WEBVTT NOTE The "Austrian" Theory of the Trade Cycle 1 00:00:00.000 --> 00:00:05.400 The Austrian Theory of the Trade Cycle by Ludwig von Mises 2 00:00:05.400 --> 00:00:11.900 Nowadays it is usual in economics to talk about the Austrian theory of the trade cycle. 3 00:00:11.900 --> 00:00:16.500 This description is extremely flattering for us Austrian economists, 4 00:00:16.500 --> 00:00:19.700 and we greatly appreciate the honor thereby given us. 5 00:00:19.700 --> 00:00:23.000 Like all other scientific contributions, however, 6 00:00:23.000 --> 00:00:27.400 the modern theory of economic crises is not the work of one nation. 7 00:00:27.400 --> 00:00:37.400 As with the other elements of our present economic knowledge, this approach is the result of the mutual collaboration of the economists of all countries. 8 00:00:37.400 --> 00:00:41.400 The monetary explanation of the trade cycle is not entirely new. 9 00:00:41.400 --> 00:00:51.400 The English Currency School has already tried to explain the boom by the extension of credit resulting from the issue of banknotes without metallic backing. 10 00:00:51.400 --> 00:01:06.400 Nevertheless, this school did not see that bank accounts, which could be drawn upon at any time by means of checks, that is to say, current accounts, play exactly the same role in the extension of credit as banknotes. 11 00:01:06.400 --> 00:01:18.400 Consequently, the expansion of credit can result not only from the excessive issue of banknotes, but also from the opening of excessive current accounts. 12 00:01:18.400 --> 00:01:37.400 It is because it misunderstood this truth that the currency school believed that it would suffice, in order to prevent the recurrence of economic crises, to enact legislation restricting the issue of banknotes without metallic backing, while leaving the expansion of credit, by means of current accounts, unregulated. 13 00:01:37.400 --> 00:01:46.400 Peale's Bank Act of 1844 and similar laws in other countries did not accomplish their intended effect. 14 00:01:46.400 --> 00:01:57.400 From this, it was wrongly concluded that the English School's attempt to explain the trade cycle in monetary terms had been refuted by the facts. 15 00:01:57.400 --> 00:02:13.400 The currency school's second defect is that its analysis of the credit expansion mechanism and the resulting crisis was restricted to the case where credit is expended in only one country, while the banking policy of all the others remains conservative. 16 00:02:13.400 --> 00:02:18.900 The reaction which is produced in this case results from foreign trade effects. 17 00:02:18.900 --> 00:02:25.400 The internal rise in prices encourages imports and paralyzes exports. 18 00:02:25.400 --> 00:02:28.900 Metallic money drains away to foreign countries. 19 00:02:28.900 --> 00:02:34.900 As a result, the banks face increased demands for repayment of the instruments they have put into circulation, 20 00:02:34.900 --> 00:02:42.900 such as unbacked notes and current accounts, until such time as they find they have to restrict credit. 21 00:02:42.900 --> 00:02:48.400 Ultimately, the outflow of specie checks the rise in prices. 22 00:02:48.400 --> 00:02:51.800 The currency school analyzed only this particular case. 23 00:02:51.800 --> 00:02:59.000 It did not consider credit expansion on an international scale by all the capitalist countries simultaneously. 24 00:02:59.000 --> 00:03:05.000 In the second half of the 19th century, this theory of the trade cycle fell into discredit, 25 00:03:05.000 --> 00:03:10.200 and the notion that the trade cycle had nothing to do with money and credit gained acceptance. 26 00:03:10.200 --> 00:03:17.200 The attempt of Vicksel, 1898, to rehabilitate the currency school was short-lived. 27 00:03:17.200 --> 00:03:26.200 The founders of the Austrian School of Economics, Carl Menger, Boehm-Bawerk and Wieser, were not interested in the problem of the trade cycle. 28 00:03:26.200 --> 00:03:32.200 The analysis of this problem was to be the task of the second generation of Austrian economists. 29 00:03:32.200 --> 00:03:46.200 In issuing fiduciary media, by which I mean banknotes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. 30 00:03:46.200 --> 00:03:58.200 The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. 31 00:03:58.200 --> 00:04:12.200 They intervene on the market in this case as suppliers of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. 32 00:04:12.200 --> 00:04:31.200 The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought profitable if the rate of interest had not been influenced by the manipulations of the banks, and which therefore would not have been undertaken, are nevertheless found profitable and can be initiated. 33 00:04:31.200 --> 00:04:42.200 The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads in turn to an increase in prices of consumption goods. 34 00:04:42.200 --> 00:04:51.200 If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. 35 00:04:51.200 --> 00:04:56.560 But the banks do not deflect from their course of action. They continue to expand credit on a 36 00:04:56.560 --> 00:05:02.400 larger and larger scale, and prices and wages correspondingly continue to rise. The subword 37 00:05:02.400 --> 00:05:08.160 movement could not, however, continue indefinitely. The material means of production and the labor 38 00:05:08.160 --> 00:05:14.080 available have not increased. All that has increased is the quantity of the fiduciary media, 39 00:05:14.080 --> 00:05:19.280 which can play the same role as money in the circulation of goods. The means of production 40 00:05:19.280 --> 00:05:23.520 Expansion and labor, which have been diverted to the new enterprises, have had to be taken 41 00:05:23.520 --> 00:05:26.160 away from other enterprises. 42 00:05:26.160 --> 00:05:30.360 Society is not sufficiently rich to permit the creation of new enterprises without taking 43 00:05:30.360 --> 00:05:33.000 anything away from other enterprises. 44 00:05:33.000 --> 00:05:37.640 As long as the expansion of credit is continued this will not be noticed, but this extension 45 00:05:37.640 --> 00:05:40.280 cannot be pushed indefinitely. 46 00:05:40.280 --> 00:05:44.880 For if an attempt were made to prevent the sudden halt of the upward movement and the 47 00:05:44.880 --> 00:05:49.600 The collapse of prices, which would result, by creating more and more credit, a continuous 48 00:05:49.600 --> 00:05:53.120 and even more rapid increase of prices would result. 49 00:05:53.120 --> 00:05:56.760 But the inflation and the boom can continue smoothly only as long as the public thinks 50 00:05:56.760 --> 00:06:01.080 that the upward movement of prices will stop in the near future. 51 00:06:01.080 --> 00:06:05.480 As soon as public opinion becomes aware that there is no reason to expect an end to the 52 00:06:05.480 --> 00:06:10.440 inflation and that prices will continue to rise, panic sets in. 53 00:06:10.440 --> 00:06:14.380 No one wants to keep his money, because its possession implies greater and greater losses 54 00:06:14.380 --> 00:06:19.460 From one day to the next, everyone rushes to exchange money for goods. People buy things 55 00:06:19.460 --> 00:06:23.140 they have no considerable use for without even considering the price, just in order 56 00:06:23.140 --> 00:06:28.140 to get rid of the money, such as the phenomenon that occurred in Germany and in other countries 57 00:06:28.140 --> 00:06:33.180 that followed a policy of prolonged inflation and that was known as the flight into real 58 00:06:33.180 --> 00:06:38.540 values. Commodity prices rise enormously as do foreign exchange rates, while the price 59 00:06:38.540 --> 00:06:43.700 of the domestic money falls almost to zero. The value of the currency collapses, as was 60 00:06:43.700 --> 00:06:46.980 was the case in Germany in 1923. 61 00:06:46.980 --> 00:06:50.860 If on the contrary the banks decided to halt the expansion of credit in time to prevent 62 00:06:50.860 --> 00:06:55.780 the collapse of the currency, and if a break is thus put on the boom, it will quickly be 63 00:06:55.780 --> 00:07:01.420 seen that the false impression of profitability created by the credit expansion has led to 64 00:07:01.420 --> 00:07:06.720 unjustified investments, many enterprises or business endeavours which had been launched 65 00:07:06.720 --> 00:07:11.660 thanks to the artificial lowering of the interest rate, and which had been sustained thanks 66 00:07:11.660 --> 00:07:16.720 Businesses to the equally artificial increase of prices no longer appear profitable. 67 00:07:16.720 --> 00:07:22.940 Some enterprises cut back their scale of operation, others close down or fail, prices collapse, 68 00:07:22.940 --> 00:07:24.940 crises and depression follow the boom. 69 00:07:24.940 --> 00:07:30.860 The crisis and the insuring period of depression are the culmination of the period of unjustified 70 00:07:30.860 --> 00:07:34.700 investment brought about by the extension of credit. 71 00:07:34.700 --> 00:07:39.220 The projects, which owe their existence to the fact that they once appeared profitable 72 00:07:39.220 --> 00:07:43.740 in the artificial conditions created on the market by the expansion of credit, and the 73 00:07:43.740 --> 00:07:49.100 increase in prices which resulted from it, have ceased to be profitable. 74 00:07:49.100 --> 00:07:54.460 The capital invested in these enterprises is lost to the extent that it is locked in. 75 00:07:54.460 --> 00:08:01.460 The economy must adapt itself to these losses, and to the situation that they bring about. 76 00:08:01.460 --> 00:08:07.560 In this case, the thing to do, first of all, is to curtail consumption, and by economizing, 77 00:08:07.560 --> 00:08:13.200 to build up new capital funds in order to make the productive apparatus conform to the 78 00:08:13.200 --> 00:08:19.120 actual wants and not to artificial wants which could never be manifested and considered as 79 00:08:19.120 --> 00:08:25.120 real except as a consequence of the false calculation of profitability based on the extension 80 00:08:25.120 --> 00:08:27.080 of credit. 81 00:08:27.080 --> 00:08:31.880 The artificial boom had been brought on by the extension of credit and by lowering of 82 00:08:31.880 --> 00:08:36.920 the rate of interest consequent on the intervention of the banks during the period of credit 83 00:08:36.920 --> 00:08:42.080 Extension, it is true that the banks progressively raise the rate of interest. From a purely 84 00:08:42.080 --> 00:08:47.660 arithmetical point of view, it ends up higher than it had been at the beginning of the boom. 85 00:08:47.660 --> 00:08:52.640 This raising of the rate of interest is nevertheless insufficient to reestablish equilibrium on 86 00:08:52.640 --> 00:08:57.960 the market and put a stop to the unhealthy boom. For in a market where the prices are 87 00:08:57.960 --> 00:09:03.400 rising continually, gross interest must include, in addition to interest on capital in the 88 00:09:03.400 --> 00:09:13.400 in the strict sense, i.e. the net rate of interest, still another element representing a compensation for the rise in prices arising during the period of the loan. 89 00:09:13.400 --> 00:09:24.400 If the prices rise in a continuous manner, and if the borrower as a result gains a supplementary profit from the sale of the merchandise which he bought with the borrowed money, 90 00:09:24.400 --> 00:09:30.400 he will be disposed to pay a higher rate of interest than he would have paid in a period of stable prices. 91 00:09:30.400 --> 00:09:35.840 Services. The capitalist, on the other hand, will not be disposed to lend under these conditions 92 00:09:35.840 --> 00:09:41.000 unless the interest includes a compensation for the losses which the diminution in the 93 00:09:41.000 --> 00:09:47.020 purchasing power of money entails for creditors. If the banks do not take account of these 94 00:09:47.020 --> 00:09:52.480 conditions in setting the gross interest rate they demand, their rate ought to be considered 95 00:09:52.480 --> 00:09:57.760 as being maintained artificially at too low a level, even if from a purely arithmetical 96 00:09:57.760 --> 00:10:21.200 Once the reversal of the trade cycle sets in following the change in banking policy, 97 00:10:21.200 --> 00:10:27.040 it becomes very difficult to obtain loans because of the general restriction of credit. 98 00:10:27.040 --> 00:10:32.400 The rate of interest consequently rises very rapidly as a result of a sudden panic. Presently, 99 00:10:32.400 --> 00:10:38.160 it will fall again. It is a well-known phenomenon, indeed, that in a period of depressions, a 100 00:10:38.160 --> 00:10:43.340 very low rate of interest, considered from the arithmetical point of view, does not succeed 101 00:10:43.340 --> 00:10:49.160 in stimulating economic activity. The cash reserves of individuals and of banks grow, 102 00:10:49.160 --> 00:10:55.320 liquid funds accumulate, yet the depression continues. In the present 1936 crisis, the 103 00:10:55.320 --> 00:11:01.320 The accumulation of these inactive gold reserves has for a particular reason taken on inordinate proportions. 104 00:11:01.320 --> 00:11:09.320 As is natural, capitalists wish to avoid the risk of losses from the devaluations contemplated by various governments. 105 00:11:09.320 --> 00:11:17.320 Given that the considerable monetary risks, which the possession of bonds or of other interest-bearing securities entail, 106 00:11:17.320 --> 00:11:21.320 are not compensated by a corresponding increase of the rate of interest, 107 00:11:21.320 --> 00:11:36.320 Capitalists prefer to hold their funds in a form that permits them in such a case to protect their money from the losses inherent in an eventual devaluation by a rapid conversion to a currency not immediately menaced by the prospect of devaluation. 108 00:11:36.320 --> 00:11:45.320 This is the very simple reason why capitalists today are reluctant to tie themselves through permanent investments to a particular currency. 109 00:11:45.320 --> 00:11:56.320 This is why they allow their bank accounts to grow, even though they return only very little interest, and hoard gold, which not only pays no interest, but also involves storage expenses. 110 00:11:56.320 --> 00:12:03.320 Another factor, which is helping to prolong the present period of depression, is the rigidity of wages. 111 00:12:03.320 --> 00:12:11.320 Wages increase in periods of expansion. In periods of contraction they ought to fall, not only in money terms, but in real terms as well. 112 00:12:11.320 --> 00:12:16.760 Well, by successfully preventing the lowering of wages during a period of depression, the 113 00:12:16.760 --> 00:12:21.480 policy of the trade unions makes unemployment a massive and persistent phenomenon. 114 00:12:21.480 --> 00:12:26.120 Moreover, this policy postpones the recovery indefinitely. 115 00:12:26.120 --> 00:12:31.860 A normal situation cannot return until prices and wages adapt themselves to the quantity 116 00:12:31.860 --> 00:12:34.080 of money in circulation. 117 00:12:34.080 --> 00:12:39.040 Public opinion is perfectly right to see the end of the boom and the crisis as a consequence 118 00:12:39.040 --> 00:12:41.120 of the policy of the banks. 119 00:12:41.120 --> 00:12:45.200 The banks could undoubtedly have delayed the unfavorable developments for some further 120 00:12:45.200 --> 00:12:46.200 time. 121 00:12:46.200 --> 00:12:50.800 They could have continued their policy of credit expansion for a while, but, as we have 122 00:12:50.800 --> 00:12:55.640 already seen, they could not have persisted indefinitely without risking the complete 123 00:12:55.640 --> 00:12:58.160 collapse of the monetary system. 124 00:12:58.160 --> 00:13:03.080 The boom brought about by the banks' policy of extending credit must necessarily end sooner 125 00:13:03.080 --> 00:13:04.420 or later. 126 00:13:04.420 --> 00:13:08.720 Unless they are willing to let their policy completely destroy the monetary and credit 127 00:13:08.720 --> 00:13:38.720 The banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion, and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments, and of the inordinate speculation characterizing the boom. And as a result, the longer will be the period of depression, and the more uncertain the date of recovery and return to normal economic activity. It has often been suggested 128 00:13:38.720 --> 00:13:51.720 to stimulate economic activity and to prime the pump by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions. 129 00:13:51.720 --> 00:14:01.720 The advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not-too-distant future. 130 00:14:01.720 --> 00:14:24.720 Finally, it will be necessary to understand that the attempts to artificially lower the rate of interest which arises on the market through an expansion of credit can only produce temporary results, and that the initial recovery will be followed by a deeper decline which will manifest itself as a complete stagnation of commercial and industrial activity. 131 00:14:24.720 --> 00:14:29.280 The economy will not be able to develop harmoniously and smoothly unless all artificial measures 132 00:14:29.280 --> 00:14:34.280 that interfere with the level of prices, wages and interest rates, as determined by the free 133 00:14:34.280 --> 00:14:38.800 play of economic forces, are renounced once and for all. 134 00:14:38.800 --> 00:14:43.720 It is not the task of the banks to remedy the consequences of the scarcity of capital 135 00:14:43.720 --> 00:14:47.600 or the effects of wrong economic policy by extension of credit. 136 00:14:47.600 --> 00:14:52.440 It is certainly unfortunate that the return to a normal economic situation today is delayed 137 00:14:52.440 --> 00:14:58.520 by the pernicious policy of shackling commerce, by armaments, and by the only too justified 138 00:14:58.520 --> 00:15:02.320 fear of war, not to mention the rigidity of wages. 139 00:15:02.320 --> 00:15:08.680 But it is not by banking measures and credit expansion that this situation will be corrected. 140 00:15:08.680 --> 00:15:13.160 In the preceding pages, I have given only a brief and necessarily insufficient sketch 141 00:15:13.160 --> 00:15:16.100 of the monetary theory of economic crises. 142 00:15:16.100 --> 00:15:20.320 It is unfortunately impossible for me, in the limits set by this article, to enter into 143 00:15:20.320 --> 00:15:25.520 of Greater Detail. Those who are interested in the subject will be able to find more in 144 00:15:25.520 --> 00:15:27.840 the various publications I have mentioned.