The essence of Ludwig von Mises’s business cycle theory

In the slump of a cycle, businesses that were thriving come to experience difficulties or go under. They do so not because of firm-specific entrepreneurial errors but rather in tandem with whole sectors of the economy. People who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs.

Businessmen themselves are confused as to why. They cannot make sense of why certain business practices that were profitable yesterday are losing money today. Bad business conditions emerge when least expected — just when all businesses are holding the view that a new age of steady and rapid progress has emerged.

In his writings, Ludwig von Mises argued against the prevailing explanation of the business cycle by overproduction and under-consumption theories, and he critically addressed various theories that depended on vague notions of mass psychology and irregular shocks.

In the psychological explanation, an increase in people’s confidence regarding future business conditions gives rise to an economic boom. Conversely, a sudden fall in confidence sets in motion business stagnation. Now, there can be no doubt that during a recession people are less confident about the future than during good times. But to observe this is not to explain it. Likewise theories that view various shocks and disruptions as the central cause behind boom-bust cycles do not advance our knowledge regarding the boom-bust cycle phenomenon.

Neither explains how the boom and bust come about, or why they are of a recurrent nature. To arrive at a correct explanation Mises held, we need to trace the change in business conditions back to previously established and identified phenomena, and that is precisely what these theories do not do. Hence Mises concluded that all these theories do not provide an explanation but rather describe the phenomenon in a different way.

Mises also held that various statistical and mathematical methods are another way of describing but not explaining events. Statistical methods make it possible to generate charts of data fluctuations but they do not improve on our knowledge of what causes the fluctuations.

The Circulation Credit Theory of Business Cycles

Mises made a distinction between credit that is backed by savings, and credit that does not have any backing. The first type of credit he labelled commodity credit. The second he labelled circulation credit. It is circulation credit that plays the key role in setting the boom-bust cycle process.

Consider a producer of consumer goods who consumes part of his produce while saving the rest. In the market economy, our producer could exchange the saved goods for money. The money that he receives can be seen as a receipt as it were for the goods produced and saved. The receipt is his claim on the goods. He can then make a decision to lend the money to another producer through the mediation of a bank. By lending the money of the original saver, the lender transfers his claims on real savings to the borrower. The borrower can now use the money — i.e., the claims — and secure consumer goods that will support him while he is engaged in the production of other goods (say, tools and machinery).

The credit in this case is fully backed by savings and permits the expansion of tools and machinery. With better infrastructure, it is now possible to produce not only more goods but goods of a better quality. The expansion of real wealth is now possible. Once a lender lends his money, he relinquishes his claims on real goods for the duration of the loan.

In an unhampered market economy, borrowers are users of savings who make sure that savings are employed in the most efficient way: generating profits. This means that real savings are employed in accordance with consumers’ most important priorities. We can thus see here that as long as banks facilitate commodity credit, they should be seen as the agents of wealth generation.

In contrast, whenever banks embark on the lending of circulation credit they in fact become the agents of real wealth destruction. As opposed to commodity credit, circulation credit is not supported by any real saving. This type of credit is just an empty claim created by banks. In the case of commodity credit, the borrower secures goods that were produced and saved for him. This is, however, not the case with respect to the circulation credit. No goods were produced and saved here. Once the borrower uses the unbacked claims, it is at the expense of the holders of fully backed claims. In this way, circulation credit undermines the true wealth generators.

Now, as a result of an increase in the supply of circulation credit, money market interest rates fall below the natural rate, that is, the rate that would be established by supply and demand if real goods were loaned directly in barter without the use of money. (In his later articles, Mises referred to the natural rate as the rate that would be established in a free market.)

As a result of the artificial lowering of interest rates, businesses undertake various new capital projects to expand and lengthen the production structure. Prior to the lowering of interest rates, these capital projects didn’t appear to be profitable. Now, however, as money market rates are kept below the natural rate, economic activity zooms ahead and an economic boom emerges.

Such a situation cannot last. Mises here explains the important role played by the subsistence fund. The expansion of the production structure is always constrained by the availability of the means of sustenance (saved consumer goods) to maintain workers during the period of the expansion and the enhancement of the production structure.

The forced lowering of interest rates bring into being production processes that would not otherwise be undertaken. A production structure is now created that produces goods and services that consumers in fact cannot afford. Instead of using the limited pool of the means of sustenance to make tools and machinery that will generate consumer goods on the highest individual priority list, the means of sustenance are wasted on capital goods that are geared towards the production of low-priority consumer goods. At some point, the producers of such goods will discover that they cannot make a profit or even complete their plans. What we have here is not over-investment but misdirected investment or mal-investment.

The expansion of the production structure takes time and the limited subsistence fund may not be sufficient to support the expansion of the capital structure. If the new flow of the production of consumer goods does not emerge quickly enough to replace the currently consumed consumer goods, the subsistence fund comes under pressure.

At some point in time, banks discover that marginal businesses are starting to under-perform. This causes them to slow-down the expansion of circulation credit, which in turn puts an upward pressure on interest rates. As a result this starts to undermine various other business activities (non marginal), and can often be the precipitating event that leads to an economic bust.

Mises wrote that the bust phase of the business cycle process could be precipitated by other events. The expansion in the money supply enriches the early receivers of money. Those individuals who have now become wealthier as a result of receiving the money may alter their pattern of consumption. This may force businesses to adjust to this new setup. Once the rate of expansion in money slows down or comes to a halt, the new pattern of consumption cannot be supported and the new capital structure that was erected becomes unprofitable and must be abandoned.

It is not surprising that Mises was strongly opposed to the idea that central banks should impose “low” interest rates during a recession in order to keep the economy going. Instead, he believed that the policy makers should not engage in the artificial lowering of interest rates but rather refrain from any attempts to manage the economy via monetary policy. By curtailing its interference with businesses, the central bank provides breathing space to wealth generators and thereby lays the foundation for a durable economic recovery.

A version of this article was previously published at


  • mrg says:

    What are some good examples of malinvestments in the UK in the recent boom? Were these the trigger for the bust?

    We don’t have a glut of empty houses, like they appear to have in the US and China, and it seems to me that people were burning their money on foreign-made consumer goods, rather than tying it up in “capital projects to expand and lengthen the production structure”.

  • I agree with mrg. The artificially low rates of interest caused by private banks creating savings out of thin air will certainly cause more investment than optimum, but I don’t see why this should come to any great extent in the form of “lengthening the production structure”. The extent to which the “structure is lengthened” in any particular industry will depend on the technology in that industry.

    As to the AVERAGE PROPORTION of additional investment that takes the form “production structure lengthening” rather than investments which DON’T lengthen the structure, I have no idea what that is, and I doubt von Misis did either.

    Also, Shostak claims in respect of the additional investment caused by artificially low interest rates that “At some point, the producers of such goods will discover that they cannot make a profit or even complete their plans.” Why? Strikes me that if private banks are allowed to create savings out of thin air where previously they were not so permitted, then there will just be a PERMANENT rise in the stock of investment because investments can be funded by the new lower interest rates. I.e. a new equilibrium is established. There is no reason for that equilibrium to collapse.

    I suggest that what DOES CAUSE the collapse is what might be called the “asset price / collateral / additional lending feed-back mechanism”. I.e. house prices rise (or shares in the 1920s). That makes houses or shares a better form of collateral. So people borrow more to buy bigger houses or more shares. And banks are happy to lend moe on the basis of the collateral which has increased in value. That pushes house prices or shares up even further, etc, etc.

    Then everyone realises that NINJA mortgagors just can’t repay their mortgages.

  • Mikey MCD says:

    Perhaps another installment could discuss personal liberty as another reason not to have circulation credit (central bank)… yet another could discuss the hidden confiscation of assets via inflation thanks to circulation credit (central bank).

  • waramess says:

    The Mises explanation is far more compelling than the alternatives. Additionally Circulation Credit will increase the stock of money by increasing velocity in a quite dramatic way and, the increased velocity will itself increase the demand for credit.

    Looks like a win win situation until the big lending banks discovered,in each recession,that as a result of their declining lending standards the quality of their assets had become very suspect and prompted the fear that the other banks may have an even worse problem

    The result is they stop lending to other banks and the banks generally, as a consequence of the paucity of funding on the interbank market, stop lending to commercial entities.

    Every major recession and depression has displayed a dramatic fall in velocity of money. The 1929 depression for example saw a fall of nearly fifty percent which had the same effect as halving the amount of money in circulation.

    In 2008 the big question was, where did all the money go; well by now we all know.

  • Damien Phillips says:

    Very interesting article. For further explanation, it would be useful to feature examples from industries where this occurred – real world examples demonstrating the theory in action. And I agree with Mikey, it would be good to feature the other arguments against an expanding money supply – the devaluation of the currency, its effect on individual freedom etc.

  • Paul Marks says:

    The comments seem to show the same lack of knowledge of Central Bank policy in Britain that Mr King showed (if one can really believe that he honestly knows nothing about the policy of his own institution).

    Every step of the way the Bank of England activelly SUPPORTED the expansion of credit-money (just as Alan Greenspan’s Federal Reserve did in the United States).

    “There was no bubble”.

    The entire United Kingdom economy was the bubble – and it still is (for the Bank of England is still desperatly trying to prevent the credit-bubble economy collapseing).

    There must be massive liquidation – trying to prevent it (as the Bank of England, the Federal Reserve and ….., are trying to do) is just prolonging the agony.

  • John Spiers says:

    Shostak is excellent, and to the commenters:

    @ mrg, you have your answer in the question, the lengthening of the process goes all the way back to China, the source of the consumer goods imported. Mustn’t limited your view to within the UK boundaries.

    @ musgrave, the NINJA crash is the end of the lengthened cycle, not the entire lengthened cycle.

    @ MCD, these are topics Rothbard dwelt on at length, start with “what have they done with our money?”

    @ Phillips, start at the top and work your way down: banking, housing, consumer goods, automobiles, medicine, education… lay out the template and expand or contract it and you’ll see Mises explanation fits over the facts of the situation. You should write that article and offer it to Mr. Baxendale!

    John Spiers

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