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Apart from the Austrian School, all of today's various
schools of economic thought, regardless of their many
differences and the myriad causes that they attribute to the
cycle, agree on this vital point: the business cycle
originates somewhere deep within the bowels of the market
economy. Marx believed that periodic depressions would get
worse and worse until the masses would revolt and overthrow
capitalism. Today's political and economic mainstream, on
the other hand, believes that the state can successfully
manage the cycle's ups and downs—and when things really go
awry, the state must intervene massively and will ride
successfully to the rescue. Albeit for very different
reasons, both Marxists and mainstreamers agree that free
markets are inherently unstable.
Unfortunately for today's
mainstream, some intractable problems accompany the
assumption that the market economy triggers the business
cycle. Perhaps most notably, because economists simply do
not bother to reconcile their theories of the business cycle
and of the price mechanism, they have long been utterly
baffled by the peculiar breakdown of the entrepreneurial
function at times of economic crisis.(2)
In the market economy, one of the most vital tasks of the
businessman is to act as an "entrepreneur"—that is, a man
who buys equipment and hires labour in order to produce
something that he intends (but cannot be sure) will reap him
a return that outweighs his risk. In short, the function of
the entrepreneur is to forecast an inherently uncertain
future.
Before embarking upon any investment or line of production,
he must estimate present and future costs and present and
future revenues—and therefore how much profit he might earn.
If he forecasts significantly better than his competitors,
he will reap substantial profits. The better his forecasts,
the higher will be his profits. If, on the other hand, he
overestimates the demand for his good or service, he will
not fulfil his plans and may suffer losses. And if his
losses are sufficiently severe, he will face bankruptcy,
cease production and exit the market.
The market economy thus
contains a built-in mechanism, a kind of natural selection,
which ensures (1) the survival and prosperity of the
superior forecaster and (2) the failure and extinction of
the inferior one. This culling occurs over time. Accordingly,
at any given point in time we would expect that relatively
few businesses would be incurring losses. Hence the very odd
fact that demands explanation: how is it that, the business
world periodically and suddenly suffers a cluster of severe
losses? Why does the moment arrive when businessmen, who on
the whole had hitherto been highly astute entrepreneurs,
abruptly become dunces? Why have so many entrepreneurs,
hitherto able to forecast all manner of commercial and
technological and other developments, so rapidly and
unexpectedly dropped the ball?
Clearly, an adequate
theory of the business cycle must explain the tendency,
which has been observed time after time, of the economy to
move from boom to bust and back to boom. It must explain why
the modern world shows no sign of settling into any
reasonable facsimile of a smoothly moving approximation of
an equilibrium situation. In particular, such a theory must
account for the mammoth cluster of errors which appears
suddenly at a moment of economic crisis, and lingers through
the bust (or recession, depression, etc., according to your
preferred term) period until recovery.
Fortunately, a correct
theory of the business cycle does exist, even though
today's economists either resolutely ignore it or are
blithely ignorant of it. This is inexcusable, for this
theory is grounded deeply within—and has a long and
honourable tradition in—economic thought.
The theory owes its origins to the late-18th century
Scottish philosopher and economist David Hume and the early-19th
century English classical economist David Ricardo. Hume and
Ricardo saw what Marx did not, and what his heirs in today's
mainstream will not: namely that another crucial institution
rose to prominence alongside the factory, industrial and
capitalist system in the mid-18th century. This was the
fractional-reserve bank and its capacity to expand credit
and the supply of money (first in the form of paper money or
bank notes, and later in the form of demand deposits, a. k.
a cheque accounts, that are instantly redeemable in cash at
the bank). Hume and Ricardo understood that the operations
of these banks held the key to the mysteriously recurring
cycles of expansion and contraction, of up and down and boom
and bust, and profit and loss, that had first appeared in
and had puzzled observers since the mid-18th century.
The Humeian and Ricardian
conception and analysis of the business cycle has several
hallmarks. First, the natural moneys that emerge on the free
market are useful commodities—generally gold and silver. If
money were confined simply to these commodities, then the
economy would work in the aggregate much as it does in
unfettered markets: a smooth adjustment of supply and demand,
and therefore no cycles of boom and bust. But the injection
of bank credit adds a crucial and disruptive element. The
banks expand credit in the form of notes or deposits which
are theoretically redeemable on demand in gold, but in
practice clearly are not. Fractional reserve banks, in other
words, are inherently bankrupt (see also
Letter 102-104).
For example, if a bank
has 1000 ounces of gold in its vaults and it issues
instantly-redeemable warehouse receipts for 2500 ounces,
then it has obviously issued 1500 ounces more than it can
possibly redeem. Consequently and equally clearly, this bank
is insolvent. But so long as there is no concerted "run" on
its deposits, i.e., no sudden and massive demand to exchange
these receipts for gold, its warehouse-receipts function on
the market as an equivalent of gold, and therefore the bank
can expand (inflate) the country's money supply by 1500
ounces of gold.
Realising that the more
they expand credit the greater will be their profits, the
banks happily begin to inflate. As the supply of paper and
bank money within a country (say, England) increases, the
incomes and expenditures of Englishmen—and the prices of
English goods—rise. The result of fractional reserve banks'
inflation is a boom within the country. But this boom sows
the seeds of its own demise. For as the supply of money and
incomes in England increases, Englishmen tend to purchase
more goods from abroad. Moreover, as English prices rise,
English goods begin to lose their competitiveness vis-à-vis
the products of other countries which have not inflated, or
have been inflating to a lesser degree. Englishmen begin to
buy relatively less at home and comparatively more abroad,
while foreigners buy less in England and more at home; the
result is a deficit of the English balance of payments.
But if imports exceed
exports, then money must flow from England to foreign
countries. And what money will this be? Probably not English
banknotes or deposits, for Frenchmen or Germans or Italians
have little desire to retain their funds in Perfidious
Albion. These foreigners will therefore take their notes and
deposits and present them to the English banks for
redemption into gold. Hence gold will be the type of money
that will tend to emigrate as the English inflation proceeds.
But this means that English bank credit will be ever more
precariously pyramiding atop a dwindling base of gold in the
English bank's vaults. As the boom proceeds, our
hypothetical bank will expand its warehouse receipts issued
from, say 2500 ounces to 4000 ounces, while its gold base
dwindles to, say, 800. This bank, in other words, becomes
ever more highly leveraged.
As this process
intensifies, this bank—and other banks that do business with
it—will become frightened. Their problem is that they must
redeem their notes for gold; yet this bank's stock of gold
is dwindling. Hence the banks will eventually lose their
nerve, stop their expansion of credit and, in order to save
themselves, contract their volume of loans outstanding.
Often, this retreat is precipitated by runs on some banks (usually
but not invariably the most heavily-leveraged) by panicked
members of the public, who had also been getting
increasingly nervous about the banks' ever more shaky
condition.
This contraction of
credit reverses the economic picture: retrenchment and bust
inevitably follow inflation and boom. The banks pull in
their horns, and businesses suffer as the pressure mounts
for the repayment of debt and downward pressure upon the
prices of English goods and services mounts. As the prices
of English goods and services decrease, they become
relatively more attractive in terms of foreign products, and
the balance of payments gradually reverses itself. As gold
flows into the country, and as bank money contracts on top
of an expanding gold base, the condition of the banks
becomes sounder.(3)
Hence the vital
importance of the depression phase of the business cycle
generated by fractional-reserve banking. It is not
something to be avoided at all costs: rather, it is an
inevitable consequence of the preceding expansionary boom,
and is a necessary condition of a return to economic health.
The preceding phase of boom makes necessary the subsequent
phase of bust. During the depression, the market economy
adjusts, removes the excesses and distortions of the
previous inflationary boom and re-establishes a sound
economic base. The depression is the unpleasant but
indispensible reaction to the distortions and excesses of
the boom. It is the hangover the drunk must suffer and the
cold-turkey the addict must endure.
Why, then, does the next cycle begin? Why do business cycles
tend to recur? When fractional-reserve banks return to a
sounder condition, they can resume their fraudulent
raison d'être, namely the expansion of credit backed by
thin air rather than genuine savings. The next boom is thus
ignited, which sows the seeds for the next bust.
But if fractional-reserve
banking causes the business cycle, and if banks are a
legitimate part of a free market economy, can't we still say
that the free market is the culprit? No. If not for the
intervention and encouragement—indeed, the protective
legislation—of government, the fractional reserve banks
within a country would never be able to expand credit in
concert. For if banks were truly competitive, any expansion
of credit by one bank would quickly accumulate on the
balance sheets of its competitors, and these competitors
would promptly call upon the expanding bank for redemption
of this credit into gold. In short, a bank's rivals will
call upon it to redeem in gold in the same way as do
foreigners, except that the process is much faster and would
nip any incipient inflation in the bud before it proceeded
very far.(4)
In short, the fractional-reserve
banks within a country can only inflate in unison when a
central bank exists to cover their backs. Such a bank
typically decrees the terms and conditions of the fiat
currency, enjoys a monopoly of government business and also
exercises a privileged position (imposed by government) over
the entire banking system. It is only when central banks
became established in major countries, and connived with
fractional-reserve banks to inflate the money supply, that
the banks were able to inflate for any length of time and
the business cycle established itself.
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