Human Action: A Treatise on Economics

by Ludwig VonMises

  5. The Effects of Changes in the Money Relation Upon Originary Interest

  Like every change in the market data, changes in the money relation can possibly influence the rate of originary interest. According to the inflationist view of history, inflation by and large tends to increase the earnings of the entrepreneurs. Commodity prices rise sooner and to a steeper level than wage rates. On the one hand, wage earners and salaried people, classes who spend the greater part of their income for consumption and save little, are adversely affected and must accordingly restrict their expenditures. On the other hand, the proprietary strata of the population, whose propensity to save a considerable part of their income is much greater, are favored; they do not increase their consumption in proportion, but also increase their savings. Thus in the community as a whole there arises a tendency toward an intensified accumulation of new capital. Additional investment is the corollary of the restriction of consumption imposed upon that part of the population which consumes the much greater part of the annual produce of the economic system. This forced saving lowers the rate of originary interest. It accelerates the pace of economic progress and the improvement in technological methods.

  It is important to realize that such forced saving can originate from an inflationary movement and actually often did so originate in the past. In dealing with the effects of changes in the money relation upon the height of interest rates, one must not neglect the fact that such changes can under certain circumstances really alter the rate of originary interest. But several other facts must be taken into account, too.

  First one must realize that forced saving can result from inflation, but need not necessarily. It depends on the particular data of each instance of inflation whether or not the rise in wage rates lags behind the rise in commodity prices. A tendency for real wage rates to drop is not an inescapable consequence of a decline in the monetary unit’s purchasing power. It could happen that nominal wage rates rise more than or sooner than commodity prices.4

  Furthermore, it is necessary to remember that the greater propensity of the wealthier classes to save and to accumulate capital is merely a psychological and not a praxeological fact. It could happen that these people to whom the inflationary movement conveys additional proceeds do not save and invest their boon but employ it for an increase in their consumption. It is impossible to predict with the apodictic definiteness which characterizes all theorems of economics, in what way those profiting from the inflation will act. History can tell us what happened in the past. But it cannot assert that it must happen in the future.

  It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption. One of its consequences is that it falsifies economic calculation and accounting. It produces the phenomenon of imaginary or apparent profits. If the annual depreciation quotas are determined in such a way as not to pay full regard to the fact that the replacement of worn-out equipment will require higher costs than the amount for which it was purchased in the past, they are obviously insufficient. If in selling inventories and products the whole difference between the price spent for their acquisition and the price realized in the sale is entered in the books as a surplus, the error is the same. If the rise in the prices of stocks and real estate is considered as a gain, the illusion is no less manifest. What makes people believe that inflation results in general prosperity is precisely such illusory gains. They feel lucky and become openhanded in spending and enjoying life. They embellish their homes, they build new mansions and patronize the entertainment business. In spending apparent gains, the fanciful result of false reckoning, they are consuming capital. It does not matter who these spenders are. They may be businessmen or stock jobbers. They may be wage earners whose demand for higher pay is satisfied by the easygoing employers who think that they are getting richer from day to day. They may be people supported by taxes which usually absorb a great part of the apparent gains.

  Finally, with the progress of inflation more and more people become aware of the fall in purchasing power. For those not personally engaged in business and not familiar with the conditions of the stock market, the main vehicle of saving is the accumulation of savings deposits, the purchase of bonds and life insurance. All such savings are prejudiced by inflation. Thus saving is discouraged and extravagance seems to he indicated. The ultimate reaction of the public, the “flight into real values,” is a desperate attempt to salvage some debris from the ruinous breakdown. It is, viewed from the angle of capital preservation, not a remedy, but merely a poor emergency measure. It can, at best, rescue a fraction of the saver’s funds.

  The main thesis of the champions of inflationism and expansionism is thus rather weak. It may be admitted that in the past inflation often, but not always, resulted in forced saving and an increase in capital available. However, this does not mean that it must produce the same effects in the future, too. On the contrary, one must realize that under modern conditions the forces driving toward capital consumption are more likely to prevail under inflationary conditions than those driving toward capital accumulation. At any rate, the final effect of such changes upon saving, capital, and the originary rate of interest depends upon the particular data of each instance.

  The same is valid with the necessary changes with regard to the analogous consequences and effects of a deflationist or restrictionist movement.

  6. The Gross Market Rate of Interest as Affected by Inflation and Credit Expansion

  Whatever the ultimate effects of an inflationary or deflationary movement upon the height of the rate of originary interest may be, there is no correspondence between them and the temporary alterations which a cashinduced change in the money relation can bring about in the gross market rate of interest. If the inflow of money and moneysubstitutes into the market system or the outflow from it affects the loan market first, it temporarily disarranges the congruity between the gross market rates of interest and the rate of originary interest. The market rate rises or drops on account of the decrease or increase in the amount of money offered for lending, with no correlation to changes in the originary rate of interest which in the later course of events can possibly occur from the changes in the money relation. The market rate deviates from the height determined by that of the originary rate of interest, and forces come into operation which tend to adjust it anew to the ratio which corresponds to that of originary interest. It may happen that in the period of time which this adjustment requires, the height of originary interest varies, and this change can also be caused by the inflationary or deflationary process which brought about the deviation. Then the final rate of originary interest determining the final market rate toward which the readjustment tends is not the same rate which prevailed on the eve of the disarrangement. Such an occurrence may affect the data of the process of adjustment, but it does not affect its essence.

  The phenomenon to be dealt with is this: The rate of originary interest is determined by the discount of future goods as against present goods. It is essentially independent of the supply of money and moneysubstitutes, notwithstanding the fact that changes in the supply of money and moneysubstitutes can indirectly affect its height. But the gross market rate of interest can be affected by changes in the money relation. A readjustment must take place. What is the nature of the process which brings it about?

  In this section we are concerned only with inflation and credit expansion. For the sake of simplicity we assume that the whole additional amount of money and moneysubstitutes flows into the loan market and reaches the rest of the market only via the loans granted. This corresponds precisely to the conditions of an expansion of circulation credit.5 Our scrutiny thus amounts to an analysis of the process caused by credit expansion.

  In dealing with this analysis, we must refer again to the price premium. It has been mentioned already that at the very beginning of a credit expansion no positive price premium arises. A price premium cannot appear until the additional supply of money (i
n the broader sense) has already begun to affect the prices of commodities and services. But as long as credit expansion goes on and additional quantities of fiduciary media are hurled on the loan market, there continues a pressure upon the gross market rate of interest. The gross market rate would have to rise on account of the positive price premium which, with the progress of the expansionist process, would have to rise continually. But as credit expansion goes on, the gross market rate continues to lag behind the height at which it would cover both originary interest plus the positive price premium.

  It is necessary to stress this point because it explodes the customary methods according to which people distinguish between what they consider low and high rates of interest. It is usual to take into account merely the arithmetical height of the rates or the trend which appears in their movement. Public opinion has definite ideas about a “normal” rate, something between 3 and 5 per cent. When the market rate rises above this height or when the market rates—without regard to their arithmetical ratio—are rising above their previous height, people believe that they are right in speaking of high or rising interest rates. As against these errors, it is necessary to emphasize that under the conditions of a general rise in prices (drop in the monetary unit’s purchasing power) the gross market rate of interest can be considered as unchanged with regard to conditions of a period of a by and large unchanging purchasing power only if it includes a by and large adequate positive price premium. In this sense, the German Reichsbank’s discount rate of 90 per cent was, in the fall of 192 3, a low rate—indeed a ridiculously low rate—as it considerably lagged behind the price premium and did not leave anything for the other components of the gross market rate of interest. Essentially the same phenomenon manifests itself in every instance of a prolonged credit expansion. Gross market rates of interest rise in the further course of every expansion, but they are nonetheless low as they do not correspond to the height required by the expected further general rise in prices.

  In analyzing the process of credit expansion, suppose we assume that the economic system’s process of adjustment to the market data and of movement toward the establishment of final prices and interest rates is disturbed by the appearance of a new datum, namely, an additional quantity of fiduciary media offered on the loan market. At the gross market rate which prevailed on the eve of this disturbance, all those who were ready to borrow money at this rate, due allowance being made for the entrepreneurial component of each instance, could borrow as much as they wanted. Additional loans can be placed only at a lower gross market rate. It does not matter whether this drop in the gross market rate expresses itself in an arithmetical drop in the percentage stipulated in the loan contracts. It could happen that the nominal interest rates remain unchanged and that the expansion manifests itself in the fact that at these rates loans are negotiated which would not have been made before on account of the height of the entrepreneurial component included. Such an outcome too amounts to a drop in gross market rates and brings about the same consequences.

  A drop in the gross market rate of interest affects the entrepreneur’s calculation concerning the chances of the profitability of projects considered. Along with the prices of the material factors of production, wage rates, and the anticipated future prices of the products, interest rates are items that enter into the planning businessman’s calculation. The result of this calculation shows the businessman whether or not a definite project will pay. It shows him what investments can be made under the given state of the ratio in the public’s valuation of future goods as against present goods. It brings his actions into agreement with this valuation. It prevents him from embarking upon projects the realization of which would be disapproved by the public because of the length of the waiting time they require. It forces him to employ the available stock of capital goods in such a way as to satisfy best the most urgent wants of the consumers.

  But now the drop in interest rates falsifies the businessman’s calculation. Although the amount of capital goods available did not increase, the calculation employs figures which would be utilizable only if such an increase had taken place. The result of such calculations is therefore misleading. They make some projects appear profitable and realizable which a correct calculation, based on an interest rate not manipulated by credit expansion, would have shown as unrealizable. Entrepreneurs embark upon the execution of such projects. Business activities are stimulated. A boom begins.

  The additional demand on the part of the expanding entrepreneurs tends to raise the prices of producers’ goods and wage rates. With the rise in wage rates the prices of consumers’ goods rise too. Besides, the entrepreneurs are contributing a share to the rise in the prices of consumers’ goods as they too, deluded by the illusory gains which their business accounts show, are ready to consume more. The general upswing in prices spreads optimism. If only the prices of producers’ goods had risen and those of consumers’ goods had not been affected, the entrepreneurs would have become embarrassed. They would have had doubts concerning the soundness of their plans, as the rise in costs of production would have upset their calculations. But they are reassured by the fact that the demand for consumers’ goods is intensified and makes it possible to expand sales in spite of rising prices. Thus they are confident that production will pay, notwithstanding the higher costs it involves. They are resolved to go on.

  Of course, in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher. 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 altogether, the boom must very soon stop. The entrepreneurs cannot procure the funds they need for the further conduct of their ventures. The gross market rate of interest rises because the increased demand for loans is not counterpoised by a corresponding increase in the quantity of money available for lending. Commodity prices drop because some entrepreneurs are selling inventories and others abstain from buying. The size of business activities shrinks again. The boom ends because the forces which brought it about are no longer in operation. The additional quantity of circulation credit has exhausted its operation upon prices and wage rates. Prices, wage rates, and the various individuals’ cash holdings are adjusted to the new money relation; they move toward the final state which corresponds to this money relation, without being disturbed by further injections of additional fiduciary media. The rate of originary interest which is coordinated to this new structure of the market acts with full momentum upon the gross market rate of interest. The gross market rate is no longer subject to disturbing influences exercised by cashinduced changes in the supply of money (in the broader sense).

  The main deficiency of all attempts to explain the boom—viz., the general tendency to expand production and of all prices to rise— without reference to changes in the supply of money or fiduciary media, is to be seen in the fact that they disregard this circumstance. A general rise in prices can only occur if there is either a drop in the supply of all commodities or an increase in the supply of money (in the broader sense). Let us, for the sake of argument, admit for the moment that the statements of these nonmonetary explanations of the boom and the trade cycle are correct. Prices advance and business activities expand although no increase in the supply of money has occurred. Then very soon a tendency toward a drop in prices must arise, the demand for loans must increase, the gross market rates of interest must rise, and the shortlived boom comes to an end. In fact, every nonmonetary trade-cycle doctrine tacitly assumes—or ought logically to assume—that credit expansion is an attendant phenomenon of the boom.6 It cannot help admitting that in the absence of such a credit expansion no boom could emerge and that the increase in the supply of money (in the broader sense) is a necessary condition of the general upwar
d movement of prices. Thus on close inspection the statements of the nonmonetary explanations of cyclical fluctuations shrink to the assertion that credit expansion, while an indispensable requisite of the boom, is in itself alone not sufficient to bring it about and that some further conditions are required for its appearance.

  Yet, even in this restricted sense, the teachings of the nonmonetary doctrines are vain. It is evident that every expansion of credit must bring about the boom as described above. The boom-creating tendency of credit expansion can fail to come only if another factor simultaneously counterbalances its growth. If, for instance, while the banks expand credit, it is expected that the government will completely tax away the businessmen’s “excess” profits or that it will stop the further progress of credit expansion as soon as “pump-priming” will have resulted in rising prices, no boom can develop. The entrepreneurs will abstain from expanding their ventures with the aid of the cheap credits offered by the banks because they cannot expect to increase their gains. It is necessary to mention this fact because it explains the failure of the New Deal’s pump-priming measures and other events of the ‘thirties.

  The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.