Human Action: A Treatise on Economics

by Ludwig VonMises

  Accidental institutional and psychological circumstances generally turn the outbreak of the crisis into a panic. The description of these awful events can be left to the historians. It is not the task of catallactic theory to depict in detail the calamities of panicky days and weeks and to dwell upon their sometimes grotesque aspects. Economics is not interested in what is accidental and conditioned by the individual historical circumstances of each instance. Its aim is, on the contrary, to distinguish what is essential and apodictically necessary from what is merely adventitious. It is not interested in the psychological aspects of the panic, but only in the fact that a credit-expansion boom must unavoidably lead to a process which everyday speech calls the depression. It must realize that the depression is in fact the process of readjustment, of putting production activities anew in agreement with the given state of the market data: the available supply of factors of production, the valuations of the consumers, and particularly also the state of originary interest as manifested in the public’s valuations.

  These data, however, are no longer identical with those that prevailed on the eve of the expansionist process. A good many things have changed. Forced saving and, to an even greater extent, regular voluntary saving may have provided new capital goods which were not totally squandered through malinvestment and overconsumption as induced by the boom. Changes in the wealth and income of various individuals and groups of individuals have been brought about by the unevenness inherent in every inflationary movement. Apart from any causal relation to the credit expansion, population may have changed with regard to figures and the characteristics of the individuals comprising them; technological knowledge may have advanced, demand for certain goods may have been altered. The final state to the establishment of which the market tends is no longer the same toward which it tended before the disturbances created by the credit expansion.

  Some of the investments made in the boom period appear, when appraised with the sober judgment of the readjustment period, no longer dimmed by the illusions of the upswing, as absolutely hopeless failures. They must simply be abandoned because the current means required for their further exploitation cannot be recovered in selling their products; this “circulating” capital is more urgently needed in other branches of want-satisfaction; the proof is that it can be employed in a more profitable way in other fields. Other malinvestments offer somewhat more favorable chances. It is, of course, true that one would not have embarked upon putting capital goods into them if one had correctly calculated. The inconvertible investments made on their behalf are certainly wasted. But as they are inconvertible, a fait accompli, they present further action with a new problem. If the proceeds which the sale of their products promises are expected to exceed the costs of current operation, it is profitable to carry on. Although the prices which the buying public is prepared to allow for their products are not high enough to make the whole of the inconvertible investment profitable, they are sufficient to make a fraction, however small, of the investment profitable. The rest of the investment must be considered as expenditure without any offset, as capital squandered and lost.

  If one looks at this outcome from the point of view of the consumers, the result is, of course, the same. The 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. But as things are now, they cannot but put up with what is irrevocable. They must for the time being renounce certain amenities which they could have enjoyed if the boom had not engendered malinvestment. But, on the other hand, they can find partial compensation in the fact that some enjoyments are now available to them which would have been beyond their reach if the smooth course of economic activities had not been disturbed by the orgies of the boom. It is slight compensation only, as their demand for those other things which they do not get because of inappropriate employment of capital goods is more intense than their demand for these “substitutes,” as it were. But it is the only choice left to them as conditions and data are now.

  The final outcome of the credit expansion is general impoverishment. Some people may have increased their wealth; they did not let their reasoning be obfuscated by the mass hysteria, and took advantage in time of the opportunities offered by the mobility of the individual investor. Other individuals and groups of individuals may have been favored, without any initiative of their own, by the mere time lag between the rise in the prices of the goods they sell and those they buy. But the immense majority must foot the bill for the malinvestments and the overconsumption of the boom episode.

  One must guard oneself against a misinterpretation of this term impoverishment. It does not mean impoverishment when compared with the conditions that prevailed on the eve of the credit expansion. Whether or not an impoverishment in this sense takes place depends on the particular data of each case; it cannot be predicated apodictically by catallactics. What catallactics has in mind when asserting that impoverishment is an unavoidable outgrowth of credit expansion is impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom. The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living. The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by malinvestment and overconsumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning; it appears impoverished only when compared with the potentialities which existed for a still better state of satisfaction.

  The Alleged Absence of Depressions Under Totalitarian Management

  Many socialist authors emphasize that the recurrence of economic crises and business depressions is a phenomenon inherent in the capitalist mode of production. On the other hand, a socialist system is safe against this evil.

  As has already become obvious and will be shown later again, the cyclical fluctuations of business are not an occurrence originating in the sphere of the unhampered market, but a product of government interference with business conditions designed to lower the rate of interest below the height at which the free market would have fixed it.8 At this point we have only to deal with the alleged stability as secured by socialist planning.

  It is essential to realize that what makes the economic crisis emerge is the democratic process of the market. The consumers disapprove of the employment of the factors of production as effected by the entrepreneurs. They manifest their disapprobation by their conduct in buying and abstention from buying. The entrepreneurs, misled by the illusions of the artificially lowered gross market rate of interest, have failed to invest in those lines in which the most urgent needs of the public would have been satisfied in the best possible way. As soon as the credit expansion comes to an end, these faults become manifest. The attitudes of the consumers force the businessmen to adjust their activities anew to the best possible want-satisfaction. It is this process of liquidation of the faults committed in the boom and of readjustment to the wishes of the consumers which is called the depression.

  But in a socialist economy it is only the government’s value judgments that count, and the people are deprived of any means of making their own value judgments prevail. A dictator does not bother about whether or not the masses approve of his decision concerning how much to devote for current consumption and how much for additional investment. If the dictator invests more and thus curtails the means available for current consumption, the people must eat less and hold their tongues. No crisis emerges because the subjects have no opportunity to utter their dissatisfaction. Where there is no business at all, business can be neither good nor bad. There may be starvation, and famine, but no depression in the se
nse in which this term is used in dealing with the problems of a market economy. Where the individuals are not free to choose, they cannot protest against the methods applied by those directing the course of production activities.

  It is no answer to this to object that public opinion in the capitalist countries favors the policy of cheap money. The masses are misled by the assertions of the pseudo-experts that cheap money can make them prosperous at no expense whatever. They do not realize that investment can be expanded only to the extent that more capital is accumulated by saving. They are deceived by the fairy tales of monetary cranks. Yet what counts in reality is not fairy tales, but people’s conduct. If men are not prepared to save more by cutting down their current consumption, the means for a substantial expansion of investment are lacking. These means cannot be provided by printing banknotes and by credit on the bank books.

  It is a common phenomenon that the individual in his capacity as a voter virtually contradicts his conduct on the market. Thus, for instance, he may vote for measures which will raise the price of one commodity or of all commodities, while as a buyer he wants to see these prices low. Such conflicts arise out of ignorance and error. As human nature is, they can happen. But in a social organization in which the individual is neither a voter nor a buyer, or in which voting and buying are merely a sham, they are absent.

  7. The Gross Market Rate of Interest as Affected by Deflation and Credit Contraction

  We assume that in the course of a deflationary process the whole amount by which the supply of money (in the broader sense) is reduced is taken from the loan market. Then the loan market and the gross market rate of interest are affected at the very beginning of the process, at a moment at which the prices of commodities and services are not yet altered by the change going on in the money relation. We may, for instance, posit that a government aiming at deflation floats a loan and destroys the paper money borrowed. Such a procedure has been, in the last two hundred years, adopted again and again. The idea was to raise, after a prolonged period of inflationary policy, the national monetary unit to its previous metallic parity. Of course, in most cases the deflationary projects were soon abandoned as their execution encountered increasing opposition and, moreover, heavily burdened the treasury. Or we may assume that the banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit. A third possibility would be that the crisis has resulted in the bankruptcy of banks which granted circulation credit and that the annihilation of the fiduciary media issued by these banks reduces the supply of credit on the loan market.

  In all these cases a temporary tendency toward a rise in the gross market rate of interest ensues. Projects which would have appeared profitable before appear so no longer. A tendency develops toward a fall in the prices of factors of production and later toward a fall in the prices of consumers’ goods also. Business becomes slack. The deadlock ceases only when prices and wage rates are by and large adjusted to the new money relation. Then the loan market too adapts itself to the new state of affairs, and the gross market rate of interest is no longer disarranged by a shortage of money offered for advances. Thus a cashinduced rise in the gross market rate of interest produces a temporary stagnation of business. Deflation and credit contraction no less than inflation and credit expansion are elements disarranging the smooth course of economic activities, and sources of disturbance. However, it is a blunder to look upon deflation and contraction as if they were simply counterparts of inflation and expansion.

  Expansion produces first the illusory appearance of prosperity. It is extremely popular because it seems to make the majority, even everybody, more affluent. It has an enticing quality. A special moral effort is needed to stop it. On the other hand, contraction immediately produces conditions which everybody is ready to condemn as evil. Its unpopularity is even greater than the popularity of expansion. It creates violent opposition. Very soon the political forces fighting it become irresistible.

  Fiat money inflation and cheap loans to the government convey additional funds to the treasury; deflation depletes the treasury’s vaults. Credit expansion is a boon for the banks, contraction is a forfeiture. There is a temptation in inflation and expansion and a repellent in deflation and contraction.

  But the dissimilarity between the two opposite modes of money and credit manipulation not only consists in the fact that while one of them is popular the other is universally loathed. Deflation and contraction are less likely to spread havoc than inflation and expansion not merely because they are only rarely resorted to. They are less disastrous also on account of their inherent effects. Expansion squanders scarce factors of production by malinvestment and overconsumption. If it once comes to an end, a tedious process of recovery is needed in order to wipe out the impoverishment it has left behind. But contraction produces neither malinvestment nor overconsumption. The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of the discharged wage earners and the owners of the material factors of production the sales of which drop. No protracted scars are left. When the contraction comes to an end, the process of readjustment does not need to make good for losses caused by capital consumption.

  Deflation and credit restriction never played a noticeable role in economic history. The outstanding examples were provided by Great Britain’s return, both after the wartime inflation of the Napoleonic wars and after that of the first World War, to the prewar gold parity of the sterling. In each case Parliament and Cabinet adopted the deflationist policy without having weighed the pros and cons of the two methods open for a return to the gold standard. In the second decade of the nineteenth century they could be exonerated, as at that time monetary theory had not yet clarified the problems involved. More than a hundred years later it was simply a display of inexcusable ignorance of economics as well as of monetary history.9

  Ignorance manifests itself also in the confusion of deflation and contraction and of the process of readjustment into which every expansionist boom must lead. It depends on the institutional structure of the credit system which created the boom whether or not the crisis brings about a restriction in the amount of fiduciary media. Such a restriction may occur when the crisis results in the bankruptcy of banks granting circulation credit and the falling off is not counterpoised by a corresponding expansion on the part of the remaining banks. Rut it is not necessarily an attendant phenomenon of the depression; it is beyond doubt that it has not appeared in the last eighty years in Europe and that the extent to which it occurred in the United States under the Federal Reserve Act of 1913 has been grossly exaggerated. The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises—not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict the scope of their activities. But there is no means of avoiding these secondary consequences of the preceding boom. They are inevitable.

  As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cashinduced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater c
ash holding. The causation is the other way around. Prices of the factors of production—both material and human—have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.

  Even economists often failed to comprehend this concatenation. They argued thus: The structure of prices as it developed in the boom was a product of the expansionist pressure. If the further increase in fiduciary media comes to an end, the upward movement of prices and wages must stop. But, if there were no deflation, no drop in prices and wage rates could result.

  This reasoning would be correct if the inflationary pressure had not affected the loan market before it had exhausted its direct effects upon commodity prices. Let us assume that a government of an isolated country issues additional paper money in order to pay doles to the citizens of moderate income. The rise in commodity prices thus brought about would disarrange production; it would tend to shift production from the consumers’ goods regularly bought by the nonsubsidized groups of the nation to those which the subsidized groups are demanding. If the policy of subsidizing some groups in this way is later abandoned, the prices of the goods demanded by those formerly subsidized will drop and the prices of the goods demanded by those formerly nonsubsidized will rise more sharply. But there will be no tendency of the monetary unit’s purchasing power to return to the state of the pre-inflation period. The structure of prices will be lastingly affected by the inflationary venture if the government does not withdraw from the market the additional quantity of paper money it has injected in the shape of subsidies.