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Monetary Fallacies and Inflationary Bubbles

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Looking to the next few years ahead, is America and the world going to continue riding a wave of economic growth, improving standards of living, falling and lower unemployment, and technological changes that will continue to raise the quality and variety of life? Or will this turn out to be, at least partly, an artificial economic boom that will end in another economic and financial bust? Reading the economic tealeaves is never an easy task. But the “Austrian” theory of the business cycle offers a guidebook to better see through the confusions and complexities of what the future may hold in store.

Ninety years ago, in 1928, the famous Austrian economist, Ludwig von Mises, published a monograph called, Monetary Stabilization and Cyclical Policy. It was intended to be a partial restatement and extension of his earlier work, The Theory of Money and Credit, which first appeared in 1912, and in a revised edition in 1924.

Many things have happened, of course, over the last nine decades — the Great Depression, the Second World War, the Cold War, the end of the Soviet Union, roller coasters of inflations and recessions, the replacement of gold with paper monies virtually everywhere in the world, the dramatic growth of the interventionist-welfare state, and the era of massive government debt fed by seemingly perpetual deficit spending to cover the costs of political largess in an epoch of pervasive special interest politicking.

Yet, the laws of economics have not been overturned. As a result, like causes still bring about like effects. Minimum wage laws still price some workers out of the labor market whose value added to the employer is less than what the government dictates he must be paid. Rent controls and restrictive zoning laws create housing shortages when government interferes with market-based pricing of rental housing and limits increases in housing supplies in the face of growing demand.

Mises’ Monetary and Business Cycle Analysis Still Relevant Today

This is no less the case in the area of money and banking (the financial intermediation between savers and borrowers). When Mises published Monetary Stabilization and Cyclical Policy in 1928 most of the major countries of the world where still on some version of the gold standard. But that world was still recovering from the political, economic, social and monetary catastrophes of the First World War (1914-1918). And the world was on the eve of what was soon to be the start of the Great Depression in 1929-1930.

Then, as today, many governments were busy manipulating the supply of money and credit, and influencing interest rates in the financial markets. The particular goals and targets of governments and their central banks may have been somewhat different ninety years ago. But they followed the same logic as now: monetary central planning under the rationale of trying to manage the economy as a whole.

In 1928, it had only been ten years since the end of the First World War, and Mises made a point of reminding his readers that before 1914, the leading nations of the world, especially in Europe and North America, had monetary systems based on a gold standard. These were, indeed, government-managed gold standards through national central banks, but nonetheless they had placed significant breaks on the ability of arbitrary and dramatic increases in the amount of currencies that these national monetary authorities could inject into their respective economies. To a noticeable degree, Mises emphasized, it had removed the government’s hand from the handle of the monetary printing press, on a day-by-day basis. There were still ways that government’s could influence the monetary system and the value of money. But these were more indirect and less open to constant manipulation for political and related purposes.

In the wake of the monetary madness during and immediately following the First World War, when some countries suffered massive and widely destructive hyperinflations (such as in Germany and in Mises’ native Austria), there had been halting and partial attempts to return to versions of the gold standard. See my articles, “War, Big Government, and Lost Freedoms” and “Lessons from the Great Austrian Inflation”.)

Price Level Stabilization vs. the Changing Value of Money

In the 1920s, the goal of government monetary policy, especially in the United States, became price level stabilization. American economists, particular one of the leading ones in the country at that time, Irving Fisher, argued that central banks should manage the creation of money and credit to prevent either a rising or a falling general level of prices. This would require injections of larger quantities of money into the economy when a general price index was measured as tending to decline and withdrawals of money from the economy when such a price index was tending to rise.

Mises’ critical response was two pronged. First, he pointed out that all general price indices were statistical fictions that had no absolute scientific validity or precision. Money is the most widely used and generally accepted medium of exchange. It facilitates an easier and less costly exchange of goods and services between multitudes of market transactors.

But money has no one single price or exchange ratio in the market, unlike other goods. In a money-using economy, it becomes the practice and pattern for everyone to first trade the good or service they specialize in offering on the market for a sum of money: two dollars for a box of breakfast cereal; twenty-five dollars for a restaurant meal; seventy-five dollars for a pair of blue jeans; four hundred dollar for a pair of prescription sun glasses, etc. Thus, every good offered on the market tends to, competitively, have one market price at any moment of time – its money price.

Individuals use the monetary revenues earned in their roles as a producers and sellers in the market to then turn around and spend those dollars back in the market place in their roles as a consumers, now buying at the existing market prices the goods and services their fellow market participants are offering them to buy.

But money in the market place, unlike all these other goods, has not single price. It possesses as many prices as those diverse and multitude of other individual goods against which it trades. Hence, money’s general value or purchasing power is represented in the set, or array, or structure of relative money prices, and not by any one price.

The Fictions of a Price Index

For many decades in the nineteenth century economic historians and statisticians had diligently worked hard to devise various ways to construct “index numbers” as an average measurement of the general value of money and changes in it. But Mises had become well known as a critic of all such attempts to measure the value of money through the use of index numbers. He pointed out the limits and ambiguities in the construction of a hypothetical “basket” of goods the value or cost of which was to be tracked through time:

(a) There had to be a decision as to which goods were to be considered “representative” of the purchases of an average consumer and placed in this imaginary basket, when in reality there are as many buying patterns for different goods and combinations of goods as there are individuals making spending choices in the market;

(b) There needed to be a decision concerning the “weight” to assign to each of goods in the imaginary basket, that is, the relative amounts of each presumed to be consumed per period of time for following the cost of buying the basket, when in reality these relative amounts can widely vary, based upon each person’s own tastes and preferences, and ability to pay;

(c) It needed to be assumed that in spite of constant real-world changes in market supplies and demands that might influence a person’s willingness or ability or interest in buying different amounts or types of goods in this basket, this representative consumer’s buying patterns remained the same over time; and,

(d) It needed to be assumed that changes in the qualities and characteristics of the goods offered on the market through product improvements over time did not influence this representative consumer’s judgment concerning the real relative worth or value of any of the goods that might otherwise affect this artificial buyer’s purchasing decisions.

Without some version of these assumptions, there is no common dominator – a given basket of particular goods unchanging in the relative amounts purchased due to no change in the artificial representative consumer’s buying patterns from either a change in tastes or the relative prices or worth of the items bought – so to compare what the same basket of goods costs to buy over extended periods of time. And, thus, whether, the basket has become more or less costly to buy “tomorrow” compared to “today,” or perhaps simply costs the same.

The details and construction of various price indices may have become more sophisticated and complex since Mises wrote his original criticism of index number methods (for example, “chain-weighted” techniques meant to reduce the impact of any changes in the basket by averaging out these changes over periods of time). But the core criticisms, I would suggest, remain the same due to the assuming away of the reality of the diversity and changeability in the buying patterns of actual individuals whose choices and decisions make up the market process, with, in principle, no one individual in the market even having any of the buying characteristics reflected in the statistical index construction built by the economic statisticians. (See my article, “The Consumer Price Index, A False Indicator of Our Individual Costs-of-Living,”)

The Complexity of Inflation and the Non-Neutrality of Money

Secondly, Mises emphasized that when focusing on the average change in a general “price level,” it is an easy to fall victim to the assumption that changes in the supply of money and credit impact on prices more or less at the same time and to the same degree. Mises also became well known for drawing attention to the fact that changes in the supply of money and credit, in fact, are “non-neutral” in their effects in the economy.

That is, changes in the money supply are not like manna from heaven impacting everyone at the same time, to the same degree. The impact and influence of any monetary changes reflect the “inject” point from which they are introduced. Suppose there is an increase, say, in the gold supply due to the discovery and mining of new gold fields. The nineteenth century classical economist, John E. Cairnes, insightfully traced out the history of how the Australian gold discoveries beginning in the 1840s and 1850s set in motion a monetary rippling effect around the world.

It started in the Australian coastal cities and towns where the gold prospectors and miners first spent their newly mined gold, raising the prices for the particular goods and services they demanded from Australian merchants and retailers. As the new gold supplies passed into the hands of these Australian sellers of consumer products, they demanded more goods for import from British and other European wholesalers and manufacturers, which slowly but surely then pushed up prices in European markets. Then these European producers spent their new gold money receipts on increasing their demands for resources and raw materials and other inputs, which they imported from other areas of the world in Latin America, Asia and Africa.

Prices around the world increased as a result of the increase in the quantity of gold money injected into the global market starting in Australia. But, as Cairnes emphasized, there was a temporal sequence, with prices rising in a distinct pattern over time reflecting who had the new money first, second, third, and so on, bringing about, first a rise in some prices, then others, and then still others, until finally prices in general were affected around the world, but to varying degrees and amount. The final result, of course, was a decrease the value or purchasing power of money due to an increase in the supply of money relative to people’s demand for holding money for transaction and other purposes. But it was neither proportional nor simultaneous. (See, John E. Cairnes, Essays in Political Economy: Theoretical and Applied [1873] pp. 1-165.)

Savings, Investment and the Rate of Interest

The other major theme in Mises’ Monetary Stabilization and Cyclical Policy was that the institutional manner in which governments attempt to influence the amount of money and credit within an economy carried with it the potential to set in motion the phases of the business cycle, that is, an inflationary boom followed by a recessionary bust.

Central banks inject additional “reserves” into the banking system, which then serves as the means for financial institutions to increase their lending to interested and willing borrowers. However, a primary means by which banks with new excess reserves can attract potential borrowers to take on additional lending is to reduce the cost of loans. This means lowering the rates of interest at which additional money loans may be had.

What is the purpose of market-based rates of interest? They are the intertemporal prices at which savers choose to set aside for a period of time portions of previously earned income in the form of savings, which is made available to others who desire access to portions of the scarce means of production for, most frequently, investment purposes that their own incomes and revenues are not sufficient to completely undertake. Thus, interest rates are meant to facilitate the transfer of and access to the use of resources and the employment of labor from desirable uses closer to the present to those involving more time-consuming production processes the finished output from which will not be available for sale and use until some point further into the future.

Thus, market interest rates are meant to reflect the supply of and demand for real savings, and to balance the two sides of the market so investment activities are limited to and are undertaken for investment periods consistent with the willingness and decisions of other income-earners to forgo the use of that savings for equivalent periods of time. Thus, market-based interest rates coordinate savings and investment in consistent ways cross time. Investment plans tend to be compatible with the demands of savers willing to forgo finished goods in the present in exchange for more and different consumer goods in the future.

Monetary Expansion and Interest Rates Manipulation  

The heart of Ludwig von Mises’ “Austrian” theory of the business cycle is that by expanding the money supply through the banking system and, as a consequence, tending to lower rates of interest in the financial markets, like any price artificially pushed below its market-clearing or “equilibrium” level, it generates a quantity demanded in excess of quantity supplied. In any other market, if the government artificially sets or manipulates a price below its market-clearing level, it tends to bring about a shortage, that is, a desire by people to buy more of a good than is available to purchase from willing sellers.

But with monetary expansion, an illusion is created that there is, in fact, more real savings available to undertake more investments and more time-consuming investments that is actually the case. People do not trade saved goods and resources across time from the hands of savers into the hands of investment borrowers, like might be the case in some hypothetical system of direct barter exchange.

Instead, the trading of goods and services are done through the use of money, the market’s medium of exchange. People forgo buying all the real goods and services they might have with the money income they have previously earned. They supply that money savings to interested investment borrowers through the intermediation of banks with which those savers have deposited and left their savings. Those borrowers take up that money savings through banks and then use it to hire, purchase and employ available factors of production that have been freed up for such uses preciously by the decision of savers to not demand their use for more immediate consumer goods purposes.

But, now, the central bank has created an increased amount of the medium of exchange through the banking system. Borrowers are able to obtain larger and increased money loans, not representing real savings (in the form of money) set aside by actual savers, but with created bank credit that investment borrowers can now use to enter the market and demand a greater amount of those scarce means of production than otherwise would have been the case.

With an increase in the amount of money available for spending and investment purposes in the economy as a whole, over time there will be (all other things given) a tendency for a general rise in prices that is, a possible price inflation. But a central point in Mises’ analysis is to argue that prices do not rise simultaneously or to the same degree. The banking system serves as the “injection point” from which the inflationary process is set in motion.

First, the prices for those goods demanded by investment borrowers will tend to be nudged up. The money they spend is then passed on as additional revenues and income to those from whom they buy (or in the case of labor, those they hire) for the investment projects of different types and durations they now attempt to undertake. Those who have received these additional sums of created money as additional revenues and income increase their demands for the specific goods and services they wish to buy and acquire. And that, now, leads to the new money passing into the hands of a third wave of sellers in the market.

In this inflationary process some demands and prices necessarily rise before others. This influences the relative profitability of different economic and investment activities, which, in turn, influences the allocation and use of resources, labor and capital goods in different ways across sectors in the economy. The entire structure of the economy is skewed toward greater and more time consuming investment projects that, in fact, the actual savings in the economy cannot sustain in the long-run, given peoples real desires for consumer goods relative to their willingness to save to support investment projects in the economy.

Unsustainability of the Boom Phase of the Business Cycle

The inflation-induced distortions of investment activities and resource uses, including labor, will be found to be unsustainable in the longer run. The use of resources across time is out of balance with the desire and willingness of actual income earners to consume and save. The “crisis” comes when these imbalances finally reach a breaking point, and it is discovered that the hoped for investment profitability has been unmasked as serious mal-investments, many of which not only turn unprofitable but which cannot be brought to completion. The economy now goes through an adjustment period, a process of “rebalancing” of prices and  costs, as well as reallocations of labor and resources between various sectors of the markets that is labeled the “recession” or the “bust” or, when severe enough, the “depression” phase of the business cycle.

This “Austrian” analysis became the basis for Ludwig von Mises and his younger friend and protégé, Friedrich A. Hayek, to explain in the 1930s the causes and consequences of the coming of the Great Depression after 1929. The attempt to “stabilize” the general price level though central bank monetary manipulation, especially by the American Federal Reserve in the 1920s, created the appearance of a healthy and well-balanced growing economy; in fact, beneath the surface of that relatively “stable” price level, central bank policy had generated unbalanced and distorted patterns of investment activities and resource uses that meant that the “good times” were going to come to an end.

The severity and the duration of the Great Depression, the Austrian Economists argued, was not due to any inherent flaws in the market economy, as John Maynard Keynes and the “Keynesians” who followed him insisted was the case as the 1930s progressed. It was due to governments, including the U.S. government under Herbert Hoover and Franklin D. Roosevelt, introducing regulations, controls, interventions, and tax burdens that hindered the market from successfully “rebalancing” the economy in what should have been a relative short period of time, based upon recoveries from economic downturns before the 1930s. (See my eBook Monetary Central Planning and the State, for a detailed analysis and comparison of the “Austrian” and Keynesian theories, and their respective interpretations of the causes and cures for the Great Depression.)

Relevancy of Mises’ Analysis to Today’s Monetary and Financial Situation

The financial and economic crisis of 2008-2009 can easily be analyzed within the “Austrian” framework: a large money expansion, artificially low interest rates and reduced credit standards fostered unsustainable investment, housing and consumer spending booms that finally ended with a major stock market crash. This was followed by a slow economic recovery with potentially new distortions due to even greater monetary expansion and interest rate manipulations since 2009, combined with a grab bag of Federal Reserve tricks to influence banks not to lend a good part of the money the Fed created in in the banking system since 2009. (See my articles, “Low Interest Rates Cannot Save a House of Cards,” and “Austrian Monetary Theory vs. Federal Reserve Inflation Targeting” and “Ten Years On: Recession, Recovery and the Regulatory State”.)

If carefully read and reflected on, Ludwig von Mises’ Monetary Stabilization and Cyclical Policy still has much to teach us about money and the central banking problems of our own time. This includes a section in which Mises argues that the only long run, lasting solution to the periodic occurrence of the business cycle is the end to central banking and its replacement with private, competitive free banking.

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    Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).