade cycle—the regular return of periods of economic depression. In Great Britain from the end of the eighteenth century on, and later in those countries of the world that entered step by step into the system of modern capitalism and modern banking methods, we could observe from time to time an almost regular occurrence of events, i.e., the emergence of periods of economic depression, economic crises. We do not mean economic crises brought about by some obvious event that makes it possible to explain the emergence of this crisis. For instance, in the early 1860s the American Civil War made it impossible to ship cotton from the United States to Europe; and the U.S. Southern states were at that time the only suppliers of cotton to Europe. There was a very bad economic crisis, starting in the cotton-goods industries in Europe and as a consequence other industries suffered also. But everyone realized what was causing this crisis—it was the American Civil War and the stoppage of shipments of cotton to Europe. We do not deal with such crises due to a definite identifiable situation. We deal with a genuine crisis in all branches of business—although it is sometimes worse in some branches than in others—a crisis for which people couldn’t see any special reason.
From the beginning of the nineteenth century on, people began to consider these periodic crises as one of the most important problems of economic research. In the 1830s and 1840s British economists answered this question by saying, “What we have to study is not the economic depression. This depression is always the consequence of a preceding boom. We must ask ourselves not ‘What is the cause of the crisis?’—we must ask ‘What is the cause of the preceding boom?’ And we must ask ourselves what is the reason why the unquestionable and certain development of economic conditions that takes place in all countries with capitalism does not proceed steadily upward, but follows a wave-like movement, a movement in which there are repeated boom periods that always are followed by periods of depression.” In this way the crisis problem was transformed into the problem of the trade cycle. And for the problem of the trade cycle many more or less wrong explanations were offered.
I want to mention only one. This was the doctrine of an otherwise famous economist, William Stanley Jevons [1835–1882]. His doctrine acquired some fame. He attributed economic crises to sunspots. He said that sunspots bring about bad harvests, and this means bad business. If this was so, why then didn’t business adjust to this natural phenomenon as it learned to adjust to other natural phenomena?
If there is credit expansion, it must necessarily lower the rate of interest. If the banks are to find borrowers for additional credit, they must lower the rate of interest or lower the credit qualifications of would-be borrowers. Because all those who wanted loans at the previous rate of interest had gotten them, the banks must either offer loans at a lower interest rate or include in the class of businesses to whom loans are granted at the previous rate less-promising businesses, people of lower credit quality.
When individuals consume less than they produce, the surplus production is set aside as savings. Thus when the money given out in loans comes from savers, it represents actual goods which are available for further production. But when the loans are granted out of credit expansion, businessmen are misled; there are no goods standing behind them, only newly created credit. This leads to a falsification of economic calculation. Credit expansion brings about a systematic falsification—it gives to the individual businessman the impression that a project that couldn’t be executed yesterday because there were not enough capital goods, can now be executed on account of the credit expansion. As a result, there is an intensification of business activity, which means that higher prices are offered for the factors of production. But there has been no increase in the quantity of capital goods. Therefore the intensification of business activity means an artificial boom. Producers of factors of production are happy when they see that the prices they are getting are higher than they were yesterday. But this cannot go on forever, because no more material factors of production have been produced. The prices of these factors of production are going up more and more as borrowers of the new credit compete and bid up their prices. Then finally two alternatives are possible.
Business is asking for more and more credit. Either (1) the banks grant this demand by creating more and more credit (this happened in Germany in 1923, when it led to a complete breakdown of the currency). Or (2) one day, because they realize for some reason or other that they must stop credit expansion, the banks do stop creating new credit to lend. Then the firms that have expanded cannot get credit to pay for the factors of production necessary for the completion of the investment projects which they have already committed themselves. Because they cannot pay their bills, they sell off their inventories cheap. Then comes the panic, the breakdown. And the depression starts.
On account of the credit expansion the whole economic system of the country or of the world is in the situation of a man who has a limited supply of building materials available and wants to construct a home. But being poor in technological calculations, he makes some mistakes. He thinks he can build a bigger house out of his limited supply of building materials than he really can. Therefore, he starts by constructing too large a foundation. Only later does he discover that he has made a mistake and that he cannot finish the house in the way he had intended. Then he must either abandon the whole project, or use the materials still available to build a smaller house, leaving part of the foundation unused. This is the situation in which a country or in which the world finds itself at the end of a crisis caused by credit expansion. Because of the easy credit businessmen make mistakes in their economic calculations and find themselves with over-ambitious plans which cannot be completed because of insufficient factors of production.
In every boom period that precedes a crisis, in Great Britain and then later in other parts of the world, indeed, in every country in the world which has experienced credit expansion, you always find people who have said, “This is not a boom that will be followed by a crisis; only people who do not know what is going on can say such a thing. This is the final prosperity—an everlasting prosperity. We will never again have such a crisis.” The more people believe in this slogan of everlasting prosperity, the more desperate they become when they discover that the “everlasting” prosperity doesn’t last forever.
One thing that made matters worse following 1929, than in preceding periods of depression, was that the American unions were really very powerful and they would not tolerate that the crisis should bring about those results which were the consequence of earlier crises in this country and in other countries—i.e., they would not tolerate a considerable drop in money wage rates. In some branches of business, money wages went a little bit down. But by and large the unions were successful in maintaining the wage rates which had been developed artificially during the boom. Therefore, the number of unemployed remained considerable, and unemployment continued for a very long time. On the other hand, those workers who did not lose their jobs enjoyed a situation in which their wages did not drop to the same extent as commodity prices. The living conditions of some groups of labor even improved.
This was the same situation that led to the conditions in England in the latter part of the 1920s, which were important in bringing about the doctrines of Lord Keynes and the ideas of credit expansion that have been practiced in recent years. The British government made a very serious mistake in the 1920s. It was necessary for Great Britain to stabilize the currency. But they did not simply stabilize. In 1925, they returned to the pre-war gold value of the pound. That meant that the pound was a heavier pound afterwards and had a greater purchasing power than the pound, of let us say, 1920. A country like Great Britain that imports raw materials and foodstuffs and exports manufactures should not have made the pound more expensive. As Hitler expressed it, “They must either export or starve.” In such a country, in which the unions did not tolerate a drop in wage rates, it meant that the costs in pounds of manufacturing British products were increased in relation to production costs in countries which had not made a similar return to the gold standard. With higher costs, you must ask higher prices to stay in business. So you can sell fewer units and must cut production. Therefore, unemployment increased, and there was permanent mass unemployment.
Because it was impossible to deal with the unions concerning this problem, the government proceeded in 1931 to devalue the pound much more than it had been revalued in 1925, in order, they said, to encourage export trade. Other countries did the same. Czechoslovakia did it twice. The United States followed in 1933. The countries of the French standard (France, Switzerland) followed in 1936. I mention this because it is necessary to realize why the crisis of 1929—it was merely a crisis of credit expansion—had much longer and more serious consequences than those crises in preceding times. Of course, the Marxians say, every crisis must be worse and worse; the Russians, they say, have no trade cycle. Of course the Russians don’t; they have a depression all the time.
We must realize the tremendous “psychological” importance, the enormous importance of the fact that in the history of the nineteenth and twentieth centuries, credit expansion was limited. Nevertheless, it was the general opinion of businessmen, economists, statesmen, and the people, that bank credit expansion was necessary, that the rate of interest was an obstacle to prosperity, and that an “easy money” policy was a good policy to have. Everyone, businessmen as well as economists, considered credit expansion necessary and they became very angry if somebody tried to say that it might have some drawbacks. At the end of the nineteenth century, it was considered practically indecent to support the British Currency School, which was opposed to credit expansion.
When I started to study the theory of money and credit I found in the whole world of literature only one living author, a Swedish economist, Knut Wicksell [1851–1926], who really saw the problems in credit expansion. The idea prevails even today that we cannot do without credit expansion. It will be impossible, without a very serious struggle which really has to be fought, to defeat all those ideological forces that are operating in favor of credit expansion. Most people, of course, don’t give any thought to credit expansion. But the governments have a very clear idea about it—they say, “We can’t do without it.”
Credit expansion is fundamentally really a problem of civil rights. Representative government is based on the principle that the citizens need to pay to the government only those taxes that have been legally promulgated in a constitutional way: “No taxation without representation.” However, governments believe they cannot ask their citizens to pay as much in taxes as is needed to cover the whole of government expenditures. When governments cannot cover their expenses out of legally enacted taxes, they borrow from the commercial banks and so expand credit. Therefore, representative government can actually be the instigator of credit expansion and inflation.
If the institution of credit expansion and other types of government inflation had been invented in the seventeenth century the history of the struggle of the Stuarts with the British Parliament would have been very different. Charles I [1600–1649] wouldn’t have had any problems in getting the money he needed if he could simply have ordered the Bank of England, which didn’t exist in his time, to grant him credit. He would then have been in a position to organize an army of the King and to defeat Parliament. This is only one aspect.
The second aspect—I don’t believe that this country could stand psychologically a recurrence of a crisis like that of 1929. And the only way to avoid such a crisis is by preventing the boom. We are already very far along in this boom, but we could still stop it in time. However, there is a great danger. While capital goods are limited in amount and are scarce and would, therefore, limit those projects which can be executed and make many projects appear impossible for the time being, credit expansion can hide by the illusion of an increase in the capital reported in dollars on the books. Credit expansion creates the illusion of available capital, while in fact there is not.
The fundamental problem of the nineteenth century was that people didn’t realize these things. As a result, capitalism was very much discredited, for people believed that the almost periodic occurrence of depressions was a phenomenon of capitalism. Marx and his followers expected the depressions to get progressively worse, and Stalin still says openly every day: “We have only to wait. There will be a very bad crisis in the capitalist countries.” If we want to thwart these plans we must realize that sound credit policies acknowledge the fact that there is a scarcity of capital goods, that capital cannot simply be increased by credit expansion. This must come to be recognized by our businessmen and politicians.