“Money can never be neutral,” declares von Mises in his great work, Human Action. It matters what is used for money, how much of it there is, and at what rate it’s contracting or expanding. To neglect the impact of the medium of exchange, itself, upon an economy is “a serious blunder.”
Von Mises blames all serious economic downturns on the inappropriate increase in the amount of money in circulation. In fact, he implies that the repeating business cycle, itself, is caused by nothing other than the periodic over-inflation of a nation’s money supply. Thus, von Mises can boldly proclaim that “the first aim of monetary policy must be to prevent government from embarking upon inflation and from creating conditions which encourage credit expansion on the part of the banks.”
Von Mises believes that policies increasing the money supply will drive down interest rates, making loans more attractive, increasing borrowing, and creating a CREDIT EXPANSION.
Von Mises, despite the immense size of his master work, never really goes into detail concerning the connection between money supply and interest rates, so allow me to give you my take on it. Other economists may explain it differently, but I see the connection as explainable in two ways:
ONE: When the amount of money sloshing about in the general economy is unduly increased, it becomes less scarce, and thus, less precious or valuable. The same is true for any commodity. The “price” of money is reflected in its interest rate. When the amount of money available for lending is increased, its “price”– the interest charged on lending it out– goes down.
TWO: You can also look at it this way… At any given interest rate, lenders have lent all they wish to lend at that rate, and debtors have borrowed all they wish to borrow at that rate. However, if the supply of money available for loans increases, then lenders will of course wish to loan it out and put it to work. Trouble is, debtors are already happy with the amount of debt they’ve taken on at the current interest rate, so banks must LOWER THE INTEREST RATE when the supply of money goes up if they wish to lend out the new excess.
Von Mises states that an increased money supply creates the most mischief when the loan market reacts to the excessive funds BEFORE wages or prices are affected. I believe von Mises’s point here can be explained by the fact that the investments for which businesses are taking out loans will look EVEN MORE enticing if the costs and wages involved in their projects are still relatively low. Therefore, more businesses may be inclined to borrow more money, and more lenders inclined to approve more loan applications. This will send more money out into the economy faster, exacerbating the over-supply of money. It is important here to note that an increase in loans-extended is the primary way the increased money supply is injected into the economy.
If, on the other hand, prices and wages inflate before or simultaneous with the lowering of interest rates, then investments will not look as attractive. This will provide at least a slight brake on the amount of money being loaned and thus distributed through the economy.
Von Mises believes that when interest rates are lowered due to a money-supply increase, investors are misled in at least TWO ways:
DECEPTION ONE: Projects which did not appear profitable when loans were more expensive, will suddenly APPEAR more attractive. This confusion can be exacerbated by the fact that an increasing money supply does not affect all prices and wages equally and at the same time.
Seeing profit where there was none before, contends von Mises, “frustrates the entrepreneur’s calculation and diverts his actions from those lines in which they would, in the best possible way, satisfy the most urgent needs of the consumers.” In other words, those investments which looked profitable before the lowered interest rates were the exact investments which consumers were telling producers to make in order to make them, the consumers, happy. However, the reduction in interest rates skewed the view, making less valuable projects appear now more profitable.
DECEPTION TWO: Businesses believe there are more resources available for use than there actually are.
Von Mises is not great at explaining Deception Two explicitly, but here’s my theory: Interest rates, when not tinkered-with via mischief with the money supply, should act as a sort of transparent glass through which businesses can look to see how much capital (raw materials, factories, etc) is available for use in their projects. If there is plenty of unused capital around, then interest rates should reflect this by being relatively low. Businesses take advantage of the lower rates, borrow money, and engage the idle or under-used resources available. However, if raw materials, factories, and other capital-inputs are already engaged, then interest rates should be relatively high. Businesses will be less inclined to borrow, and the underlying economic infrastructure will not be strained.
However, if interest rates are lowered– not due to available capital considerations– but due to the CHEAPENING of money caused by an excessive increase in the money supply, then businesses will be TRICKED into borrowing more investment funds than the economy can put to use. The underlying economic infrastructure will be strained. This can have bad effects on businesses taking out loans, for it can drive up supply prices as resources become scarce, or it can even throw their projects behind.
Von Mises may not would have explained it exactly as I did above, but the important point he is making is that interest rates are lowered ARTIFICIALLY (in a way) by an increased money supply, and not due to real and fundamental changes in market relationships. When this occurs, says von Mises, “the market rate of interest fails to fulfill the function it plays in guiding entrepreneurial decisions.”
Via this combination of 1) seeing profits in areas where there were none before, and 2) feeling a false confidence that there are available resources for increased production…. von Mises writes that entrepreneurs will then embark upon their projects, and general business activity will be stimulated. “A boom begins.”
For von Mises, the problem with a boom caused by an increased money supply is not that too many loans are being taken out, but that they are being taken out FOR THE WRONG REASONS… “The essence of the credit-expansion boom is not overinvestment,” explains von Mises, “but investment in wrong lines.” The embarked-upon projects turn-out to be “unrealizable on account of the insufficient supply of capital goods.” The investor finds that the cost of completing his project has gone up due to unanticipated shortages in the supply stream. The shortages could grow so extreme that production is even brought to a halt.
Von Mises believes that, in spite of the apparent benefits of the boomside of the business cycle, economic conditions in the long-run are worse due to the diversion of investments into wrong areas. “Consumers would be better off if the illusions created by the easy money policy had not enticed the entrepreneurs to waste scarce capital goods by investing them for the satisfaction of less urgent needs and withholding them from lines of production in which they would have satisfied more urgent needs.” Von Mises admits that, after a boom, there will products available which would not have been available without the boom, but these will be things for which there was a less intense demand then the things forgone. And though, “the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning” in absolute terms, the same economy appears impoverished “when compared to the potentialities which existed for a still better state of satisfaction.”
A HEALTHY expansion– one not precipitated by a credit expansion– should start at the BEGINNING of the supply chain– not in the middle, at the lending office. “One must begin with increasing the production of iron, steel, copper, and other such goods,” declares von Mises. Starting in the middle causes investors to over-reach. Von Mises compares this to a master-builder who “oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not over-investment, but an inappropriate employment of the means at his disposal.”
One typical scenario for how a boom plays out would be the following:
Early in a boom, even though prices are rising, sales are not slackening– due in large part to the fact that people throughout the economy are experiencing the “illusory gains” of rising stock and real estate prices and feeling pretty good about their situation. Consumers begin to “feel lucky and become openhanded in spending and enjoying life. They embellish their homes, they build new mansions, and patronize the entertainment business.” Everyone’s making money!
Besides feeling rich, the average person in an inflationary climate has less incentive to save, since this year’s dollar will buy less if one watis to spend it until next year. This is why von Mises can say that “savings are prejudiced by inflation” and that inflationary times give birth to “extravagance.”
On the other hand, the people making REAL money during a boom, people von Mises calls “the proprietary strata of the population” will be INCREASING savings since they are receiving higher prices for their goods. “Thus,” says von Mises, “in the community as a whole there arises a tendency toward an intensified accumulation of new capital.”
But beneath the surface of the economy, the perceived prosperity is already being eaten-away-at. The negative effects are subtle. For instance, says von Mises, businesses, in setting their prices or planning for future investment needs, may not be taking into account how the induced inflation is already at work stealthily raising the replacement costs of business materials. They may also be deceived by the fact that the profit-margins they are seeing are at first deceptively high because businesses are unloading inventory purchased before the onset of inflation, but they are receiving revenue from prices jacked-up by the expanding money supply.
During the hayday of the boomtime– when people are still buying in spite of rising prices– businesses have not yet had to raise the wages they are paying their laborers. Von Mises tells us that it is common for “commodity prices rise sooner and to a stepper level than wage rates.” However, sooner or later the rising prices will either: 1) cause sales to decline, or 2) force businesses to increase wage-rates for their employees. Either outcome will take a bite out of company profits.
Besides feeling the price-pressure on the retail-end of things, business start to feel the pinch of increasing prices from their suppliers, who– as mentioned earlier– are finding themselves running thin on resources. Thus, businesses will “need additional funds as the costs of production are now higher”— meaning that they will need to go a-borrowing again. At this point, says von Mises, “if the credit expansion consists merely in a single, not repeated injection of a definite amount of fiduciary media into the loan market and then ceases all together, the boom must very soon stop.” This because the time of easy money will be drawing to a close, and interest rates will not maintain their artificially low level. Von Mises believes that the only way a boom can be prolonged is if “the credit expansion progresses at an ever-accelerated pace.”
As interest rates begin to return to correct levels, investments which were deceptively inviting during easy money times will no longer appear attractive, and investors will be drawn back to the production of the goods and services which consumers truly value more highly. Von Mises calls this the “flight into real value.”
Von Mises warns us NOT to look at interest rates when trying to determine if the business cycle has entered a contraction-phase in which the credit expansion is slowing down or reversing. Banks may have reasons (such as revised risk-assessments) for increasing rates even while the money supply is still expanding.
Von Mises asserts that when the bust arrives and prices begin to decline, consumers will not start buying more but LESS– “because they expect that prices will continue to drop.” The downward economic turn will continue until “prices and wage rates are so low that a sufficient number of people assume that they will not drop still more.” Therefore, for von Mises, “the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates”— in other words, it would be bad policy to try to fix the problem by throwing more money at it in the form of continuing monetary injections.
“There is no use in interfering by means of a new credit expansion with the process of readjustment,” states von Mises. “This would at best only interrupt, disturb, and prolong the curative process of the depression, if not bring about a new boom with all its inevitable consequences.”
“The recurrence of periods of boom which are followed by periods of depression,” summarizes von Mises, “is the unavoidable outcome of the attempts, repeated again and again, to lower the gross [loan] market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion.”
Nevertheless, governments are constantly under pressure to expand credit because the general populace does not realize the ultimate consequences of such a policy. As von Mises states, “the individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverse of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the necessary collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”
Thus, “all governments are firmly committed to the policy of low interest rates, credit expansion, and inflation.” And when the “unavoidable aftermath of these short-term policies appears, they know only of one remedy“– to return tot their inflationary policies.
Von Mises, besides being against the attempt to shorten downturns via expansionary monetary policy, is also against Keynesian attempts to alleviate the situation through what is called Counter-Cyclical Spending. This is basically another way for the government to inject funds into the economy, this time through such things as public works or increases in unemployment or welfare benefits.
Von Mises believes the injection of funds via Counter-Cyclical Spending can trigger inflation, and can also exacerbate the capital-shortage problem of an economy in decline. For von Mises, “the fundamental error” of those would intervene to ameliorate an economic downturn is the failure to realize that the most direct cause of the downturn was the shortage in capital goods which caused production costs to rise. In the eyes of such interventionists, “the depression is merely caused by a mysterious lack of the people’s propensity both to consume and to invest.” […] “They do not realize that such public works must considerably INTENSIFY the real evil, the shortage of capital goods.”
If a government, in spite of all von Mises’s warnings, still wishes to pursue an expansionist monetary policy in the ill-advised attempt to turn-around the inevitable economic recession caused by the PREVIOUS monetary expansion, it will not want to allow interest rates to climb. The problem may arise, however, that investors in the now-globalized marketplace will send their savings overseas to countries offering higher rates of return. If the government were not deadset against rising rates, the natural solution would be to allow domestic interest rates to rise, thus luring money back into domestic savings, where it can then be lent out to stimulate the economy.
Von Mises states that what a government may do in this case would be to provide investment monies by injecting money directly into the economy. It is common in America to do this by borrowing money to pay for government services… in this way, the government can still infuse the market with money via earned income of its employees and contractors, but without having to just take the money back out in the form of taxes.
Although Von Mises is not against government borrowing in certain situations, he absolutely despises the notion of debt incurred for credit expansion purposes. For one thing, the taxes required to pay the interest on the debt are just more money tossed after the money “squandered in the past.” Such taxes “are not compensated by any present service rendered by the government’s apparatus.” Von Mises is doubly against such borrowing if it involves long-term or revolving debt. He considers long-term debt a “disturbing element in the structure of a market society”– although if he goes into precisely WHY, I missed it. He seems personally affronted by the idea of a permanent government debt, declaring at one point: “What an arrogant presumption to borrow and to lend money for ever and ever!”
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