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NOTE 9. Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm

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Chapter 9. Inflation and the Business Cycle. The Collapse of the Keynesian Paradigm.

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Until the years 1973 to 1974, the Keynesians, who had formed the ruling economic orthodoxy since the late 1930s, had been riding high, wide and handsome.

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Virtually everyone had accepted the Keynesian view that there is something in the free market economy

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makes it subject to swings of under- and over-spending. In practice, the Keynesian concern is almost

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exclusively with alleged under-spending, and that hence it is the function of the government

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to compensate for this market defect. The government was to compensate for this alleged

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imbalance by manipulating its spending and deficits, in practice to increase them. Guiding

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Among this vital macroeconomic function of government, of course, was to be a board of

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Keynesian economists, the Council of Economic Advisers, who would be able to fine-tune the

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economy so as to prevent either inflation or recession, and to regulate the proper amount

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of total spending so as to ensure continuing full employment without inflation.

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It was in 1973 and 1974 that even the Keynesians finally realized that something was very,

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very wrong with this confident scenario, that it was time to go back in confusion to their

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drawing boards.

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For not only had 40-odd years of Keynesian fine-tuning not eliminated a chronic inflation

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that had set in with World War II, but it was in those years that inflation escalated

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temporarily into double-digit figures to about 13% per annum.

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Not only that, it was also in 1973 and 1974 that the United States plunged into its deepest

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and longest recession since the 1930s.

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It would have been called a depression if the term hadn't long since been abandoned

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as impolitic by economists.

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This curious phenomenon of a vaunting inflation occurring at the same time as a steep recession

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was simply not supposed to happen in the Keynesian view of the world.

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Economists had always known that either the economy is in a boom period, in which case

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prices are rising, or else the economy is in a recession or depression marked by high

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unemployment, in which case prices are falling.

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In the boom, the Keynesian government was supposed to sop up excess purchasing power

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by increasing taxes according to the Keynesian prescription.

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That is, it was supposed to take spending out of the economy.

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In the recession, on the other hand, the government was supposed to increase its spending and

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its deficits in order to pump spending into the economy.

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But if the economy should be in an inflation and a recession with heavy unemployment at

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At the same time, what in the world was government supposed to do?

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How could it step on the economic accelerator and brake at the same time?

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As early as the recession of 1958, things had started to work peculiarly.

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For the first time in the midst of a recession, consumer goods prices rose, if only slightly.

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It was a cloud no bigger than a man's hand, and it seemed to give Keynesians little to

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to worry about. Consumer prices again rose in the recession of 1966, but this was such

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a mild recession that no one worried about that either. The sharp inflation of the recession

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of 1969 to 1971, however, was a considerable jolt. But it took the steep recession that

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began in the midst of the double-digit inflation of 1973 and 1974 to throw the Keynesian economic

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Establishment into Permanent Disarray.

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It made them realize that not only had fine tuning failed, not only was the supposedly

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dead and buried cycle still with us, but now the economy was in a state of chronic inflation

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and getting worse, and it was also subject to continuing bouts of recession, of inflationary

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recession or stagflation.

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It was not only a new phenomenon, it was one that could not be explained, that could not

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even exist in the theories of economic orthodoxy.

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And the inflation appeared to be getting worse.

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Approximately 1 to 2 percent per annum in the Eisenhower years, up to 3 to 4 percent

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during the Kennedy era, to 5 to 6 percent in the Johnson administration, then up to

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to about 13% in 1973 and 1974, and then falling back to about 6%, but only under the hammer blows of a steep and prolonged depression, approximately 1973 to 1976.

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There are several things, then, which need almost desperately to be explained.

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1. Why the chronic and accelerating inflation?

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2. Why an inflation even during deep depressions? And while we are at it, it would be important to explain, if we could,

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3. Why the business cycle at all? Why the seemingly unending round of boom and bust?

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Fortunately, the answers to these questions are at hand, provided by the tragically neglected Austrian School of Economics

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and its theory of the money and business cycle, developed in Austria by Ludwig von Mises and his

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follower, Friedrich A. Hayek, and brought to the London School of Economics by Hayek in the early

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1930s. Actually, Hayek's Austrian business cycle theory swept the younger economists in Britain

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precisely because it alone offered a satisfactory explanation of the Great Depression of the 1930s.

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Studies.

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Such future Keynesian leaders as John R. Hicks, Abba P. Lerner, Lionel Robbins, and Nicholas

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Caldor in England, as well as Alvin Hansen in the United States, had been Hayekians only

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a few years earlier.

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Then Keynes' general theory swept the boards after 1936 in a veritable Keynesian revolution,

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which arrogantly proclaimed that no one before it had presumed to offer any explanation

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and Whatever of the Business Cycle or of the Great Depression.

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It should be emphasized that the Keynesian theory did not win out by carefully debating

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and refuting the Austrian position.

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On the contrary, as often happens in the history of social science, Keynesianism simply became

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the new fashion, and the Austrian theory was not refuted, but only ignored and forgotten.

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For four decades the Austrian theory was kept alive, unwept, unhonored and unsung by most

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of the world of economics.

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Only Mises at NYU and Hayek at Chicago themselves and a few followers still clung to the theory.

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Surely it is no accident that the current renaissance of Austrian economics has coincided

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with the phenomenon of stagflation and its consequent shattering of the Keynesian paradigm

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Time for All to See.

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In 1974, the first conference of Austrian school economists in decades was held at Royalton

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College in Vermont.

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Later that year, the economics profession was astounded by the Nobel Prize being awarded

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to Hayek.

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Since then, there have been notable Austrian conferences at the University of Hartford,

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at Windsor Castle in England, and at New York University, with even Hicks and Lerner showing

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are the main signs of at least partially returning to their own long-neglected position.

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Regional conferences have been held on the East Coast, on the West Coast, in the Middle West, and in the Southwest.

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Books are being published in this field.

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And, perhaps most important, a number of extremely able graduate students and young professors devoted to Austrian economics have emerged

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Money and Inflation

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What then does this resurgent Austrian theory have to say about our problem?

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The first thing to point out is that inflation is not ineluctably built into the economy,

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nor is it a prerequisite for a growing and thriving world.

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During most of the 19th century, apart from the years of the War of 1812 and the Civil

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War, prices were falling, and yet, the economy was growing and industrializing.

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Falling prices put no damper whatsoever on business or economic prosperity.

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Thus, falling prices are apparently the normal functioning of a growing market economy.

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So how is it that the very idea of steadily falling prices is so counter to our experience

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that it seems a totally unrealistic dream world?

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Why, since World War II, have prices gone up continuously and even swiftly in the United

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States and throughout the world?

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Before that point, prices had gone up steeply during World War I and World War II.

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In between, they fell slightly, despite the great boom of the 1920s, and then fell steeply

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during the Great Depression of the 1930s.

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In short, apart from wartime experiences, the idea of inflation as a peacetime norm

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really arrived after World War II.

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The favorite explanation of inflation is that greedy businessmen persist in putting up prices

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in order to increase their profits.

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But surely the quotient of business greed has not suddenly taken a great leap forward since

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World War II.

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Weren't businesses equally greedy in the 19th century and up to 1941?

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So why was there no inflation trend then?

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Moreover, if businessmen are so avaricious as to jack up prices 10% per year, why do

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they stop there?

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Why do they wait?

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Why don't they raise prices by 50% or double or triple them immediately?

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What holds them back?

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A similar flaw rebuts another favorite explanation of inflation, that unions insist on higher

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wage rates, which in turn leads businessmen to raise prices.

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Apart from the fact that inflation appeared as long ago as ancient Rome and long before

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For unions arrived on the scene, and apart from the lack of evidence that union wages

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go up faster than non-union, or that prices of unionized products rise faster than of

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non-unionized, a similar question arises.

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Why don't businesses raise their prices anyway?

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What is it that permits them to raise prices by a certain amount, but not by more?

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If unions are that powerful and businesses that responsive, why don't wages and prices

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A government-inspired TV propaganda campaign a few years ago got a bit closer to the mark.

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Consumers were blamed for inflation by being too piggy, by eating and spending too much.

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We have here at least the beginning of an explanation of what holds businesses or unions

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Back from Demanding Still Higher Prices. Consumers Won't Pay Them. Coffee prices zoomed upward

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a few years ago. A year or two later, they fell sharply because of consumer resistance.

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To some extent, from a flashy consumer boycott, but more importantly, from a shift in consumer

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buying habits away from coffee and toward lower-priced substitutes. So, a limit on consumer

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Consumer Demand holds them back.

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But this pushes the problem one step backward.

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For if consumer demand, as seems logical, is limited at any given time, how come it

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keeps going up, year after year, and validating or permitting price and wage increases?

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And if it can go up by 10%, what keeps it from going up by 50%?

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In short, what enables consumer demand to keep going up year after year and yet keeps

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it from going up any further?

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To go any further in this detective hunt, we must analyze the meaning of the term price.

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What exactly is a price?

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The price of any given quantity of a product is the amount of money the buyer must spend

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on it.

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In short, if someone must spend $7 on 10 loaves of bread, then the price of those 10 loaves

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is $7.

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Or since we usually express price per unit of product, the price of bread is 70 cents

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per loaf.

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So there are two sides to this exchange, the buyer with money and the seller with bread.

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It should be clear that the interaction of both sides brings about the ruling price in

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In short, if more bread comes on to the market, the price of bread will be bid down, increased

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supply lowers the price.

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While on the other hand, if the bread buyers have more money in their wallets, the price

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of bread will be bid higher, increased demand raises the price.

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We have now found the crucial element that limits and holds back the amount of consumer

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More Demand and hence the price, the amount of money in the consumer's possession.

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If the money in their pockets increases by 20%, then the limitation on their demand is

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relaxed by 20%.

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And other things remaining equal, prices will tend to rise by 20% as well.

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We have found the crucial factor, the stock or the supply of money.

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If we consider prices across the board for the entire economy, then the crucial factor

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is the total stock or supply of money in the whole economy.

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In fact, the importance of the money supply in analyzing inflation may be seen in extending

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our treatment from the bread or coffee market to the overall economy.

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For all prices are determined inversely by the supply of the good and directly by the

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and the demand for it.

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But the supplies of goods are in general going up year after year in our still growing economy,

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so that from the point of view of the supply side of the equation, most prices should be

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falling, and we should right now be experiencing a 19th century style steady fall in prices

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– deflation.

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If chronic inflation were due to the supply side, to activities by producers such as business

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In the 19th century too, but at a much slower pace, far slower than the increase of goods and services.

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But since World War II, the increase in the money supply, both here and abroad, has been much faster than in the supply of goods. Hence, inflation.

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The crucial question then becomes who or what controls and determines the money supply and keeps increasing its amount, especially in recent decades.

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To answer this question, we must first consider how money arises to begin with in the market economy.

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For money first arises on the market as individuals begin to choose one or several useful commodities to act as a money.

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The best money commodities are those that are in high demand, that have a high value per unit weight, that are durable so they can be stored a long time, mobile so they can be moved readily from one place to another, and easily recognizable, and that can be readily divisible into small parts without losing their value.

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Over the centuries, various markets and societies have chosen a large number of commodities as money, from salt, to sugar, to cowrie shells, to cattle, to tobacco, down to cigarettes and POW camps during World War II.

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But over all these centuries, two commodities have always won out in the competitive race to become monies when they have been available, gold and silver.

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Metals always circulate by their weight, a ton of iron, a pound of copper, etc., and their prices are reckoned in terms of these units of weight.

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Gold and silver are no exception. Every one of the modern currency units originated as units of weight of either gold or silver.

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Thus the British unit, the pound sterling, is so named because it originally meant simply one pound of silver.

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To see how the pound has lost value in the centuries since, we should note that the pound sterling is now worth two-fifths of an ounce of silver on the market.

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This is the effect of British inflation, of the debasement of the value of the pound.

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The dollar was originally a bohemian coin consisting of an ounce of silver.

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Later on, the dollar came to be defined as one-twentieth of an ounce of gold.

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When a society or a country comes to adopt a certain commodity as a money, and its unit

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of weight then becomes the unit of currency, the unit of reckoning in everyday life, then

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that country is said to be on that particular commodity standard.

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Since markets have universally found gold or silver to be the best standards whenever

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they are available, the natural course of these economies is to be on the gold or silver

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In that case, the supply of gold is determined by market forces, by the technological conditions of supply, the prices of other commodities, etc.

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From the beginning of market adoption of gold and silver as money, the state has been moving in to seize control of the money supply function, the function of determining and creating the supply of money in the society.

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It should be obvious why the state should want to do so.

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This would mean seizing control over the money supply from the market and turning it over to a group of people in charge of the state apparatus.

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Why they should want to do so is clear.

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Here would be an alternative to taxation, which the victims of a tax always consider onerous.

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For now, the rulers of the state can simply create their own money and spend it or lend it out to their favorite allies.

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None of this was easy until the discovery of the art of printing.

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After that, the state could contrive to change the definition of the dollar, the pound, the mark, etc. from units of weight of gold or silver

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into simply the names for pieces of paper printed by the central government.

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Then that government could print them costlessly and virtually ad lib, and then spend or lend them out to its heart's content.

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It took centuries for this complex movement to be completed, but now the stock and the issuance of money is totally in the hands of every central government.

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The consequences are increasingly visible all around us.

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Consider what would happen if the government should approach one group of people, say, the Jones family, and say to them,

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Here, we give you the absolute and unlimited power to print dollars, to determine the number of dollars in circulation,

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and you will have an absolute monopoly power.

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Anyone else who presumes to use such power will be jailed for a long, long time as an evil and subversive counterfeiter.

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We hope you use this power wisely.

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We can pretty well predict what the Jones family will do with this newfound power.

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At first it will use the power slowly and carefully to pay off its debts, perhaps buy

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itself a few particularly desired items.

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But then, habituated to the heady whine of being able to print their own currency, they

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will begin to use the power to the hilt, to buy luxuries, reward their friends, etc.

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The result will be continuing and even accelerated increases in the money supply, and therefore

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continuing and accelerated inflation.

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But this is precisely what governments, all governments, have done, except that instead

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of granting the monopoly power to counterfeit to the Jones or other families, government

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has granted the power to itself.

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Just as the state arrogates to itself a monopoly power over legalized kidnapping and calls

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it conscription, just as it has acquired a monopoly over legalized robbery and calls

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it taxation, so too it has acquired the monopoly power to counterfeit and calls it increasing

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the supply of dollars, or francs, marks, or whatever.

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Instead of a gold standard, instead of a money that emerges from and whose supply is determined

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and by the free market, we are living under a fiat paper standard.

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That is, the dollar, franc, etc. are simply pieces of paper with such names stamped upon

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them, issued at will by the central government, by the state apparatus.

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Furthermore, since the interest of a counterfeiter is to print as much money as he can get away

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with, so too will the state print as much money as it can get away with, just as it

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It will employ the power to tax in the same way, to extract as much money as it can without

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raising too many howls of protest.

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Government control of money supply is inherently inflationary then, for the same reason that

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any system in which a group of people obtains control over the printing of money is bound

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to be inflationary.

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The Federal Reserve and Fractional Reserve Banking

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Inflating by simply printing more money, however, is now considered old-fashioned.

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For one thing, it is too visible.

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With a lot of high-denomination bills floating around, the public might get the troublesome

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idea that the cause of the unwelcome inflation is the government's printing of all the bills,

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and the government might be stripped of that power.

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Instead, governments have come up with a much more complex and sophisticated and much less

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visible means of doing the same thing, of organizing increases in the money supply to

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give themselves more money to spend and to subsidize favored political groups.

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The idea was this, instead of stressing the printing of money, retain the paper dollars

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Bankers or Marks or Franks as the basic money, the legal tender, and then pyramid on top

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of that a mysterious and invisible but no less potent checkbook money or bank demand

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deposits.

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The result is an inflationary engine controlled by government which no one but bankers, economists

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and government central bankers understands, and designedly so.

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First, it must be realized that the entire commercial banking system in the United States

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or elsewhere is under the total control of the central government, a control that the

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banks welcome, for it permits them to create money.

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The banks are under the complete control of the central bank, a government institution,

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a control stemming largely from the central bank's compulsory monopoly over the printing

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of money.

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In the United States, the Federal Reserve System performs this central banking function.

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The Federal Reserve, the Fed, then permits the commercial banks to pyramid bank demand

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deposits, checkbook money, on top of their own reserves, deposits at the Fed, by a multiple

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of approximately 6 to 1.

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In other words, if bank reserves at the Fed increase by $1 billion, the banks can and

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do pyramid their deposits by $6 billion. That is, the banks create $6 billion worth of new money.

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Why do bank demand deposits constitute the major part of the money supply?

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Officially, they are not money or legal tender in the way that Federal Reserve notes are money.

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But they constitute a promise by a bank that it will redeem its demand deposits in cash,

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Federal Reserve notes anytime that the deposit holder, the owner of the checking account, may desire.

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00:26:50.120 --> 00:26:57.000
The point, of course, is that the banks don't have the money. They cannot, since they owe

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six times their reserves, which are their own checking account at the Fed. The public, however,

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is induced to trust the banks by the penumbra of soundness and sanctity laid about them by

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by the Federal Reserve System.

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For the Fed can and does bail out banks in trouble.

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If the public understood the process and descended in a storm upon the banks demanding their

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money, the Fed, in a pinch, if it wanted, could always print enough money to tide the

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banks over.

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The Fed, then, controls the rate of monetary inflation by adjusting the multiple 6 to 1

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of Bank Money Creation, or more importantly, by determining the total amount of bank reserves.

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In other words, if the Fed wishes to increase the total money supply by $6 billion, instead

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of actually printing the $6 billion, it will contrive to increase bank reserves by $1 billion

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and then leave it up to the banks to create $6 billion of new checkbook money.

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The public, meanwhile, is kept ignorant of the process, or of its significance.

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How do the banks create new deposits?

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Simply by lending them out in the process of creation.

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Suppose for example that the banks receive the $1 billion of new reserves.

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The banks will lend out $6 billion and create the new deposits in the course of making these

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00:28:29.640 --> 00:28:31.520
new loans.

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In short, when the commercial banks lend money to an individual, a business firm or the government,

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they are not re-lending existing money that the public laboriously had saved and deposited

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00:28:43.900 --> 00:28:47.840
in their vaults, as the public usually believes.

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They lend out new demand deposits that they create in the course of the loan, and they

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are limited only by the reserve requirements, by the required maximum multiple of deposit

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00:28:59.880 --> 00:29:03.520
to Reserves, for example, 6 to 1.

290
00:29:03.520 --> 00:29:08.880
For after all, they are not printing paper dollars or digging up pieces of gold.

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00:29:08.880 --> 00:29:15.660
They are simply issuing deposit or checkbook claims upon themselves for cash, claims which

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00:29:15.660 --> 00:29:21.000
they wouldn't have a prayer of honoring if the public as a whole should ever rise up

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00:29:21.000 --> 00:29:25.720
at once and demand such a settling of their accounts.

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00:29:25.720 --> 00:29:32.280
How then does the Fed contrive to determine, almost always to increase, the total reserves

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00:29:32.280 --> 00:29:34.640
of the commercial banks?

296
00:29:34.640 --> 00:29:41.880
It can and does lend reserves to the banks, and it does so at an artificially cheap rate,

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00:29:41.880 --> 00:29:44.400
the re-discount rate.

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00:29:44.400 --> 00:29:50.260
But still, the banks do not like to be heavily in debt to the Fed, and so the total loans

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00:29:50.260 --> 00:29:54.820
outstanding from the Fed to the banks is never very high.

300
00:29:54.820 --> 00:30:00.380
By far the most important route for the Fed's determining of total reserves is little known

301
00:30:00.380 --> 00:30:06.100
or understood by the public, the method of open market purchases.

302
00:30:06.100 --> 00:30:10.860
What this simply means is that the Federal Reserve Bank goes out into the open market

303
00:30:10.860 --> 00:30:13.100
and buys an asset.

304
00:30:13.100 --> 00:30:17.460
Strictly it doesn't matter what kind of an asset the Fed buys.

305
00:30:17.460 --> 00:30:21.900
It could, for example, be a pocket calculator for $20.

306
00:30:21.900 --> 00:30:28.340
Suppose that the Fed buys a pocket calculator from XYZ Electronics for $20.

307
00:30:28.340 --> 00:30:35.140
The Fed acquires a calculator, but the important point for our purposes is that XYZ Electronics

308
00:30:35.140 --> 00:30:40.380
acquires a check for $20 from the Federal Reserve Bank.

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00:30:40.380 --> 00:30:45.900
Now the Fed is not open to checking accounts from private citizens, only from banks and

310
00:30:45.900 --> 00:30:48.060
the Federal Government itself.

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00:30:48.060 --> 00:30:58.060
XYZ Electronics, therefore, can only do one thing with its $20 check, deposit it at its own bank, say, the Acme Bank.

312
00:30:58.060 --> 00:31:09.060
At this point, another transaction takes place. XYZ gets an increase of $20 in its checking account, in its demand deposits.

313
00:31:09.060 --> 00:31:16.060
In return, Acme Bank gets a check made over to itself from the Federal Reserve Bank.

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00:31:16.060 --> 00:31:29.060
Now the first thing that has happened is that XYZ's money stock has gone up by $20, its newly increased account at the Acme Bank, and nobody else's money stock has changed at all.

315
00:31:29.060 --> 00:31:39.060
So at the end of this initial phase, phase one, the money supply has increased by $20, the same amount as the Fed's purchase of an asset.

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00:31:39.060 --> 00:31:53.060
If one asks, where did the Fed get the $20 to buy the calculator, then the answer is, it created the $20 out of thin air by simply writing out a check upon itself.

317
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No one, neither the Fed nor anyone else, had the $20 before it was created in the process of the Fed's expenditure.

318
00:32:03.060 --> 00:32:11.060
But this is not all. For now, the Acme Bank, to its delight, finds it has a check on the Federal Reserve.

319
00:32:11.060 --> 00:32:22.060
It rushes to the Fed, deposits it, and acquires an increase of $20 in its reserves, that is, in its demand deposits with the Fed.

320
00:32:22.060 --> 00:32:29.060
Now that the banking system has an increase in $20, it can and does expand credit,

321
00:32:29.060 --> 00:32:42.060
That is, create more demand deposits in the form of loans to business or to consumers or government, until the total increase in checkbook money is $120.

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00:32:42.060 --> 00:32:51.060
At the end of Phase 2, then, we have an increase of $20 in bank reserves generated by Fed purchase of a calculator for that amount,

323
00:32:51.060 --> 00:33:01.060
An increase in $120 in bank demand deposits, and an increase of $100 in bank loans to business or others.

324
00:33:01.060 --> 00:33:20.060
The total money supply has increased by $120, of which $100 was created by the banks in the course of lending out checkbook money to business, and $20 was created by the Fed in the course of buying the calculator.

325
00:33:20.060 --> 00:33:26.060
In practice, of course, the Fed does not spend much of its time buying haphazard assets.

326
00:33:26.060 --> 00:33:35.060
Its purchases of assets are so huge in order to inflate the economy that it must settle on a regular, highly liquid asset.

327
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In practice, this means purchases of U.S. government bonds and other U.S. government securities.

328
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The U.S. government bond market is huge and highly liquid, and the Fed does not have to get into the political conflicts that would be involved in figuring out which private stocks or bonds to purchase.

329
00:33:56.060 --> 00:34:07.060
For the government, this process also has the happy consequence of helping to prop up the government security market and keep up the price of government bonds.

330
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Suppose, however, that some bank, perhaps under the pressure of its depositors,

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00:34:11.860 --> 00:34:17.620
might have to cash in some of its checking account reserves in order to acquire hard currency.

332
00:34:18.580 --> 00:34:24.660
What would happen to the Fed then, since its checks had created new bank reserves out of thin air?

333
00:34:25.460 --> 00:34:28.340
Wouldn't it be forced to go bankrupt or the equivalent?

334
00:34:29.220 --> 00:34:35.540
No, because the Fed has a monopoly on the printing of cash, and it could and would

335
00:34:35.540 --> 00:34:40.980
simply redeem its demand deposit by printing whatever Federal Reserve notes are needed.

336
00:34:41.940 --> 00:34:48.020
In short, if a bank came to the Fed and demanded 20 dollars in cash for its reserve,

337
00:34:48.020 --> 00:34:54.740
or indeed if it demanded 20 million dollars, all the Fed would have to do is print that amount

338
00:34:54.740 --> 00:35:01.700
and pay it out. As we can see, being able to print its own money places the Fed in a uniquely

339
00:35:01.700 --> 00:35:04.380
and the Enviable Position.

340
00:35:04.380 --> 00:35:10.660
So here we have at long last the key to the mystery of the modern inflationary process.

341
00:35:10.660 --> 00:35:16.660
It is a process of continually expanding the money supply through continuing Fed purchases

342
00:35:16.660 --> 00:35:20.420
of government securities on the open market.

343
00:35:20.420 --> 00:35:25.940
Let the Fed wish to increase the money supply by $6 billion and it will purchase government

344
00:35:25.940 --> 00:35:32.420
Securities on the open market to a total of $1 billion, if the money multiplier of demand

345
00:35:32.420 --> 00:35:38.660
deposits to reserves is 6 to 1, and the goal will be speedily accomplished.

346
00:35:38.660 --> 00:35:44.700
In fact, week after week, even as these lines are being read, the Fed goes into the open

347
00:35:44.700 --> 00:35:49.780
market in New York and purchases whatever amount of government bonds it has decided

348
00:35:49.780 --> 00:35:55.940
upon and thereby helps decide upon the amount of monetary inflation.

349
00:35:55.940 --> 00:36:01.620
The monetary history of this century has been one of repeated loosening of restraints on

350
00:36:01.620 --> 00:36:08.660
the state's propensity to inflate, the removal of one check after another until now the government

351
00:36:08.660 --> 00:36:14.020
is able to inflate the money supply and therefore prices at will.

352
00:36:14.020 --> 00:36:20.680
In 1913, the Federal Reserve system was created to enable this sophisticated pyramiding process

353
00:36:20.680 --> 00:36:22.560
to take place.

354
00:36:22.560 --> 00:36:27.860
The new system permitted a large expansion of the money supply and of inflation to pay

355
00:36:27.860 --> 00:36:31.500
for war expenditures in World War I.

356
00:36:31.500 --> 00:36:35.260
In 1933, another fateful step was taken.

357
00:36:35.260 --> 00:36:41.180
The United States government took the country off the gold standard, that is, dollars, while

358
00:36:41.180 --> 00:36:46.700
While still legally defined in terms of a weight of gold, were no longer redeemable

359
00:36:46.700 --> 00:36:48.580
in gold.

360
00:36:48.580 --> 00:36:55.140
In short, before 1933 there was an important shackle upon the Fed's ability to inflate

361
00:36:55.140 --> 00:36:58.080
and expand the money supply.

362
00:36:58.080 --> 00:37:04.240
Federal Reserve notes themselves were payable in the equivalent weight of gold.

363
00:37:04.240 --> 00:37:09.260
There is, of course, a crucial difference between gold and Federal Reserve notes.

364
00:37:09.260 --> 00:37:13.260
The government cannot create new gold at will.

365
00:37:13.260 --> 00:37:17.880
Gold has to be dug in a costly process out of the ground.

366
00:37:17.880 --> 00:37:25.320
But Federal Reserve notes can be issued at will at virtually zero cost in resources.

367
00:37:25.320 --> 00:37:31.980
In 1933, the United States government removed the gold restraint on its inflationary potential

368
00:37:31.980 --> 00:37:38.680
by shifting to fiat money, to making the paper dollar itself the standard of money.

369
00:37:38.680 --> 00:37:42.500
with government, the monopoly supplier of dollars.

370
00:37:42.500 --> 00:37:47.660
It was going off the gold standard that paved the way for the mighty U.S. money and price

371
00:37:47.660 --> 00:37:52.080
inflation during and after World War II.

372
00:37:52.080 --> 00:37:58.520
But there was still one fly in the inflationary ointment, one restraint left on the U.S. government's

373
00:37:58.520 --> 00:38:01.160
propensity for inflation.

374
00:38:01.160 --> 00:38:06.840
While the United States had gone off gold domestically, it was still pledged to redeem

375
00:38:06.840 --> 00:38:13.160
any paper dollars and ultimately bank dollars held by foreign governments in gold should

376
00:38:13.160 --> 00:38:15.520
they desire to do so.

377
00:38:15.520 --> 00:38:22.280
We were, in short, still on a restricted and aborted form of gold standard internationally.

378
00:38:22.280 --> 00:38:29.800
Hence, as the United States inflated the money supply and prices in the 1950s and 1960s,

379
00:38:29.800 --> 00:38:36.120
the dollars and dollar claims in paper and checkbook money piled up in the hands of European

380
00:38:36.120 --> 00:38:37.960
and Governments.

381
00:38:37.960 --> 00:38:43.600
After a great deal of economic finagling and political arm-twisting to induce foreign governments

382
00:38:43.600 --> 00:38:51.440
not to exercise their right to redeem dollars in gold, the United States in August 1971

383
00:38:51.440 --> 00:38:57.920
declared national bankruptcy by repudiating its solemn contractual obligations and closing

384
00:38:57.920 --> 00:39:00.320
the gold window.

385
00:39:00.320 --> 00:39:05.320
It is no coincidence that this tossing off of the last vestige of gold restraint upon

386
00:39:05.320 --> 00:39:11.300
from the Governments of the World was followed by the double-digit inflation of 1973 and

387
00:39:11.300 --> 00:39:18.000
1974, and by similar inflation in the rest of the world.

388
00:39:18.000 --> 00:39:23.240
We have now explained the chronic and worsening inflation in the contemporary world and in

389
00:39:23.240 --> 00:39:29.340
the United States, the unfortunate product of a continuing shift in this century from

390
00:39:29.340 --> 00:39:35.300
gold to government-issued paper as the standard money, and of the development of central

391
00:39:35.300 --> 00:39:41.940
Federal banking and the pyramiding of checkbook money on top of inflated paper currency.

392
00:39:41.940 --> 00:39:47.820
Both interrelated developments amount to one thing, the seizure of control over the money

393
00:39:47.820 --> 00:39:51.020
supply by government.

394
00:39:51.020 --> 00:39:55.660
If we have explained the problem of inflation, we have not yet examined the problem of the

395
00:39:55.660 --> 00:40:02.500
business cycle, of recessions and of inflationary recession or stagflation.

396
00:40:02.500 --> 00:40:11.440
Why the Business Cycle and Why the New Mysterious Phenomenon of Stagflation

397
00:40:11.440 --> 00:40:15.420
Bank Credit and the Business Cycle

398
00:40:15.420 --> 00:40:20.700
The business cycle arrived in the western world in the latter part of the 18th century.

399
00:40:20.700 --> 00:40:25.340
It was a curious phenomenon because there seemed to be no reason for it, and indeed

400
00:40:25.340 --> 00:40:28.220
it had not existed before.

401
00:40:28.220 --> 00:40:33.900
The business cycle consisted of a regularly recurring though not strictly periodical series

402
00:40:33.900 --> 00:40:40.700
of booms and busts, of inflationary periods marked by increased business activity, higher

403
00:40:40.700 --> 00:40:47.700
employment and higher prices, followed sharply by recessions or depressions marked by declining

404
00:40:47.700 --> 00:40:52.680
business activity, higher unemployment and price declines.

405
00:40:52.680 --> 00:40:58.360
And then, after a term of such recession, recovery takes place, and the boom phase begins

406
00:40:58.360 --> 00:40:59.360
again.

407
00:40:59.360 --> 00:41:07.040
A priori, there is no reason to expect this sort of cyclical pattern of economic activity.

408
00:41:07.040 --> 00:41:11.680
There will be cyclical waves in specific types of activity, of course.

409
00:41:11.680 --> 00:41:17.080
Thus, the cycle of the seven-year locust will cause a seven-year cycle in locust-fighting

410
00:41:17.080 --> 00:41:23.260
Banking Activity, in the production of anti-locust sprays and equipment, etc.

411
00:41:23.260 --> 00:41:28.720
But there is no reason to expect boom-bust cycles in the overall economy.

412
00:41:28.720 --> 00:41:34.640
In fact, there is reason to expect just the opposite, for usually the free market works

413
00:41:34.640 --> 00:41:40.540
smoothly and efficiently, and especially with no massive cluster of errors such as becomes

414
00:41:40.540 --> 00:41:47.460
is evident when boom turns suddenly to bust and severe losses are incurred.

415
00:41:47.460 --> 00:41:53.780
And indeed before the late 18th century there were no such overall cycles.

416
00:41:53.780 --> 00:41:58.980
Generally business went along smoothly and evenly until a sudden interruption occurred.

417
00:41:58.980 --> 00:42:03.240
A wheat famine would cause a collapse in an agricultural country.

418
00:42:03.240 --> 00:42:09.060
The king would seize most of the money in the hands of financiers causing a sudden depression.

419
00:42:09.060 --> 00:42:12.560
A war would disrupt trading patterns.

420
00:42:12.560 --> 00:42:19.240
In each of these cases, there was a specific blow to trade brought about by an easily identifiable

421
00:42:19.240 --> 00:42:25.080
one-shot cause, with no need to search further for explanation.

422
00:42:25.080 --> 00:42:29.340
So why the new phenomenon of the business cycle?

423
00:42:29.340 --> 00:42:35.180
It was seen that the cycle occurred in the most economically advanced areas of each country,

424
00:42:35.180 --> 00:42:40.320
In the port cities, in the areas engaged in trade with the most advanced world centers

425
00:42:40.320 --> 00:42:47.000
of production and activity, two different and vitally important phenomena began to emerge

426
00:42:47.000 --> 00:42:53.080
on a significant scale in Western Europe during this period, precisely in the most advanced

427
00:42:53.080 --> 00:42:59.420
centers of production and trade, industrialization and commercial banking.

428
00:42:59.420 --> 00:43:04.580
The commercial banking was the same sort of fractional reserve banking we have analyzed

429
00:43:04.580 --> 00:43:10.420
above, with London, the site of the world's first central bank, the Bank of England, which

430
00:43:10.420 --> 00:43:14.180
originated at the turn of the 18th century.

431
00:43:14.180 --> 00:43:19.900
By the 19th century, in the new discipline of economics and among financial writers and

432
00:43:19.900 --> 00:43:24.900
commentators, two types of theories began to emerge in an attempt to explain the new

433
00:43:24.900 --> 00:43:31.560
and unwelcome phenomenon, those focusing the blame on the existence of industry and those

434
00:43:31.560 --> 00:43:54.560
The former, in sum, saw the responsibility for the business cycle to lie deep within the free market economy, and it was easy for such economists to call either for the abolition of the market, for example, Karl Marx, or for its drastic control and regulation by the government in order to alleviate the cycle, for example, Lord Keynes.

435
00:43:54.560 --> 00:43:57.900
For example, Lord Keynes.

436
00:43:57.900 --> 00:44:02.400
On the other hand, those economists who saw the fault to lie in the fractional reserve

437
00:44:02.400 --> 00:44:09.080
banking system placed the blame outside the market economy and onto an area, money and

438
00:44:09.080 --> 00:44:14.440
banking, which even English classical liberalism had never taken away from tight government

439
00:44:14.440 --> 00:44:16.140
control.

440
00:44:16.140 --> 00:44:21.680
Even in the 19th century then, blaming the banks meant essentially blaming government

441
00:44:21.680 --> 00:44:24.680
for the Boom-Bust Cycle.

442
00:44:24.680 --> 00:44:29.780
We cannot go into details here on the numerous fallacies of the schools of thought that blamed

443
00:44:29.780 --> 00:44:32.700
the market economy for the cycles.

444
00:44:32.700 --> 00:44:38.480
Suffice it to say that these theories cannot explain the rise in prices in the boom or

445
00:44:38.480 --> 00:44:44.480
the fall in the recession or the massive cluster of error that emerges suddenly in the form

446
00:44:44.480 --> 00:44:49.460
of severe losses when the boom turns to bust.

447
00:44:49.460 --> 00:44:54.820
The first economists to develop a cycle theory centering on the money and banking system

448
00:44:54.820 --> 00:45:01.100
were the early 19th century English classical economist David Ricardo and his followers,

449
00:45:01.100 --> 00:45:05.340
who developed the monetary theory of the business cycle.

450
00:45:05.340 --> 00:45:08.660
The Ricardian theory went somewhat as follows.

451
00:45:08.660 --> 00:45:14.660
The fractional reserve banks, spurred and controlled by the government and its central bank, expand

452
00:45:14.660 --> 00:45:27.660
As credit is expanded and pyramided on top of paper money and gold, the money supply in the form of bank deposits, or in that historical period bank notes, expands.

453
00:45:27.660 --> 00:45:34.660
The expansion of the money supply raises prices and sets the inflationary boom into motion.

454
00:45:34.660 --> 00:45:43.660
As the boom continues, fueled by the pyramiding of bank notes and deposits on top of gold, domestic prices also increase.

455
00:45:43.660 --> 00:45:55.660
But this means that domestic prices will be higher and still higher than the prices of imported goods, so that imports will increase and exports to foreign lands will decline.

456
00:45:55.660 --> 00:46:06.660
A deficit in the balance of payments will emerge and widen, and it will have to be paid for by gold flowing out of the inflating country and into the hard money countries.

457
00:46:06.660 --> 00:46:12.900
countries, but as gold flows out the expanding money and banking pyramid will

458
00:46:12.900 --> 00:46:17.700
become increasingly top-heavy and the banks will find themselves in increasing

459
00:46:17.700 --> 00:46:22.940
danger of going bankrupt. Finally the government and banks will have to stop

460
00:46:22.940 --> 00:46:28.100
their expansion and to save themselves the banks will have to contract their

461
00:46:28.100 --> 00:46:34.340
bank loans and checkbook money. The sudden shift from bank credit expansion

462
00:46:34.340 --> 00:46:40.900
Conversion to contraction reverses the economic picture and bust quickly follows boom.

463
00:46:40.900 --> 00:46:46.700
The banks must pull in their horns and businesses and economic activity suffer as the pressure

464
00:46:46.700 --> 00:46:50.620
mounts for debt repayment and contraction.

465
00:46:50.620 --> 00:46:57.200
The fall in the supply of money, in turn, leads to a general fall in prices, deflation.

466
00:46:57.200 --> 00:47:00.740
The recession or depression phase has arrived.

467
00:47:00.740 --> 00:47:07.340
However, as the money supply and prices fall, goods again become more competitive with foreign

468
00:47:07.340 --> 00:47:14.260
products and the balance of payments reverses itself, with a surplus replacing the deficit.

469
00:47:14.260 --> 00:47:20.120
Gold flows into the country and as banknotes and deposits contract on top of an expanding

470
00:47:20.120 --> 00:47:27.780
gold base, the condition of the banks becomes much sounder and recovery gets underway.

471
00:47:27.780 --> 00:47:31.340
The Ricardian theory had several notable features.

472
00:47:31.340 --> 00:47:36.440
It accounted for the behavior of prices by focusing on changes in the supply of bank

473
00:47:36.440 --> 00:47:42.920
money, which indeed always increased in booms and declined in busts.

474
00:47:42.920 --> 00:47:46.860
It also accounted for the behavior of the balance of payments.

475
00:47:46.860 --> 00:47:52.600
And moreover, it linked the boom and the bust, so that the bust was seen to be the consequence

476
00:47:52.600 --> 00:47:55.020
of the preceding boom.

477
00:47:55.020 --> 00:48:00.860
not only the consequence but the salutary means of adjusting the economy to the unwise

478
00:48:00.860 --> 00:48:06.060
intervention that created the inflationary boom.

479
00:48:06.060 --> 00:48:11.420
In short, for the first time the bust was seen to be neither a visitation from hell

480
00:48:11.420 --> 00:48:17.940
nor a catastrophe generated by the inner workings of the industrialized market economy.

481
00:48:17.940 --> 00:48:23.700
The Ricardians realized that the major evil was the preceding inflationary boom caused

482
00:48:23.700 --> 00:48:29.340
by Government Intervention in the Money and Banking System, and that the recession, unwelcome

483
00:48:29.340 --> 00:48:35.060
though its symptoms may be, is really the necessary adjustment process by which that

484
00:48:35.060 --> 00:48:40.060
interventionary boom gets washed out of the economic system.

485
00:48:40.060 --> 00:48:46.060
The depression is the process by which the market economy adjusts, throws off the excesses

486
00:48:46.060 --> 00:48:52.900
and distortions of the inflationary boom, and reestablishes a sound economic condition.

487
00:48:52.900 --> 00:48:58.740
The Depression is the unpleasant but necessary reaction to the distortions and excesses of

488
00:48:58.740 --> 00:49:00.820
the previous boom.

489
00:49:00.820 --> 00:49:03.940
Why then does the business cycle recur?

490
00:49:03.940 --> 00:49:08.540
Why does the next boom and bust cycle always begin?

491
00:49:08.540 --> 00:49:13.980
To answer that, we have to understand the motivations of the banks and the government.

492
00:49:13.980 --> 00:49:20.660
The commercial banks live and profit by expanding credit and by creating a new money supply,

493
00:49:20.660 --> 00:49:26.500
So they are naturally inclined to do so, to monetize credit if they can.

494
00:49:26.500 --> 00:49:31.800
The government also wishes to inflate, both to expand its own revenue either by printing

495
00:49:31.800 --> 00:49:38.160
money or so that the banking system can finance government deficits, and to subsidize favored

496
00:49:38.160 --> 00:49:43.280
economic and political groups through a boom and cheap credit.

497
00:49:43.280 --> 00:49:46.560
So we know why the initial boom began.

498
00:49:46.560 --> 00:49:51.600
The government and the banks had to retreat when disaster threatened and the crisis point

499
00:49:51.600 --> 00:49:53.240
had arrived.

500
00:49:53.240 --> 00:49:58.360
But as gold flows into the country, the condition of the banks becomes sounder, and when the

501
00:49:58.360 --> 00:50:03.120
banks have pretty well recovered, they are then in the confident position to resume their

502
00:50:03.120 --> 00:50:07.960
natural tendency of inflating the supply of money and credit.

503
00:50:07.960 --> 00:50:15.960
And so, the next boom proceeds on its way, sowing the seeds for the next inevitable bust.

504
00:50:15.960 --> 00:50:22.120
Thus the Ricardian theory also explained the continuing recurrence of the business cycle.

505
00:50:22.120 --> 00:50:24.560
But two things it did not explain.

506
00:50:24.560 --> 00:50:30.440
First, and most important, it did not explain the massive cluster of error that businessmen

507
00:50:30.440 --> 00:50:36.540
are suddenly seen to have made when the crisis hits and bust follows boom.

508
00:50:36.540 --> 00:50:41.740
For businessmen are trained to be successful forecasters, and it is not like them to make

509
00:50:41.740 --> 00:50:47.740
make a sudden cluster of grave error that forces them to experience widespread and severe

510
00:50:47.740 --> 00:50:48.740
losses.

511
00:50:48.740 --> 00:50:54.080
Second, another important feature of every business cycle has been the fact that both

512
00:50:54.080 --> 00:51:00.340
booms and busts have been much more severe in the capital goods industries, the industries

513
00:51:00.340 --> 00:51:08.000
making machines, equipment, plant or industrial raw materials, than in consumer goods industries.

514
00:51:08.000 --> 00:51:13.560
and the Ricardian theory had no way of explaining this feature of the cycle.

515
00:51:13.560 --> 00:51:19.520
The Austrian or Misesian theory of the business cycle built on the Ricardian analysis and

516
00:51:19.520 --> 00:51:26.400
developed its own monetary overinvestment or more strictly monetary malinvestment theory

517
00:51:26.400 --> 00:51:28.580
of the business cycle.

518
00:51:28.580 --> 00:51:34.240
The Austrian theory was able to explain not only the phenomena explicated by the Ricardians

519
00:51:34.240 --> 00:51:40.640
but also the Cluster of Error and the Greater Intensity of Capital Good cycles, and as we

520
00:51:40.640 --> 00:51:48.640
shall see, it is the only one that can comprehend the modern phenomenon of stagflation.

521
00:51:48.640 --> 00:51:51.800
Mises begins as did the Ricardians.

522
00:51:51.800 --> 00:51:56.960
Government and its central bank stimulate bank credit expansion by purchasing assets

523
00:51:56.960 --> 00:52:00.380
and thereby increasing bank reserves.

524
00:52:00.380 --> 00:52:05.820
The banks proceed to expand credit and hence the nation's money supply in the form of

525
00:52:05.820 --> 00:52:11.380
checking deposits, private bank notes having virtually disappeared.

526
00:52:11.380 --> 00:52:17.260
As with the Ricardians, Mises sees that this expansion of bank money drives up prices and

527
00:52:17.260 --> 00:52:20.000
causes inflation.

528
00:52:20.000 --> 00:52:26.060
But as Mises pointed out, the Ricardians understated the unfortunate consequences of bank credit

529
00:52:26.060 --> 00:52:27.700
inflation.

530
00:52:27.700 --> 00:52:31.340
For something even more sinister is at work.

531
00:52:31.340 --> 00:52:38.100
Bank credit expansion not only raises prices, it also artificially lowers the rate of interest,

532
00:52:38.100 --> 00:52:44.580
and thereby sends misleading signals to businessmen, causing them to make unsound and uneconomic

533
00:52:44.580 --> 00:52:46.980
investments.

534
00:52:46.980 --> 00:52:52.320
For on the free and unhampered market, the interest rate on loans is determined solely

535
00:52:52.320 --> 00:52:58.280
by the time preferences of all the individuals that make up the market economy.

536
00:52:58.280 --> 00:53:04.680
For the essence of any loan is that a present good, money which can be used at present,

537
00:53:04.680 --> 00:53:12.520
is being exchanged for a future good, an IOU which can be used at some point in the future.

538
00:53:12.520 --> 00:53:18.040
Since people always prefer having money right now to the present prospect of getting the

539
00:53:18.040 --> 00:53:27.240
Present Goods always command a premium over future goods in the market.

540
00:53:27.240 --> 00:53:33.120
That premium, or agio, is the interest rate, and its height will vary according to the

541
00:53:33.120 --> 00:53:38.520
degree to which people prefer the present to the future, that is, the degree of their

542
00:53:38.520 --> 00:53:41.240
time preferences.

543
00:53:41.240 --> 00:53:46.320
People's time preferences also determine the extent to which people will save and invest

544
00:53:46.320 --> 00:53:51.580
for Future Use, as compared to how much they will consume now.

545
00:53:51.580 --> 00:53:56.520
If people's time preferences should fall, that is, if their degree of preference for

546
00:53:56.520 --> 00:54:02.920
present over future declines, then people will tend to consume less now and save and

547
00:54:02.920 --> 00:54:04.760
invest more.

548
00:54:04.760 --> 00:54:10.600
At the same time, and for the same reason, the rate of interest, the rate of time discount,

549
00:54:10.600 --> 00:54:13.200
will also fall.

550
00:54:13.200 --> 00:54:18.520
growth comes about largely as the result of falling rates of time preference, which bring

551
00:54:18.520 --> 00:54:24.200
about an increase in the proportion of saving and investment to consumption, as well as

552
00:54:24.200 --> 00:54:26.880
a falling rate of interest.

553
00:54:26.880 --> 00:54:32.100
But what happens when the rate of interest falls not because of voluntary lower time

554
00:54:32.100 --> 00:54:37.760
preferences and higher savings on the part of the public, but from government interference

555
00:54:37.760 --> 00:54:42.640
that promotes the expansion of bank credit and bank money?

556
00:54:42.640 --> 00:54:47.300
For the new checkbook money created in the course of bank loans to business will come

557
00:54:47.300 --> 00:54:53.180
onto the market as a supplier of loans and will therefore at least initially lower the

558
00:54:53.180 --> 00:54:55.200
rate of interest.

559
00:54:55.200 --> 00:55:00.760
What happens, in other words, when the rate of interest falls artificially due to intervention

560
00:55:00.760 --> 00:55:05.760
rather than naturally from changes in the valuations and preferences of the consuming

561
00:55:05.760 --> 00:55:07.640
public?

562
00:55:07.640 --> 00:55:10.260
What happens is trouble.

563
00:55:10.260 --> 00:55:16.060
For businessmen, seeing the rate of interest fall will react as they always must to such

564
00:55:16.060 --> 00:55:18.180
a change of market signals.

565
00:55:18.180 --> 00:55:21.380
They will invest more in capital goods.

566
00:55:21.380 --> 00:55:28.900
Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable,

567
00:55:28.900 --> 00:55:33.300
now seem profitable because of the fall in the interest charge.

568
00:55:33.300 --> 00:55:39.960
In short, businessmen react as they would have if savings had genuinely increased.

569
00:55:39.960 --> 00:55:43.640
They move to invest those supposed savings.

570
00:55:43.640 --> 00:55:49.880
They expand their investment in durable equipment, in capital goods, in industrial raw material

571
00:55:49.880 --> 00:55:55.640
and in construction, as compared with their direct production of consumer goods.

572
00:55:55.640 --> 00:56:01.240
Thus, businesses happily borrow the newly expanded bank money that is coming to them

573
00:56:01.240 --> 00:56:03.060
at cheaper rates.

574
00:56:03.060 --> 00:56:08.440
They use the money to invest in capital goods, and eventually this money gets paid out in

575
00:56:08.440 --> 00:56:12.760
and higher wages to workers in the capital goods industries.

576
00:56:12.760 --> 00:56:17.900
The increased business demand bids up labor costs, but businesses think they will be able

577
00:56:17.900 --> 00:56:23.460
to pay these higher costs because they have been fooled by the government and bank intervention

578
00:56:23.460 --> 00:56:29.320
in the loan market and by its vitally important tampering with the interest rate signal of

579
00:56:29.320 --> 00:56:34.360
the marketplace, the signal that determines how many resources will be devoted to the

580
00:56:34.360 --> 00:56:40.160
The Production of Capital Goods and How Many to Consumer Goods

581
00:56:40.160 --> 00:56:44.680
Problems surface when the workers begin to spend the new bank money that they have received

582
00:56:44.680 --> 00:56:47.120
in the form of higher wages.

583
00:56:47.120 --> 00:56:51.920
For the time preferences of the public have not really gotten lower.

584
00:56:51.920 --> 00:56:58.080
The public doesn't want to save more than it has, so the workers set about to consume

585
00:56:58.080 --> 00:57:05.520
most of their new income, in short, to reestablish their old consumer saving proportions.

586
00:57:05.520 --> 00:57:10.720
This means that they now redirect spending in the economy back to the consumer goods

587
00:57:10.720 --> 00:57:17.040
industries, and that they don't save and invest enough to buy the newly produced machines,

588
00:57:17.040 --> 00:57:21.540
capital equipment, industrial raw materials, etc.

589
00:57:21.540 --> 00:57:26.980
This lack of enough saving and investment to buy all the new capital goods at expected

590
00:57:26.980 --> 00:57:33.380
and Existing Prices, reveals itself as a sudden sharp depression in the capital goods industries.

591
00:57:34.340 --> 00:57:40.180
For once the consumers reestablish their desired consumption investment proportions,

592
00:57:40.180 --> 00:57:46.340
it is thus revealed that business had invested too much in capital goods, hence the term

593
00:57:46.340 --> 00:57:52.180
monetary overinvestment theory, and had also under-invested in consumer goods.

594
00:57:52.180 --> 00:58:04.180
Business had been seduced by the governmental tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there.

595
00:58:04.180 --> 00:58:12.180
As soon as the new bank money filtered through the system and the consumers re-established their old time preference proportions,

596
00:58:12.180 --> 00:58:22.180
It became clear that there were not enough savings to buy all the producers' goods, and that business had misinvested the limited savings available.

597
00:58:22.180 --> 00:58:25.180
Monetary Malinvestment Theory

598
00:58:25.180 --> 00:58:32.180
Business had over-invested in capital goods and under-invested in consumer goods.

599
00:58:32.180 --> 00:58:38.180
The inflationary boom thus leads to distortions of the pricing and production system.

600
00:58:38.180 --> 00:58:43.880
Boehm. Prices of labor, raw materials and machines in the capital goods industries are

601
00:58:43.880 --> 00:58:50.120
bid up too high during the boom to be profitable once the consumers are able to reassert their

602
00:58:50.120 --> 00:58:56.820
old consumption investment preferences. The depression is thus seen, even more than in

603
00:58:56.820 --> 00:59:02.340
the Ricardian theory, as the necessary and healthy period in which the market economy

604
00:59:02.340 --> 00:59:09.520
economy sloughs off and liquidates the unsound, uneconomic investments of the boom, and reestablishes

605
00:59:09.520 --> 00:59:16.780
those proportions between consumption and investment that are truly desired by the consumers.

606
00:59:16.780 --> 00:59:22.260
The depression is the painful but necessary process by which the free market rids itself

607
00:59:22.260 --> 00:59:28.200
of the excesses and errors of the boom, and reestablishes the market economy in its function

608
00:59:28.200 --> 00:59:32.400
of Efficient Service to the Mass of Consumers.

609
00:59:32.400 --> 00:59:38.760
Since the prices of factors of production—land, labor, machines, raw materials—have been

610
00:59:38.760 --> 00:59:44.320
bid too high in the capital goods industries during the boom, this means that these prices

611
00:59:44.320 --> 00:59:51.040
must be allowed to fall in the recession until proper market proportions of prices and production

612
00:59:51.040 --> 00:59:53.600
are restored.

613
00:59:53.600 --> 00:59:59.280
In another way, the inflationary boom will not only increase prices in general, it will

614
00:59:59.280 --> 01:00:06.680
also distort relative prices, will distort relations of one type of price to another.

615
01:00:06.680 --> 01:00:13.200
In brief, inflationary credit expansion will raise all prices, but prices and wages in

616
01:00:13.200 --> 01:00:19.580
the capital goods industries will go up faster than the prices of consumer goods industries.

617
01:00:19.580 --> 01:00:25.060
In short, the boom will be more intense in the capital goods than in the consumer goods

618
01:00:25.060 --> 01:00:26.620
industries.

619
01:00:26.620 --> 01:00:32.020
On the other hand, the essence of the depression adjustment period will be to lower prices

620
01:00:32.020 --> 01:00:37.820
and wages in the capital goods industries relative to consumer goods, in order to induce

621
01:00:37.820 --> 01:00:45.460
resources to move back from the swollen capital goods to the deprived consumer goods industries.

622
01:00:45.460 --> 01:00:51.860
All prices will fall because of the contraction of bank credit, but prices and wages in capital

623
01:00:51.860 --> 01:00:56.240
goods will fall more sharply than in consumer goods.

624
01:00:56.240 --> 01:01:01.780
In short, both the boom and the bust will be more intense in the capital than in the

625
01:01:01.780 --> 01:01:03.940
consumer goods industries.

626
01:01:03.940 --> 01:01:11.820
Hence, we have explained the greater intensity of business cycles in the former type of industry.

627
01:01:11.820 --> 01:01:15.220
There seems to be a flaw in the theory, however.

628
01:01:15.220 --> 01:01:20.900
For since workers receive the increased money in the form of higher wages fairly rapidly

629
01:01:20.900 --> 01:01:27.980
and then begin to reassert their desired consumer investment proportions, how is it that booms

630
01:01:27.980 --> 01:01:34.740
go on for years without facing retribution, without having their unsound investments revealed

631
01:01:34.740 --> 01:01:41.020
or their errors caused by bank tampering with market signals made evident?

632
01:01:41.020 --> 01:01:46.580
In short, why does it take so long for the depression adjustment process to begin its

633
01:01:46.580 --> 01:01:47.900
work?

634
01:01:47.900 --> 01:01:53.900
The answer is that the booms would indeed be very short-lived, say a few months, if

635
01:01:53.900 --> 01:01:59.060
the bank credit expansion and the subsequent pushing of interest rates below the free market

636
01:01:59.060 --> 01:02:02.780
level were just a one-shot affair.

637
01:02:02.780 --> 01:02:08.120
But the crucial point is that the credit expansion is not one-shot.

638
01:02:08.120 --> 01:02:14.460
It proceeds on and on, never giving the consumers the chance to reestablish their preferred

639
01:02:14.460 --> 01:02:20.600
proportions of consumption and saving, never allowing the rise in cost in the capital goods

640
01:02:20.600 --> 01:02:25.620
industries to catch up to the inflationary rise in prices.

641
01:02:25.620 --> 01:02:31.580
Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable

642
01:02:31.580 --> 01:02:38.380
will come up by repeated and accelerating doses of the stimulant of bank credit.

643
01:02:38.380 --> 01:02:44.540
It is only when bank credit expansion must finally stop or sharply slow down, either

644
01:02:44.540 --> 01:02:49.860
because the banks are getting shaky or because the public is getting restive at the continuing

645
01:02:49.860 --> 01:02:55.060
inflation, that retribution finally catches up with the boom.

646
01:02:55.060 --> 01:03:01.260
As soon as credit expansion stops, the piper must be paid, and the inevitable readjustments

647
01:03:01.260 --> 01:03:07.300
This must liquidate the unsound overinvestments of the boom and redirect the economy more

648
01:03:07.300 --> 01:03:10.220
toward consumer goods production.

649
01:03:10.220 --> 01:03:14.960
And of course, the longer the boom is kept going, the greater the malinvestments that

650
01:03:14.960 --> 01:03:21.140
must be liquidated, and the more harrowing the readjustments that must be made.

651
01:03:21.140 --> 01:03:26.480
Thus the Austrian theory accounts for the massive cluster of error, overinvestments

652
01:03:26.480 --> 01:03:31.780
in Capital Goods Industries suddenly revealed as such by the stopping of the artificial

653
01:03:31.780 --> 01:03:37.360
stimulant of credit expansion, and for the greater intensity of boom and bust in the

654
01:03:37.360 --> 01:03:43.720
capital goods than in the consumer goods industries. Its explanation for the recurrence, for the

655
01:03:43.720 --> 01:03:49.440
inauguration of the next boom, is similar to the Ricardian. Once the liquidations and

656
01:03:49.440 --> 01:03:55.200
bankruptcies are undergone and the price and production adjustments completed, the economy

657
01:03:55.200 --> 01:04:00.080
Many and the banks begin to recover, and the banks can set themselves to return to their

658
01:04:00.080 --> 01:04:05.240
natural and desired course of credit expansion.

659
01:04:05.240 --> 01:04:11.300
What of the Austrian explanation, the only proffered explanation, of stagflation?

660
01:04:11.300 --> 01:04:16.840
How is it that in recent recessions, prices continue to go up?

661
01:04:16.840 --> 01:04:22.800
We must amend this first by pointing out that it is particularly consumer goods prices that

662
01:04:22.800 --> 01:04:28.160
that continue to rise during recessions and that confound the public by giving them the

663
01:04:28.160 --> 01:04:34.320
worst of both worlds at the same time, high unemployment and increases in the cost of

664
01:04:34.320 --> 01:04:35.320
living.

665
01:04:35.320 --> 01:04:43.940
Thus, during the most recent 1974 to 1976 depression, consumer goods prices rose rapidly,

666
01:04:43.940 --> 01:04:50.100
but wholesale prices remained level, while industrial raw material prices fell rapidly

667
01:04:50.100 --> 01:04:52.400
and substantially.

668
01:04:52.400 --> 01:04:58.720
So how is it that the cost of living continues to rise in current recessions?

669
01:04:58.720 --> 01:05:04.560
Let us go back and examine what happened to prices in the classic or old-fashioned boom-bust

670
01:05:04.560 --> 01:05:08.220
cycle pre-World War II vintage.

671
01:05:08.220 --> 01:05:11.440
In the booms, the money supply went up.

672
01:05:11.440 --> 01:05:13.840
Prices in general therefore went up.

673
01:05:13.840 --> 01:05:19.560
But the prices of capital goods rose by more than consumer goods, drawing resources out

674
01:05:19.560 --> 01:05:23.740
Part of consumer and into capital goods industries.

675
01:05:23.740 --> 01:05:30.620
In short, abstracting from general price increases relative to each other, capital goods prices

676
01:05:30.620 --> 01:05:35.300
rose and consumer prices fell in the boom.

677
01:05:35.300 --> 01:05:36.840
What happened in the bust?

678
01:05:36.840 --> 01:05:38.580
The opposite situation.

679
01:05:38.580 --> 01:05:44.340
The money supply went down, prices in general therefore fell, but the prices of capital

680
01:05:44.340 --> 01:05:50.700
Capital goods fell by more than consumer goods, drawing resources back out of capital goods

681
01:05:50.700 --> 01:05:53.660
into consumer goods industries.

682
01:05:53.660 --> 01:06:00.860
In short, abstracting from general price declines relative to each other, capital goods prices

683
01:06:00.860 --> 01:06:06.200
fell and consumer prices rose during the bust.

684
01:06:06.200 --> 01:06:12.460
The Austrian point is that this scenario in relative prices in boom and bust is still

685
01:06:12.460 --> 01:06:15.700
still taking place unchanged.

686
01:06:15.700 --> 01:06:22.040
During the booms, capital goods prices still rise and consumer goods prices still fall

687
01:06:22.040 --> 01:06:26.840
relative to each other, and vice versa during the recession.

688
01:06:26.840 --> 01:06:31.980
The difference is that a new monetary world has arrived, as we have indicated earlier

689
01:06:31.980 --> 01:06:33.920
in this chapter.

690
01:06:33.920 --> 01:06:40.300
For now that the gold standard has been eliminated, the Fed can and does increase the money supply

691
01:06:40.300 --> 01:06:45.020
all the time, whether it be boom or recession.

692
01:06:45.020 --> 01:06:49.980
There hasn't been a contraction of the money supply since the early 1930s, and there is

693
01:06:49.980 --> 01:06:53.580
not likely to be another in the foreseeable future.

694
01:06:53.580 --> 01:07:01.080
So now that the money supply always increases, prices in general are always going up, sometimes

695
01:07:01.080 --> 01:07:04.700
more slowly, sometimes more rapidly.

696
01:07:04.700 --> 01:07:10.700
In short, in the classic recession, consumer goods prices were always going up relative

697
01:07:10.700 --> 01:07:12.220
to capital goods.

698
01:07:12.220 --> 01:07:18.860
Thus, if consumer goods prices fell by 10% in a particular recession, and capital goods

699
01:07:18.860 --> 01:07:26.980
prices fell by 30%, consumer prices were rising substantially in relative terms.

700
01:07:26.980 --> 01:07:31.780
But from the point of view of the consumer, the fall in the cost of living was highly

701
01:07:31.780 --> 01:07:38.820
Welcome, and indeed was the blessed sugar coating on the pill of recession or depression.

702
01:07:38.820 --> 01:07:44.420
Even in the Great Depression of the 1930s, with very high rates of unemployment, the

703
01:07:44.420 --> 01:07:50.360
75 to 80 percent of the labor force still employed enjoyed bargain prices for their

704
01:07:50.360 --> 01:07:52.720
consumer goods.

705
01:07:52.720 --> 01:07:58.240
But now, with Keynesian fine-tuning at work, the sugar coating has been removed from the

706
01:07:58.240 --> 01:07:59.660
pill.

707
01:07:59.660 --> 01:08:06.100
Now that the supply of money, and hence general prices, is never allowed to fall, the rise

708
01:08:06.100 --> 01:08:11.580
in relative consumer goods prices during a recession will hit the consumer as a visible

709
01:08:11.580 --> 01:08:15.080
rise in nominal prices as well.

710
01:08:15.080 --> 01:08:22.060
His cost of living now goes up in a depression, and so he reaps the worst of both worlds.

711
01:08:22.060 --> 01:08:26.660
In the classical business cycle, before the rule of Keynes and the Council of Economic

712
01:08:26.660 --> 01:08:33.020
Advisors, he at least had to suffer only one calamity at a time.

713
01:08:33.020 --> 01:08:38.120
What then are the policy conclusions that arise rapidly and easily from the Austrian

714
01:08:38.120 --> 01:08:40.600
analysis of the business cycle?

715
01:08:40.600 --> 01:08:45.440
They are the precise opposite from those of the Keynesian establishment.

716
01:08:45.440 --> 01:08:51.340
For since the virus of distortion of production and prices stems from inflationary bank credit

717
01:08:51.340 --> 01:08:57.380
Expansion, the Austrian prescription for the business cycle will be, First, if we are in

718
01:08:57.380 --> 01:09:03.560
a boom period, the government and its banks must cease inflating immediately.

719
01:09:03.560 --> 01:09:09.200
It is true that this cessation of artificial stimulant will inevitably bring the inflationary

720
01:09:09.200 --> 01:09:15.100
boom to an end, and will inaugurate the inevitable recession or depression.

721
01:09:15.100 --> 01:09:20.460
But the longer the government delays this process, the harsher the necessary readjustments

722
01:09:20.460 --> 01:09:22.380
This will have to be.

723
01:09:22.380 --> 01:09:27.620
For the sooner the depression readjustment is gotten over with, the better.

724
01:09:27.620 --> 01:09:33.380
This also means that the government must never try to delay the depression process.

725
01:09:33.380 --> 01:09:39.180
The depression must be allowed to work itself out as quickly as possible so that real recovery

726
01:09:39.180 --> 01:09:41.220
can begin.

727
01:09:41.220 --> 01:09:46.020
This means, too, that the government must particularly avoid any of the interventions

728
01:09:46.020 --> 01:09:48.720
so dear to Keynesian hearts.

729
01:09:48.720 --> 01:09:52.900
It must never try to prop up unsound business situations.

730
01:09:52.900 --> 01:09:57.580
It must never bail out or lend money to business firms in trouble.

731
01:09:57.580 --> 01:10:03.600
For doing so will simply prolong the agony and convert a sharp and quick depression phase

732
01:10:03.600 --> 01:10:07.280
into a lingering and chronic disease.

733
01:10:07.280 --> 01:10:12.760
The government must never try to prop up wage rates or prices, especially in the capital

734
01:10:12.760 --> 01:10:14.600
goods industries.

735
01:10:14.600 --> 01:10:19.680
Doing so will prolong and delay indefinitely the completion of the depression adjustment

736
01:10:19.680 --> 01:10:21.200
process.

737
01:10:21.200 --> 01:10:26.740
It will also cause indefinite and prolonged depression and mass unemployment in the vital

738
01:10:26.740 --> 01:10:29.320
capital goods industries.

739
01:10:29.320 --> 01:10:34.920
The government must not try to inflate again in order to get out of the depression, for

740
01:10:34.920 --> 01:10:41.260
even if this reinflation succeeds, which is by no means assured, it will only sow greater

741
01:10:41.260 --> 01:11:11.260
The Government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption investment ratio, when the only thing that could speed up the adjustment process is to lower the consumption savings ratio, so that more of the currently unsound investments will become validated and become equal.

742
01:11:11.260 --> 01:11:29.260
The only way the government can aid in this process is to lower its own budget, which will increase the ratio of investment to consumption in the economy, since government spending may be regarded as consumption spending for bureaucrats and politicians.

743
01:11:29.260 --> 01:11:38.260
Thus what the government should do, according to the Austrian analysis of the depression and the business cycle, is absolutely nothing.

744
01:11:38.260 --> 01:11:46.260
It should stop its own inflating, and then it should maintain a strict hands-off laissez-faire policy.

745
01:11:46.260 --> 01:11:52.260
Anything it does will delay and obstruct the adjustment processes of the market.

746
01:11:52.260 --> 01:12:01.260
The less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.

747
01:12:01.260 --> 01:12:07.260
The Austrian prescription for a depression is thus the diametric opposite of the Keynesian.

748
01:12:07.260 --> 01:12:18.260
It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.

749
01:12:18.260 --> 01:12:28.260
It should be clear that the Austrian analysis of the business cycle meshes handsomely with the libertarian outlook toward government and a free economy.

750
01:12:28.260 --> 01:12:41.260
Since the state would always like to inflate and to interfere in the economy, a libertarian prescription would stress the importance of absolute separation of money and banking from the state.

751
01:12:41.260 --> 01:12:51.260
This would involve at the very least the abolition of the Federal Reserve system and the return to a commodity money, for example gold or silver,

752
01:12:51.260 --> 01:12:57.100
so that the money unit would once again be a unit of weight of a market-produced commodity

753
01:12:57.100 --> 01:13:02.620
rather than the name of a piece of paper printed by the state's counterfeiting apparatus.