The Economic Consequences of Cheap Money

Tink123 2012/09/11 13:48:00

The Economic Consequences of Cheap Money

Mises Daily:
Monday, September 10, 2012

[From a memorandum, dated April 24, 1946, prepared in English by
Professor Mises for a committee of businessmen for whom he served as a
consultant, this article appears in The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression (2006) as chapter 5, "The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money."]

The author of this paper is fully aware of its insufficiency. Yet,
there is no means of dealing with the problem of the trade cycle in a
more satisfactory way if one does not write a treatise embracing all
aspects of the capitalist market economy. The author fully agrees with
the dictum of Böhm-Bawerk: "A theory of the trade cycle, if it is not to
be mere botching, can only be written as the last chapter or the last
chapter but one of a treatise dealing with all economic problems."

It is only with these reservations that the present writer presents this rough sketch to the members of the Committee.

I. The Unpopularity of Interest

One of the characteristic features of this age of wars and
destruction is the general attack launched by all governments and
pressure groups against the rights of creditors. The first act of the
Bolshevik Government was to abolish loans and payment of interest
altogether. The most popular of the slogans that swept the Nazis into
power was Brechung der Zinsknechtschaft, abolition of
interest-slavery. The debtor countries are intent upon expropriating the
claims of foreign creditors by various devices, the most efficient of
which is foreign exchange control. Their economic nationalism aims at
brushing away an alleged return to colonialism. They pretend to wage a
new war of independence against the foreign exploiters as they venture
to call those who provided them with the capital required for the
improvement of their economic conditions. As the foremost creditor
nation today is the United States, this struggle is virtually directed
against the American people. Only the old usages of diplomatic reticence
make it advisable for the economic nationalists to name the devil they
are fighting not the Yankees, but "Wall Street."

"Wall Street" is no less the target at which the monetary authorities
of this country are directing their blows when embarking upon an
"easy-money" policy. It is generally assumed that measures designed to
lower the rate of interest, below the height at which the unhampered
market would fix it, are extremely beneficial to the immense majority at
the expense of a small minority of capitalists and hardboiled
moneylenders. It is tacitly implied that the creditors are the idle rich
while the debtors are the industrious poor. However, this belief is
atavistic and utterly misjudges contemporary conditions.

In the days of Solon, Athens's wise legislator, in the time of
ancient Rome's agrarian laws, in the Middle Ages and even for some
centuries later, one was by and large right in identifying the creditors
with the rich and the debtors with the poor. It is quite different in
our age of bonds and debentures, of savings banks, of life insurance and
social security. The proprietary classes are the owners of big plants
and farms, of common stock, of urban real estate and, as such, they are
very often debtors. The people of more modest income are bondholders,
owners of saving deposits and insurance policies and beneficiaries of
social security. As such, they are creditors. Their interests are
impaired by endeavors to lower the rate of interest and the national
currency's purchasing power.

It is true that the masses do not think of themselves as creditors
and thus sympathize with the noncreditor policies. However, this
ignorance does not alter the fact that the immense majority of the
nation are to be classified as creditors and that these people, in
approving of an "easy-money" policy, unwittingly hurt their own material
interests. It merely explodes the Marxian fable that a social class
never errs in recognizing its particular class interests and always acts
in accordance with these interests.

The modern champions of the "easy-money" policy take pride in calling
themselves unorthodox and slander their adversaries as orthodox,
old-fashioned, and reactionary. One of the most eloquent spokesmen of
what is called functional finance, Professor Abba Lerner, pretends that
in judging fiscal measures he and his friends resort to what "is known
as the method of science as opposed to scholasticism." The truth is that
Lord Keynes, Professor Alvin H. Hansen and Professor Lerner, in their
passionate denunciation of interest, are guided by the essence of
Medieval Scholasticism's economic doctrine, the disapprobation of
interest. While emphatically asserting that a return to the 19th
century's economic policies is out of the question, they are zealously
advocating a revival of the methods of the Dark Ages and of the
orthodoxy of old canons.

II. The Two Classes of Credit

There is no difference between the ultimate objectives of the
anti-interest policies of canon law and the policies recommended by
modern interest-baiting. But the methods applied are different. Medieval
orthodoxy was intent first upon prohibiting by decree interest
altogether and later upon limiting the height of interest rates by the
so-called usury laws. Modern self-styled unorthodoxy aims at lowering or
even abolishing interest by means of credit expansion.

Every serious discussion of the problem of credit expansion must
start from the distinction between two classes of credit: commodity
credit and circulation credit.

Commodity credit is the transfer of savings from the hands of the
original saver into those of the entrepreneurs who plan to use these
funds in production. The original saver has saved money by not consuming
what he could have consumed by spending it for consumption. He
transfers purchasing power to the debtor and thus enables the latter to
buy these nonconsumed commodities for use in further production. Thus
the amount of commodity credit is strictly limited by the amount of
saving, i.e., abstention from consumption. Additional credit can only be
granted to the extent that additional savings have been accumulated.
The whole process does not affect the purchasing power of the monetary

Circulation credit is credit granted out of funds especially created
for this purpose by the banks. In order to grant a loan, the bank prints
banknotes or credits the debtor on a deposit account. It is creation of
credit out of nothing. It is tantamount to the creation of fiat money,
to undisguised, manifest inflation. It increases the amount of money
substitutes, of things which are taken and spent by the public in the
same way in which they deal with money proper. It increases the buying
power of the debtors. The debtors enter the market of factors of
production with an additional demand, which would not have existed
except for the creation of such banknotes and deposits. This additional
demand brings about a general tendency toward a rise in commodity prices
and wage rates.

While the quantity of commodity credit is rigidly fixed by the amount
of capital accumulated by previous saving, the quantity of circulation
credit depends on the conduct of the bank's business. Commodity credit
cannot be expanded, but circulation credit can. Where there is no
circulation credit, a bank can only increase its lending to the extent
that the savers have entrusted it with more deposits. Where there is
circulation credit, a bank can expand its lending by what is, curiously
enough, called "being more liberal."

Credit expansion not only brings about an inextricable tendency for
commodity prices and wage rates to rise it also affects the market rate
of interest. As it represents an additional quantity of money offered
for loans, it generates a tendency for interest rates to drop below the
height they would have reached on a loan market not manipulated by
credit expansion. It owes its popularity with quacks and cranks not only
to the inflationary rise in prices and wage rates which it engenders,
but no less to its short-run effect of lowering interest rates. It is
today the main tool of policies aiming at cheap or easy money.

III. The Function of Prices, Wage Rates, and Interest Rates

The rate of interest is a market phenomenon. In the market economy it
is the structure of prices, wage rates and interest rates, as
determined by the market, that directs the activities of the
entrepreneurs toward those lines in which they satisfy the wants of the
consumers in the best possible and cheapest way. The prices of the
material factors of production, wage rates and interest rates on the one
hand and the anticipated future prices of the consumers' goods on the
other hand are the items that enter into the planning businessman's
calculations. The result of these calculations shows the businessman
whether or not a definite project will pay. If the market data
underlying his calculations are falsified by the interference of the
government, the result must be misleading. Deluded by an arithmetical
operation with illusory figures, the entrepreneurs embark upon the
realization of projects that are at variance with the most urgent
desires of consumers. The disagreement of the consumers becomes manifest
when the products of capital malinvestment reach the market and cannot
be sold at satisfactory prices. Then, there appears what is called "bad

If, on a market not hampered by government tampering with the market
data, the examination of a definite project shows its unprofitability,
it is proved that under the given state of affairs the consumers prefer
the execution of other projects. The fact that a definite business
venture is not profitable means that the consumers, in buying its
products, are not ready to reimburse entrepreneurs for the prices of the
complementary factors of production required, while on the other hand,
in buying other products, they are ready to reimburse entrepreneurs for
the prices of the same factors. Thus the sovereign consumers express
their wishes and force business to adjust its activities to the
satisfaction of those wants which they consider the most urgent. The
consumers thus bring about a tendency for profitable industries to
expand and for unprofitable ones to shrink.

It is permissible to say that what proximately prevents the execution
of certain projects is the state of prices, wage rates and interest
rates. It is a serious blunder to believe that if only these items were
lower, production activities could be expanded. What limits the size of
production is the scarcity of the factors of production. Prices, wage
rates and interest rates are only indices expressive of the degree of
this scarcity. They are pointers, as it were. Through these market
phenomena, society sends out a warning to the entrepreneurs planning a
definite project: Don't touch this factor of production; it is earmarked
for the satisfaction of another, more urgent need.

The expansionists, as the champions of inflation style themselves
today, see in the rate of interest nothing but an obstacle to the
expansion of production. If they were consistent, they would have to
look in the same way at the prices of the material factors of production
and at wage rates. A government decree cutting down wage rates to 50
percent of those on the unhampered labor market would likewise give to
certain projects, which do not appear profitable in a calculation based
on the actual market data, the appearance of profitability. There is no
more sense in the assertion that the height of interest rates prevents a
further expansion of production than in the assertion that the height
of wage rates brings about these effects. The fact that the
expansionists apply this kind of fallacious argumentation only to
interest rates and not also to the prices of primary commodities and to
the prices of labor is the proof that they are guided by emotions and
passions and not by cool reasoning. They are driven by resentment. They
envy what they believe is the rich man's take. They are unaware of the
fact that in attacking interest they are attacking the broad masses of
savers, bondholders and beneficiaries of insurance policies.

IV. The Effects of Politically Lowered Interest Rates

The expansionists are quite right in asserting that credit expansion
succeeds in bringing about booming business. They are mistaken only in
ignoring the fact that such an artificial prosperity cannot last and
must inextricably lead to a slump, a general depression.

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."[1] But this miracle, on closer examination, appears no less questionable than the tricks of Indian fakirs.

There are only two alternatives.

One, the expanding banks may stubbornly cling to their expansionist
policies and never stop providing the money business needs in order to
go on in spite of the inflationary rise in production costs. They are
intent upon satisfying the ever increasing demand for credit. The more
credit business demands, the more it gets. Prices and wage rates
sky-rocket. The quantity of banknotes and deposits increases beyond all
measure. Finally, the public becomes aware of what is happening. People
realize that there will be no end to the issue of more and more money
substitutes — that prices will consequently rise at an accelerated pace.
They comprehend that under such a state of affairs it is detrimental to
keep cash. In order to prevent being victimized by the progressing drop
in money's purchasing power, they rush to buy commodities, no matter
what their prices may be and whether or not they need them. They prefer
everything else to money. They arrange what in 1923 in Germany, when the
Reich set the classical example for the policy of endless credit
expansion, was called die Flucht in die Sachwerte, the flight
into real values. The whole currency system breaks down. Its unit's
purchasing power dwindles to zero. People resort to barter or to the use
of another type of foreign or domestic money. The crisis emerges.

The other alternative is that the banks or the monetary authorities
become aware of the dangers involved in endless credit expansion before
the common man does. They stop, of their own accord, any further
addition to the quantity of banknotes and deposits. They no longer
satisfy the business applications for additional credits. Then the panic
breaks out. Interest rates jump to an excessive level, because many
firms badly need money in order to avoid bankruptcy. Prices drop
suddenly, as distressed firms try to obtain cash by throwing inventories
on the market dirt cheap. Production activities shrink, workers are

Thus, credit expansion unavoidably results in the economic crisis. In
either of the two alternatives, the artificial boom is doomed. In the
long run, it must collapse. The short-run effect, the period of
prosperity, may last sometimes several years. While it lasts, the
authorities, the expanding banks and their public relations agencies
arrogantly defy the warnings of the economists and pride themselves on
the manifest success of their policies. But when the bitter end comes,
they wash their hands of it.

The artificial prosperity cannot last because the lowering of the
rate of interest, purely technical as it was and not corresponding to
the real state of the market data, has misled entrepreneurial
calculations. It has created the illusion that certain projects offer
the chances of profitability when, in fact, the available supply of
factors of production was not sufficient for their execution. Deluded by
false reckoning, businessmen have expanded their activities beyond the
limits drawn by the state of society's wealth. They have underrated the
degree of the scarcity of factors of production and overtaxed their
capacity to produce. In short: they have squandered scarce capital goods
by malinvestment.

The whole entrepreneurial class is, as it were, in the position of a
master builder whose task it is to construct a building out of a limited
supply of building materials. If this man overestimates the quantity of
the available supply, he drafts a plan for the execution of which the
means at his disposal are not sufficient. He overbuilds the groundwork
and the foundations and discovers only later, in the progress of the
construction, that he lacks the material needed for the completion of
the structure. This belated discovery does not create our master
builder's plight. It merely discloses errors committed in the past. It
brushes away illusions and forces him to face stark reality.

There is need to stress this point, because the public, always in
search of a scapegoat, is as a rule ready to blame the monetary
authorities and the banks for the outbreak of the crisis. They are
guilty, it is asserted, because in stopping the further expansion of
credit, they have produced a deflationary pressure on trade. Now, the
monetary authorities and the banks were certainly responsible for the
orgies of credit expansion and the resulting boom; although public
opinion, which always approves such inflationary ventures
wholeheartedly, should not forget that the fault rests not alone with
others. The crisis is not an outgrowth of the abandonment of the
expansionist policy. It is the inextricable and unavoidable aftermath of
this policy. The question is only whether one should continue
expansionism until the final collapse of the whole monetary and credit
system or whether one should stop at an earlier date. The sooner one
stops, the less grievous are the damages inflicted and the losses

Public opinion is utterly wrong in its appraisal of the phases of the
trade cycle. The artificial boom is not prosperity, but the deceptive
appearance of good business. Its illusions lead people astray and cause
malinvestment and the consumption of unreal apparent gains which amount
to virtual consumption of capital. The depression is the necessary
process of readjusting the structure of business activities to the real
state of the market data, i.e., the supply of capital goods and the
valuations of the public. The depression is thus the first step on the
return to normal conditions, the beginning of recovery and the
foundation of real prosperity based on the solid production of goods and
not on the sands of credit expansion.

Additional credit is sound in the market economy only to the extent
that it is evoked by an increase in the public's savings and the
resulting increase in the amount of commodity credit. Then, it is the
public's conduct that provides the means needed for additional
investment. If the public does not provide these means, they cannot be
conjured up by the magic of banking tricks. The rate of interest, as it
is determined on a loan market not manipulated by an "easy-money"
policy, is expressive of the people's readiness to withhold from current
consumption a part of the income really earned and to devote it to a
further expansion of business. It provides the businessman reliable
guidance in determining how far he may go in expanding investment, what
projects are in compliance with the true size of saving and capital
accumulation and what are not. The policy of artificially lowering the
rate of interest below its potential market height seduces the
entrepreneurs to embark upon certain projects of which the public does
not approve. In the market economy, each member of society has his share
in determining the amount of additional investment. There is no means
of fooling the public all of the time by tampering with the rate of
interest. Sooner or later, the public's disapproval of a policy of
over-expansion takes effect. Then the airy structure of the artificial
prosperity collapses.

Interest is not a product of the machinations of rugged exploiters.
The discount of future goods as against present goods is an eternal
category of human action and cannot be abolished by bureaucratic
measures. As long as there are people who prefer one apple available
today to two apples available in twenty-five years, there will be
interest. It does not matter whether society is organized on the basis
of private ownership of the means of production, viz., capitalism, or on
the basis of public ownership, viz., socialism or communism. For the
conduct of affairs by a totalitarian government, interest, the different
valuation of present and of future goods, plays the same role it plays
under capitalism.

Of course, in a socialist economy, the people are deprived of any
means to make their own value judgments prevail and only the
government's value judgments count. A dictator does not bother whether
or not the masses approve of his decision of 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. But in the market economy, with its economic democracy,
the consumers are supreme. Their buying or abstention from buying
creates entrepreneurial profit or loss. It is the ultimate yardstick of
business activities.

V. The Inevitable Ending

It is essential to realize that what makes the economic crisis emerge
is the public's disapproval of the expansionist ventures made possible
by the manipulation of the rate of interest. The collapse of the house
of cards is a manifestation of the democratic process of the market.

It is vain to object that the public 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 savings. They are deceived by the fairy
tales of monetary cranks from John Law down to Major C.H. Douglas. 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 or by loans on the bank

In discussing the situation as it developed under the expansionist
pressure on trade created by years of cheap interest rates policy, one
must be fully aware of the fact that the termination of this policy will
make visible the havoc it has spread. The incorrigible inflationists
will cry out against alleged deflation and will advertise again their
patent medicine, inflation, rebaptizing it re-deflation. What generates
the evils is the expansionist policy. Its termination only makes the
evils visible. This termination must at any rate come sooner or later,
and the later it comes, the more severe are the damages which the
artificial boom has caused. As things are now, after a long period of
artificially low interest rates, the question is not how to avoid the
hardships of the process of recovery altogether, but how to reduce them
to a minimum. If one does not terminate the expansionist policy in time
by a return to balanced budgets, by abstaining from government borrowing
from the commercial banks and by letting the market determine the
height of interest rates, one chooses the German way of 1923.

Ludwig von Mises was the acknowledged leader of the Austrian School of
economic thought, a prodigious originator in economic theory, and a
prolific author. Mises's writings and lectures encompassed economic
theory, history, epistemology, government, and political philosophy.

Copyright © 2012 by the Ludwig von Mises Institute. Permission to
reprint in whole or in part is hereby granted, provided full credit is

Read More: http://mises.org/daily/6081/The-Economic-Consequen...

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  • Margaret 2012/10/01 02:12:34
    With all the information here it is still lacking as was acknowledged.
    The fact that America was established as a Republic with the Federal Government in control of our money that was backed by a solid currency - gold and the government controlled interest rates.
    When the Democrats voted to establish the Federal Reserve Banks in 1913 is when our currency became controlled by private interest banks and all foreign chartered banks were required to become members. Thus establishing the Federal Reserve Note replacing the dollar. This is the system we are ruled by today that also controls interest rates. This put an entire new slant to the above.
    Banks control our financial well being and as such have cause the Great Depression and other financial hard times that we are experiencing today. Our government has little to do with control of it. When Obama asks to raise the debt he is asking approval for what the Federal Reserve has already said it wants. In other words he works for them to put us further into debt.
  • Rick James 2012/09/13 14:56:00
  • Chokmah 2012/09/12 01:59:45
    Very interesting... and very long.
  • Latti Ice Nerd Gangsta of P... 2012/09/11 22:43:36
  • Tink123 Latti I... 2012/09/11 22:56:54
    Mises will explode heads... lol The dude was a Master. Only Bastiat could surpass him. imho
  • Gracie - Proud Conservative 2012/09/11 21:39:18
    Gracie - Proud Conservative
    If only our universities would teach von Mises and Hayek. Government will always ignore the facts of non-intervention over economic engineering. I just finished another biography on Calvin Coolidge, the man who did so much for the country by keeping government out of the way.
  • Tink123 Gracie ... 2012/09/11 21:46:32
    And the progs labeled him one of the least educated president's for it. That's handy. Big fan of Coolidge here.
  • Gracie ... Tink123 2012/09/11 21:53:21
    Gracie - Proud Conservative
    Sure, they had to label him like that because he was in between the great Progressives of all time...Wilson and FDR! They think that anyone who doesn't meddle and tinker and abuse federal power is an ignorant hayseed. It's amazing what a President without a giant ego and narcissistic personality can actually do for the country.
  • Tink123 Gracie ... 2012/09/11 22:10:03
    I know one thing, the stats from his presidency were a fountain of knowledge. It's just too bad that so many before and after him learned nothing from it.

    When even Trotsky himself was forced to recognize the comeuppance of the 'working class' as a direct result of predominantly Laissez Faire policy, you'd think the progs would learn from that.
  • Gracie ... Tink123 2012/09/12 01:24:41
    Gracie - Proud Conservative
    There is a difference between understanding the truth and being able to ignore it to suit your agenda. I'm looking for a good bio on Trotsky, have you read any good ones?
  • Tink123 Gracie ... 2012/09/12 13:35:35
    "There is a difference between understanding the truth and being able to ignore it to suit your agenda."

    Yes, purposeful ignorance is indeed a favored tool of collectivists. No denying that one.

    Robert Service has a good one: "Trotsky"
  • Gracie ... Tink123 2012/09/12 21:22:12
    Gracie - Proud Conservative
    I noticed he has good ones on Stalin also. I can't get any of his on audible and that's how I can get through long books while I'm working. My sitting down and reading time is more limited. I guess I'll have to suck it up and do it.
  • Tink123 Gracie ... 2012/09/12 21:30:51
    Ahh, didn't know that. Well, Service is a fellow at the Hoover Institute (same as T. Sowell) that's why I recommended that one.
  • Gracie ... Tink123 2012/09/12 21:34:58
    Gracie - Proud Conservative
    Well, I didn't realize that he was at the Hoover, I'll definitely get his!
  • Tink123 Gracie ... 2012/09/12 21:41:01
  • Theresa 2012/09/11 15:46:32
    Makes you think!
  • mk, Smartass Oracle 2012/09/11 14:00:53
  • irish 2012/09/11 14:00:40
    excellent ,and detailed info!

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