The business cycle has been attributed to many factors by many different economists, but other than the Austrian Business Cycle Theory, none have been able to pinpoint the exact causations for an economic recession (or depression). Most of the explanations attempt to lay the blame on the “inherent” instability of the free-market economy.[1] But, none of these theories have been able to explain what exactly is instable about the market. The only theory which has consistently been able to pinpoint the cause the business cycle is the Austrian theory; a theory which presents the problem as a problem of fractional-reserve banking. Although not specifically an argument against government, fractional-reserve banking has historically been an unstable business and only through legal protection of perpetrating bankers (who are theoretically committing theft and fraud[2]) has it been allowed to thrive. Furthermore, Austrian school economists, such as Murray Rothbard, have tied the increasing severity of recessions to central banking, such as the Federal Reserve.[3] Recently, prominent Austrian school economists have suggested that the boom-bust cycle is only a product of the Federal Reserve’s fiscal policy (namely, cutting interest rates by flooding the market with “cheap credit”).[4] Although, no doubt a contributing factor (as is all creation of money “out of thin air”[5]), it’s not the principal cause.
Banks practice fractional-reserve banking under the impression that the depositor will only require a certain amount of money at any given point. As a result, they hold a minimum reserve of deposits in their vaults, to satisfy the demand for money. The remainder of the money is loaned out as credit. We will avoid the legal arguments against fractional-reserve banking, except to make sure that it is understood that the legal contract between the bank and depositor maintains that the bank should have one hundred percent of a depositor’s money on demand (this is specific to demand deposits, not time deposits). Let’s say that depositor A deposits $1,000 in a bank. That bank has a reserve ratio of 10%, meaning that $100 is maintained in reserve, while the other $900 is loaned out. The bank must maintain in its books that there is $1,000 on demand deposit for Depositor A, but must also now write that it has loaned out $900 in credit. As a result, in this simple case the money supply of the bank has increased to $1,900. This is the nature of fractional-reserve banking. Jesús Huerta de Soto provides the mathematical formula for a single bank practicing fractional-reserve banking:
X = d (1 – c) / 1 + k (c – 1)
d: the money originally deposited in the bank’s vaults;
c: the cash or reserve ratio maintained by the bank;
k: the proportion of loans granted which, on average, remain unused by borrowers at any given time
x: the bank’s maximum possible credit expansion starting from d
Now, let’s look at the formula when dealing with a banking cartel, or basically a monopoly, as existent through the Federal Reserve. In this case, k=1; this is because a borrower has no other options other than maintaining as deposits all funds they are lent, or the recipients of the money are also client of the cartel (the current banking system). Therefore, the formula turns into:
X = d (1 – c) / c
Let’s say that the original deposit was $1,000,000:
X = 1,000,000 (1 – 0.1) / 0.1 = 1,000,000 × 0.9 / 0.1 = 9,000,000
It has basically multiplied the money supply by ten (9,000,000 + 1,000,000 = 10,000,000). This is, in effect, the mathematics to how the reserve ratio and the “multiplier” work. However, running the math one sees that the amount of credit created ex nihilo by a banking cartel is many times that created by a sole bank.[6]
Austrian economists believe that sustainable economic growth comes strictly through capital accumulation. That is, by saving, rather than spending. They are not suggesting that consumers stop consuming to save; they argue that the consumer be allowed to spend or save based on the consumer’s time preference. This concept simply refers to the consumer’s demand for present or future goods. This rise in aggregate savings causes a decrease in the market-set interest. It sends a message to entrepreneurs that it is now profitable to invest in production processes farther away from the consumer (this refers to goods which require longer production times, or the production of capital-goods). An increase in savings creates a disparity between rates of profit in the different stages of production.[7] Therefore, the amount of saving over a period of time signals the entrepreneur whether or not he or she should continue investing by expanding the production process horizontally[8] or vertically[9], or finish production at whatever stage the production process is at, at the time. Because of the increase in savings, there is a decrease in demand for goods. There is also a decrease in supply, because industries must now shift resources from production of present-goods to production of future-goods. At the end of the production phase, there will be an increase in supply, leading to a further decrease in the general price level of goods. This increases real wages and leads to greater wealth (in terms of capital available).[10]
To the contrary, an increase in the money supply to provide an artificial stimulus to investment and spending will only inevitably lead to a bust of similar proportions. Knowing and understanding the view on savings and economic growth, credit expansion by part of the banking sector (propelled by the cartelization provided by the Federal Reserve, or any central bank) leads to an artificial decrease in interest rates. It gives the impression to entrepreneurs that there has been an increase in savings. It’s important to realize that entrepreneurs do not necessarily know that interest rates lower due to an increase in savings. Businessmen are not economists. However, they respond to low interest rates by investing, because there is the illusion that it is profitable to invest. As a result, there is an increase in production of consumer-goods farther away from the consumer, or goods which require longer and more production stages. However, there has not been a real increase in savings. There is no demand for future-goods. This is the root of the unsustainability of booms caused by artificial credit expansion. It alters the temporal management of the free-market, and will inevitably lead to a bust, as businesses’ investments suddenly are no longer profitable. Only this can explain the cluster of errors which represents an economic bust.[11]
In the words of Ludwig von Mises:
If the market rate of interest is reduced by credit expansion, many projects which were previously deemed unprofitable get the appearance of profitability. The entrepreneur who embarks upon their execution must, however, very soon discover that his calculation was based on erroneous assumptions. He has reckoned with those prices of the factors of production which corresponded to market conditions as they were on the eve of the credit expansion. But now, as a result of credit expansion, these prices have risen. The project no longer appears so promising as before. The businessman’s funds are not sufficient for the purchase of the required factors of production. He would be forced to discontinue the pursuit of his plans if the credit expansion were not to continue. However, as the banks do not stop expanding credit and providing business with “easy money,” the entrepreneurs see no cause to worry. They borrow more and more. Prices and wage rates boom. Everybody feels happy and is convinced that now finally mankind has overcome forever the gloomy state of scarcity and reached everlasting prosperity.
In fact, all this amazing wealth is fragile, a castle built on the sands of illusion. It cannot last. There is no means to substitute banknotes and deposits for nonexisting capital goods. Lord Keynes, in a poetical mood, asserted that credit expansion has performed “the miracle… of turning a stone into bread.” But this miracle, on closer examination, appears no less questionable than the tricks of Indian fakirs.[12]
As aforementioned, the Austrian Business Cycle Theory is the only theory truly capable of explaining the exact reasons behind the business cycle. It proves that it is not an inherent instability in the market, but only the product of artificial credit expansion. Interestingly, despite the theory’s attack on other theories proposed by Keynesian, Proto-Keynesian, Neo-Keynesian, Monetarist and Neoclassical economists, none of them have been able to debunk Ludwig von Mises’ theory on the business cycle. Unfortunately, the theory is not popular, because it calls for a decrease in the role of government (and, it was Murray Rothbard who virtually founded anarcho-capitalism, using von Mises’ and Hayek’s theories). Instead, we find ourselves in an economy which is being continuously fed with artificial credit by the central bank. One could say that perhaps the future will be brighter for the Austrians, as the world will learn its lesson; unfortunately, this did not happen after the Great Depression and is unlikely to happen after this forthcoming depression.
[1] Arnold (2008), p. 114.
[2] De Soto (2009), pp. 1–165. De Soto’s first three chapters cover the definitions of different types of deposits, especially the irregular deposit (checking deposit), the legal case against fractional-reserve banking from the point of view of classical Roman law, historic cases of fractional-reserve banking and subsequent punishment and finally the failed attempts of legalizing it, and the consequent illogical arguments in attempt to defend it.
[3] Rothbard (1994), pp. 57–58:
“Central banking began in England, when the Bank of England was chartered in 1694. Other large nations have copied this institution over the next two centuries, the role of the Central Bank reaching its now familiar form with the English Peel Act of 1844. The United States was the last major nation to enjoy the dubious blessings of Central Banking, adopting the Federal Reserve System in 1913… The Central Bank has always had two major roles… (2) to cartelize the private commercial banks in the country, as to remove the two great market limits on their expansion of credit…”
The Federal Reserve was, however, not the United States’ first central bank. There was at least one previous attempt at central banking in the United States, which failed—DiLorenzo (2008), pp. 76–78.
[4] Woods (2009), p. 87. Woods’ book is, no doubt, one of the most important books published to date on the current financial crises, but unfortunately Woods does a poor job of properly explaining the Austrian theory on the business cycle.
[5] The idea of money creation “out of thin air” is even supported by “neutral”, or predominately neo-Keynesian, publications; Arnold (2008), p. 265.
[6] Huerta de Soto gives a complete coverage of the credit expansion formula in chapter four of his book, Money, Bank Credit and Economic Cycles.
[7] The production process for a higher-order good, that is one farther away from the consumer, is split through several productive stages, each representing a capital-good. For example, the construction of a car is not one long production process. There must be the production of the car parts, et cetera.
[8] Lengthen the time for each production stage.
[9] Add more stages.
[10] Huerta de Soto (2009), 317–341; although not Austrian economists, monetarists Anna Schwartz and Milton Friedman studies decreases in the general price level during the late 19th century, and proved that deflation in the price level is not synonymous with economic contraction; quite to the contrary, there was rapid economic growth, despite the lack of price inflation and money supply inflation (Friedman & Schwartz (1971), A Monetary History of the United States 1867–1960). Also see: Hülsmann (2008), Deflation and Liberty.
[11] Rothbard (2008), pp. 16–18.
[12] Von Mises (2006), p. 197.
