by Ludwig von Mises
I. The Unpopularity of Interest
One of the characteristic features of this age of wars
and destruction is the general attack launched by all governments and pressure
groups against the rights of creditors. The first act of the Bolshevik
Government was to abolish loans and payment of interest altogether. The most
popular of the slogans that swept the Nazis into power was Brechung der Zinsknechtschaft, abolition of
interest-slavery. The debtor countries are intent upon expropriating the claims
of foreign creditors by various devices, the most efficient of which is foreign
exchange control. Their economic nationalism aims at brushing away an alleged
return to colonialism. They pretend to wage a new war of independence against
the foreign exploiters as they venture to call those who provided them with the
capital required for the improvement of their economic conditions. As the
foremost creditor nation today is the United States, this struggle is virtually
directed against the American people. Only the old usages of diplomatic
reticence make it advisable for the economic nationalists to name the devil
they are fighting not the Yankees, but "Wall Street."
"Wall Street" is no less the target at which
the monetary authorities of this country are directing their blows when
embarking upon an "easy-money" policy. It is generally assumed that
measures designed to lower the rate of interest, below the height at which the
unhampered market would fix it, are extremely beneficial to the immense
majority at the expense of a small minority of capitalists and hardboiled
moneylenders. It is tacitly implied that the creditors are the idle rich while
the debtors are the industrious poor. However, this belief is atavistic and
utterly misjudges contemporary conditions.
In the days of Solon, Athens's wise legislator, in the
time of ancient Rome's agrarian laws, in the Middle Ages and even for some
centuries later, one was by and large right in identifying the creditors with
the rich and the debtors with the poor. It is quite different in our age of
bonds and debentures, of savings banks, of life insurance and social security.
The proprietary classes are the owners of big plants and farms, of common
stock, of urban real estate and, as such, they are very often debtors. The people
of more modest income are bondholders, owners of saving deposits and insurance
policies and beneficiaries of social security. As such, they are creditors.
Their interests are impaired by endeavors to lower the rate of interest and the
national currency's purchasing power.
It is true that the masses do not think of themselves
as creditors and thus sympathize with the noncreditor policies. However, this
ignorance does not alter the fact that the immense majority of the nation are
to be classified as creditors and that these people, in approving of an
"easy-money" policy, unwittingly hurt their own material interests.
It merely explodes the Marxian fable that a social class never errs in
recognizing its particular class interests and always acts in accordance with
these interests.
The modern champions of the "easy-money"
policy take pride in calling themselves unorthodox and slander their
adversaries as orthodox, old-fashioned, and reactionary. One of the most
eloquent spokesmen of what is called functional finance, Professor Abba Lerner,
pretends that in judging fiscal measures he and his friends resort to what
"is known as the method of science as opposed to scholasticism." The
truth is that Lord Keynes, Professor Alvin H. Hansen and Professor Lerner, in
their passionate denunciation of interest, are guided by the essence of
Medieval Scholasticism's economic doctrine, the disapprobation of interest.
While emphatically asserting that a return to the 19th century's economic
policies is out of the question, they are zealously advocating a revival of the
methods of the Dark Ages and of the orthodoxy of old canons.
II. The Two Classes of Credit
There is no difference between the ultimate objectives
of the anti-interest policies of canon law and the policies recommended by
modern interest-baiting. But the methods applied are different. Medieval
orthodoxy was intent first upon prohibiting by decree interest altogether and
later upon limiting the height of interest rates by the so-called usury laws.
Modern self-styled unorthodoxy aims at lowering or even abolishing interest by
means of credit expansion.
Every serious discussion of the problem of credit
expansion must start from the distinction between two classes of credit:
commodity credit and circulation credit.
Commodity credit is the transfer of savings from the
hands of the original saver into those of the entrepreneurs who plan to use
these funds in production. The original saver has saved money by not consuming
what he could have consumed by spending it for consumption. He transfers
purchasing power to the debtor and thus enables the latter to buy these
nonconsumed commodities for use in further production. Thus the amount of
commodity credit is strictly limited by the amount of saving, i.e., abstention
from consumption. Additional credit can only be granted to the extent that
additional savings have been accumulated. The whole process does not affect the
purchasing power of the monetary unit.
Circulation credit is credit granted out of funds
especially created for this purpose by the banks. In order to grant a loan, the
bank prints banknotes or credits the debtor on a deposit account. It is
creation of credit out of nothing. It is tantamount to the creation of fiat
money, to undisguised, manifest inflation. It increases the amount of money
substitutes, of things which are taken and spent by the public in the same way
in which they deal with money proper. It increases the buying power of the
debtors. The debtors enter the market of factors of production with an additional
demand, which would not have existed except for the creation of such banknotes
and deposits. This additional demand brings about a general tendency toward a
rise in commodity prices and wage rates.
While the quantity of commodity credit is rigidly
fixed by the amount of capital accumulated by previous saving, the quantity of
circulation credit depends on the conduct of the bank's business. Commodity
credit cannot be expanded, but circulation credit can. Where there is no
circulation credit, a bank can only increase its lending to the extent that the
savers have entrusted it with more deposits. Where there is circulation credit,
a bank can expand its lending by what is, curiously enough, called "being
more liberal."
Credit expansion not only brings about an inextricable
tendency for commodity prices and wage rates to rise it also affects the market
rate of interest. As it represents an additional quantity of money offered for
loans, it generates a tendency for interest rates to drop below the height they
would have reached on a loan market not manipulated by credit expansion. It
owes its popularity with quacks and cranks not only to the inflationary rise in
prices and wage rates which it engenders, but no less to its short-run effect
of lowering interest rates. It is today the main tool of policies aiming at
cheap or easy money.
III. The Function of Prices, Wage Rates, and
Interest Rates
The rate of interest is a market phenomenon. In the
market economy it is the structure of prices, wage rates and interest rates, as
determined by the market, that directs the activities of the entrepreneurs
toward those lines in which they satisfy the wants of the consumers in the best
possible and cheapest way. The prices of the material factors of production,
wage rates and interest rates on the one hand and the anticipated future prices
of the consumers' goods on the other hand are the items that enter into the
planning businessman's calculations. The result of these calculations shows the
businessman whether or not a definite project will pay. If the market data
underlying his calculations are falsified by the interference of the
government, the result must be misleading. Deluded by an arithmetical operation
with illusory figures, the entrepreneurs embark upon the realization of
projects that are at variance with the most urgent desires of consumers. The
disagreement of the consumers becomes manifest when the products of capital
malinvestment reach the market and cannot be sold at satisfactory prices. Then,
there appears what is called "bad business."
If, on a market not hampered by government tampering
with the market data, the examination of a definite project shows its
unprofitability, it is proved that under the given state of affairs the
consumers prefer the execution of other projects. The fact that a definite
business venture is not profitable means that the consumers, in buying its
products, are not ready to reimburse entrepreneurs for the prices of the
complementary factors of production required, while on the other hand, in
buying other products, they are ready to reimburse entrepreneurs for the prices
of the same factors. Thus the sovereign consumers express their wishes and
force business to adjust its activities to the satisfaction of those wants
which they consider the most urgent. The consumers thus bring about a tendency
for profitable industries to expand and for unprofitable ones to shrink.
It is permissible to say that what proximately
prevents the execution of certain projects is the state of prices, wage rates
and interest rates. It is a serious blunder to believe that if only these items
were lower, production activities could be expanded. What limits the size of
production is the scarcity of the factors of production. Prices, wage rates and
interest rates are only indices expressive of the degree of this scarcity. They
are pointers, as it were. Through these market phenomena, society sends out a
warning to the entrepreneurs planning a definite project: Don't touch this
factor of production; it is earmarked for the satisfaction of another, more
urgent need.
The expansionists, as the champions of inflation style
themselves today, see in the rate of interest nothing but an obstacle to the
expansion of production. If they were consistent, they would have to look in
the same way at the prices of the material factors of production and at wage
rates. A government decree cutting down wage rates to 50 percent of those on
the unhampered labor market would likewise give to certain projects, which do
not appear profitable in a calculation based on the actual market data, the
appearance of profitability. There is no more sense in the assertion that the
height of interest rates prevents a further expansion of production than in the
assertion that the height of wage rates brings about these effects. The fact
that the expansionists apply this kind of fallacious argumentation only to
interest rates and not also to the prices of primary commodities and to the
prices of labor is the proof that they are guided by emotions and passions and
not by cool reasoning. They are driven by resentment. They envy what they
believe is the rich man's take. They are unaware of the fact that in attacking
interest they are attacking the broad masses of savers, bondholders and
beneficiaries of insurance policies.
IV. The Effects of Politically Lowered Interest
Rates
The expansionists are quite right in asserting that
credit expansion succeeds in bringing about booming business. They are mistaken
only in ignoring the fact that such an artificial prosperity cannot last and
must inextricably lead to a slump, a general depression.
If the market rate of interest is reduced by credit
expansion, many projects which were previously deemed unprofitable get the
appearance of profitability. The entrepreneur who embarks upon their execution
must, however, very soon discover that his calculation was based on erroneous
assumptions. He has reckoned with those prices of the factors of production
which corresponded to market conditions as they were on the eve of the credit
expansion. But now, as a result of credit expansion, these prices have risen.
The project no longer appears so promising as before. The businessman's funds
are not sufficient for the purchase of the required factors of production. He
would be forced to discontinue the pursuit of his plans if the credit expansion
were not to continue. However, as the banks do not stop expanding credit and
providing business with "easy money," the entrepreneurs see no cause
to worry. They borrow more and more. Prices and wage rates boom. Everybody
feels happy and is convinced that now finally mankind has overcome forever the
gloomy state of scarcity and reached everlasting prosperity.
In fact, all this amazing wealth is fragile, a castle
built on the sands of illusion. It cannot last. There is no means to substitute
banknotes and deposits for nonexisting capital goods. Lord Keynes, in a
poetical mood, asserted that credit expansion has performed "the miracle …
of turning a stone into bread."[1] But this miracle, on
closer examination, appears no less questionable than the tricks of Indian
fakirs.
There are only two alternatives.
One, the expanding banks may stubbornly cling to their
expansionist policies and never stop providing the money business needs in
order to go on in spite of the inflationary rise in production costs. They are
intent upon satisfying the ever increasing demand for credit. The more credit
business demands, the more it gets. Prices and wage rates sky-rocket. The
quantity of banknotes and deposits increases beyond all measure. Finally, the
public becomes aware of what is happening. People realize that there will be no
end to the issue of more and more money substitutes — that prices will
consequently rise at an accelerated pace. They comprehend that under such a
state of affairs it is detrimental to keep cash. In order to prevent being
victimized by the progressing drop in money's purchasing power, they rush to
buy commodities, no matter what their prices may be and whether or not they
need them. They prefer everything else to money. They arrange what in 1923 in
Germany, when the Reich set the classical example for the policy of endless
credit expansion, was called die Flucht in die Sachwerte, the
flight into real values. The whole currency system breaks down. Its unit's
purchasing power dwindles to zero. People resort to barter or to the use of
another type of foreign or domestic money. The crisis emerges.
The other alternative is that the banks or the
monetary authorities become aware of the dangers involved in endless credit
expansion before the common man does. They stop, of their own accord, any
further addition to the quantity of banknotes and deposits. They no longer
satisfy the business applications for additional credits. Then the panic breaks
out. Interest rates jump to an excessive level, because many firms badly need
money in order to avoid bankruptcy. Prices drop suddenly, as distressed firms
try to obtain cash by throwing inventories on the market dirt cheap. Production
activities shrink, workers are discharged.
Thus, credit expansion unavoidably results in the
economic crisis. In either of the two alternatives, the artificial boom is
doomed. In the long run, it must collapse. The short-run effect, the period of
prosperity, may last sometimes several years. While it lasts, the authorities,
the expanding banks and their public relations agencies arrogantly defy the
warnings of the economists and pride themselves on the manifest success of
their policies. But when the bitter end comes, they wash their hands of it.
The artificial prosperity cannot last because the
lowering of the rate of interest, purely technical as it was and not
corresponding to the real state of the market data, has misled entrepreneurial
calculations. It has created the illusion that certain projects offer the
chances of profitability when, in fact, the available supply of factors of
production was not sufficient for their execution. Deluded by false reckoning,
businessmen have expanded their activities beyond the limits drawn by the state
of society's wealth. They have underrated the degree of the scarcity of factors
of production and overtaxed their capacity to produce. In short: they have
squandered scarce capital goods by malinvestment.
The whole entrepreneurial class is, as it were, in the
position of a master builder whose task it is to construct a building out of a
limited supply of building materials. If this man overestimates the quantity of
the available supply, he drafts a plan for the execution of which the means at
his disposal are not sufficient. He overbuilds the groundwork and the
foundations and discovers only later, in the progress of the construction, that
he lacks the material needed for the completion of the structure. This belated
discovery does not create our master builder's plight. It merely discloses
errors committed in the past. It brushes away illusions and forces him to face
stark reality.
There is need to stress this point, because the
public, always in search of a scapegoat, is as a rule ready to blame the
monetary authorities and the banks for the outbreak of the crisis. They are
guilty, it is asserted, because in stopping the further expansion of credit,
they have produced a deflationary pressure on trade. Now, the monetary
authorities and the banks were certainly responsible for the orgies of credit
expansion and the resulting boom; although public opinion, which always
approves such inflationary ventures wholeheartedly, should not forget that the
fault rests not alone with others. The crisis is not an outgrowth of the abandonment
of the expansionist policy. It is the inextricable and unavoidable aftermath of
this policy. The question is only whether one should continue expansionism
until the final collapse of the whole monetary and credit system or whether one
should stop at an earlier date. The sooner one stops, the less grievous are the
damages inflicted and the losses suffered.
Public opinion is utterly wrong in its appraisal of
the phases of the trade cycle. The artificial boom is not prosperity, but the
deceptive appearance of good business. Its illusions lead people astray and
cause malinvestment and the consumption of unreal apparent gains which amount
to virtual consumption of capital. The depression is the necessary process of
readjusting the structure of business activities to the real state of the
market data, i.e., the supply of capital goods and the valuations of the
public. The depression is thus the first step on the return to normal
conditions, the beginning of recovery and the foundation of real prosperity based
on the solid production of goods and not on the sands of credit expansion.
Additional credit is sound in the market economy only
to the extent that it is evoked by an increase in the public's savings and the
resulting increase in the amount of commodity credit. Then, it is the public's
conduct that provides the means needed for additional investment. If the public
does not provide these means, they cannot be conjured up by the magic of
banking tricks. The rate of interest, as it is determined on a loan market not
manipulated by an "easy-money" policy, is expressive of the people's
readiness to withhold from current consumption a part of the income really
earned and to devote it to a further expansion of business. It provides the
businessman reliable guidance in determining how far he may go in expanding
investment, what projects are in compliance with the true size of saving and
capital accumulation and what are not. The policy of artificially lowering the
rate of interest below its potential market height seduces the entrepreneurs to
embark upon certain projects of which the public does not approve. In the
market economy, each member of society has his share in determining the amount
of additional investment. There is no means of fooling the public all of the
time by tampering with the rate of interest. Sooner or later, the public's
disapproval of a policy of over-expansion takes effect. Then the airy structure
of the artificial prosperity collapses.
Interest is not a product of the machinations of rugged
exploiters. The discount of future goods as against present goods is an eternal
category of human action and cannot be abolished by bureaucratic measures. As
long as there are people who prefer one apple available today to two apples
available in twenty-five years, there will be interest. It does not matter
whether society is organized on the basis of private ownership of the means of
production, viz., capitalism, or on the basis of public ownership, viz.,
socialism or communism. For the conduct of affairs by a totalitarian
government, interest, the different valuation of present and of future goods,
plays the same role it plays under capitalism.
Of course, in a socialist economy, the people are
deprived of any means to make their own value judgments prevail and only the
government's value judgments count. A dictator does not bother whether or not
the masses approve of his decision of how much to devote for current
consumption and how much for additional investment. If the dictator invests
more and thus curtails the means available for current consumption, the people
must eat less and hold their tongues. No crisis emerges, because the subjects
have no opportunity to utter their dissatisfaction. But in the market economy,
with its economic democracy, the consumers are supreme. Their buying or
abstention from buying creates entrepreneurial profit or loss. It is the
ultimate yardstick of business activities.
V. The Inevitable Ending
It is essential to realize that what makes the
economic crisis emerge is the public's disapproval of the expansionist ventures
made possible by the manipulation of the rate of interest. The collapse of the
house of cards is a manifestation of the democratic process of the market.
It is vain to object that the public favors the policy
of cheap money. The masses are misled by the assertions of the pseudo-experts
that cheap money can make them prosperous at no expense whatever. They do not
realize that investment can be expanded only to the extent that more capital is
accumulated by savings. They are deceived by the fairy tales of monetary cranks
from John Law down to Major C.H. Douglas. Yet, what counts in reality is not
fairy tales, but people's conduct. If men are not prepared to save more by
cutting down their current consumption, the means for a substantial expansion
of investment are lacking. These means cannot be provided by printing banknotes
or by loans on the bank books.
In discussing the situation as it developed under the
expansionist pressure on trade created by years of cheap interest rates policy,
one must be fully aware of the fact that the termination of this policy will
make visible the havoc it has spread. The incorrigible inflationists will cry
out against alleged deflation and will advertise again their patent medicine,
inflation, rebaptizing it re-deflation. What generates the evils is the
expansionist policy. Its termination only makes the evils visible. This termination
must at any rate come sooner or later, and the later it comes, the more severe
are the damages which the artificial boom has caused. As things are now, after
a long period of artificially low interest rates, the question is not how to
avoid the hardships of the process of recovery altogether, but how to reduce
them to a minimum. If one does not terminate the expansionist policy in time by
a return to balanced budgets, by abstaining from government borrowing from the
commercial banks and by letting the market determine the height of interest
rates, one chooses the German way of 1923
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