Booms and Busts
Expert from America's Great Depression (1963)
by Murray N. Rothbard
Study of business cycles must be based upon a
satisfactory cycle theory. Gazing at sheaves of statistics without
"prejudgment" is futile. A cycle takes place in the economic world,
and therefore a usable cycle theory must be integrated with general economic
theory. And yet, remarkably, such integration, even attempted integration, is
the exception, not the rule. Economics, in the last two decades, has fissured
badly into a host of airtight compartments — each sphere hardly related to the
others. Only in the theories of Schumpeter and Mises has cycle theory been
integrated into general economics.[1]
The bulk of cycle specialists, who spurn any
systematic integration as impossibly deductive and overly simplified, are
thereby (wittingly or unwittingly) rejecting economics itself. For if one may
forge a theory of the cycle with little or no relation to general economics,
then general economics must be incorrect, failing as it does to account for
such a vital economic phenomenon. For institutionalists — the pure data
collectors — if not for others, this is a welcome conclusion. Even institutionalists,
however, must use theory sometimes, in analysis and recommendation; in fact,
they end by using a concoction of ad hoc hunches, insights, etc., plucked
unsystematically from various theoretical gardens. Few, if any, economists have
realized that the Mises theory of the trade cycle is not just another theory:
that, in fact, it meshes closely with a general theory of the economic system.[2] The Mises theory is, in
fact, the economic analysis of the necessary consequences of intervention in the free market by bank credit
expansion. Followers of the Misesian theory have often displayed excessive
modesty in pressing its claims; they have widely protested that the theory is
"only one of many possible explanations of business cycles," and that
each cycle may fit a different causal theory. In this, as in so many other
realms, eclecticism is misplaced. Since the Mises theory is the only one that
stems from a general economic theory, it is the only one that can provide a
correct explanation. Unless we are prepared to abandon general theory, we must
reject all proposed explanations that do not mesh with general economics.
Business Cycles and Business Fluctuations
It is important, first, to distinguish between business cycles and ordinary business fluctuations. We live necessarily in a society
of continual and unending change, change that can never be precisely charted in
advance. People try to forecast and anticipate changes as best they can, but
such forecasting can never be reduced to an exact science. Entrepreneurs are in
the business of forecasting changes on the market, both for conditions of
demand and of supply. The more successful ones make profits pari passus with their accuracy of judgment, while
the unsuccessful forecasters fall by the wayside. As a result, the successful
entrepreneurs on the free market will be the ones most adept at anticipating
future business conditions. Yet, the forecasting can never be perfect, and
entrepreneurs will continue to differ in the success of their judgments. If this
were not so, no profits or losses would ever be made in business.
Changes, then, take place continually in all spheres
of the economy. Consumer tastes shift; time preferences and consequent
proportions of investment and consumption change; the labor force changes in
quantity, quality, and location; natural resources are discovered and others
are used up; technological changes alter production possibilities; vagaries of
climate alter crops, etc. All these changes are typical features of any
economic system. In fact, we could not truly conceive of a changeless society,
in which everyone did exactly the same things day after day, and no economic
data ever changed. And even if we could conceive of such a society, it is
doubtful whether many people would wish to bring it about.
It is, therefore, absurd to expect every business
activity to be "stabilized" as if these changes were not taking
place. To stabilize and "iron out" these fluctuations would, in
effect, eradicate any rational productive activity. To take a simple,
hypothetical case, suppose that a community is visited every seven years by the
seven-year locust. Every seven years, therefore, many people launch
preparations to deal with the locusts: produce anti-locust equipment, hire
trained locust specialists, etc. Obviously, every seven years there is a
"boom" in the locust-fighting industry, which, happily, is
"depressed" the other six years. Would it help or harm matters if
everyone decided to "stabilize" the locust-fighting industry by
insisting on producing the machinery evenly every year, only to have it rust
and become obsolete? Must people be forced to build machines before they want
them; or to hire people before they are needed; or, conversely, to delay
building machines they want — all in the name of "stabilization"? If
people desire more autos and fewer houses than formerly, should they be forced
to keep buying houses and be prevented from buying the autos, all for the sake
of stabilization? As Dr. F.A. Harper has stated:
This sort of business fluctuation runs all through our
daily lives. There is a violent fluctuation, for instance, in the harvest of
strawberries at different times during the year. Should we grow enough
strawberries in greenhouses so as to stabilize that part of our economy throughout
the year.[3]
We may, therefore, expect specific business fluctuations all the time. There
is no need for any special "cycle theory" to account for them. They
are simply the results of changes in economic data and are fully explained by
economic theory. Many economists, however, attribute general business
depression to "weaknesses" caused by a "depression in
building" or a "farm depression." But declines in specific
industries can never ignite a general depression. Shifts in data will cause
increases in activity in one field, declines in another. There is nothing here
to account for a general business depression —
a phenomenon of the true "business cycle." Suppose, for example, that
a shift in consumer tastes, and technologies, causes a shift in demand from
farm products to other goods. It is pointless
to say, as many people do, that a farm depression will ignite a general
depression, because farmers will buy less goods, the people in industries
selling to farmers will buy less, etc. This ignores the fact that people
producing the other goods now favored by
consumers will prosper; their demands will
increase.
The problem of the business cycle is one of general
boom and depression; it is not a problem of exploring specific industries and
wondering what factors make each one of them relatively prosperous or
depressed. Some economists — such as Warren and Pearson or Dewey and Dakin —
have believed that there are no such things as general business fluctuations —
that general movements are but the results of different cycles that take place,
at different specific time-lengths, in the various economic activities. To the
extent that such varying cycles (such as the 20-year "building cycle"
or the 7-year locust cycle) may exist, however, they are irrelevant to a study
of business cycles in general or to
business depressions in particular. What we are trying to explain aregeneral booms and busts in business.
In considering general movements in business, then, it
is immediately evident that such movements must be transmitted through the
general medium of exchange — money. Money forges the connecting link between
all economic activities. If one price goes up and another down, we may conclude
that demand has shifted from one industry to another; but if all prices move up or down together, some change
must have occurred in the monetary sphere.
Only changes in the demand for, and/or the supply of, money will cause general
price changes. An increase in the supply of money, the demand for money
remaining the same, will cause a fall in the purchasing power of each dollar,
i.e., a general rise in prices; conversely, a drop in the money supply will
cause a general decline in prices. On the other hand, an increase in the
general demand for money, the supply remaining given, will bring about a rise
in the purchasing power of the dollar (a general fall in prices); while a fall
in demand will lead to a general rise in prices. Changes in prices in general,
then, are determined by changes in the supply of and demand for money. The
supply of money consists of the stock of money existing in the society. The
demand for money is, in the final analysis, the willingness of people to hold
cash balances, and this can be expressed as eagerness to acquire money in
exchange, and as eagerness to retain money in cash balance. The supply of goods
in the economy is one component in the social demand for money; an increased
supply of goods will, other things being equal,
increase the demand for money and therefore tend to lower prices. Demand for
money will tend to be lower when the purchasing power of the money-unit is
higher, for then each dollar is more effective in cash balance. Conversely, a
lower purchasing power (higher prices) means that each dollar is less
effective, and more dollars will be needed to carry on the same work.
The purchasing power of the dollar, then, will remain
constant when the stock of, and demand for, money are in equilibrium with each
other: i.e., when people are willing to hold in their cash balances the exact
amount of money in existence. If the demand for money exceeds the stock, the
purchasing power of money will rise until the demand is no longer excessive and
the market is cleared; conversely, a demand lower than supply will lower the
purchasing power of the dollar, i.e., raise prices.
Yet, fluctuations in general business, in the
"money relation," do not by themselves provide the clue to the
mysterious business cycle. It is true that any cycle in general business must
be transmitted through this money relation: the relation between the stock of,
and the demand for, money. But these changes in themselves explain little. If
the money supply increases or demand falls, for example, prices will rise; but
why should this generate a "business cycle"? Specifically, why should
it bring about a depression? The early business cycle theorists were correct in
focusing their attention on the crisis and depression: for these are the phases that puzzle and
shock economists and laymen alike, and these are the phases that most need to
be explained.
The Problem: The Cluster of Error
The explanation of depressions, then, will not be
found by referring to specific or even general business fluctuations per se.
The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors? This
is the first question for any cycle theory. Business activity moves along
nicely with most business firms making handsome profits. Suddenly, without
warning, conditions change and the bulk of business firms are experiencing
losses; they are suddenly revealed to have made grievous errors in forecasting.
A general review of entrepreneurship is now in order.
Entrepreneurs are largely in the business of forecasting. They must invest and
pay costs in the present, in the expectation of recouping a profit by sale either
to consumers or to other entrepreneurs further down in the economy's structure
of production. The better entrepreneurs, with better judgment in forecasting
consumer or other producer demands, make profits; the inefficient entrepreneurs
suffer losses. The market, therefore, provides a training ground for the reward
and expansion of successful, far-sighted entrepreneurs and the weeding out of
inefficient businessmen. As a rule only some businessmen suffer losses at any
one time; the bulk either break even or earn profits. How, then, do we explain
the curious phenomenon of the crisis when almost all entrepreneurs suffer
sudden losses? In short, how did all the country's astute businessmen come to
make such errors together, and why were they all suddenly revealed at this
particular time? This is the great problem of cycle theory.
It is not legitimate to reply that sudden changes in
the data are responsible. It is, after all, the business of entrepreneurs to
forecast future changes, some of which are sudden. Why did their forecasts fail
so abysmally?
Another common feature of the business cycle also
calls for an explanation. It is the well-known fact that capital-goods industries fluctuate more widely than do the
consumer-goods industries. The capital-goods industries —
especially the industries supplying raw materials, construction, and equipment
to other industries — expand much further in the boom, and are hit far more
severely in the depression.
A third feature of every boom that needs explaining is
the increase in the quantity of money in the economy. Conversely, there is
generally, though not universally, a fall in the money supply during the
depression.
The Explanation: Boom and Depression
In the purely free and unhampered market, there will
be no cluster of errors, since trained entrepreneurs will not all make errors
at the same time.[4] The "boom-bust" cycle is generated by
monetary intervention in the market, specifically bank credit expansion to
business. Let us suppose an economy with a given supply of money. Some of the
money is spent in consumption; the rest is saved and invested in a mighty
structure of capital, in various orders of production. The proportion of
consumption to saving or investment is determined by people's time preferences — the degree to which they prefer
present to future satisfactions. The less they prefer them in the present, the
lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time
preferences of the individuals in society. A lower time-preference rate will be
reflected in greater proportions of investment to consumption, a lengthening of
the structure of production, and a building-up of capital. Higher time
preferences, on the other hand, will be reflected in higher pure interest rates
and a lower proportion of investment to consumption. The final market rates of
interest reflect the pure interest rate plus or minus entrepreneurial risk and
purchasing power components. Varying degrees of entrepreneurial risk bring
about a structure of interest rates instead of a single
uniform one, and purchasing-power components reflect changes in the purchasing
power of the dollar, as well as in the specific position of an entrepreneur in
relation to price changes. The crucial factor, however, is the pure interest
rate. This interest rate first manifests itself in the "natural rate"
or what is generally called the going "rate of profit." This going
rate is reflected in the interest rate on the loan market, a rate which is
determined by the going profit rate.[5]
Now what happens when banks print new money (whether
as bank notes or bank deposits) and lend it to business?[6] The new money pours forth on the loan market and
lowers the loan rate of interest. It looks as if the
supply of saved funds for investment has increased, for the effect is the same:
the supply of funds for investment apparently increases, and the interest rate
is lowered. Businessmen, in short, are misled by the bank inflation into
believing that the supply of saved funds is greater than it really is. Now,
when saved funds increase, businessmen invest in "longer processes of
production," i.e., the capital structure is lengthened, especially in the
"higher orders" most remote from the consumer. Businessmen take their
newly acquired funds and bid up the prices of capital and other producers'
goods, and this stimulates a shift of investment from the "lower"
(near the consumer) to the "higher" orders of production (furthest
from the consumer) — from consumer-goods to capital-goods industries.[7]
If this were the effect of a genuine fall in time
preferences and an increase in saving, all would be well and good, and the new
lengthened structure of production could be indefinitely sustained. But this
shift is the product of bank credit expansion. Soon the new money percolates
downward from the business borrowers to the factors of production: in wages,
rents, interest. Now, unless time preferences have changed, and there is no
reason to think that they have, people will rush to spend the higher incomes in
the old consumption–investment proportions. In short,
people will rush to reestablish the old proportions, and demand will shift back
from the higher to the lower orders. Capital goods industries will find that
their investments have been in error: that what they thought profitable really
fails for lack of demand by their entrepreneurial customers. Higher orders of
production have turned out to be wasteful, and the malinvestment must be
liquidated.
A favorite explanation of the crisis is that it stems
from "under-consumption" — from a failure of consumer demand for
goods at prices that could be profitable. But this runs contrary to the
commonly known fact that it is capital-goods, and
not consumer-goods, industries that really suffer in a depression. The failure
is one of entrepreneurial demand for the
higher order goods, and this in turn is caused by the shift of demand back to
the old proportions.
In sum, businessmen were misled by bank credit
inflation to invest too much in higher-order capital goods, which could only be
prosperously sustained through lower time preferences and greater savings and
investment; as soon as the inflation permeates to the mass of the people, the
old consumption–investment proportion is reestablished, and business
investments in the higher orders are seen to have been wasteful.[8] Businessmen were led to this error by the credit
expansion and its tampering with the free-market rate of interest.
The "boom," then, is actually a period of
wasteful misinvestment. It is the time when errors are made, due to bank
credit's tampering with the free market. The "crisis" arrives when
the consumers come to reestablish their desired proportions. The
"depression" is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer
desires. The adjustment process consists in rapid liquidation of the wasteful investments. Some of
these will be abandoned altogether (like the Western ghost towns constructed in
the boom of 1816–1818 and deserted during the Panic of 1819); others will be
shifted to other uses. Always the principle will be not to mourn past errors,
but to make most efficient use of the existing stock of capital. In sum, the
free market tends to satisfy voluntarily-expressed consumer desires with
maximum efficiency, and this includes the public's relative desires for present
and future consumption. The inflationary boom hobbles this efficiency, and
distorts the structure of production, which no longer serves consumers
properly. The crisis signals the end of this inflationary distortion, and the
depression is the process by which the economy returns to the efficient service
of consumers. In short, and this is a highly important point to grasp, the
depression is the "recovery" process, and the end of the depression
heralds the return to normal, and to optimum efficiency. The depression, then,
far from being an evil scourge, is the necessary and
beneficial return of the economy to normal after the distortions imposed by the
boom. The boom, then, requires a
"bust."
Since it clearly takes very little time for the new
money to filter down from business to factors of production, why don't all
booms come quickly to an end? The reason is that the banks come to the rescue.
Seeing factors bid away from them by consumer-goods industries, finding their
costs rising and themselves short of funds, the borrowing firms turn once again
to the banks. If the banks expand credit further, they can again keep the
borrowers afloat. The new money again pours into business, and they can again
bid factors away from the consumer-goods industries. In short, continually
expanded bank credit can keep the borrowers one step ahead of consumer
retribution. For this, we have seen, is what the crisis and depression are: the
restoration by consumers of an efficient economy, and the ending of the
distortions of the boom. Clearly, the greater the credit expansion and the
longer it lasts, the longer will the boom last. The boom will end when bank
credit expansion finally stops. Evidently, the longer the boom goes on the more
wasteful the errors committed, and the longer and more severe will be the
necessary depression readjustment.
Thus, bank credit expansion sets into motion the business
cycle in all its phases: the inflationary boom, marked by expansion of the
money supply and by malinvestment; the crisis, which arrives when credit
expansion ceases and malinvestments become evident; and the depression
recovery, the necessary adjustment process by which the economy returns to the
most efficient ways of satisfying consumer desires.[9]
What, specifically, are the essential features of the
depression-recovery phase? Wasteful projects, as we have said, must either be
abandoned or used as best they can be. Inefficient firms, buoyed up by the
artificial boom, must be liquidated or have their debts scaled down or be
turned over to their creditors. Prices of producers' goods must fall,
particularly in the higher orders of production — this includes capital goods,
lands, and wage rates. Just as the boom was marked by a fall in the rate of
interest, i.e., of price differentials between stages of production (the
"natural rate" or going rate of profit) as well as the loan rate, so
the depression-recovery consists of a rise in this interest differential. In
practice, this means a fall in the prices of the higher-order goods relative to
prices in the consumer-goods industries. Not only prices of particular machines
must fall, but also the prices of whole aggregates of capital, e.g.,
stock-market and real-estate values. In fact, these values must fall more than
the earnings from the assets, through reflecting the general rise in the rate
of interest return.
Since factors must shift from the higher to the lower
orders of production, there is inevitable "frictional" unemployment
in a depression, but it need not be greater than unemployment attending any
other large shift in production. In practice, unemployment will be aggravated
by the numerous bankruptcies, and the large errors revealed, but it still need
only be temporary. The speedier the adjustment, the more fleeting will the
unemployment be. Unemployment will progress beyond the "frictional"
stage and become really severe and lasting only if wage rates are kept
artificially high and are prevented from falling. If wage rates are kept above
the free-market level that clears the demand for and supply of labor, laborers
will remain permanently unemployed. The greater the degree of discrepancy, the
more severe will the unemployment be.
Notes
[1] Various neo-Keynesians have advanced cycle
theories. They are integrated, however, not with general economic theory, but with holistic
Keynesian systems — systems which are very partial indeed.
[2] There is, for example, not a hint of such
knowledge in Haberler's well-known discussion. See Gottfried Haberler, Prosperity and Depression (2nd ed., Geneva,
Switzerland: League of Nations, 1939).
[3] F.A. Harper, Why Wages Rise (Irvington-on-Hudson,
N.Y.: Foundation for Economic Education, 1957), pp. 118–19.
[4] Siegfried Budge, Grundzüge
der Theoretische Nationalökonomie (Jena, 1925), quoted in Simon
S. Kuznets, "Monetary Business Cycle Theory in Germany," Journal of Political Economy (April, 1930):
127–28.
Under conditions
of free competition … the market is … dependent upon supply and demand … there
could [not] develop a disproportionality in the production of goods, which
could draw in the whole economic system … such a disproportionality can arise
only when, at some decisive point, the price structure does not base itself
upon the play of only free competition, so that some arbitrary influence
becomes possible.
Kuznets himself criticizes the Austrian theory from
his empiricist, anti-cause and effect-standpoint, and also erroneously
considers this theory to be "static."
[5] This is the "pure time preference
theory" of the rate of interest; it can be found in Ludwig von Mises, Human Action (New Haven, Conn.: Yale University
Press, 1949); in Frank A. Fetter, Economic Principles (New
York: Century, 1915), and idem, "Interest Theories Old and New, "American Economic Review (March, 1914):
68–92.
[6] "Banks," for many purposes, include
also savings and loan associations, and life insurance companies, both of which
create new money via credit expansion to business. See below for further
discussion of the money and banking question.
[7] On the structure of production, and its relation
to investment and bank credit, see F.A. Hayek, Prices
and Production (2nd ed., London: Routledge and Kegan Paul,
1935); Mises, Human Action; and Eugen von
Böhm-Bawerk, "Positive Theory of Capital," in Capital and Interest (South Holland, Ill.:
Libertarian Press, 1959), vol. 2.
[8] "Inflation" is here defined as an increase in the money supply not consisting of an increase in the
money metal.
[9] This "Austrian" cycle theory settles
the ancient economic controversy on whether or not changes in the quantity of
money can affect the rate of interest. It supports the "modern"
doctrine that an increase in the quantity of money lowers the rate of interest
(if it first enters the loan market); on the other hand, it supports the
classical view that, in the long run, quantity of money does not affect the
interest rate (or can only do so if time preferences change). In fact, the
depression-readjustment is the market's return to the desired free-market rate
of interest.
