When the English-language edition of Ludwig von Mises’s The Theory of Money and Credit was published 90 years ago, in 1934, the world was in the midst of the Great Depression. The American stock market crash in October 1929 soon snowballed into a severe economic downtown in 1930 and 1931 that reached its lowest point in terms of rising unemployment and falling industrial and agricultural output in 1932 and early 1933.
In Europe, the economic conditions were no better. Great Britain and France, for instance, were experiencing the same negative effects of falling outputs and rising joblessness, though the worst of it, in terms of these two indicators of economic “bad times,” was being experienced in Germany. Intensifying the global impact of the economic downturn was a return to trade protectionism in many of the leading economies, including the United States, along with foreign exchange controls that led, not surprisingly, to a dramatic fall in international trade and investment.
Government and the Great Depression
Why was the severity and depth of this economic depression the most serious in virtually anyone’s living memory? In Mises’s view, it was due to the degree to which governments almost everywhere were introducing policies that hindered and prevented the market economy from readjusting and rebalancing following what had turned out to be the false prosperity of the 1920s. Not that all that had happened in the 1920s was unsustainable or lost. Technological innovations, cost-
efficiencies, improvements in organization and management of industry and manufacturing, had represented real improvements in the standards and qualities of life for many around the world, especially in the United States.
But overlaying these impressive improvements in production potentials had been monetary policies followed in the United States and in Europe that had brought about mismatches and imbalances between savings and investment that had set the stage for an inescapable period of correction, due to unsustainable price and wage relationships and resource and capital uses, if there was to be a return to longer term growth and stability of the market economies in these countries.
There had been economic booms and busts, inflations and depressions in the past. These earlier downturns, however, had rarely been anywhere nearly as severe and disruptive as was being experienced in the 1930s. In the past, governments, for the most part, had kept a fairly “hands off” policy approach, allowing financial and investment and consumer markets to adjust and find their new coordinating price and wage patterns and resource and capital uses across sectors of the economy to return to full employment and output potentials.
The gold standard and growing government intervention
However, in the 1930s, governments did the opposite. The British government had ended the gold standard as the basis of the country’s monetary system in September 1931. Following the inauguration of Franklin D. Roosevelt in the United States in March 1933, the United States was taken off the gold standard in June of that year with the command that Americans had to turn in their gold coins and bullion in exchange for Federal Reserve paper money under threat of arrest, confiscation, and imprisonment.
First under Republican President Herbert Hoover and then under FDR’s New Deal programs, the U.S. government ran large budget deficits, raised taxes on business, undertook sizable public works projects, and interfered with market-based adjustments of wages and prices to restore balance between supplies and demands. Indeed, with the coming of the New Deal, Roosevelt imposed a fascist-style system of economic planning over industry and agriculture that for all intents and purposes did away with the American market economy. Only a series of Supreme Court decisions in 1935 and 1936 that declared some of the major New Deal programs as unconstitutional saved America from the possibility of a permanent command economy.
In the 1920s, Germany had a weak post–World War I democratic government, known as the Weimar Republic. In 1931 and 1932, the three largest political parties represented in the German parliament were the Social Democrats, the National Socialists (Nazis), and the Communists. In January 1933, Adolf Hitler was appointed Chancellor (prime minister), and within months, the Nazis were rapidly transforming the country into a totalitarian dictatorship, with government-directed spending and investment as the keystones of the National Socialist economic program. The Nazis formally introduced four-year central planning in 1936.
In neighboring Austria, where Mises was living and working as a senior economic analyst for the Vienna Chamber of Commerce, a brief civil war broke out in February 1934 between the fascist-oriented government and the armed forces of the Social Democratic Party, which ended with the defeat of the Austrian socialists. Soon after, a new constitution was instituted that officially established an authoritarian political system and a corporativist economy. In October 1934, Mises left Austria and took up his first full-time professorship at the Graduate Institute of International Studies in Geneva, Switzerland. This enabled him to escape both from living under the fascist dictatorship in his home country and the rising tide of aggressive anti-Semitism in both Nazi Germany and in the Republic of Austria that became violent and deadly in Mises’s homeland after Hitler entered Vienna in March 1938 and Austria was annexed into the German Third Reich. (See my article “Celebrating the Arrival of Ludwig von Mises in America,” Future of Freedom, August 2020.)
Mises on the causes of the Great Depression
In February 1931, Mises delivered a lecture on “The Causes of the Economic Crisis,” which was soon afterwards published in German in an expanded version. The countries of Europe and the United States were caught in this Great Depression precisely because governments had failed to allow market-based readjustments and rebalancing to restore production and employment.
Instead, governments did their utmost to maintain prices and wages at nonmarket levels through various forms of intervention and regulation. Tariffs protected uncompetitive domestic producers from foreign rivals; trade unions were privileged with unofficial power to shut down businesses and use violence to prevent nonunion workers from filling the jobs of union workers on strike as part of the attempt to impose higher-than-market wages; unemployment insurance was used to reduce the pressure on unions from the jobless; taxes on private enterprise reduced investment and threatened the consumption of capital; and government deficit spending was used to “create” jobs bound to be found to be mostly wasteful and unnecessary. From this Mises concluded:
If everything possible is done to prevent the market from fulfilling its function of bringing supply and demand into balance, it should come as no surprise that a serious disproportionality between supply and demand persists, that commodities remain unsold, factories stand idle, many millions are unemployed, destitution and misery are growing and that finally, in the wake of all these, destructive radicalism is rampant in politics.… With the economic crisis, the breakdown of interventionist economic policy — the policy being followed today by all governments, irrespective of whether they are responsible to parliaments or ruled opening as dictatorships — becomes apparent.
The corrupting influence of the interventionist state
The corrosive effect such interventionist policies had on the functioning of the market and the perverse antisocial incentives it fostered in the private sector was explained by Mises a year later, in 1932, in an essay entitled, “The Myth of the Failure of Capitalism”:
In the interventionist state it is no longer of crucial importance for the success of an enterprise that the business should be managed in a way that it satisfies the demands of consumers in the best and least costly manner. It is far more important that one has “good relations” with the political authorities so that the interventions work to the advantage and not the disadvantage of the enterprise. A few marks more tariff protection for the products of the enterprise and a few marks less for the raw materials used in the manufacturing process can be of far more benefit to the enterprise than the greatest care in managing the business. No matter how well an enterprise may be managed, it will fail if it does not know how to protect its interests in the drawing up of the customs rates, and in the negotiations before the arbitration boards, and with cartel authorities. To have “connections” becomes more important than to produce well and cheaply.
So, the leadership positions within enterprises are no longer achieved by men who understand how to organize companies and to direct production in the way the market situation demands, but by men who are well thought of “above” and “below,” men who understand how to get along with the press and all the political parties, especially with the radicals, so that they and their company give no offense. It is that class of general directors that negotiate far more with state functionaries and party leaders than with those from whom they buy and to whom they sell.
Since it is a question of obtaining political favors for these enterprises, the directors must repay the politicians with favors. In recent years, there have been relatively few large enterprises that have not had to spend very considerable sums … [on] campaign contributions, public welfare organizations and the like…. The crisis from which the world is suffering today is the crisis of interventionism and of national and municipal socialism, in short, it is the crisis of anti-capitalist policies.
The German economic environment was one in which a symbiotic relationship closely connected those in politics and the bureaucracy with special-interest groups desiring favors and privileges at others’ expense. It is not too surprising that a year later, in 1933, the corrupt and corrupting interventionist state transitioned easily into the National Socialist command and control economy — and that in Mises’s own country of Austria, authoritarian fascism and the planned economy followed a year later in 1934.
Mises’s theory of the business cycle
However, even if a growing spiderweb of government interventionist policies explains how and why the Great Depression of the 1930s became so deep and prolonged, there still was the question of how and why the depression had occurred at all. In other words, what were the monetary and banking policies that preceded the Great Depression that made an economic downturn inevitable. Mises had first presented what later became known as the Austrian theory of the business cycle in The Theory of Money and Credit, and then in his monograph, Monetary Stabilization and Cyclical Policy (1928).
Mises’s theory of money, banking, and the business cycle was a synthesis of Carl Menger’s theory of money, Eugen von Böhm-Bawerk’s theory of capital, and Knut Wicksell’s theory of interest rates and prices. As we saw, earlier, building on Menger, Mises developed an analysis of the non-neutrality of money, that is, how changes in the money supply works its way through the market in temporal-sequential patterns that influence the structure of relative prices and wages and the allocations of resources and capital among sectors of the economy.
Mises adapted Böhm-Bawerk’s theory of a time structure of investment and production, focusing on the price-coordinating market processes by which resources and labor are combined in the required stages of production to both produce capital goods and with capital to manufacture desired finished goods wanted by consumers. Each of these of stages of production must be successfully coordinated with the others. The “length” of the respective time-structures must also be consistent with the amount of overall savings in the economy so the needed and necessary resources, labor, and capital goods may be available to complete and maintain the complex processes of production through period after period of time.
As we also saw, the market-generated rate of interest assures that investments undertaken are able to be maintained and kept within the bounds of the savings set aside by income-earners. In a world of scarcity, the uses for the resources of any society are in competition between different applications of them both in the present and between the present and time horizons of the future. More of them used in one direction means that there is less available to utilize in alternative ways.
Knut Wicksell on interest rates and the inflationary process
The Swedish economist Knut Wicksell (1851–1926) argued in Interest and Prices (1898) that if goods in the present directly traded for goods in the future, that is, as in barter transactions, the intertemporal competitively determined price between goods in the present and the future would tend to assure that investment was kept in balance with savings. The intertemporal price of present goods for future goods is the equilibrium “natural rate of interest.” However, in actual markets, all trades, including those across time, are undertaken through the medium of money. Money in the present (and the purchasing power over various goods that sum of money represents) is traded for a sum of money in the future (and the purchasing power over various goods that sum of money is expected to represent).
If the money rate of interest coincides with the hypothetical equilibrium “natural” rate of interest, then savings and investment are kept in coordinated balance even in a money-using economy. The problem, Wicksell pointed out, is that the quantity of money offered through the banking system for investment purposes may exceed the quantity of money that income-earners had originally deposited in the banking system as desired savings. Or banks could lend less in the form of money loans than had had been deposited with them as money savings. Thus, there could be either total money investments undertaken greater than money savings, or more money savings than money loans issued within the banking system. Thus, total investments greater than available savings, or total investments less than available savings.
Banks might try to extend money loans greater than deposited savings by setting the interest rate below the natural rate through the creation of bank notes or increased checking deposits for those additional borrowers to spend. But since scarcity continues to limit the real total of economic activities that can be undertaken, the increased quantity of money only ends up generating a cumulative rise in prices (price inflation) for as long as the money rate of interest is kept below the natural rate. Similarly, if the money rate of interest were to be set above the natural rate, total money loans undertaken would be less than available money savings, with part of the total quantity of money in the economy taken out of circulation, resulting in a cumulative decline in prices (price deflation) for as long as the money rate of interest was kept higher than natural rate.
Free banking and the limits on inflationary currencies
This was the backdrop to Mises’s theory of the business cycle. As he developed the theory through the 1920s and 1930s, Mises argued that if there prevailed private competitive free banking, there would be market-based checks and balances preventing such imbalances between savings and investment from occurring to any significant degree. If any one or number of banks decided to increase their respective quantity of bank notes or checking accounts by lowering the money rate of interest at which they were extending loans to potential borrowers, the sums borrowed would soon be spent by those borrowers on various goods and services they wanted to buy.
Those receiving the banknotes issued in this way by, say, the Adam Smith Bank would deposit them in their own banks, say, the Thomas Malthus Bank and the David Ricardo Bank. The Thomas Malthus and David Ricardo Banks, receiving deposits of the banknotes of Adam Smith Bank from their bank customers, would trade them in through what is called the “clearing house,” demanding the gold or silver that those banknotes represent from the bank that issued them. Banks that have overissued their banknotes relative to other banks will experience a net outflow of their gold and silver deposit reserves. If they continue their own monetary expansion in this manner, they threaten, over time, to face insolvency or even bankruptcy as the total number of banknotes claimed against them threaten a loss of all their gold and silver reserves.
At the same time, if their own depositors become concerned about the bank’s solvency, that bank would risk facing a bank run, that is, many of their depositors all demanding their gold and silver money more or less simultaneously. Thus, in their own self-interest, under the pressures of the clearing house process and maintaining the confidence of their own depositor customers, private banks, under a competitive free-banking system, would have incentives to resist excessive creation of fiduciary media (banknotes and deposits not fully covered by gold and silver reserves).
Unjustifiable creations of bank-notes and checking deposits (that is, in excess of actual gold and silver money deposited with that financial institution) would be kept in narrow bounds under private competitive banking. Looking over the market as a whole, therefore, investment would be kept within the scarcity constraints of actual savings set aside by income-earners for such purposes. As Mises explained it in Monetary Stabilization and Cyclical Policy, in a free banking environment, there might still be fiduciary media issued by banks:
However, banks would have to be especially cautious because of the sensitivity to loss of reputation of their fiduciary media, which no one would be forced to accept. In the course of time, the inhabitants of capitalistic countries would learn to differentiate between good and bad banks…. The management of solvent and highly respected banks, the only banks whose fiduciary media would enjoy the general confidence essential for money-substitute quality, would have learned from past experiences.
The cautious policy of restraint on the part of respected and well-established banks would compel the more irresponsible managers of other banks to follow suit.… For the expansion of circulation credit can never be the act of one individual bank alone, nor even a group of individual banks…. If several banks of issue, each enjoying equal rights, existed side by side, and if some of them sought to expand the volume of circulation credit while others did not alter their conduct, then at every bank clearing, demand balances would regularly appear in favor of the conservative banks. As a result of the presentation of notes for redemption and withdrawal of their cash balances, the expanding banks would very quickly be compelled once more to limit the scale of their emissions…. It may be that a final solution of the problem of [unjustifiable monetary expansion] can be arrived at only through the establishment of completely free banking.
Central banks and monetary expansion
However, this was not how the banking systems had developed in Europe or North America. It is true that in the nineteenth century, after earlier experiences with paper-money inflations caused by governments or their central banks, new rules were established under which many of the leading central banks managed their systems according to the rules of the gold standard. But these remained, nonetheless, monopoly monetary systems controlled and managed by government central banks.
Governments and their central banks would periodically oversee undue expansions of fiduciary media and the artificial lowering of money interest rates through the banking systems under their control. This would set the stage for the types of price inflationary booms and price deflationary busts that Wicksell had outlined in Interest and Prices. This was only exacerbated in the twentieth century when central banks were taken off the gold standard by their respective governments, with no longer the check and fear of losing gold reserves underlying a country’s monetary system.
The additional aspect to the Wicksellian process that Mises developed was a focus on the non-neutral manner in which monetary and credit expansions through the banking system distorted the relative price structure and the allocations and use of capital and labor across sectors of the market. Such an artificial lowering of the money rate of interest below the “natural” rate results in the newly created money and credit first passing into the hands of borrowers who utilize the new money at their disposal to undertake investment projects for which the amounts of real resources to complete and sustain them will be found to be insufficient in the longer-run.
They place orders with the suppliers of capital equipment and construction enterprises to start or expand investment projects, and they hire workers to assist in these endeavors. The resources, labor and capital for these undertakings are drawn from more immediate consumption goods production through the offering of higher prices and wages made possible by the expansion of the money and credit by which those loans have been extended to them.
If these factors of production had been redirected into the more time-consuming investment sectors due to actual increases in people’s savings preferences (and therefore an implied decrease in preferences for consumer goods), the increased demands for inputs in investment goods production would have been counter-balanced by a decrease in the demands for consumer goods production. The changes in relative prices and wages, and reallocations of inputs from some areas of the market to others, would have brought about the needed recoordinated equilibrium. In time, the greater savings and completed investment activities would bring forth the improved and increased supplies of consumer goods that would be the future “reward” for foregone consumption in the more immediate present.
Monetary expansion and misallocation of resources
But this is not the case. Instead, the central bank monetary authority increases the lending reserves of the banks (in the case of the Federal Reserve of the United States, most frequently by purchasing U.S. government securities that the federal government has issued to cover deficit spending), which expands their ability to extend additional investment loans to interested borrowers in the private sector at lower rates of interest made possible by the increase in loanable funds in the banking system.
Borrowers compete away the resources, labor, and capital to initiate their investment projects by offering higher factor prices from their current employments in the consumer-goods sectors. But there are no corresponding decreases in consumer goods prices or the factor prices in these parts of the market since there has been no decrease in consumer demands. Those drawn into the investment goods sectors may be presumed to have the same consumption-savings preferences they had before their new employments. They use their higher money incomes to demand the same proportions of consumer goods as before. Therefore, prices in the consumer goods and complementary factor markets rise, with those still employed in consumer-goods sectors experiencing also increases in their money wages and factor prices. But these higher prices and wages in the consumer goods parts of the economy act as a “pull” to attract workers and resources away from the investment goods markets and back to consumer-goods production.
If the monetary expansion, with the resulting lower rates of interest and greater investment borrowing, was a “one-off” act by the central bank, relative prices and wages and resource, labor, and capital uses would reestablish themselves after a short period of time in the pattern reflecting income earners’ underlying preferences for consumption and savings. But historically, the central-banking authorities, once they have initiated an expansionary monetary and lower interest-rate policy, continue it period after period, with new injections of lendable funds into the banking system and with interest rates pressed down below where the market would set them in a noninflationary environment.
Prices continue to rise following in the temporal sequence in which the money is introduced, spent first on investment activities, followed by rising factor incomes, and then by increased money demand for consumer and other goods and services. A tug-of-war occurs with investment goods producers and consumer goods producers competing against each other in the attempt to pull the factors of production in one direction and then another.
If the “twisted” production house of cards is to be maintained indefinitely, the central-bank authority finds it necessary to accelerate the rate of monetary expansion so in the temporal sequence of rising prices, the “injections” are great enough to keep the relative prices of production goods ahead of the relative prices of consumer goods. Otherwise, if consumer goods prices completely catch up with or start to rise at a faster rate than production good prices, the monetary-induced investment patterns will be found to be unsustainable, and the recession phase of the business cycle will set it. And, indeed, unless the monetary authority allows the inflation to get completely out of control, with a resulting hyperinflation of economic chaos, the inflation must be ended or significantly slowed down, at which point the recession can no longer be avoided.
Stabilizing the price level destabilized the market process
In the 1920s, the Federal Reserve had attempted to maintain a stabilized “price level” in an economy of growing output, productivity increases, and cost efficiencies that would have otherwise resulted in falling consumer prices to the betterment of the buying public now able to purchase more and better goods at lower prices. Instead, the Federal Reserve increased the money supply in an attempt to counteract this benign price deflation. As a result, it in fact created a hidden price inflation by keeping prices in general higher than they otherwise would have been if the money supply had not been increased.
Thus, beneath the surface of a relatively stable “price level,” central bank monetary policy had set in motion a distortion and mismatch between savings and investment that inevitably had to end in an economic downturn. But an economic downturn became the Great Depression only because government interventions of sundry sorts had prevented the market process from bringing about a healthy rebalancing of supplies and demands and prices that would have brought back full employment without the economic disaster of the 1930s.
This article was originally published in the May 2024 issue of Future of Freedom.
