At the Mises Academy we are just wrapping up the inaugural class, on the Austrian theory of the business cycle. During the class, one issue that came up repeatedly was whether the Mises/Hayek story of the trade cycle could occur on a completely free market, using gold as money and a banking system that operated on 100 percent reserves.
As any good (and annoying) teacher would, I avoided giving a definitive answer one way or the other. Instead, I tried to give the best possible case for each answer, to prod the students to think it through for themselves. In this article, I summarize how even a Rothbardian could plausibly answer this question either in the affirmative or the negative.
Review: ABCT under Fiat Money and Fractional-Reserve Banking
Before jumping into the hard case, let’s do the easy one first. According to Mises, Hayek, and Rothbard, the modern commercial banking system triggers the familiar boom-bust cycle when it floods the credit market with “excess” money.
Suppose we have an economy that is originally in equilibrium, where the interest rate reflects the genuine amount of savings that private individuals are taking out of their incomes. Suddenly, the commercial banks decide to grant $100 million in new loans even though this new credit doesn’t correspond to anyone’s extra saving. (I describe the process here.)
Because of the greater supply of credit, the market interest rate drops. This “false signal” leads entrepreneurs to borrow more funds and start longer projects than they otherwise would have. A false, unsustainable boom starts, giving most people an illusory sense of prosperity.
Later on, when the banks become worried about rising price inflation, they will slow down or even reverse their injections of unbacked new money. The market interest rate will rise back toward its correct value, and many businesses will be caught with their pants down. They’ll need to reduce output, or even shut down altogether. Workers and other resources will be released from those sectors that were stimulated the most during the boom. A general bust or recession sets in.
What If Gold Is Money, and Banks Maintain 100% Reserves?
Now the hard part: Suppose we were in a dream Rothbardian world, where gold itself is money—price tags are quoted in ounces of the yellow metal, people walk around with actual gold coins clinking in their pockets, and so forth. Furthermore, the banks practice 100 percent reserves with their demand deposits (checking accounts).
In this scenario, isn’t it theoretically possible that the Misesian boom-bust cycle could still occur? Specifically, suppose that the owner of a gold mine stumbles upon the mother lode. In a very short time, he gains physical possession of several tons of new gold that nobody knew existed the month before.
Instead of going to the casino or the yacht dealership, the gold miner goes to his bank and explains, “I am lending you this new money. I recognize that you run a tight 100-percent-reserve ship, but I am adding this to my savings account, not my checking account. I know that I am giving up my money now, in exchange for your promise to pay me back the loan, with interest, down the road.”
Now the bank can enter the credit markets with a huge influx of loanable funds. This new supply of savings will clearly push down the market rate of interest, allowing many businesses to expand and start long-term projects that were unprofitable before the gold discovery.
We finally see the conundrum: Is this an example of an unsustainable boom? After all, nobody in the community restricted consumption in order to free up physical resources. So how is this scenario essentially different from the case where the fractional-reserve bankers simply create new loans out of thin air?
As I explained in the introduction, I am not here to say what the definitive answer to this question is. I want to show that one could give a fairly “Rothbardian” answer that goes either way. I think modern Austrians who subscribe to Rothbard’s 100-percent-reserves dictum might come down on different sides of this question.
Door #1: The Gold Influx Would Cause an Unsustainable Boom
Both Mises and Rothbard viewed interest as a “real” phenomenon. They both argued that in the undisturbed market economy, the “natural” interest rate reflects the subjective preferences people have for consuming sooner rather than later.
Mises and Rothbard also stressed the point that there was no “optimum” quantity of money. Any amount of money could perform its services as a universally accepted medium of exchange, once prices adjusted. The community would obviously grow wealthier (per capita) if farmers harvested more wheat, or if musicians held more concerts. But if the government printed up more paper money, this didn’t make the community richer on average, because the same amount of real goods and services were produced. The new money simply raised prices.
Indeed, even in the case of a commodity money such as gold, new quantities delivered to the market did not make the community richer, except insofar as the new gold was used for industrial or commercial applications. For example, if some of the newly mined gold went towards arthritis treatment, or toward the production of more necklaces, then this increase would be socially beneficial. But the crucial point is that in its monetary capacity, five million tons of gold is just as useful as one million or ten million.
After stressing these standard Misesian and Rothbardian insights on the nature of interest and money, one could very plausibly argue that our mother-lode scenario would trigger an unsustainable boom. After all, suppose the gold miner didn’t dump the new tons on the credit market, but instead spent them on consumption goods. Clearly this would just redistribute wealth from the rest of the community into the hands of the miner.
Consider: The total production of cars, food, clothing, and houses wouldn’t go up simply because someone stumbled on a bunch of yellow metal. Therefore, the increased consumption of the gold miner could only come at the expense of others in the community, who did not get their hands on the new gold until late in the game.
Note that there is nothing unethical or dubious about a gold miner spending his justly acquired property in order to boost his consumption. We are merely arguing that this extra gold “production” is not socially useful in the same way that extra production by the farmers or dentists would be.
If we can see that spending the new gold on consumption would merely rearrange the same total quantity of real goods and services, then it is clear that the community’s real income hasn’t risen on account of the discovery of the mother lode.
Finally, if the analysis so far has been correct, then it obviously follows that if the gold miner takes his new money and lends it out at interest, he will distort the production structure away from its proper configuration. At the lower interest rate, businesses will borrow more money (consisting in ounces of gold) for investment spending. Yet nobody in the community will have cut back on consumption just because some guy happened to stumble on a few tons of new gold. If anything, people will consume more once interest rates drop.
Thus we see that a standard Rothbardian analysis could very plausibly conclude that a boom–bust cycle is theoretically possible on a free market.
Door #2: An Unsustainable Credit Expansion Can’t Happen on a Free Market
Although the above analysis was purposely constructed along Rothbardian lines, it presents a problem: Murray Rothbard thought that the boom-bust cycle could not possibly happen on a genuinely free market. That’s why he placed the analysis of Austrian business cycle theory in the section dealing with government intervention in his treatise Man, Economy, and State.
To my knowledge, Rothbard never specifically addressed the theoretical scenario we are imagining in this article. But if a Rothbardian wanted to deny that a free market could lead to a boom-bust cycle, even under these hypothetical conditions, how might he argue?
First, let’s be a bit more concrete in our description of the normal, month-to-month operations of the gold miner. Other businesses collect payment from their customers in physical gold, and they pay their expenses the same way. At the end of each month, the net income of the business is the excess revenues over expenses, measured in gold ounces.
But for the man who owns a gold mine, things are different. He has to pay employees in gold ounces (or grams), and he has to pay for his electricity, gasoline, and other inputs with gold ounces too — just like any other businessman.
The difference is that the revenues of the gold miner come, not from paying customers, but from the new gold that is brought to the surface. In this hypothetical economy, the man is literally finding money buried in the ground. After suitably polishing it up (and perhaps having someone turn it into recognizable coins), these hunks of yellow metal are perfectly interchangeable with the other units of money in people’s pockets.
Now we have to ask: is there anything odd or illegitimate about this constant stream of income for the gold miner, month after month? After all, he is able to use his gold production each month to pay his business expenses and to enjoy a nice lifestyle himself.
When push comes to shove, it is hard to see how a Rothbardian could, in any way, object to the miner’s real income (assuming he had acquired ownership to the mine in a legal and proper fashion). In the first place, the new gold lowers the purchasing power of an ounce of gold, allowing everyone to benefit more readily from gold’s nonmonetary uses (dental work, jewelry, etc.).
If we try to argue that the portion of gold that goes into cash balances (as opposed to necklaces and tooth fillings) is somehow socially useless, we run into the problem that these transactions occur on a voluntary basis, and the people trading for the gold would definitely report that they gained from the exchange.
“It’s not our job as economists to say whether the customers’ preferences are ‘legitimate’ or ‘socially useful’ from some objective standpoint.”Generally speaking, Rothbardians don’t think economic science can deny the social utility of an exchange, so long as it is truly voluntary and no one else’s property rights are violated. If a producer wants to burn half his coffee crop in order to extract more revenues from his customers, Rothbard has no problem with that outcome — again, so long as the government plays no part in the restrictive policy.
In this light, then, it’s hard to see how a Rothbardian could claim that the gold miner’s net income is somehow less deserved or “real” than anyone else’s. After all, a Rothbardian would say that a fortune teller’s monthly income is due to her “marginal productivity,” as measured by her customers’ willingness to pay. It’s not our job as economists to say whether the customers’ preferences are “legitimate” or “socially useful” from some objective standpoint.
If we’ve come this far, it’s a short step to say that a massive gold discovery doesn’t change the essence of the argument. If it’s perfectly legitimate and “efficient” for the gold miner to bring, say, 1,000 new ounces of gold to market every month, there’s no reason our opinion should change if he suddenly brings 10 tons of gold to market. That is still his income, and the community is that much richer, in nominal terms.
It’s true, we might quibble and say in real terms — adjusted for price inflation — the community isn’t richer. That is fine. We can look at the increase in the gold prices of milk, eggs, gasoline, and so forth, to account for the fact that a new influx of 10 tons of gold will cause (gold) price inflation. That still doesn’t change the fact that the gold miner’s nominal income was what it was, and is just as legitimate as it would have been had he only brought 1,000 ounces of gold to market, as usual.
We’ve finally reached our destination: If we accept that the gold miner’s nominal income — measured in gold — is every bit as “legitimate” as anybody else’s, then if he decides to save 9.5 tons of his new gold holdings by lending them out, it is perfectly accurate to say that the amount of savings in the community has increased.
Again, if we wish we can bring up the distinction between nominal and real (price-inflation adjusted) savings, but as good Misesians we must not lose sight of the “driving force of money.” We can’t fall into the mainstream trap of thinking about the economy as a set of “real” exchanges, and then throwing money on as an afterthought. Yes, the new influx of gold will drive up the gold-prices of goods and services in the community, and this rise in prices will cause lenders to insist on a higher nominal interest rate than they would otherwise. This inclusion of a “price premium” in the gross-market interest rate will work in the opposition direction of the increased savings, keeping the interest rate from falling as much as it otherwise would have.
In any event, it is difficult to see how a Rothbardian could claim that the gold miner’s actions — bringing new gold to market, which everyone is eager to acquire, and then deciding to save a large portion of his windfall income, rather than blowing it on Caribbean cruises — are somehow detrimental to the rest of the community.
Rothbard argued against the very concept of a negative externality, so long as everyone’s property rights were respected. The “correct” market interest rate in our hypothetical scenario would be just as we have described — it is the interest rate that would spontaneously emerge from the voluntary trades of everyone in the community, including the gold miner.
Conclusion
In this essay I have deliberately ignored certain tensions between the two sides, lest I come down one way or another on the issue. We know that it can’t be the case that the two trains of thought above are both correct, because they lead to opposite conclusions. And yet, the reader must agree that each is a plausible application of Rothbardian thought.
In the real world, of course, the real danger of credit expansion and the boom-bust cycle comes from fiat money and fractional-reserve banking. Yet it is still important for economists in the Austrian tradition to think through hypothetical scenarios in order to refine our thinking and weed out any inconsistencies in our principles.
