Montreal, December 15, 2008 • No 262




Chris Leithner grew up in Canada. He is director of Leithner & Co. Pty. Ltd., a private investment company based in Brisbane, Australia.




by Chris Leithner

          It'd be laughable if it weren't pathetic: the conception of the business cycle that has prevailed since the early 20th century—and which rules the roost in Australia, Britain, Canada the U.S. and elsewhere—owes most to Karl Marx. He saw that, before the Industrial Revolution, no general pattern of economic boom and bust had occurred.(1) These cycles appeared on the scene at about the same time as factories and industrialisation. Hence Marx—who was hardly the first to confuse causation and correlation—erroneously concluded that business cycles were an inherent feature of capitalism.


          Apart from the Austrian School, all of today's various schools of economic thought, regardless of their many differences and the myriad causes that they attribute to the cycle, agree on this vital point: the business cycle originates somewhere deep within the bowels of the market economy. Marx believed that periodic depressions would get worse and worse until the masses would revolt and overthrow capitalism. Today's political and economic mainstream, on the other hand, believes that the state can successfully manage the cycle's ups and downs—and when things really go awry, the state must intervene massively and will ride successfully to the rescue. Albeit for very different reasons, both Marxists and mainstreamers agree that free markets are inherently unstable.

          Unfortunately for today's mainstream, some intractable problems accompany the assumption that the market economy triggers the business cycle. Perhaps most notably, because economists simply do not bother to reconcile their theories of the business cycle and of the price mechanism, they have long been utterly baffled by the peculiar breakdown of the entrepreneurial function at times of economic crisis.(2)

A built-in mechanism

          In the market economy, one of the most vital tasks of the businessman is to act as an "entrepreneur"—that is, a man who buys equipment and hires labour in order to produce something that he intends (but cannot be sure) will reap him a return that outweighs his risk. In short, the function of the entrepreneur is to forecast an inherently uncertain future.

          Before embarking upon any investment or line of production, he must estimate present and future costs and present and future revenues—and therefore how much profit he might earn. If he forecasts significantly better than his competitors, he will reap substantial profits. The better his forecasts, the higher will be his profits. If, on the other hand, he overestimates the demand for his good or service, he will not fulfil his plans and may suffer losses. And if his losses are sufficiently severe, he will face bankruptcy, cease production and exit the market.

          The market economy thus contains a built-in mechanism, a kind of natural selection, which ensures (1) the survival and prosperity of the superior forecaster and (2) the failure and extinction of the inferior one. This culling occurs over time. Accordingly, at any given point in time we would expect that relatively few businesses would be incurring losses. Hence the very odd fact that demands explanation: how is it that, the business world periodically and suddenly suffers a cluster of severe losses? Why does the moment arrive when businessmen, who on the whole had hitherto been highly astute entrepreneurs, abruptly become dunces? Why have so many entrepreneurs, hitherto able to forecast all manner of commercial and technological and other developments, so rapidly and unexpectedly dropped the ball?

          Clearly, an adequate theory of the business cycle must explain the tendency, which has been observed time after time, of the economy to move from boom to bust and back to boom. It must explain why the modern world shows no sign of settling into any reasonable facsimile of a smoothly moving approximation of an equilibrium situation. In particular, such a theory must account for the mammoth cluster of errors which appears suddenly at a moment of economic crisis, and lingers through the bust (or recession, depression, etc., according to your preferred term) period until recovery.

          Fortunately, a correct theory of the business cycle does exist, even though today's economists either resolutely ignore it or are blithely ignorant of it. This is inexcusable, for this theory is grounded deeply within—and has a long and honourable tradition in—economic thought.

Hume and Ricardo saw it

          The theory owes its origins to the late-18th century Scottish philosopher and economist David Hume and the early-19th century English classical economist David Ricardo. Hume and Ricardo saw what Marx did not, and what his heirs in today's mainstream will not: namely that another crucial institution rose to prominence alongside the factory, industrial and capitalist system in the mid-18th century. This was the fractional-reserve bank and its capacity to expand credit and the supply of money (first in the form of paper money or bank notes, and later in the form of demand deposits, a. k. a cheque accounts, that are instantly redeemable in cash at the bank). Hume and Ricardo understood that the operations of these banks held the key to the mysteriously recurring cycles of expansion and contraction, of up and down and boom and bust, and profit and loss, that had first appeared in and had puzzled observers since the mid-18th century.

          The Humeian and Ricardian conception and analysis of the business cycle has several hallmarks. First, the natural moneys that emerge on the free market are useful commodities—generally gold and silver. If money were confined simply to these commodities, then the economy would work in the aggregate much as it does in unfettered markets: a smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds a crucial and disruptive element. The banks expand credit in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not. Fractional reserve banks, in other words, are inherently bankrupt (see also Letter 102-104).

          For example, if a bank has 1000 ounces of gold in its vaults and it issues instantly-redeemable warehouse receipts for 2500 ounces, then it has obviously issued 1500 ounces more than it can possibly redeem. Consequently and equally clearly, this bank is insolvent. But so long as there is no concerted "run" on its deposits, i.e., no sudden and massive demand to exchange these receipts for gold, its warehouse-receipts function on the market as an equivalent of gold, and therefore the bank can expand (inflate) the country's money supply by 1500 ounces of gold.

          Realising that the more they expand credit the greater will be their profits, the banks happily begin to inflate. As the supply of paper and bank money within a country (say, England) increases, the incomes and expenditures of Englishmen—and the prices of English goods—rise. The result of fractional reserve banks' inflation is a boom within the country. But this boom sows the seeds of its own demise. For as the supply of money and incomes in England increases, Englishmen tend to purchase more goods from abroad. Moreover, as English prices rise, English goods begin to lose their competitiveness vis-à-vis the products of other countries which have not inflated, or have been inflating to a lesser degree. Englishmen begin to buy relatively less at home and comparatively more abroad, while foreigners buy less in England and more at home; the result is a deficit of the English balance of payments.

          But if imports exceed exports, then money must flow from England to foreign countries. And what money will this be? Probably not English banknotes or deposits, for Frenchmen or Germans or Italians have little desire to retain their funds in Perfidious Albion. These foreigners will therefore take their notes and deposits and present them to the English banks for redemption into gold. Hence gold will be the type of money that will tend to emigrate as the English inflation proceeds. But this means that English bank credit will be ever more precariously pyramiding atop a dwindling base of gold in the English bank's vaults. As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2500 ounces to 4000 ounces, while its gold base dwindles to, say, 800. This bank, in other words, becomes ever more highly leveraged.

          As this process intensifies, this bank—and other banks that do business with it—will become frightened. Their problem is that they must redeem their notes for gold; yet this bank's stock of gold is dwindling. Hence the banks will eventually lose their nerve, stop their expansion of credit and, in order to save themselves, contract their volume of loans outstanding. Often, this retreat is precipitated by runs on some banks (usually but not invariably the most heavily-leveraged) by panicked members of the public, who had also been getting increasingly nervous about the banks' ever more shaky condition.

          This contraction of credit reverses the economic picture: retrenchment and bust inevitably follow inflation and boom. The banks pull in their horns, and businesses suffer as the pressure mounts for the repayment of debt and downward pressure upon the prices of English goods and services mounts. As the prices of English goods and services decrease, they become relatively more attractive in terms of foreign products, and the balance of payments gradually reverses itself. As gold flows into the country, and as bank money contracts on top of an expanding gold base, the condition of the banks becomes sounder.(3)

          Hence the vital importance of the depression phase of the business cycle generated by fractional-reserve banking. It is not something to be avoided at all costs: rather, it is an inevitable consequence of the preceding expansionary boom, and is a necessary condition of a return to economic health. The preceding phase of boom makes necessary the subsequent phase of bust. During the depression, the market economy adjusts, removes the excesses and distortions of the previous inflationary boom and re-establishes a sound economic base. The depression is the unpleasant but indispensible reaction to the distortions and excesses of the boom. It is the hangover the drunk must suffer and the cold-turkey the addict must endure.

The next cycle

          Why, then, does the next cycle begin? Why do business cycles tend to recur? When fractional-reserve banks return to a sounder condition, they can resume their fraudulent raison d'être, namely the expansion of credit backed by thin air rather than genuine savings. The next boom is thus ignited, which sows the seeds for the next bust.

          But if fractional-reserve banking causes the business cycle, and if banks are a legitimate part of a free market economy, can't we still say that the free market is the culprit? No. If not for the intervention and encouragement—indeed, the protective legislation—of government, the fractional reserve banks within a country would never be able to expand credit in concert. For if banks were truly competitive, any expansion of credit by one bank would quickly accumulate on the balance sheets of its competitors, and these competitors would promptly call upon the expanding bank for redemption of this credit into gold. In short, a bank's rivals will call upon it to redeem in gold in the same way as do foreigners, except that the process is much faster and would nip any incipient inflation in the bud before it proceeded very far.(4)

          In short, the fractional-reserve banks within a country can only inflate in unison when a central bank exists to cover their backs. Such a bank typically decrees the terms and conditions of the fiat currency, enjoys a monopoly of government business and also exercises a privileged position (imposed by government) over the entire banking system. It is only when central banks became established in major countries, and connived with fractional-reserve banks to inflate the money supply, that the banks were able to inflate for any length of time and the business cycle established itself.

"The less the government tries to do, and hence the less damage it consequently does, the more rapidly will individuals be able to adjust to the reality the government had tried to deny and obey the natural laws of economics the state had presumed to flout, and quicker and the sounder the economic recovery that will ensue."

          Hence the business cycle derives not from any failing of the free market, but from the systematic and pervasive intervention by the state into markets for money and credit. Government intervention, not laissez-faire, generates inflation and the expansion of credit; and when the inflationary boom ends, the depression-adjustment arrives. The state is not just the doting father of the boom: it is also the absentee parent of the bust.

The correct Austrian cure for busts

          The Hume-Ricardo theory is essentially correct. But it leaves several features of the cycle unexplained or incompletely explained. Building upon Hume and Ricardo, the Austrian economist Ludwig von Mises developed the correct and fully developed (in the sense that it subsumes more reality than any other, and is more consistent with the real world than any other) theory. Hints of Mises' eventual solution to the puzzle of the business cycle first appeared in The Theory of Money and Credit (1912). Mises extended and elaborated his theory during the 1920s, and perfected it in his monumental treatise Human Action (1949).

          Friedrich von Hayek, who left Vienna to teach at the London School of Economics in the early 1930s, brought Mises' theory of the business cycle to the attention English-speaking world.(5) Hayek was Mises's leading disciple, and published two books which applied and elaborated Mises's theory: Monetary Theory and the Trade Cycle (1933) and Prices and Production (1935). Because Mises and Hayek were Austrians, and also because they advanced the tradition of the great 19th century Austrian School economists, this theory has become known as the "Austrian" theory of the business cycle.(6)

          What does Mises reckon the government should do once the unavoidable bust, recession or depression arrives? If it genuinely desires that the country emerges as quickly as possible from a recession, what role should the government play?

          First, the central bank must cease its policy of inflation. It's true that this will hasten the boom's demise (if the fears of commercial banks haven't killed it already). But the longer the government and the central bank wait, the worse the readjustment will have to be. The sooner they and everybody else face the music, the better.(7)

          Second, the government must never try to support unsound businesses; it must never "bail out" or "rescue" or lend money to or otherwise "support" businesses that find themselves in trouble. To do so is simply to prolong the agony and to convert an acute-but-transient condition into a lingering and chronic disease such as that which Japan has endured for most of the years since the late-1980s. Similarly, the government must never try to uphold wage rates or prices of goods and services or of stocks or bonds or real estate. Again, doing so will simply delay, prolong and correct the depression-adjustment.

          A third and closely-related point is that the state must not, in a misguided attempt to evade or short-circuit or otherwise lessen the harsh but necessary effects the depression, try to reinflate. In other words, it must not continue to suppress interest rates below the level that would prevail in an unfettered market. Even if this reinflation temporarily "stimulates the economy," it will simply brew greater trouble down the track.

          The government must not encourage consumption, particularly debt-financed consumption, and it must not increase its own spending, for this will further derange the appropriate ratio—which can only be discovered by individuals acting in free markets—between consumption and investment. Drastically cutting the government budget and slashing taxation will improve the ratio; so too will eliminating as many regulations as possible. In short, and in order to purge some of the misguided "malinvestments" of the boom, what both consumers and producers require is not more consumption but more saving.

          What the government should do, according to the Misesian analysis, is—apart from trim its own sails, clean its own stables and reduce the burdens it imposes upon its subjects—absolutely nothing. It should, from the point of view of economic health and for the sake of ending the depression as quickly as possible, maintain a strict hands-off or laissez-faire policy. Any intervention into—and thus bastardisation of—the market, any derangement of market signals and the information they convey, will simply delay and obstruct the process of adjustment.

          The less the government tries to do, and hence the less damage it consequently does, the more rapidly will individuals be able to adjust to the reality the government had tried to deny and obey the natural laws of economics the state had presumed to flout, and quicker and the sounder the economic recovery that will ensue.(8) The Misesian prescription is thus the exact opposite of the mainstream (interventionist) one. The government's task is to keep its clumsy hands off the economy, and to confine itself to stopping its own inflation, eliminating its stupid and harmful regulations and cutting its bloated budget.

The bankruptcy of mainstream economics

          The world does indeed face a crisis. It's the bankruptcy of mainstream economics and finance, and of its conception of money, credit, interest, banking and the business cycle, that confronts us.

          It's in a crisis, when emotion threatens to overwhelm reason and the pressure to conform becomes intense, that we can distinguish people who stick to their principles from those who repudiate them—or never really believed them in the first place.

          During the boom, fair-weather free marketers fitfully opposed a few minor interventions here and there—but enthusiastically championed the welfare state of credit, central banks and their policy of high inflation. And now, during the bust which is the inevitable consequence of the very monetary arrangements and policies they espoused, they have quickly folded their colours, squealed like piglets and defected en masse into the ranks of their erstwhile opponents.

          How can this be? More generally, how can they offer half-hearted criticism of the state's intervention in some areas, but when it comes to money, banking and credit enthusiastically climb aboard the Marxist bandwagon? (The fact that they don't know that they're doing so simply magnifies their stupidity.)

          The answer is that, for all practical purposes, Friedmanites, supply-siders, Chicago Schoolies, public choicers and Keynesians comprise a single—statist—category. None possesses a lucid theory of capital, interest and the business cycle; all have succumbed to the temptation of political influence; and they know or care nothing about the Austrian School. Hence mainstream economists and finance journalists simply cannot offer a coherent analysis of the monetary distemper of our times. They oppose neither the existence nor the terrifying power of central banks—which are the equivalent of Soviet-style central-planners applied to the monetary realm.

          The virtual-unanimity within the mainstream about the state's monopolisation of money and credit explains why the part-nationalisation of the American, British and other banking systems is barely raising a mainstream eyebrow. If, deep down, your faith rests ultimately in central planning practised by central bankers, then the monopolisation of credit and the nationalisation of banking is the achievement of your fondest wish.

          Only the Austrian School offers a coherent analysis of monetary cause and effect. It has long discerned the storm clouds on the horizon, and it now offers an alternative to the mainstream policies that will exacerbate rather than attenuate matters. Today's crisis, in effect, places you at a fork in the road. You must choose which path you will follow. On the one hand are the Austrians, and on the other the Marxists.

1. True, economic crises often erupted when a king suddenly made war or confiscated more than his usual quota of his subjects’ property; but before the 18th century there was no sign of general and fairly regular expansions and contractions of financial and economic fortunes.
2. The basic laws of supply and demand—whose existence not even Marx denied!—demonstrates that in the market supply and demand always tend towards equilibrium, and therefore that the prices of end products as well as of the factors of production are always tending towards equilibrium. Although changes of data, which are always taking place, prevent the actual occurrence of equilibrium, there is nothing in the general theory of the market system that would account for regular and recurring boom-and-bust phases of the business cycle.
Most economists “solve” this problem by keeping their general price and market theory and their business cycle theory in separate and even watertight compartments. Never are the two juxtaposed; and less still less is one rendered logically and empirically consistent with the other. Alas, economists have forgotten that there is only one economic reality, and therefore that there is room for just one integrated economic theory. Yet most economists are content to apply totally separate—and, indeed, mutually exclusive—theories for general price analysis and for business cycles.
3. Note carefully the discipline which a genuine gold standard—even when corrupted by fractional reserve banking—imposes upon banks, businesses and consumers. It is precisely this innate discipline that provides its ultimate and unassailable justification—and explains why politicians, central bankers and their shills in the universities and mass media despise sound (i. e., gold-based) money. One of its many virtues is that it renders total war economically unviable—which is precisely why a genuine gold standard was junked during the First World War, and why it has never returned.
4. For details, see Lawrence White, Free Banking in Britain: Theory, Experience and Debate, 1800-1845 (Institute of Economic Affairs, 1995).
5. If it weren’t tragic, it would be absurd: the Austrian (or Austrian-inspired) economists of the 1930s offered far more logically and empirically rigorous accounts and explanations of the Great Depression than do today’s mainstream. See in particular Constantini Bresciani-Turroni, The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany (John Dickens & Co., 1937); C.A. Phillips et al., Banking and the Business Cycle: A Study of the Great Depression in the United States (Macmillan, 1937); Lionel Robbins, The Great Depression (Macmillan, 1934); Wilhelm Röpke, Crises and Cycles (William Hodge and Co., 1936); and Richard von Strigl, Capital and Production (Julius Springer, 1934).
6. See also "Hayek on the Business Cycle" by Joseph Salerno. For further evidence corroborating the theory, see Barry Eichengreen and Kris Mitchener, "The Great Depression as a Credit Boom Gone Wrong" (Bank of International Settlements Working Paper No. 137, 2003); Paul Kasriel, "All We Are Sayin’ Is Give Free Markets a Chance" and "The US Economy: A Textbook Austrian School Business Cycle?" and  J.P. Keeler, "Empirical Evidence on the Austrian Business Cycle Theory" (Review of Austrian Economics, 2001). Also worth studying is the debate between Joseph Salerno (a defender of the theory) and Gordon Tullock (a critic). See Tullock’s "Why the Austrians Are Wrong About Depressions." Review of Austrian Economics (1988), Salerno’s "Comment on Tullock’s 'Why Austrians Are Wrong About Depressions'" Review of Austrian Economics (1989) and Tullock’s "Reply to Comment by Joseph T. Salerno," Review of Austrian Economics (1989).
7. A good analogy is with a forest and fires. If nature is left undisturbed, then the detritus which accumulates on the forest floor regularly alights. Yes, these fires destroy some young trees and some wildlife; at the same time, they release nutrients into the soil and thereby set the stage for healthy growth and regeneration. Human intervention is this natural state of affairs typically has perverse consequences. When well-meaning people actively prevent the occurrence of natural fires, then the detritus on the forest floor eventually builds to unnatural and dangerous levels. And when it finally ignites, the fire is often severe enough to destroy not just most of the wildlife but also most of the trees. Such it is with the managed economy. By refusing to allow junk on the forest’s floor (i. e., malinvestments) to alight, that is, by attempting to abolish the bust phase of the business cycle, well-meaning interventionists allow the malinvestments to accumulate. But eventually they do ignite, and the rarer but much more severe conflagration (depression) causes much more damage than the more frequent but shorter busts would have. Today’s mainstream boasts that present arrangements are “stable.” Alas, they do not realise that they are not stable: they are merely artificial.
8. See also Michael Rozeff, "Depression Mitigation," and Martin Masse, "Let the Recession Run Its Course."