Some Key Points from F.A. Hayek's "Monetary Theory and the Trade Cycle"

F.A. Hayek's seminal paper, Monetary Theory and the Trade Cycle, is a must-read for anyone keen on a deeper understanding of the Austrian Business Cycle Theory (ABCT). Together with Hayek's other seminal paper on this subject, Prices and Production (these two papers were highly influential in securing Hayek the Nobel Prize in Economics in 1974), and Ludwig von Mises's papers and chapters (refer to his book Human Action), these writings are a natural starting point for understanding the theory. Studying the writings of these two masters of Austrian Economics and the ABCT also serve as a safeguard against being mislead by less thorough explanations of the theory. Links to theses papers and chapters can be found at the bottom of this post. In general, Mises.org is by far the best online resource for Austrian Economics. 

Below is a selection of some of the most crucial paragraphs from Hayek's Monetary Theory and the Trade Cycle in my opinion. The below headings correspond to those in the original paper. Although skimming through this selection is no substitute for reading the full paper, hopefully it will fuel your interest to read more on the subject. 

Some Key Points from

F.A. Hayek's Monetary Theory and the Trade Cycle (published in June 1932)

Preface

·                     In particular, my Prices and Production, originally published in England, should be considered as an essential complement to the present publication.

While I have here emphasized the monetary causes which start the cyclical fluctuations, I have, in that later publication, concentrated on the successive changes in the real structure of production, which constitute those fluctuations. This essential complement of my theory seems to me to be the more important since, in consequence of actual economic developments, the over-simplified monetary explanations have gained undeserved prominence in recent times.

·                     It is a curious fact that the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organization exclusively responsible for our present plight. And the same stabilizers who believed that nothing was wrong with the boom and that it might last indefinitely because prices did not rise, now believe that everything could be set right again if only we would use the weapons of monetary policy to prevent prices from falling. The same superficial view which sees no other harmful effect of a credit expansion but the rise of the price level, now believes that our only difficulty is a fall in the price level, caused by credit contraction.

There can, of course, be little doubt that, at the present time, a deflationary process is going on and that an indefinite continuation of that deflation would do inestimable harm. But this does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that, by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, Central Banks, particularly in the United States, have been making earlier and more far-reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion — with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices which existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.

It is very probable that the much discussed rigidities, which had already grown up in many parts of the modern economic system before 1929, would, in any case, have made the process of readjustment much slower and more painful. It is also probable that these very resistances to readjustment would have set up a severe deflationary process which would finally have overcome those rigidities. To what extent, under the given situation of a relatively rigid price and wage system, this deflationary process is perhaps not only inevitable but is even the quickest way of bringing about the required result, is a very difficult question, about which, on the basis of our present knowledge, I should be afraid to make any definite pronouncement.

It seems certain, however, that we shall merely make matters worse if we aim at curing the deflationary symptoms and, at the same time (by the erection of trade barriers and other forms of state intervention) do our best to increase rather than to decrease the fundamental maladjustments. More than that: while the advantages of such a course are, to say the least, uncertain, the new dangers which it creates are great. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end.

·                     But whatever may be our hope for the future, the one thing of which we must be painfully aware at the present time —a fact which no writer on these problems should fail to impress upon his readers — is how little we really know of the forces which we are trying to influence by deliberate management; so little indeed that it must remain an open question whether we would try if we knew more.

The Problem of the Trade Cycle

·                     Trade cycle theory itself is only expected to explain how certain prices are determined, and to state their influence on production and consumption; and the determining conditions of these phenomena are already given by elementary theory.

·                     There is a fundamental difficulty inherent in all Trade Cycle theories which take as their starting point an empirically ascertained disturbance of the equilibrium of the various branches of production. This difficulty arises because, in stating the effects of that disturbance, they have to make use of the logic of equilibrium theory. Yet this logic, properly followed through, can do no more than demonstrate that such disturbances of equilibrium can come only from outside — i.e. that they represent a change in the economic data — and that the economic system always reacts to such changes by its well-known methods of adaptation, i.e. by the formation of a new equilibrium. No tendency towards the special expansion of certain branches of production, however plausibly adduced, no chance shift in demand, in distribution or in productivity, could adequately explain, within the framework of this theoretical system, why a general 'disproportionality' between supply and demand should arise. For the essential means of explanation in static theory, which is, at the same time, the indispensable assumption for the explanation of particular price variations, is the assumption that prices supply an automatic mechanism for equilibrating supply and demand.

The next section will deal with these difficulties in more detail: a mere hint should therefore be sufficient at this point. At the moment we have only to draw attention to the fact that the problem before us cannot be solved by examining the effect of a certain cause within the framework, and by the methods, of equilibrium theory. Any theory which limits itself to the explanation of empirically observed interconnections by the methods of elementary theory necessarily contains a self-contradiction.

·                     Money being a commodity which, unlike all others, is incapable of finally satisfying demand, its introduction does away with the rigid interdependence and self-sufficiency of the 'closed system of equilibrium, and makes possible movements which would be excluded from the latter. Here we have a starting-point which fulfils the essential conditions for any satisfactory theory of the Trade Cycle. It shows, in a purely deductive way, the possibility and the necessity of movements which do not at any given moment tend towards a situation which, in the absence of changes in the economic 'data', could continue indefinitely. It shows that, on the contrary, these movements lead to such a 'disproportionality' between certain parts of the system that the given situation cannot continue.

But while it seems that it was a sound instinct which led economists to begin by looking on the monetary side for an explanation of cyclical fluctuations, it also seems probable that the one-sided development of the theory of money has, as yet, prevented any satisfactory solution to the problem being found. Monetary theories of the Trade Cycle succeeded in giving prominence to the right questions and, in many cases, made important contributions towards their solution; but the reason why an unassailable solution has not yet been put forward seems to reside in the fact that all the adherents of the monetary theory of the Trade Cycle have sought an explanation either exclusively or predominantly in the superficial phenomena of changes in the value of money, while failing to pursue the far more profound and fundamental effects of the process by which money is introduced into the economic system, as distinct from its effect on prices in general. Nor did they follow up the consequences of the fundamental diversity between a money economy and the pure barter economy which is assumed in static theory.

·                     It will be shown, in particular, that the Wicksell-Mises theory of the effects of a divergence between the 'natural' and the money rate of interest already contains the most important elements of an explanation, and has only to be freed from any direct reference to a purely imaginary 'general money value* (as has already been partly done by Prof. Mises) in order to form the basis of a Trade Cycle theory sufficing for a deductive explanation of all the elements in the Trade Cycle.

Non-Monetary Theories of the Trade Cycle

·                     As has already been indicated in the first chapter, none of them [the non-monetary theories] is able to overcome the contradiction between the course of economic events as described by them and the fundamental ideas of the theoretical system which they have to utilize in order to explain that course.

·                     The task is made rather easier by the fact that there does exist to-day, on at least one point, a far-reaching agreement among the different theories. They all regard the emergence of a disproportionality among the various productive groups, and in particular the excessive production of capital goods, as the first and main thing to be explained.

·                     The phenomena of the upward trend of the cycle and of the culminating boom constitute a problem only because they inevitably bring about a slump in sales — i.e. a falling-off of economic activity — which is not occasioned by any corresponding change in the original economic data.

·                     The prevailing disproportionality theories are in agreement in one respect. They all see the cause of the slump in the fact that, during the boom, for various reasons, the productive apparatus is expanded more than is warranted by the corresponding flow of consumption; there finally appears a scarcity of finished consumption goods, thus causing a rise in the price of production goods (which amounts to the same thing as a rise in the rate of interest) so that it becomes unprofitable to employ the enlarged productive apparatus or, in many cases, to complete it.

·                     In the first place there is nothing to be gained from an examination of those theories which seek to explain cyclical fluctuations by corresponding cyclical changes in certain external circumstances, while merely using the unquestionable methods of equilibrium theory to explain the economic phenomena which follow from these changes. To decide on the correctness of these theories is beyond the competence of Economics. In the second place, it is best, for the moment, to exclude from consideration those theories whose argument depends so entirely on the assumption of monetary changes that when the latter are excluded no systematic explanation is left.

·                     It is not, therefore, the simple fact of fluctuation in the production of capital goods (which is certainly inevitable in the course of economic growth) which has to be explained.

The real problem is the growth of excessive fluctuations in the capital goods industries out of the inevitable and irregular fluctuations of the rest of the economic system, and the disproportional development, arising from these, of the two main branches of production.

·                     The simplest way of deductively explaining excessive fluctuations in the production of capital goods is by reference to the long period of time which is necessary, under modern conditions, for preparing the fixed capital goods which enable the expansion of the productive process to take place.

·                     But none of them get over the real difficulty — namely: Why do the forces tending to restore equilibrium become temporarily ineffective and why do they only come into action again when it is too late?

·                     Production is generally guided not by any knowledge of the actual size of the total demand, but by the price to be obtained in the market.

·                     It is however, the task of Trade Cycle theory to show under what conditions a break may occur in that tendency towards equilibrium which is described in pure analysis – i.e. why prices, in contradiction to the conclusions of static theory, do not bring about such changes in the quantities produced as would correspond to an equilibrium situation.

·                     We may attempt this task by asking what kind of reactions will be brought about by the original change in the economic data, which is supposed to cause the excessive extension of the production of capital goods, and how, in such cases, a new equilibrium can result. Whether the original impetus comes from the demand side or the supply side, the assumption from which we have to start is always a price —or rather an expected price — which renders it profitable, under the new conditions, to extend production.

·                     …every attempt to extend the productive apparatus must necessarily bring about, besides the rise in factor prices, a further checking force – viz. a rise in the rate of interest. This greatly strengthens the effect of the rise in factor prices. It makes a greater margin between factor-prices and product-prices necessary just when this margin threatens to diminish. The maintenance of equilibrium is thus further secured.

…all contemporary theories agree in regarding the function of interest as one of equalising the supply of capital and the demand arising in various branches of production. Until some special reason can be adduced why it should not fulfil this function in any given case, we have to assume, in accordance with the fundamental thesis of static theory, that it always keeps the supply of capital goods in equilibrium with that of consumption goods. This assumption is just as indispensable, and just as inevitable, as a starting-point, as the main assumption that the supply of and demand for any kind of goods will be equilibrated by movements in the prices of those goods.

·                     Only when we come to consider the second group of prices (those paid for borrowed capital or, in other words, interest) is it conceivable that disturbances might creep in, since, in this case, price formation does not act directly, by equalising demand for and supply of capital goods, but indirectly, through its effect on money capital, whose supply need not correspond to that of real capital [the first group is prices of goods and services used for productive purposes]

·                     Assuming that the rate of interest always determines the point to which the available volume of savings enables productive plant to be extended – and is it only by this assumption that we can explain what determines the rate of interest at all – any allegations of a discrepancy between savings and investments must be backed up by a demonstration why, in the given case, interest does not fulfil this function.

·                     At one point or another, all theories which start to explain cyclical fluctuations by miscalculations or ignorance as regards the economic situation fall into the same error as those naïve explanations which base themselves on the “planlessness” of the economic system. They overlook the fact that, in the exchange economy, production is governed by prices, independently of any knowledge of the whole process on the part of individual producers, so that it is only when the pricing process is itself disturbed that a misdirection of production can occur. The “wrong” prices, on the other hand, which lead to “wrong” dispositions, cannot in turn be explained by mistake.

·                     Once we assume that, even at a single point, the pricing process fails to equilibrate supply and demand, so that over a more or less long period demand may be satisfied at prices at which the available supply is inadequate to meet total demand, then the march of economic events loses its determinateness and a range of indeterminateness appears, within which movements can originate leading away from equilibrium. And it is rightly assumed, as we shall see later on, that it is precisely the behaviour of interest, the price of credit, which makes possible these disturbances in price formation.

·                     One must regard it [credit] rather as a new determining factor whose appearance causes these deviations and whose effects must form our starting-point when deducing all those phenomena which can be observed in cyclical fluctuations. Only when we have succeeded in doing this can we claim to have explained the phenomena described.

·                     ...the proposition that, in a barter economy, interest forms a sufficient regulator for the proportional development of the production of capital goods and consumption goods, respectively. If it is admitted that, in the absence of money, interest would effectively prevent any excessive extension of the production of production goods, by keeping it within the limits of the available supply of savings, and that an extension of the stock of capital goods which is based on a voluntary postponement of consumers’ demand into the future can never lead to disproportionate extensions, then it must also necessarily be admitted that disproportional developments in the production of capital goods can arise only through the independence of the supply of free money capital from the accumulation of savings; which in turn arises from the elasticity of the volume of money.

·                     A change in the volume of money, on the other hand, represents as it were a one-sided change in demand, which is not counterbalanced by an equivalent change in supply.

·                     One instance of these disturbances in the price mechanism, brought about by monetary influences – and the one which is the most important from the point of view of Trade Cycle theory – is that putting out of action of the “interest brake”…

·                     For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements which are capable of relaxing these rigid inter-relationships.

Monetary Theories of the Trade Cycle

·                     ….the main reason for the necessity of the monetary approach to Trade Cycle theory. It arises from the circumstances that the automatic adjustment of supply and demand can only be disturbed when money is introduced into the economic system. This adjustment must be considered, according to the reasoning which is most clearly expressed in Say’s [Law], as being always present in a state of the natural economy.

·                     …the influence of money should be sought in the fact that when the volume of money is elastic, there may exist a lack of rigidity in the relationship between saving and the creation of real capital.

·                     The only proper starting-point for any explanation based on equilibrium theory must be the effect of a change in the volume of money; for this, in itself, constitutes a new state of affairs, entirely different from that generally treated within the framework of static theory.

·                     In complete contrast to those economic changes conditioned by 'real* forces, influencing simultaneously total supply and total demand, changes in the volume of money have, so to speak, a one-sided influence which elicits no reciprocal adjustment in the economic activity of different individuals. By deflecting a single factor, without simultaneously eliciting corresponding changes in other parts of the system, it dissolves its 'closedness', makes a breach in the rigid reaction mechanism of the system (which rests on the ultimate identity of supply and demand) and opens a way for tendencies leading away from the equilibrium position. As a theory of these one-sided influences, the theory of monetary economy should, therefore, be able to explain the occurrence of phenomena which would be inconceivable in the barter economy, and notably the disproportional developments which give rise to crises. A starting-point for such explanations should be found in the possibility of alterations in the quantity of money occurring automatically and in the normal course of events, under the present organization of money and credit, without the need for violent or artificial action by any external agency.

·                     The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price-level stable, is always lower than the rate which would keep the amount of available loan-capital equal to the amount simultaneously saved by the public, and thus, despite the stability of the price-level, it makes possible a development leading away from the equilibrium position.

·                     Increases in the volume of circulation, which in an expanding economy serve to prevent a drop in the price level, present a typical instance of a change in the monetary factor calculated to cause a discrepancy between the money and natural rate of interest without affecting the price-level. These change are consequently neglected, as a rule, in dealing with phenomena of disproportionality; but they are bound to lead to a distribution of productive resources between capital-goods and consumption goods which differs from the equilibrium distribution, just as those changes in the monetary factor which do manifest themselves in changes in the price-level. This case is particularly important, because under contemporary currency systems the automatic adjustment of the value of money, in the form of a flow of precious metals, will regularly make available new supplies of purchasing power which will depress the money rate of interest below its natural level.

·                     Since a stable price-level has been regarded as normal hitherto, far too little investigation has been made into the effects of these changes in the volume of money, which necessarily cause a development different from that which would be expected on the basis of static theory, and which lead to the establishment of a structure of production incapable of perpetuating itself once the change in the monetary factor has ceased to operate. Economists have overlooked the fact that the changes in the volume of money, which, in an expanding economy, are necessary to maintain price stability, lead to a new state of affairs foreign to static analysis, so that the development which occurs under a stable price level cannot be regarded as consonant with static laws. Thus the disturbances described as resulting from changes in the value of money form only a small part of the much wider category of deviations from the static course of events brought about by changes in the volume of money — which may often exist without changes in the value of money, while they may also fail to accompany changes in value of money when the latter occur.

·                     …most of the objections raised against monetary theories of cyclical fluctuations rest on the mistaken idea that their significant contribution consists in deducing changes in the volume of production from the movement of prices en bloc.

·                     We have already shown that it is not even necessary, in order to ascribe the cause of cyclical fluctuations to monetary changes, to assume that these monetary causes act through changes in the general price-level.

It is therefore impossible to maintain that the importance of monetary theories lies solely in an explanation of price cycles.

·                     But general price changes are no essential feature of a monetary theory of the Trade Cycle; they are not only unessential, but they would be completely irrelevant if only they were completely general— that is, if they affected all prices at the same time and in the same proportion. The point of real interest to Trade Cycle theory is the existence of certain deviations in individual price relations occurring because changes in the volume of money appear at certain individual points; deviations, that is, away from the position which is necessary to maintain the whole system in equilibrium. Every disturbance of the equilibrium of prices leads necessarily to shifts in the structure of production, which must therefore be regarded a consequences of monetary change, never as additional separate assumptions. The nature of the changes in the composition of the existing stock of goods, which are effected through such monetary changes, depends of course on the point at which the money is injected into the economic system.

·                     The assumption of a 'time lag between the successive changes in various prices has not been spun out of thin air solely for the purposes of Trade Cycle theory; it is a correction, based on systematic reasoning, of the mistaken conceptions of older monetary theories. Of course, the expression 'time lag,' borrowed from Anglo-American writers and denoting a temporary lagging behind of the changes in the price of some goods relatively to the changes in the price of other goods, is a very unsuitable expression when the shifts in relative prices are due to changes in demand which are themselves conditioned by monetary changes. For such shifts are bound to continue so long as the change in demand persists. They disappear only with the disappearance of the disturbing monetary factor. They cease when money ceases to increase or diminish further; not, however, when the increase or diminution has itself been wiped out. But, whatever expression we may use to denote these changes in relative prices and the changes in the structure of production conditioned by them, there can be no doubt that they are, in turn, conditioned by monetary causes, which alone make them possible.

·                     …it can be urged that those changes which are constantly taking place in our money

and credit organization cause a certain price, the rate of interest, to deviate from the equilibrium position, and that deviations of this kind necessarily lead to such changes in the relative position of the various branches of production as are bound later to precipitate the crisis. There is one important point, however, which must be emphasized against the above-named critics; namely, that it is not only when the crisis is directly occasioned by a new monetary factor, separate from that which originally brought about the boom, that it is to be regarded as conditioned by monetary causes. Once the monetary causes have brought about that development in the whole economic system which is known as a boom, sufficient forces have already been set in motion to ensure that, sooner or later, when the monetary influence has ceased to operate, a crisis must occur. The 'cause' of the crisis is, then, the disequilibrium of the whole economy occasioned by monetary changes and maintained through a longer period, possibly, by a succession of further monetary changes — a disequilibrium the origin of which can only be explained by monetary disturbances.

·                     …the reason for its [the cycle] continuous recurrence lies in an 'immanent necessity of the monetary and credit mechanism.'

·                     Among the phenomena which are fundamentally independent of changes in the value of money, we must include, first of all, the effects of a rate of interest lowered by monetary influences, which must necessarily lead to the excessive production of capital goods. Wicksell and Mises both rightly emphasize the decisive importance of this factor in the explanation of cyclical phenomena, as its effect will occur even when the increase in circulation is only just sufficient to prevent a fall in the price level. Besides this, there exist a number of other phenomena, by virtue of which a money economy (in the sense of an economy with a variable money supply) differs from a static economy, which for this reason are important for a true understanding of the course of the Trade Cycle. They have been partly described already by Mises, but they can only be clearly observed by taking as the central subject of investigation not changes in general prices but the divergences of the relation of particular prices as compared with the price system of static equilibrium.

The Fundamental Cause of Cyclical Fluctuations

So far we have not answered, or have only hinted at an answer to the question why, under the existing organization of the economic system, we constantly find those deviations of the money rate of interest from the equilibrium rate which, as we have seen, must be regarded as the cause of the periodically recurring disproportionalities in the structure of production. The problem is, then, to discover the gap in the reaction mechanism of the modern economic system which is responsible for the fact that certain changes of data, so far from being followed by a prompt readjustment (i.e. the formation of a new equilibrium) are, actually, the cause of recurrent shifts in economic activity which subsequently have to be reversed before a new equilibrium can be established.

·                     The new element which we are seeking is, therefore, to be found in the 'elasticity' of the volume of money at the disposal of the economic system. It is this element whose presence forms the 'necessary and sufficient condition for the emergence of the Trade Cycle

·                     Yet Professor Mises himself—who is certainly to be regarded as the most respected and consistent exponent of the monetary theory of the Trade Cycle in Germany — has, in his latest work, afforded ample justification for this view of his theory by attributing the periodic recurrence of the Trade Cycle to the general tendency of Central Banks to depress the money rate of interest below the natural rate

·                     By disregarding those divergencies between the natural and money rate of interest which arise automatically in the course of economic development, and by emphasizing those caused by an artificial lowering of the money rate, the Monetary Theory of the Trade Cycle deprives itself of one of its strongest arguments; namely, the fact that the process which it describes must always recur under the existing credit organization, and that it thus represents a tendency inherent in the economic system, and is in the fullest sense of the word an endogenous theory.

·                     It is an apparently unimportant difference in exposition which leads one to this view that the Monetary Theory can lay claim to an endogenous position. The situation in which the money rate of interest is below the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the natural rate (at which the demand for and the supply of savings are equal) above its previous level; while the banks refrain from raising their rate of interest to a proportionate extent, but continue to lend at the previous rate, and thus enable a greater demand for loans to be satisfied than would be possible by the exclusive use of the available supply of savings. The decisive significance of the case quoted is not, in my view, due to the fact that it is probably the commonest in practice, but to the fact that it must inevitably recur under the existing credit organization.

·                     Altogether, there are three elements which regulate the volume of circulating media within a country — changes in the volume of cash, caused by inflows and outflows of gold; changes in the note circulation of the Central Banks: and last, and in many ways most important, the often-disputed 'creation' of deposits by other banks. The interrelations of these are, naturally, complicated.

·                     It has already been pointed out that, in principle, an increase in the volume of cash, occasioned by an increase in the volume of trade, also implies a lowering of the money rate of interest — which gives rise to shifts in the structure of production which seem, though only temporarily, to be advantageous.

·                     If in the course of our investigation, it is possible to prove that the rate of interest charged by the banks to their borrowers is not promptly adjusted to all changes in the economic data (as it would be if the volume of money in circulation were constant) •—either because the supply of bank credits is, within certain limits, fundamentally independent of changes in the supply of savings, or because the banks have no particular interest in keeping the supply of bank credit in equilibrium with the supply of savings and because it is, in any case, impossible for them to do so — then we shall have proved that, under the existing credit organization, monetary fluctuations must inevitably occur and must represent an immanent feature of our economic system — a feature deserving of the closest examination.

·                     What interests us is precisely the question whether the banks are able to satisfy the increased demands of business men for credits without being obliged immediately to raise their interest charges —as would be the case if the supply of savings and the demand for credits were to be in direct contact, without the agency of the banks (as for example in the hypothetical Savings market' of theory); or whether it is even possible for the banks to raise their interest charges immediately the demand for credits increases. Even the bitterest opponents of this theory of bank credit are forced to admit that there can be no doubt that, with the upward swing of the Trade Cycle, a certain expansion of bank credits takes place.'

·                     So far, the starting point of our argument concerning the origin of additional credits has been the assumption that the banks receive an increased in-flow of cash which they then use as a basis for new credits on a much larger scale. We must now inquire how banks behave when an increased demand for credit makes itself felt. Assuming, as is preferable, that this increased demand was not caused by a lowering of their own interest rates, this additional demand is always a sign that the natural rate of interest has risen — that is, that a given amount of money can now find more profitable employment than hitherto. The reasons for this can be of very different kinds.

New inventions or discoveries, the opening up of new markets, or even bad harvests, the appearance of entrepreneurs of genius who originate 'new combinations' (Schumpeter), a fall in wage rates due to heavy immigration; and the destruction of great blocks of capital by a natural catastrophe, or many others. We have already seen that none of these reasons is in itself sufficient to account for an excessive increase of investing activity, which necessarily engenders a subsequent crisis; but that they can lead to this result only through the increase in the means of credit which they inaugurate. But how is it possible for the banks to extend credit, as they undoubtedly do, following an increase in demand, when no additional cash is flowing into their vaults? There is no reason to assume that the same cause which has led to an increased demand for credit will also influence another factor, the cash position of the banks — which as we know is the only factor determining the extent to which credit can be granted. So long as the banks maintain a constant proportion between their cash reserves and their deposits it would be impossible to satisfy the new demand for credit. The fact that in reality deposits always do expand relatively to cash reserves, in the course of the boom, so that the liquidity of the banks is always impaired in such periods, does not of course constitute a sufficient starting point for an argument in which the increase in credits is regarded as the decisive factor determining the course and extent of the cyclical movement. We must attempt to understand fully the causes and nature of this credit expansion and in particular, its limits. The key to this problem can only be found in the fact that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable. But we shall achieve a satisfactory solution only by showing that the reason for this variability in the reserve is not based on the arbitrary decisions of the bankers, but is itself conditioned by the general economic situation. Such an examination of the causes determining the size of the reserve ratio desired by the banks is all the more important since we had no theoretical warrant for our previous assumption that it always tends to be constant.

·                     …assuming that the bank recognizes that it can satisfy its eventual need for cash only at correspondingly higher rates, we can see that the greater loss of profit entailed by keeping the cash reserve intact will, as a rule, lead the bank to a policy which involves diminishing the size of this non-earning asset. Besides this, we have the consideration that, in the upward phase of the cycle, the risks of borrowing are less; and therefore a smaller cash reserve may suffice to provide the same degree of security. But it is above all for reasons of competition that the bank which first feels the effect of an increased demand for credits cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks which had not yet experienced a similarly increased demand for credits. There can be little doubt, therefore, that the bank or banks which are the first to feel the effects of new credit requirements will be forced to satisfy these even at the cost of reducing their liquidity.

·                     But once one bank or group of banks has started the expansion, then all the other banks receive, as already described, a flow of cash which at first enables them to expand credit on their own account without impairing their liquidity. They make use of this possibility the more readily since they, in turn, soon feel the increased demand for credit. Once the process of expansion has become general, however, the banks soon realize that, for the moment at any rate, they can safely modify their ideas of liquidity. While expansion by a single bank will soon confront it with a clearinghouse deficit of practically the same magnitude as the original new credit, a general expansion carried on at about the same rate by all banks will give rise to clearing-house claims which, although larger, mainly compensate one another and so induce only a relatively unimportant cash drain. If a bank does not at first keep pace with the expansion it will, sooner or later, be induced to do so, since it will continue to receive cash at the clearing house as long as it does not adjust itself to the new standard of liquidity.

So long as this process goes on, it is practically impossible for any single bank, acting alone, to apply the only control by which the demand for credit can, in the long run, be successfully kept within bounds; that is, an increase in its interest charges. Concerted action in this direction, which for competitive reasons is the only action possible, will ensue only when the increased cash requirements of business compel the banks to protect their cash balances by checking further credit expansion, or when the Central Bank has preceded them by raising its discount rate. This, again, will only happen, as a rule, when the banks have been induced by the growing drain on their cash to increase their re-discount. Experience shows, moreover, that the relation between cheque payments and cash payments alters in favour of the latter as the boom proceeds, so that an increased proportion of the cash is finally withdrawn from the banks.

This phenomenon is easily explained in theory by the fact that a low rate of interest first raises the prices of capital goods and only subsequently those of consumption goods, so that the first increases occur in the kind of payments which are effected in large blocks.* It may lead to the consequence that banks are not only prevented from granting new credits, but even forced to diminish credits already granted. This fact may well aggravate the crisis; but it is by no means necessary in order to bring it about. For this it is quite enough that the banks should cease to extend the volume of credit; and sooner or later this must happen. Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must, despite the increased total volume in circulation, rise again to its natural level and thus render unprofitable (temporarily, at least) those investments which were created with the aid of additional credit.

·                     By creating additional credits in response to an increased demand, and thus opening up new possibilities of improving and extending production, the banks ensure that impulses towards expansion of the productive apparatus shall not be so immediately and insuperably balked by a rise of interest rates as they would be if progress were limited by the slow increase in the flow of savings. But this same policy stultifies the automatic mechanism of adjustment which keeps the various parts of the system in equilibrium, and makes possible disproportionate developments which must, sooner or later, bring about a reaction.

Elasticity in the credit supply of an economic system, is not only universally demanded but also — as the result of an organization of the credit system which has adapted itself to this requirement — an undeniable fact, whose necessity or advantages are not discussed here. But we must be quite clear on one point. An economic system with an elastic currency must, in many instances, react to external influences quite differently from an economy in which economic forces impinge on goods in their full force — without any intermediary; and we must a priori, expect any process started by an outside impulse to run an entirely different course in such an economy from that described by a theory which only takes into account changes originating on the side of goods. Once, owing to the disturbing influence of money, even a single price has been fixed at a different level from that which it would have formed in a barter economy, a shift in the whole structure of production is inevitable; and this shift, so long as we make use of static theory and the methods proper to it, can only be explained as an exclusive consequence of the peculiar influence of money. The immediate consequence of an adjustment of the volume of money to the 'requirements' of industry is the failure of the 'interest brake' to operate as promptly as it would in an economy operating without credit. This means, however, that new adjustments are undertaken on a larger scale than can be completed; a boom is thus made possible, with the inevitably recurring 'crisis.' The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.

·                     It must be emphasized first and foremost that there is no necessary reason why the initiating change, the original disturbance eliciting a cyclical fluctuation in a stationary economy, should be of monetary origin. Nor, in practice, is this even generally the case. The initial change need have no specific character at all, it may be any one among a thousand different factors which may at any time increase the profitability of any group of enterprises. For it is not the occurrence of a change of data' which is significant, but the fact that the economic system, instead of reacting to this change with an immediate 'adjustment*

(Schumpeter) — i.e. the formation of a new equilibrium — begins a particular movement of 'boom' which contains, within itself, the seeds of an inevitable reaction. This phenomenon, as we have seen, should undoubtedly be ascribed to monetary factors, and in particular to 'additional credits' which also necessarily determine the extent and duration of the cyclical fluctuation. Once this point is agreed upon, it naturally becomes quite irrelevant whether we label this explanation of the Trade Cycle as a monetary theory or not. What is important is to recognize that it is to monetary causes that we must ascribe the divergences of the pricing process, during the Trade Cycle, from the course deduced in static theory.

From the particular point of view from which we started, our theory must be regarded most decisively as a monetary one. As to the incorporation of Trade Cycle theory into the general framework of static equilibrium theory (for the clear formulation of which we are indebted to Professor A. Lowe, one of the strongest opponents of monetary Trade Cycle theory), we must maintain, in opposition to his view, not only that our own theory is undoubtedly a monetary one but that a theory other than monetary is hardly conceivable. It must be conceded that the monetary theory as we have presented it — whether one prefers to call it a monetary theory or not, and whether or not one finds it a sufficient explanation of the empirically determined fluctuations-has this definite advantage: it deals with problems which must, in any case, be dealt with for they are necessarily given when the central apparatus of economic analysis is applied to the explanation of the existing organization of exchange. Even if we had never noticed cyclical fluctuations, even if all the actual fluctuations of history were accepted as the consequences of natural events, a consequential analysis of the effects which follow from the peculiar workings of our existing credit organization would be bound to demonstrate that fluctuations caused by monetary factors are unavoidable.

·                     Whatever further hypothetical causes are adduced to explain the empirically observed course of the fluctuations, there can be no doubt (and this is the important and indispensable contribution of monetary Trade Cycle theory) that the modern economic system cannot be conceived without fluctuations ascribable to monetary influences; and therefore any other factors which may be found necessary to explain the empirically observed phenomena will have to be regarded as causes additional to the monetary cause. In other words, any non-monetary Trade Cycle theory must superimpose its system of explanation on that of the monetarily determined fluctuations; it cannot start simply from the static system as presented by pure equilibrium theory.

·                     The fact, simple and indisputable as it is, that the Elasticity' of the supply of currency media, resulting from the existing monetary organization, offers a sufficient reason for the genesis and recurrence of fluctuations in the whole economy is of the utmost importance — for it implies that no measure which can be conceived in practice would be able entirely to suppress these fluctuations.

It follows particularly from the point of view of the monetary theory of the Trade Cycle, that it is by no means justifiable to expect the total disappearance of cyclical fluctuations to accompany a stable price-level — a belief which Professor Lowe seems to regard as the necessary consequence of the Monetary Theory of the Trade Cycle. Professor Ropke is undoubtedly right when he emphasizes the fact that 'even if a stable price level could be successfully imposed on the capitalist economy the causes making for cyclical fluctuations would not be removed.

So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them. And even if it is a mistake — as the recurrence of crises would demonstrate — to suppose that we can, in this way, overcome all obstacles standing in the way of progress, it is at least conceivable that the non-economic factors of progress, such as technical and commercial knowledge, are thereby benefited in a way which we should be reluctant to forgo.

“Forced Saving” (not a headline in the book)

There have recently been increasingly frequent objections to this account of the effects of an increased volume of currency, and the artificial lowering of interest rates conditioned by it, on the grounds that it disregards certain supposedly beneficial effects which are closely connected with this phenomenon. What the objectors have in mind is the phenomenon of so-called 'forced saving' which has received great attention in recent literature. This phenomenon, we are to understand, consists in an increase in capital creation at the cost of consumption, through the granting of additional credit, without voluntary action on the part of the individuals who forgo consumption, and without their deriving any immediate benefit. According to the usual presentation of the theory of forced saving, this occurs through a fall in the general value of money, which diminishes the consumers' purchasing power; the volume of goods thus freed can be used by the producers who obtained additional credits.

We must, however, raise the same objection ta this theory which we raised against the usual account of the effects of an artificial lowering of the money rate of interest, i.e. that, in principle, forced saving takes place whenever the volume of money is increased, and does not need to manifest itself in changes in the value of money. The 'depreciation' of money in the hands of the consumer can be, and frequently will be, only relative, in the sense that those diminutions in price which would otherwise have occurred are prevented from occurring. Even this causes a part of the social dividend to be distributed to individuals who have not acquired legitimate claim to it through previous services, nor taken them over from others legitimately entitled to them. It is thus taken away from this part of the community against its will. After what has been said above, this process needs no further illumination. Nor do we need to adduce further proof that every grant of additional credit induces 'forced saving

— even if we have avoided using this rather unfortunate expression in the course of our argument. There is only one further point — the effect of this artificially induced capital accumulation — on which a few remarks should be added. It has often been argued that the forced saving arising from an artificially lowered interest rate would improve the capital supply of the economy to such an extent that the natural rate of interest would have to fall finally to the level of the money rate of interest, and thus a new state of equilibrium would be created —that is, the crisis could be avoided altogether. This view is closely connected with the thesis, which we have already rejected, that the level of the natural rate of interest depends directly upon the whole existing stock of real capital. Forced saving increases only the existing stock of real capital goods, but not necessarily the current supply of free capital disposable for investment

— that portion of total income which is not consumed but used as a provision for the upkeep and depreciation of fixed plant. But any addition to the supply of free capital available for new investment or reinvestment must come from those of the investments induced by forced savings which already yield a return; a return large enough to leave over, after providing for supplementary costs connected with the new means of production, a surplus for depreciation and for interest payments on the capital. If the capital supply from this source is to lower the natural rate of interest, it must not, of course, be offset by a diminution elsewhere — resulting from the decline of other undertakings confronted with the reinforced competition of those newly supplied with capital. The assumption that an artificial increase of fixed capital (i.e. one caused by additional credits) tends to diminish the natural rate of interest in the same way as one effected through voluntary savings activity presupposes, therefore, that the new capital must be incorporated into the economic system in such a way that the prices of the products imputed to it shall cover interest and depreciation. Now a given stock of capital goods is not a factor which will maintain and renew itself automatically, irrespective of whether it is in accordance with the current supply of savings or not. The fact that investments have been undertaken which cannot be 'undone* offers no guarantee whatever that this is the case. Whether capital can be created beyond the limits set by voluntary saving depends — and this is just as true for its renewal as for the creation of new plant — on whether the process of credit creation continues in a steadily increasing ratio. If the new processes of production are to be completed, and if those already in existence are to continue in employment, it is essential that additional credits should be continually injected at a rate which increases fast enough to keep ahead, by a constant proportion, of the expanding purchasing power of the consumer. If a new process of roundabout production can be completed while these conditions still hold good, it can contribute temporarily to a lowering of the natural rate of interest; but this provides no final solution of the difficulty.

For, eventually, a moment must inevitably arrive when the banks are unable any longer to keep up the rate of inflation required, and at that moment there must always be some processes of production, newly undertaken and not yet completed,* which were only ventured because the rate of interest was kept artificially low. It does not follow, of course, that these processes in particular will be left unfinished because of the subsequent rise in that rate; on the other hand, their existence does cause the rate of interest to be higher than it would be in their absence, when capital would be required only by processes made possible by voluntary saving without any competing demand arising from processes which were only enabled to start by 'forced saving.' The capital invested in new and not yet completed processes of production will thus merely intensify the demand for further supplies by calling for the capital necessary to complete them — an effect which will be the more pronounced the greater the ratio of capital invested to capital still required.

It may therefore quite easily come about that, in order to complete these newly initiated processes, capital may be diverted from the maintenance of complete and old-established undertakings, so that new plant is put into operation and old plant closed down, although the latter would have been kept up, and the former never put in hand, if it had been a question of building up the whole capital equipment of the economy from the start.

This does not merely mean that the total return comes to less than it otherwise would; it also means, primarily, that production is forced into channels to which it will only keep for as long as the new and spuriously produced stock of fixed capital can remain in use. The value of capital invested in processes which can be continued, and, still more, that in processes where continuance is impracticable, will shrink rapidly in value — this shrinkage being accompanied by the phenomena of a crisis. Thus on purely technical grounds it will become uneconomic to maintain them. It should be particularly remarked that, from the point of view of the fate of individual enterprises, capital invested in fixed plant, but raised by borrowing, is of precisely the same importance as working capital, i.e. the loss of value does not merely necessitate writing down, it generally makes it impossible to carry on at all. The cause of this development is, evidently, that an unwarranted accumulation of capital has been taking place; though people may regard it (under the alluring name of * forced saving') as a thoroughly desirable phenomenon. After what has been said above it is probably more proper to regard forced saving as the cause of economic crises than to expect it to restore a balanced structure of production.

------“Forced Saving” end.

·                     Here again we have to repeat what was asserted at the beginning of this book: statistics can never prove or disprove a theoretical explanation, they can only present problems or offer fields for theoretical research.

If the results of our theoretical analysis were to be subjected to statistical investigation, it is not the connection between changes in the volume of bank credit and movements in the price level which would have to be explored. Investigation would have to start on the one hand from alterations in the rate of increase and decrease in the volume and turnover of bank deposits and, on the other, from the extent of production in those industries which as a rule expand excessively as a result of credit injection.* Every increase in the circulating media brings about the same effect, so long as each stands in the same proportion to the existing volume; and only an increase in this proportion makes possible a further increase in investment activity. On the other hand, every diminution of the rate of increase in itself causes some portion of existing investment, made possible through credit creation, to become unprofitable.

It follows that a curve exhibiting the monetary influences on the course of the cycle ought to show, not the movements in the total volume of circulating media, but the alteration in the rate of change of this volume. Every up-turn of this curve would show that an artificial lowering of the money rate of interest or, if the curve was already rising, a further lowering of the money rates, was making possible additional investments for which voluntary savings would not suffice; and every down-turn would show that current credit-creation was no longer sufficient to ensure the continuance of all the enterprises which it originally called into existence. It would be of great interest to correlate this presentation of the influence causing an excessive production of capital goods with actual changes in the production of these goods, on the basis of available data.

·                     No less important would be an investigation into the volume, at any given moment, of those factors which determine credit expansion, under the other headings of bank balance sheets, and, in particular, an examination of the relation between the total amount of earning assets and the current accounts, the relation between these and the cash-circulation, and so on. Such an investigation, if it were not merely to exhibit their movements in time but also to analyse the deeper connections between them, and most especially if it were to clear up the relationship between interest rates, profits, and the liquidity of the banks, would further our insight into the factors determining credit expansion as well as our knowledge of their limits, and thus make it possible to forecast movements in the factors determining the total development of the economic situation.

Link to Hayek's "Monetary Theory and the Trade Cycle": http://mises.org/daily/3121

Link to Hayek's "Prices and Production": http://mises.org/document/681/

Link to Mises' Human Action: http://mises.org/document/3250 - Chapter XX. Interest, Credit Expansion, and the Trade Cycle deals directly with the ABCT.