In chapter 11, we depicted the workings of the monetary system of a purely free market. A free money market adopts specie, either gold or silver or both parallel, as the “standard” or money proper. Units of money are simply units of weight of the money-stuff. The total stock of the money commodity increases with new production (mining) and decreases from wear and tear and use in industrial employments. Generally, there will be a gradual secular rise in the money stock, with effects as analyzed above. The wealth of some people will increase and of others will decline, and no social usefulness will accrue from an increased supply of money—in its monetary use. However, an increased stock will raise the social standard of living and well-being by further satisfying nonmonetary demands for the monetary metal.

Intervention in this money market usually takes the form of issuing pseudo warehouse receipts as money-substitutes. As we saw in chapter 11, demand liabilities such as deposits or paper notes may come into use in a free market, but may equal only the actual value, or weight, of the specie deposited. The demand liabilities are then genuine warehouse receipts, or true money certificates, and they pass on the market as representatives of the actual money, i.e., as money-substitutes. Pseudo warehouse receipts are those issued in excess of the actual weight of specie on deposit. Naturally, their issue can be a very lucrative business. Looking like the genuine certificates, they serve also as money-substitutes, even though not covered by specie. They are fraudulent, because they promise to redeem in specie at face value, a promise that could not possibly be met were all the deposit-holders to ask for their own property at the same time. Only the complacency and ignorance of the public permit the situation to continue.105

Broadly, such intervention may be effected either by the government or by private individuals and firms in their role as “banks” or money-warehouses. The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called inflation.106 A contraction in the money supply outstanding over any period (aside from a possible net decrease in specie) may be called deflation. Clearly, inflation is the primary event and the primary purpose of monetary intervention. There can be no deflation without an inflation having occurred in some previous period of time. A priori, almost all intervention will be inflationary. For not only must all monetary intervention begin with inflation; the great gain to be derived from inflation comes from the issuer’s putting new money into circulation. The profit is practically costless, because, while all other people must either sell goods and services and buy or mine gold, the government or the commercial banks are literally creating money out of thin air. They do not have to buy it. Any profit from the use of this magical money is clear gain to the issuers.

As happens when new specie enters the market, the issue of “uncovered” money-substitutes also has a diffusion effect: the first receivers of the new money gain the most, the next gain slightly less, etc., until the midpoint is reached, and then each receiver loses more and more as he waits for the new money. For the first individuals’ selling prices soar while buying prices remain almost the same; but later, buying prices have risen while selling prices remain unchanged. A crucial circumstance, however, differentiates this from the case of increasing specie. The new paper or new demand deposits have no social function whatever; they do not demonstrably benefit some without injuring others in the market society. The increasing money supply is only a social waste and can only advantage some at the expense of others. And the benefits and burdens are distributed as just outlined: the early-comers gaining at the expense of later-comers. Certainly, the business and consumer borrowers from the bank—its clientele—benefit greatly from the new money (at least in the short run), since they are the ones who first receive it.

If inflation is any increase in the supply of money not matched by an increase in the gold or silver stock available, the method of inflation just depicted is called credit expansion—the creation of new money-substitutes, entering the economy on the credit market. As will be seen below, while credit expansion by a bank seems far more sober and respectable than outright spending of new money, it actually has far graver consequences for the economic system, consequences which most people would find especially undesirable. This inflationary credit is called circulating credit, as distinguished from the lending of saved funds— called commodity credit. In this book, the term “credit expansion” will apply only to increases in circulating credit.

Credit expansion has, of course, the same effect as any sort of inflation: prices tend to rise as the money supply increases. Like any inflation, it is a process of redistribution, whereby the inflators, and the part of the economy selling to them, gain at the expense of those who come last in line in the spending process. This is the charm of inflation—for the beneficiaries—and the reason why it has been so popular, particularly since modern banking processes have camouflaged its significance for those losers who are far removed from banking operations. The gains to the inflators are visible and dramatic; the losses to others hidden and unseen, but just as effective for all that. Just as half the economy are taxpayers and half tax-consumers, so half the economy are inflation-payers and the rest inflation-consumers.

Most of these gains and losses will be “short-run” or “one-shot”; they will occur during the process of inflation, but will cease after the new monetary equilibrium is reached. The inflators make their gains, but after the new money supply has been diffused throughout the economy, the inflationary gains and losses are ended. However, as we have seen in chapter 11, there are also permanent gains and losses resulting from inflation. For the new monetary equilibrium will not simply be the old one multiplied in all relations and quantities by the addition to the money supply. This was an assumption that the old “quantity theory” economists made. The valuations of the individuals making temporary gains and losses will differ. Therefore, each individual will react differently to his gains and losses and alter his relative spending patterns accordingly. Moreover, the new money will form a high ratio to the existing cash balance of some and a low ratio to that of others, and the result will be a variety of changes in spending patterns. Therefore, all prices will not have increased uniformly in the new equilibrium; the purchasing power of the monetary unit has fallen, but not equiproportionally over the entire array of exchange-values. Since some prices have risen more than others, therefore, some people will be permanent gainers, and some permanent losers, from the inflation.107

Particularly hard hit by an inflation, of course, are the relatively “fixed” income groups, who end their losses only after a long period or not at all. Pensioners and annuitants who have contracted for a fixed money income are examples of permanent as well as short-run losers. Life insurance benefits are permanently slashed. Conservative anti-inflationists’ complaints about “the widows and orphans” have often been ridiculed, but they are no laughing matter nevertheless. For it is precisely the widows and orphans who bear a main part of the brunt of inflation.108 Also suffering losses are creditors who have already extended their loans and find it too late to charge a purchasing-power premium on their interest rates.

Inflation also changes the market’s consumption/investment ratio. Superficially, it seems that credit expansion greatly increases capital, for the new money enters the market as equivalent to new savings for lending. Since the new “bank money” is apparently added to the supply of savings on the credit market, businesses can now borrow at a lower rate of interest; hence inflationary credit expansion seems to offer the ideal escape from time preference, as well as an inexhaustible fount of added capital. Actually, this effect is illusory. On the contrary, inflation reduces saving and investment, thus lowering society’s standard of living. It may even cause large-scale capital consumption. In the first place, as we just have seen, existing creditors are injured. This will tend to discourage lending in the future and thereby discourage saving-investment. Secondly, as we have seen in chapter 11, the inflationary process inherently yields a purchasing-power profit to the businessman, since he purchases factors and sells them at a later time when all prices are higher. The businessman may thus keep abreast of the price increase (we are here exempting from variations in price increases the terms-of-trade component), neither losing nor gaining from the inflation. But business accounting is traditionally geared to a world where the value of the monetary unit is stable. Capital goods purchased are entered in the asset column “at cost,” i.e., at the price paid for them. When the firm later sells the product, the extra inflationary gain is not really a gain at all; for it must be absorbed in purchasing the replaced capital good at a higher price. Inflation, therefore, tricks the businessman: it destroys one of his main signposts and leads him to believe that he has gained extra profits when he is just able to replace capital. Hence, he will undoubtedly be tempted to consume out of these profits and thereby unwittingly consume capital as well. Thus, inflation tends at once to repress saving-investment and to cause consumption of capital.

The accounting error stemming from inflation has other economic consequences. The firms with the greatest degree of error will be those with capital equipment bought more preponderantly when prices were lowest. If the inflation has been going on for a while, these will be the firms with the oldest equipment. Their seemingly great profits will attract other firms into the field, and there will be a completely unjustified expansion of investment in a seemingly high-profit area. Conversely, there will be a deficiency of investment elsewhere. Thus, the error distorts the market’s system of allocating resources and reduces its effectiveness in satisfying the consumer. The error will also be greatest in those firms with a greater proportion of capital equipment to product, and similar distorting effects will take place through excessive investment in heavily “capitalized” industries, offset by underinvestment elsewhere.109

• 105Although it has obvious third-person effects, this type of intervention is essentially binary because the issuer, or intervener, gains at the expense of individual holders of legitimate money. The “lines of force” radiate from the interveners to each of those who suffer losses.
• 106Inflation, in this work, is explicitly defined to exclude increases in the stock of specie. While these increases have such similar effects as raising the prices of goods, they also differ sharply in other effects: (a) simple increases in specie do not constitute an intervention in the free market, penalizing one group and subsidizing another; and (b) they do not lead to the processes of the business cycle.
• 107Cf. Mises, Theory of Money and Credit, pp. 140–42.
• 108The avowed goal of Keynes’ inflationist program was the “euthanasia of the rentier.” Did Keynes realize that he was advocating the not-so-merciful annihilation of some of the most unfit-for-labor groups in the entire population—groups whose marginal value productivity consisted almost exclusively in their savings? Keynes, General Theory, p. 376.
• 109For an interesting discussion of some aspects of the accounting error, see W.T. Baxter, “The Accountant’s Contribution to the Trade Cycle,” Economica, May, 1955, pp. 99–112. Also see Mises, Theory of Money and Credit, pp. 202–04; and Human Action, pp. 546 f.

We have already seen in chapter 8 what happens when there is net saving-investment: an increase in the ratio of gross investment to consumption in the economy. Consumption expenditures fall, and the prices of consumers’ goods fall. On the other hand, the production structure is lengthened, and the prices of original factors specialized in the higher stages rise. The prices of capital goods change like a lever being pivoted on a fulcrum at its center; the prices of consumers’ goods fall most, those of first-order capital goods fall less; those of highest-order capital goods rise most, and the others less. Thus, the price differentials between the stages of production all diminish. Prices of original factors fall in the lower stages and rise in the higher stages, and the nonspecific original factors (mainly labor) shift partly from the lower to the higher stages. Investment tends to be centered in lengthier processes of production. The drop in price differentials is, as we have seen, equivalent to a fall in the natural rate of interest, which, of course, leads to a corollary drop in the loan rate. After a while the fruit of the more productive techniques arrives; and the real income of everyone rises.

Thus, an increase in saving resulting from a fall in time preferences leads to a fall in the interest rate and another stable equilibrium situation with a longer and narrower production structure. What happens, however, when the increase in investment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? Is this a magic way of expanding the capital structure easily and costlessly, without reducing present consumption? Suppose that six million gold ounces are being invested, and four million consumed, in a certain period of time. Suppose, now, that the banks in the economy expand credit and increase the money supply by two million ounces. What are the consequences? The new money is loaned to businesses.110 These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original factors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the two million new ounces are therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors.

The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and, as we have seen in chapter 8, lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production structure is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on projects formerly unprofitable. On the free market, investment will always take place first in those projects that satisfy the most urgent wants of the consumers. Then the next most urgent wants are satisfied, etc. The interest rate regulates the temporal order of choice of projects in accordance with their urgency. A lower rate of interest on the market is a signal that more projects can be undertaken profitably. Increased saving on the free market leads to a stable equilibrium of production at a lower rate of interest. But not so with credit expansion: for the original factors now receive increased money income. In the free-market example, total money incomes remained the same. The increased expenditure on higher stages was offset by decreased expenditure in the lower stages. The “increased length” of the production structure was compensated by the “reduced width.” But credit expansion pumps new money into the production structure: aggregate money incomes increase instead of remaining the same. The production structure has lengthened, but it has also remained as wide, without contraction of consumption expenditure.

The owners of the original factors, with their increased money income, naturally hasten to spend their new money. They allocate this spending between consumption and investment in accordance with their time preferences. Let us assume that the time-preference schedules of the people remain unchanged. This is a proper assumption, since there is no reason to assume that they have changed because of the inflation. Production now no longer reflects voluntary time preferences. Business has been led by credit expansion to invest in higher stages, as if more savings were available. Since they are not, business has overinvested in the higher stages and underinvested in the lower. Consumers act promptly to re-establish their time preferences—their preferred investment/consumption proportions and price differentials. The differentials will be re-established at the old, higher amount, i.e., the rate of interest will return to its free-market magnitude. As a result, the prices at the higher stages of production will fall drastically, the prices at the lower stages will rise again, and the entire new investment at the higher stages will have to be abandoned or sacrificed.

Altering our oversimplified example, which has treated only two stages, we see that the highest stages, believed profitable, have proved to be unprofitable. The pure rate of interest, reflecting consumer desires, is shown to have really been higher all along. The banks’ credit expansion had tampered with that indispensable “signal”—the interest rate—that tells businessmen how much savings are available and what length of projects will be profitable. In the free market the interest rate is an indispensable guide, in the time dimension, to the urgency of consumer wants. But bank intervention in the market disrupts this free price and renders entrepreneurs unable to satisfy consumer desires properly or to estimate the most beneficial time structure of production. As soon as the consumers are able, i.e., as soon as the increased money enters their hands, they take the opportunity to re-establish their time preferences and therefore the old differentials and investment-consumption ratios. Overinvestment in the highest stages, and underinvestment in the lower stages are now revealed in all their starkness. The situation is analogous to that of a contractor misled into believing that he has more building material than he really has and then awakening to find that he has used up all his material on a capacious foundation (the higher stages), with no material left to complete the house.111 Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.

It should not be surprising that the market tends to revert to its preferred ratios. The same process, as we have seen, takes place in all prices after a change in the money stock. Increased money always begins in one area of the economy, raising prices there, and filters and diffuses eventually over the whole economy, which then roughly returns to an equilibrium pattern conforming to the value of the money. If the market then tends to return to its preferred price-ratios after a change in the money supply, it should be evident that this includes a return to its preferred saving-investment ratio, reflecting social time preferences.

It is true, of course, that time preferences may alter in the interim, either for each individual or as a result of the redistribution during the change. The gainers may save more or less than the losers would have done. Therefore, the market will not return precisely to the old free-market interest rate and investment/consumption ratio, just as it will not return to its precise pattern of prices. It will revert to whatever the free-market interest rate is now, as determined by current time preferences. Some advocates of coercing the market into saving and investing more than it wishes have hailed credit expansion as leading to “forced saving,” thereby increasing the capital-goods structure. But this can happen, not as a direct consequence of credit expansion, but only because effective time preferences have changed in that direction (i.e., time-preference schedules have shifted, or relatively more money is now in the hands of those with low time preferences). Credit expansion may well lead to the opposite effect: the gainers may have higher time preferences, in which case the free-market interest rate will be higher than before. Because these effects of credit expansion are completely uncertain and depend on the concrete data of each particular case, it is clearly far more cogent for advocates of forced saving to use the taxation process to make their redistribution.

The market therefore reacts to a distortion of the free-market interest rate by proceeding to revert to that very rate. The distortion caused by credit expansion deceives businessmen into believing that more savings are available and causes them to malinvest—to invest in projects that will turn out to be unprofitable when consumers have a chance to reassert their true preferences. This reassertion takes place fairly quickly—as soon as owners of factors receive their increased incomes and spend them.

This theory permits us to resolve an age-old controversy among economists: whether an increase in the money supply can lower the market rate of interest. To the mercantilists—and to the Keynesians—it was obvious that an increased money stock permanently lowered the rate of interest (given the demand for money). To the classicists it was obvious that changes in the money stock could affect only the value of the monetary unit, and not the rate of interest. The answer is that an increase in the supply of money does lower the rate of interest when it enters the market as credit expansion, but only temporarily. In the long run (and this long run is not very “long”), the market re-establishes the free-market time-preference interest rate and eliminates the change. In the long run a change in the money stock affects only the value of the monetary unit.

This process—by which the market reverts to its preferred interest rate and eliminates the distortion caused by credit expansion—is, moreover, the business cycle! Our analysis therefore permits the solution, not only of the theoretical problem of the relation between money and interest, but also of the problem that has plagued society for the last century and a half and more—the dread business cycle. And, furthermore, the theory of the business cycle can now be explained as a subdivision of our general theory of the economy.

Note the hallmarks of this distortion-reversion process. First, the money supply increases through credit expansion; then businesses are tempted to malinvest—overinvesting in higher-stage and durable production processes. Next, the prices and incomes of original factors increase and consumption increases, and businesses realize that the higher-stage investments have been wasteful and unprofitable. The first stage is the chief landmark of the “boom”; the second stage—the discovery of the wasteful malinvestments—is the “crisis.” The depression is the next stage, during which malinvested businesses become bankrupt, and original factors must suddenly shift back to the lower stages of production. The liquidation of unsound businesses, the “idle capacity” of the malinvested plant, and the “frictional” unemployment of original factors that must suddenly and en masse shift to lower stages of production—these are the chief hallmarks of the depression stage.

We have seen in chapter 11 that the major unexplained features of the business cycle are the mass of error and the concentration of error and disturbance in the capital-goods industries. Our theory of the business cycle solves both of these problems. The cluster of error suddenly revealed by entrepreneurs is due to the interventionary distortion of a key market signal—the interest rate. The concentration of disturbance in the capital-goods industries is explained by the spur to unprofitable higher-order investments in the boom period. And we have just seen that other characteristics of the business cycle are explained by this theory.

One point should be stressed: the depression phase is actually the recovery phase. Most people would be happy to keep the boom period, where the inflationary gains are visible and the losses hidden and obscure. This boom euphoria is heightened by the capital consumption that inflation promotes through illusory accounting profits. The stages that people complain about are the crisis and depression. But the latter periods, it should be clear, do not cause the trouble. The trouble occurs during the boom, when malinvestments and distortions take place; the crisis-depression phase is the curative period, after people have been forced to recognize the malinvestments that have occurred. The depression period, therefore, is the necessary recovery period; it is the time when bad investments are liquidated and mistaken entrepreneurs leave the market—the time when “consumer sovereignty” and the free market reassert themselves and establish once again an economy that benefits every participant to the maximum degree. The depression period ends when the free-market equilibrium has been restored and expansionary distortion eliminated.

It should be clear that any governmental interference with the depression process can only prolong it, thus making things worse from almost everyone’s point of view. Since the depression process is the recovery process, any halting or slowing down of the process impedes the advent of recovery. The depression readjustments must work themselves out before recovery can be complete. The more these readjustments are delayed, the longer the depression will have to last, and the longer complete recovery is postponed. For example, if the government keeps wage rates up, it brings about permanent unemployment. If it keeps prices up, it brings about unsold surplus. And if it spurs credit expansion again, then new malinvestment and later depressions are spawned.

Many nineteenth-century economists referred to the business cycle in a biological metaphor, likening the depression to a painful but necessary curative of the alcoholic or narcotic jag which is the boom, and asserting that any tampering with the depression delays recovery. They have been widely ridiculed by present-day economists. The ridicule is misdirected, however, for the biological analogy is in this case correct.

One obvious conclusion from our analysis is the absurdity of the “underconsumptionist” remedies for depression—the idea that the crisis is caused by underconsumption and that the way to cure the depression is to stimulate consumption expenditures. The reverse is clearly the truth. What has brought about the crisis is precisely the fact that entrepreneurial investment erroneously anticipated greater savings, and that this error is revealed by consumers’ re-establishing their desired proportion of consumption. “Overconsumption” or “undersaving” has brought about the crisis, although it is hardly fair to pin the guilt on the consumer, who is simply trying to restore his preferences after the market has been distorted by bank credit. The only way to hasten the curative process of the depression is for people to save and invest more and consume less, thereby finally justifying some of the malinvestments and mitigating the adjustments that have to be made.

One problem has been left unexplained. We have seen that the reversion period is short and that factor incomes increase rather quickly and start restoring the free-market consumption/saving ratios. But why do booms, historically, continue for several years? What delays the reversion process? The answer is that as the boom begins to peter out from an injection of credit expansion, the banks inject a further dose. In short, the only way to avert the onset of the depression-adjustment process is to continue inflating money and credit. For only continual doses of new money on the credit market will keep the boom going and the new stages profitable. Furthermore, only ever increasing doses can step up the boom, can lower interest rates further, and expand the production structure, for as the prices rise, more and more money will be needed to perform the same amount of work. Once the credit expansion stops, the market ratios are reestablished, and the seemingly glorious new investments turn out to be malinvestments, built on a foundation of sand.

How long booms can be kept up, what limits there are to booms in different circumstances, will be discussed below. But it is clear that prolonging the boom by ever larger doses of credit expansion will have only one result: to make the inevitably ensuing depression longer and more grueling. The larger the scope of malinvestment and error in the boom, the greater and longer the task of readjustment in the depression. The way to prevent a depression, then, is simple: avoid starting a boom. And to avoid starting a boom all that is necessary is to pursue a truly free-market policy in money, i.e., a policy of 100-percent specie reserves for banks and governments.

Credit expansion always generates the business cycle process, even when other tendencies cloak its workings. Thus, many people believe that all is well if prices do not rise or if the actually recorded interest rate does not fall. But prices may well not rise because of some counteracting force—such as an increase in the supply of goods or a rise in the demand for money. But this does not mean that the boom-depression cycle fails to occur. The essential processes of the boom—distorted interest rates, malinvestments, bankruptcies, etc.—continue unchecked. This is one of the reasons why those who approach business cycles from a statistical point of view and try in that way to arrive at a theory are in hopeless error. Any historical-statistical fact is a complex resultant of many causal influences and cannot be used as a simple element with which to construct a causal theory. The point is that credit expansion raises prices beyond what they would have been in the free market and thereby creates the business cycle. Similarly, credit expansion does not necessarily lower the interest rate below the rate previously recorded; it lowers the rate below what it would have been in the free market and thus creates distortion and malinvestment. Recorded interest rates in the boom will generally rise, in fact, because of the purchasing-power component in the market interest rate. An increase in prices, as we have seen, generates a positive purchasing-power component in the natural interest rate, i.e., the rate of return earned by businessmen on the market. In the free market this would quickly be reflected in the loan rate, which, as we have seen above, is completely dependent on the natural rate. But a continual influx of circulating credit prevents the loan rate from catching up with the natural rate, and thereby generates the business-cycle process.112 A further corollary of this bank-created discrepancy between the loan rate and the natural rate is that creditors on the loan market suffer losses for the benefit of their debtors: the capitalists on the stock market or those who own their own businesses. The latter gain during the boom by the differential between the loan rate and the natural rate, while the creditors (apart from banks, which create their own money) lose to the same extent.

After the boom period is over, what is to be done with the malinvestments? The answer depends on their profitability for further use, i.e., on the degree of error that was committed. Some malinvestments will have to be abandoned, since their earnings from consumer demand will not even cover the current costs of their operation. Others, though monuments of failure, will be able to yield a profit over current costs, although it will not pay to replace them as they wear out. Temporarily working them fulfills the economic principle of always making the best of even a bad bargain.

Because of the malinvestments, however, the boom always leads to general impoverishment, i.e., reduces the standard of living below what it would have been in the absence of the boom. For the credit expansion has caused the squandering of scarce resources and scarce capital. Some resources have been completely wasted, and even those malinvestments that continue in use will satisfy consumers less than would have been the case without the credit expansion.

• 110To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur.
• 111See Mises, Human Action, p. 557.
• 112Since Knut Wicksell is one of the fathers of this business-cycle approach, it is important to stress that our usage of “natural rate” differs from his. Wicksell’s “natural rate” was akin to our “free-market rate”; our “natural rate” is the rate of return earned by businesses on the existing market without considering loan interest. It corresponds to what has been misleadingly called the “normal profit rate,” but is actually the basic rate of interest. See chapter 6 above.

In the previous section we have presented the basic process of the business cycle. This process is often accentuated by other or “secondary” developments induced by the cycle. Thus, the expanding money supply and rising prices are likely to lower the demand for money. Many people begin to anticipate higher prices and will therefore dishoard. The lowered demand for money raises prices further. Since the impetus to expansion comes first in expenditure on capital goods and later in consumption, this “secondary effect” of a lower demand for money may take hold first in producers’-goods industries. This lowers the price-and-profit differentials further and hence widens the distance that the rate of interest will fall below the free-market rate during the boom. The effect is to aggravate the need for readjustment during the depression. The adjustment would cause some fall in the prices of producers’ goods anyway, since the essence of the adjustment is to raise price differentials. The extra distortion requires a steeper fall in the prices of producers’ goods before recovery is completed.

As a matter of fact, the demand for money generally rises at the beginning of an inflation. People are accustomed to thinking of the value of the monetary unit as inviolate and of prices as remaining at some “customary” level. Hence, when prices first begin to rise, most people believe this to be a purely temporary development, with prices soon due to recede. This belief mitigates the extent of the price rise for a time. Eventually, however, people realize that credit expansion has continued and undoubtedly will continue, and their demand for money dwindles, becoming lower than the original level.

After the crisis arrives and the depression begins, various secondary developments often occur. In particular, for reasons that will be discussed further below, the crisis is often marked not only by a halt to credit expansion, but by an actual deflation—a contraction in the supply of money. The deflation causes a further decline in prices. Any increase in the demand for money will speed up adjustment to the lower prices. Furthermore, when deflation takes place first on the loan market, i.e., as credit contraction by the banks—and this is almost always the case—this will have the beneficial effect of speeding up the depression-adjustment process. For credit contraction creates higher price differentials. And the essence of the required adjustment is to return to higher price differentials, i.e., a higher “natural” rate of interest. Furthermore, deflation will hasten adjustment in yet another way: for the accounting error of inflation is here reversed, and businessmen will think their losses are more, and profits less, than they really are. Hence, they will save more than they would have with correct accounting, and the increased saving will speed adjustment by supplying some of the needed deficiency of savings.

It may well be true that the deflationary process will overshoot the free-market equilibrium point and raise price differentials and the interest rate above it. But if so, no harm will be done, since a credit contraction can create no malinvestments and therefore does not generate another boom-bust cycle.113 And the market will correct the error rapidly. When there is such excessive contraction, and consumption is too high in relation to savings, the money income of businessmen is reduced, and their spending on factors declines—especially in the higher orders. Owners of original factors, receiving lower incomes, will spend less on consumption, price differentials and the interest rate will again be lowered, and the free-market consumption/ investment ratios will be speedily restored.

Just as inflation is generally popular for its narcotic effect, deflation is always highly unpopular for the opposite reason. The contraction of money is visible; the benefits to those whose buying prices fall first and who lose money last remain hidden. And the illusory accounting losses of deflation make businesses believe that their losses are greater, or profits smaller, than they actually are, and this will aggravate business pessimism.

It is true that deflation takes from one group and gives to another, as does inflation. Yet not only does credit contraction speed recovery and counteract the distortions of the boom, but it also, in a broad sense, takes away from the original coercive gainers and benefits the original coerced losers. While this will certainly not be true in every case, in the broad sense much the same groups will benefit and lose, but in reverse order from that of the redistributive effects of credit expansion. Fixed-income groups, widows and orphans, will gain, and businesses and owners of original factors previously reaping gains from inflation will lose. The longer the inflation has continued, of course, the less the same individuals will be compensated.114

Some may object that deflation “causes” unemployment. However, as we have seen above, deflation can lead to continuing unemployment only if the government or the unions keep wage rates above the discounted marginal value products of labor. If wage rates are allowed to fall freely, no continuing unemployment will occur.

Finally, deflationary credit contraction is, necessarily, severely limited. Whereas credit can expand (barring various economic limits to be discussed below) virtually to infinity, circulating credit can contract only as far down as the total amount of specie in circulation. In short, its maximum possible limit is the eradication of all previous credit expansion.

The business-cycle analysis set forth here has essentially been that of the “Austrian” School, originated and developed by Ludwig von Mises and some of his students.115 A prominent criticism of this theory is that it “assumes the existence of full employment” or that its analysis holds only after “full employment” has been attained. Before that point, say the critics, credit expansion will beneficently put these factors to work and not generate further malinvestments or cycles. But, in the first place, inflation will put no unemployed factors to work unless their owners, though holding out for a money price higher than their marginal value product, are blindly content to accept the necessarily lower real price when it is camouflaged as a rise in the “cost of living.” And credit expansion generates further cycles whether or not there are unemployed factors. It creates more distortions and malinvestments, delays indefinitely the process of recovery from the previous boom, and makes necessary an eventually far more grueling recovery to adjust to the new malinvestments as well as to the old. If idle capital goods are now set to work, this “idle capacity” is the hangover effect of previous wasteful malinvestments, and hence is really sub-marginal and not worth bringing into production. Putting the capital to work again will only redouble the distortions.116

• 113If some readers are tempted to ask why credit contraction will not lead to the opposite type of malinvestment to that of the boom—overinvestment in lower-order capital goods and underinvestment in higher-order goods—the answer is that there is no arbitrary choice open of investing in higher-order or lower-order goods. Increased investment must be made in the higher-order goods—in lengthening the structure of production. A decreased amount of investment simply cuts down on higher-order investment. There will thus be no excess of investment in the lower orders, but simply a shorter structure than would otherwise be the case. Contraction, unlike expansion, does not create positive malinvestments.
• 114If the economy is on a gold or silver standard, then many advocates of a free market will argue for credit contraction for the following additional reasons: (a) to preserve the principle of paying one’s contractual obligations and (b) to punish the banks for their expansion and force them back toward a 100-percent-specie reserve policy.
• 115Mises first presented the “Austrian theory” in a notable section of his Theory of Money and Credit, pp. 346–66. For a more developed statement, see his Human Action, pp. 547–83. For F.A. Hayek’s important contributions, see especially his Prices and Production, and also his Monetary Theory and the Trade Cycle (London: Jonathan Cape, 1933), and Profits, Interest, and Investment. Other works in the Misesian tradition include Robbins, The Great Depression, and Fritz Machlup, The Stock Market, Credit, and Capital Formation (New York: Macmillan & Co., 1940).
• 116See Mises, Human Action, pp. 577–78; and Hayek, Prices and Production, pp. 96–99.

Having investigated the consequences of credit expansion, we must discuss the important question: If fractional-reserve banking is legal, are there any natural limits to credit expansion by the banks? The one basic limit, of course, is the necessity of the banks to redeem their money-substitutes on demand. Under a gold or silver standard, they must redeem in specie; under a government fiat paper standard (see below), the banks have to redeem in government paper. In any case, they must redeem in standard money or its virtual equivalent. Therefore, every fractional reserve bank depends for its very existence on persuading the public—specifically its clients—that all is well and that it will be able to redeem its notes or deposits whenever the clients demand. Since this is palpably not the case, the continuance of confidence in the banks is something of a psychological marvel.117 It is certain, at any rate, that a wider knowledge of praxeology among the public would greatly weaken confidence in the banking system. For the banks are in an inherently weak position. Let just a few of their clients lose confidence and begin to call on the banks for redemption, and this will precipitate a scramble by other clients to make sure that they get their money while the banks’ doors are still open. The obvious—and justifiable—panic of the banks should any sort of “run” develop encourages other clients to do the same and aggravates the run still further. At any rate, runs on banks can wreak havoc, and, of course, if pursued consistently, could close every bank in the country in a few days.118

Runs, therefore, and the constant underlying threat of their occurrence, are one of the prime limits to credit expansion. Runs often develop during a business cycle crisis, when debts are being defaulted and failures become manifest. Runs and the fear of runs help to precipitate deflationary credit contraction.

Runs may be an ever-present threat, but, as effective limitations, they are not generally active. When they do occur, they usually wreck the banks. The fact that a bank is in existence at all signifies that a run has not developed. A more active, everyday limitation is the relatively narrow range of a bank’s clientele. The clientele of a bank consists of those people willing to hold its deposits or notes (its money-substitutes) in lieu of money proper. It is an empirical fact, in almost all cases, that one bank does not have the patronage of all people in the market society or even of all those who prefer to use bank money rather than specie. It is obvious that the more banks exist, the more restricted will be the clientele of any one bank. People decide which bank to use on many grounds; reputation for integrity, friendliness of service, price of service, and convenience of location may all play a part.

How does the narrow range of a bank’s clientele limit its potentiality for credit expansion? The newly issued money-substitutes are, of course, loaned to a bank’s clients. The client then spends the new money on goods and services. The new money begins to be diffused throughout the society. Eventually—usually very quickly—it is spent on the goods or services of people who use a different bank. Suppose that the Star Bank has expanded credit; the newly issued Star Bank’s notes or deposits find their way into the hands of Mr. Jones, who uses the City Bank. Two alternatives may occur, either of which has the same economic effect: (a) Jones accepts the Star Bank’s notes or deposits, and deposits them in the City Bank, which calls on the Star Bank for redemption; or (b) Jones refuses to accept the Star Bank’s notes and insists that the Star client—say Mr. Smith—who bought something from Jones, redeem the note himself and pay Jones in acceptable standard money.

Thus, while gold or silver is acceptable throughout the market, a bank’s money-substitutes are acceptable only to its own clientele. Clearly, a single bank’s credit expansion is limited, and this limitation is stronger (a) the narrower the range of its clientele, and (b) the greater its issue of money-substitutes in relation to that of competing banks. In illustration of the first point, let us assume that each bank has only one client. Then it is obvious that there will be very little room for credit expansion. At the opposite extreme, if one bank is used by everybody in the economy, there will be no demands for redemption resulting from its clients’ purchasing from nonclients. It is obvious that, ceteris paribus, a numerically smaller clientele is more restrictive of credit expansion.

As regards the second point, the greater the degree of relative credit expansion by any one bank, the sooner will the day of redemption—and potential bankruptcy—be at hand. Suppose that the Star Bank expands credit, while none of the competing banks do. This means that the Star Bank’s clientele have added considerably to their cash balances; as a result the marginal utility to them of each unit of money to hold declines, and they are impelled to spend a great proportion of the new money. Some of this increased spending will be on one another’s goods and services, but it is clear that the greater the credit expansion, the greater will be the tendency for their spending to “spill over” onto the goods and services of nonclients. This tendency to spill over, or “drain,” is greatly enhanced when increased spending by clients on the goods and services of other clients raises their prices. In the meanwhile, the prices of the goods sold by non-clients remain the same. As a consequence, clients are impelled to buy more from nonclients and less from one another; while nonclients buy less from clients and more from one another. The result is an “unfavorable” balance of trade from clients to nonclients.119 It is clear that this tendency of money to seek a uniform level of exchange value throughout the entire market is an example of the process by which new money (in this case, new money-substitutes) is diffused through the market. The greater the relative credit expansion by the bank, then, the greater and more rapid will be the drain and consequent pressure on an expanding bank for redemption.

The purpose of banks’ keeping any specie reserves in their vaults (assuming no legal reserve requirements) now becomes manifest. It is not to meet bank runs—since no fractional-reserve bank can be equipped to withstand a run. It is to meet the demands for redemption which will inevitably come from nonclients.

Mises has brilliantly shown that a subdivision of this process was discovered by the British Currency School and by the classical “international trade” theorists of the nineteenth century. These older economists assumed that all the banks in a certain region or country expanded credit together. The result was a rise in the prices of goods produced in that country. A further result was an “unfavorable” balance of trade, i.e., an outflow of standard specie to other countries. Since other countries did not patronize the expanding country’s banks, the consequence was a “specie drain” from the expanding country and increased pressure for redemption on its banks.

Like all parts of the overstressed and overelaborated theory of “international trade,” this analysis is simply a special subdivision of “general” economic theory. And cataloging it as “international trade” theory, as Mises has shown, underestimates its true significance.120 ,121

Thus, the more freely competitive and numerous are the banks, the less they will be able to expand fiduciary media, even if they are left free to do so. As we have noted in chapter 11, such a system is known as “free banking.”122 A major objection to this analysis of free banking has been the problem of bank “cartels.” If banks get together and agree to expand their credits simultaneously, the clientele limitation vis-à-vis competing banks will be removed, and the clientele of each bank will, in effect, increase to include all bank users. Mises points out, however, that the sounder banks with higher fractional reserves will not wish to lose the goodwill of their own clients and risk bank runs by entering into collusive agreements with weaker banks.123 This consideration, while placing limits on such agreements, does not rule them out altogether. For, after all, no fractional-reserve banks are really sound, and if the public can be led to believe that, say, an 80-percent-specie reserve is sound, it can believe the same about 60-percent- or even 10-percent-reserve banks. Indeed, the fact that the weaker banks are allowed by the public to exist at all demonstrates that the more conservative banks may not lose much good will by agreeing to expand with them.

As Mises has demonstrated, there is no question that, from the point of view of opponents of inflation and credit expansion, free banking is superior to a central banking system (see below). But, as Amasa Walker stated:

Much has been said, at different times, of the desirableness of free banking. Of the propriety and rightfulness of allowing any person who chooses to carry on banking, as freely as farming or any other branch of business, there can be no doubt. But, while banking, as at present, means the issuing of inconvertible paper, the more it is guarded and restricted the better. But when such issues are entirely forbidden, and only notes equivalent to certificates of so much coin are issued, banking may be as free as brokerage. The only thing to be secured would be that no issues should be made except upon specie in hand.124

• 117Perhaps one reason for continuing confidence in the banking system is that people generally believe that fraud is prosecuted by the government and that, therefore, any practice not so prosecuted must be sound. Governments, indeed (as we shall see below), always go out of their way to bolster the banking system.
• 118All this, of course, assumes no further government intervention in banking than permitting fractional-reserve banking. Since the advent of deposit “insurance” during the New Deal, for example, the bank-run limitation has been virtually eliminated by this act of special privilege.
• 119In the consolidated balance of payments of the clients, money income from sales to nonclients (exports) will decline, and money expenditures on the goods and services of nonclients (imports) will increase. The excess cash balances of the clients are transferred to non-clients.
• 120Older economists also distinguished an “internal drain” as well as the “external drain,” but included in the former only the drain from bank users to those who insist on standard money.
• 121See Human Action, pp. 434–35.
• 122For various views on free and central banking, see Vera C. Smith, The Rationale of Central Banking (London: P.S. King and Son, 1936).
• 123Mises, Human Action, p. 444.
• 124Amasa Walker, Science of Wealth, pp. 230–31.

Historically, governments have fostered and encouraged credit expansion to a great degree. They have done so by weakening the limitations that the market places on bank credit expansion. One way of weakening is to anesthetize the bank against the threat of bank runs. In nineteenth-century America, the government permitted banks, when they got into trouble in a business crisis, to suspend specie payment while continuing in operation. They were temporarily freed from their contractual obligation of paying their debts, while they could continue lending and even force their debtors to repay in their own bank notes. This is a powerful way to eradicate limitations on credit expansion, since the banks know that if they overreach themselves, the government will permit them blithely to avoid payment of their contractual obligations.

Under a fiat money standard, governments (or their central banks) may obligate themselves to bail out, with increased issues of standard money, any bank or any major bank in distress. In the late nineteenth century, the principle became accepted that the central bank must act as the “lender of last resort,” which will lend money freely to banks threatened with failure. Another recent American device to abolish the confidence limitation on bank credit is “deposit insurance,” whereby the government guarantees to furnish paper money to redeem the banks’ demand liabilities. These and similar devices remove the market brakes on rampant credit expansion.

A second device, now so legitimized that any country lacking it is considered hopelessly “backward,” is the central bank. The central bank, while often nominally owned by private individuals or banks, is run directly by the national government. Its purpose, not always stated explicitly, is to remove the competitive check on bank credit provided by a multiplicity of independent banks. Its aim is to make sure that all the banks in the country are co-ordinated and will therefore expand or contract together—at the will of the government. And we have seen that co-ordination of expansion greatly weakens the market’s limits.

The crucial way by which governments have established central bank control over the commercial banking system is by granting the bank a monopoly of the note issue in the country. As we have seen, money-substitutes may be issued in the form of notes or book deposits. Economically, the two forms are identical. The State has found it convenient, however, to distinguish between the two and to outlaw all note issue by private banks. Such nationalizing of the note-issue business forces the commercial banks to go to the central bank whenever their customers desire to exchange demand deposits for paper notes. To obtain notes to furnish their clients, commercial banks must buy them from the central bank. Such purchases can be made only by selling their gold coin or other standard money or by drawing on the banks’ deposit accounts with the central bank.

Since the public always wishes to hold some of its money in the form of notes and some in demand deposits, the banks must establish a continuing relationship with the central bank to be assured a supply of notes. Their most convenient procedure is to establish demand deposit accounts with the central bank, which thereby becomes the “bankers’ bank.” These demand deposits (added to the gold in their vaults) become the reserves of the banks. The central bank can also more freely create demand liabilities not backed 100 percent by gold, and these increased liabilities add to the reserves and demand deposits held by banks or else increase central bank notes outstanding. The rise in reserves of banks throughout the country will spur them to expand credit, while any decrease in these reserves will induce a general contraction in credit.

The central bank can increase the reserves of a country’s banks in three ways: (a) by simply lending them reserves; (b) by purchasing their assets, thereby adding directly to the banks’ deposit accounts with the central bank; or (c) by purchasing the I.O.U.’s of the public, which will then deposit the drafts on the central bank in the various banks that serve the public directly, thereby enabling them to use the credits on the central bank to add to their own reserves. The second process is known as discounting; the latter as open market purchase. A lapse in discounts as the loans mature will lower reserves, as will open market sales. In open market sales, the people will pay the central bank for its assets, purchased with checks drawn on their accounts at the banks; and the central bank exacts payment by reducing bank reserves on its books. In most cases, the assets purchased or sold on the open market are government I.O.U.’s.125

Thus, the banking system becomes co-ordinated under the aegis of the government. The central bank is always accorded a great deal of prestige by its creator government. Often the government makes its notes legal tender. Under the gold standard, the wide resources which it commands, added to the fact that the whole country is its clientele, usually make negligible any trouble the bank may have in redeeming its liabilities in gold. Furthermore, it is certain that no government will let its own central bank (i.e., itself) go bankrupt; the central bank will always be permitted to suspend specie payment in times of serious difficulty. It can therefore inflate and expand credit itself (through rediscounts and open market purchases) and, by adding to bank reserves, spur a multiple bank credit expansion throughout the country. The effect is multiple because banks will generally keep a certain proportion of reserves to liabilities—based on estimates of nonclient redemption—and a general increase in their reserves will induce a multiple expansion of fiduciary media. In fact, the multiple will even increase, for the knowledge that all the banks are co-ordinated and expanding together decreases the possibility of nonclient redemption and therefore the proportion of reserves that each bank will wish to keep.

When the government “goes off” the gold standard, central bank notes then become legal tender and virtually the standard money. It then cannot possibly fail, and this, of course, practically eliminates limitations on its credit expansion. In the present-day United States, for example, the current basically fiat standard (also known as a “restricted international gold bullion standard”) virtually eliminates pressure for redemption, while the central bank’s ready provision of reserves as well as deposit insurance eliminates the threat of bank failure.126 In order to insure centralized control by the government over bank credit, the United States enforces on banks a certain minimum ratio of reserves (almost wholly deposits with the central bank) to deposits.

So long as a country is in any sense “on the gold standard,” the central bank and the banking system must worry about an external drain of specie should the inflation become too great. Under an unrestricted gold standard, it must also worry about an internal drain resulting from the demands of those who do not use the banks. A shift in public taste from deposits to notes will embarrass the commercial banks, though not the central bank. Assiduous propaganda on the conveniences of banking, however, has reduced the ranks of those not using banks to a few malcontents. As a result, the only limitation on credit expansion is now external. Governments, of course, are always anxious to remove all checks on their powers of inducing monetary expansion. One way of removing the external threat is to foster international cooperation, so that all governments and central banks expand their money supply at a uniform rate. The “ideal” condition for unlimited inflation is, of course, a world fiat paper money, issued by a world central bank or other governmental authority. Pure fiat money on a national scale would serve almost as well, but there would then be the embarrassment of national moneys depreciating in terms of other moneys, and imports becoming much more expensive.127

• 125There is a fourth way by which a central bank may increase bank reserves: in countries, such as the United States, where banks must keep a legally required minimum ratio of reserves to deposits, the bank may simply lower the required ratio.
• 126Foreign central banks and governments are still permitted to redeem in gold bullion, but this is hardly a consolation for either foreign citizens or Americans. The result is that gold is still an ultimate “balancing” item between national governments, and therefore a kind of medium of exchange for governments and central banks in international transactions.
• 127The transition from gold to fiat money will be greatly smoothed if the State has previously abandoned ounces, grams, grains, and other units of weight in naming its monetary units and substituted unique names, such as dollar, mark, franc, etc. It will then be far easier to eliminate the public’s association of monetary units with weight and to teach the public to value the names themselves. Furthermore, if each national government sponsors its own unique name, it will be far easier for each State to control its own fiat issue absolutely.

With the establishment of fiat money by a State or by a World State, it would seem that all limitations on credit expansion, or on any inflation, are eliminated. The central bank can issue limitless amounts of nominal units of paper, unchecked by any necessity of digging a commodity out of the ground. They may be supplied to banks to bolster their credit at the pleasure of the government. No problems of internal or external drain exist. And if there existed a World State, or a co-operating cartel of States, with a world bank and world paper money, and gold and silver money were outlawed, could not the World State then expand the money supply at will with no foreign exchange or foreign trade difficulties, permanently redistributing wealth from the market’s choice to its own favorites, from voluntary producers to the ruling castes?

Many economists and most other people assume that the State could accomplish this goal. Actually, it could not, for there is an ultimate limit on inflation, a very wide one, to be sure, but a terrible limit that will in the end conquer any inflation. Paradoxically, this is the phenomenon of runaway inflation, or hyperinflation.

When the government and the banking system begin inflating, the public will usually aid them unwittingly in this task. The public, not cognizant of the true nature of the process, believes that the rise in prices is transient and that prices will soon return to “normal.” As we have noted above, people will therefore hoard more money, i.e., keep a greater proportion of their income in the form of cash balances. The social demand for money, in short, increases. As a result, prices tend to increase less than proportionately to the increase in the quantity of money. The government obtains more real resources from the public than it had expected, since the public’s demand for these resources has declined.

Eventually, the public begins to realize what is taking place. It seems that the government is attempting to use inflation as a permanent form of taxation. But the public has a weapon to combat this depredation. Once people realize that the government will continue to inflate, and therefore that prices will continue to rise, they will step up their purchases of goods. For they will realize that they are gaining by buying now, instead of waiting until a future date when the value of the monetary unit will be lower and prices higher. In other words, the social demand for money falls, and prices now begin to rise more rapidly than the increase in the supply of money. When this happens, the confiscation by the government, or the “taxation” effect of inflation, will be lower than the government had expected, for the increased money will be reduced in purchasing power by the greater rise in prices. This stage of the inflation is the beginning of hyperinflation, of the runaway boom.128

The lower demand for money allows fewer resources to be extracted by the government, but the government can still obtain resources so long as the market continues to use the money. The accelerated price rise will, in fact, lead to complaints of a “scarcity of money” and stimulate the government to greater efforts of inflation, thereby causing even more accelerated price increases. This process will not continue long, however. As the rise in prices continues, the public begins a “flight from money,” getting rid of money as soon as possible in order to invest in real goods—almost any real goods—as a store of value for the future. This mad scramble away from money, lowering the demand for money to hold practically to zero, causes prices to rise upward in astronomical proportions. The value of the monetary unit falls practically to zero. The devastation and havoc that the runaway boom causes among the populace is enormous. The relatively fixed-income groups are wiped out. Production declines drastically (sending up prices further), as people lose the incentive to work—since they must spend much of their time getting rid of money. The main desideratum becomes getting hold of real goods, whatever they may be, and spending money as soon as received. When this runaway stage is reached, the economy in effect breaks down, the market is virtually ended, and society reverts to a state of virtual barter and complete impoverishment.129 Commodities are then slowly built up as media of exchange. The public has rid itself of the inflation burden by its ultimate weapon: lowering the demand for money to such an extent that the government’s money has become worthless. When all other limits and forms of persuasion fail, this is the only way—through chaos and economic breakdown—for the people to force a return to the “hard” commodity money of the free market.

The most famous runaway inflation was the German experience of 1923. It is particularly instructive because it took place in one of the world’s most advanced industrial countries.130 The chaotic events of the German hyperinflation and other accelerated booms, however, are only a pale shadow of what would happen under a World State inflation. For Germany was able to recover and return to a full monetary market economy quickly, since it could institute a new currency based on exchanges with other pre-existing moneys (gold or foreign paper). As we have seen, however, Mises’ regression theorem shows that no money can be established on the market except as it can be exchanged for a previously existing money (which in turn must have ultimately related back to a commodity in barter). If a World State outlaws gold and silver and establishes a unitary fiat money, which it proceeds to inflate until a runaway boom destroys it, there will be no pre-existing money on the market. The task of reconstruction will then be enormously more difficult.

• 128Cf. the analysis by John Maynard Keynes in his A Tract on Monetary Reform (London: Macmillan & Co., 1923), chap. ii, section 1.
• 129On runaway inflation, see Mises, Theory of Money and Credit, pp. 227–31.
• 130Costantino Bresciani-Turroni, The Economics of Inflation (London: George Allen & Unwin, 1937), is a brilliant and definitive work on the German inflation.

Inflation, in recent years, has been generally defined as an increase in prices. This is a highly unsatisfactory definition. Prices are highly complex phenomena, activated by many different causal factors. They may increase or decrease from the goods side—i.e., as a result of a change in the supply of goods on the market. They may increase or decrease because of a change in the social demand for money to hold; or they may rise or fall from a change in the supply of money. To lump all of these causes together is misleading, for it glosses over the separate influences, the isolation of which is the goal of science. Thus, the money supply may be increasing, while at the same time the social demand for money is increasing from the goods side, in the form of increased supplies of goods. Each may offset the other, with no general price changes occurring. Yet both processes perform their work nevertheless. Resources will still shift as a result of inflation, and the business cycle caused by credit expansion will still appear. It is, therefore, highly inexpedient to define inflation as a rise in prices.

Movements in the supply-of-goods and in the demand-for-money schedules are all the results of voluntary changes of preferences on the market. The same is true for increases in the supply of gold or silver. But increases in fiduciary or fiat media are acts of fraudulent intervention in the market, distorting voluntary preferences and the voluntarily determined pattern of income and wealth. Therefore, the most expedient definition of “inflation” is one we have set forth above: an increase in the supply of money beyond any increase in specie.131

The absurdity of the various governmental programs for “fighting inflation” now becomes evident. Most people believe that government officials must constantly pace the ramparts, armed with a huge variety of “control” programs designed to combat the inflation enemy. Yet all that is really necessary is that the government and the banks (nowadays controlled almost completely by the government) cease inflating.132 The absurdity of the term “inflationary pressure” also becomes clear. Either the government and banks are inflating or they are not; there is no such thing as “inflationary pressure.”133

The idea that the government has the duty to tax the public in order to “sop up excess purchasing power” is particularly ludicrous.134 If inflation has been under way, this “excess purchasing power” is precisely the result of previous governmental inflation. In short, the government is supposed to burden the public twice: once in appropriating the resources of society by inflating the money supply, and again, by taxing back the new money from the public. Rather than “checking inflationary pressure,” then, a tax surplus in a boom will simply place an additional burden upon the public. If the taxes are used for further government spending, or for repaying debts to the public, then there is not even a deflationary effect. If the taxes are used to redeem government debt held by the banks, the deflationary effect will not be a credit contraction and therefore will not correct maladjustments brought about by the previous inflation. It will, indeed, create further dislocations and distortions of its own.

Keynesian and neo-Keynesian “compensatory fiscal policy” advocates that government deflate during an “inflationary” period and inflate (incur deficits, financed by borrowing from the banks) to combat a depression. It is clear that government inflation can relieve unemployment and unsold stocks only if the process dupes the owners into accepting lower real prices or wages. This “money illusion” relies on the owners’ being too ignorant to realize when their real incomes have declined—a slender basis on which to ground a cure. Furthermore, the inflation will benefit part of the public at the expense of the rest, and any credit expansion will only set a further “boom-bust” cycle into motion. The Keynesians depict the free market’s monetary-fiscal system as minus a steering wheel, so that the economy, though readily adjustable in other ways, is constantly walking a precarious tightrope between depression and unemployment on the one side and inflation on the other. It is then necessary for the government, in its wisdom, to step in and steer the economy on an even course. After our completed analysis of money and business cycles, however, it should be evident that the true picture is just about the reverse. The free market, unhampered, would not be in danger of suffering inflation, deflation, depression, or unemployment. But the intervention of government creates the tightrope for the economy and is constantly, if sometimes unwittingly, pushing the economy into these pitfalls.

• 131Inflation is here defined as any increase in the money supply greater than an increase in specie, not as a big change in that supply. As here defined, therefore, the terms “inflation” and “deflation” are praxeological categories. See Mises, Human Action, pp. 419–20. But also see Mises’ remarks in Aaron Director, ed., Defense, Controls, and Inflation (Chicago: University of Chicago Press, 1952), p. 3 n.
• 132See George Ferdinand, “Review of Albert G. Hart, Defense without Inflation,” Christian Economics, Vol. III, No. 19 (October 23, 1951).
• 133See Mises in Director, Defense, Controls, and Inflation, p. 334.
• 134See Mises in Director, Defense, Controls, and Inflation, p. 334.