Mises’ Early Austrian Business Cycle Theory

I am referring to the versions in Mises’ The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]), pp. 349–366 and his “Monetary Stabilization and Cyclical Policy” (1928). It is unclear to me if there is a similar version in the original German edition the Theorie des Geldes und der Umlaufsmittel (Munich and Leipzig, 1912) or the 2nd German edition published in 1924.

In fact, there are somewhat different early versions of the ABCT published by both Mises and Hayek, as follows:

(1) The version in Mises’ original, German first edition the Theorie des Geldes und der Umlaufsmittel (Munich and Leipzig, 1912), and the 2nd German edition published in 1924. Then in the English translation The Theory of Money and Credit (1934; trans. H. E. Batson from 2nd German edition of 1924), J. Cape, London.

And later in the 1953 version: The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]), pp. 349–366.

(2) Mises’ version in his essay “Monetary Stabilization and Cyclical Policy” (1928), available in Mises 2006 [1978], The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (Ludwig von Mises Institute, Auburn, Ala.), p. 99ff.

(3) Mises’ version in Human Action: A Treatise on Economics (Yale University Press, New Haven, CT., 1949).

(4) Hayek’s first version of ABCT in the first edition of Prices and Production (London, 1931), which was revised somewhat in the second edition Prices and Production (2nd edn.; 1935), Routledge and Kegan Paul.

(5) Hayek’s second version of ABCT in Profits, Interest and Investment (London, 1939).

Though I will make some critical remarks here and there, I am not concerned so much with criticising the theory here, but merely reviewing it out of interest.

In brief, according to Mises, when banks issue new fiduciary media in the form of credit, this tends to lower the bank rate of interest (Mises 2009 [1953]: 352).

Mises’ monetary and interest rate theory is taken over from Wicksell, though Mises did not entirely agree with Wicksell on every point (Mises 2009 [1953]: 355).

As Mises says,

“Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about. Up to this point Wicksell commands assent; but his further argument provokes contradiction.

According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upwards or downwards. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur ‘which would naturally cause the banks sooner or later to raise their rates of interest.’ Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest.” (Mises 2009 [1953]: 355).

It is quite clear that Mises’ ABCT is founded on Wicksellian loanable funds theory and the unique natural rate of interest. The fact that the unique Wicksellian natural rate cannot be defined outside a one commodity world, and therefore the Wicksellian loanable funds theory underlying Mises’ ABCT is untenable, is sufficient to refute the theory (Rogers 1989: 22) on its own, but let us move on.

Mises, however, departs from Wicksell, and Mises thinks that the banks can extend their issues of fiduciary media to a very great degree:

“Assuming uniformity of procedure, the credit-issuing banks are able to extend their issues indefinitely. It is within their power to stimulate the demand for capital by reducing the rate of interest on loans, and, except for the limits mentioned above, to go so far in this as the cost of granting the loans permits. In doing this they force their competitors in the loan market, that is all those who do not lend fiduciary media which they have created themselves, to make a corresponding reduction in the rate of interest also. Thus the rate of interest on loans may at first be reduced by the credit issuing banks almost to zero. This, of course, is true only under the assumption that the fiduciary media enjoy the confidence of the public so that if any requests are made to the banks for liquidation of the promise of prompt cash redemption which constitutes the nature of fiduciary media, it is not because the holders have any doubts as to their soundness. Assuming this, the only possible reason for the withdrawal of deposits or the presentation of notes for redemption is the existence of a demand for money for making payments to persons who do not belong to the circle of customers of the individual banks. The banks need not necessarily meet such demands by paying out money; the fiduciary media of those banks among whose customers are those persons to whom the banks’ own customers wish to make payments are equally serviceable in this case. Thus there ceases to be any necessity for the banks to hold a redemption fund consisting of money; its place may be taken by a reserve fund consisting of the fiduciary media of other banks. If we imagine the whole credit system of the world concentrated in a single bank, it will follow that there is no longer any presentation of notes or withdrawal of deposits; in fact, the whole demand for money in the narrower sense may disappear. These suppositions are not at all arbitrary. It has already been shown that the circulation of fiduciary media is possible only on the assumption that the issuing bodies enjoy the full confidence of the public, since even the dawning of mistrust would immediately lead to a collapse of the house of cards that comprises the credit circulation. We know, furthermore, that all credit-issuing banks endeavour to extend their circulation of fiduciary media as much as possible, and that the only obstacles in their way nowadays are legal prescriptions and business customs concerning the covering of notes and deposits, not any resistance on the part of the public. If there were no artificial restriction of the credit system at all, and if the individual credit-issuing banks could agree to parallel procedure, then the complete cessation of the use of money would only be a question of time. It is, therefore, entirely justifiable to base our discussion on the above assumption.

Now, if this assumption holds good, and if we disregard the limit that has already been mentioned as applying to the case of metallic money, then there is no longer any limit, practically speaking, to the issue of fiduciary media; the rate of interest on loans and the level of the objective exchange-value of money is then limited only by the banks’ running costs – a minimum, incidentally, which is extraordinarily low. By making easier the conditions on which they will grant credit, the banks can extend their issue of fiduciary media almost indefinitely. Their doing so must be accompanied by a fall in the objective exchange-value of money.” (Mises 2009 [1953]: 357–359).

For Mises, then, the banks can “extend their issue of fiduciary media almost indefinitely” and induce a corresponding inflation.

Mises next turns to the question of what happens when the bank rate is pushed below Wicksell’s unique natural rate, and what forces the two rates to equilibrate again (Mises 2009 [1953]: 359–360).

The key for Mises is longer processes of production:

“Now if the rate of interest on loans is artificially reduced below the natural rate as established by the free play of the forces operating in the market, then entrepreneurs are enabled and obliged to enter upon longer processes of production. It is true that longer roundabout processes of production may yield an absolutely greater return than shorter processes; but the return from them is relatively smaller, since although continual lengthening of the capitalistic process of production does lead to continually increasing returns, after a certain point is reached the increments themselves are of decreasing amount. Thus it is possible to enter upon a longer roundabout process of production only if this smaller additional productivity will still pay the entrepreneur. So long as the rate of interest on loans coincides with the natural rate, it will not pay him; to enter upon a longer period of production would involve a loss. On the other hand, a reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. It is true that fresh capital can be employed in production only if new roundabout processes are started. But every new roundabout process of production that is started must be more roundabout than those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout' processes of production, because they yield the greatest returns. It is only when all the short roundabout processes of production have been appropriated that capital is employed in the longer ones.” (Mises 2009 [1953]: 360–361).

Mises further explains the process:

“The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.

That is one of the ways in which the equilibrium of the loan market is re-established after it has been disturbed by the intervention of the banks. The increased productive activity that sets in when the banks start the policy of granting loans at less than the natural rate of interest at first causes the prices of production goods to rise while the prices of consumption goods, although they rise also, do so only in a moderate degree, viz., only in so far as they are raised by the rise in wages. Thus the tendency towards a fall in the rate of interest on loans that originates in the policy of the banks is at first strengthened. But soon a counter-movement sets in: the prices of consumption goods rise, those of production goods fall. That is, the rate of interest on loans rises again, it again approaches the natural rate.” (Mises 2009 [1953]: 362–363).

So the boom leads to accelerating inflation, and in fact the theory seems to predict serious or severe inflation that causes a panic that in turn leads to the bust, as Mises says in his essay “Monetary Stabilization and Cyclical Policy” (1928):

“If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?

They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged ‘flood’ of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.

Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to ‘real values,’ foreign money, the precious metals, and barter.” (Mises 2006 [1978]: 114).

Yet most business cycles do not proceed in this manner: if we look at recessions in the post-1945 era, the breakdown of the boom is not characterised by crises in inflation that set off panic. While inflation rates might well rise in the boom, nevertheless they do not rise to the levels that Mises’ theory seems to predict.

According to Mises, the bust is driven by liquidation of capital projects that are unsustainable:

“Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.” (Mises 2006 [1978]: 115).

However, as we have seen it is the inventory cycle that drives a good many recessions, which is to say, excessive accumulation of stock led to cuts in production and investment (basically, for many companies, changes in capacity utilisation) to liquidate inventories, and that in turn induces recessions. This process is a major cause of recessions, and is what drives the fall in investment, not liquidation of new, allegedly unsustainable projects.

Further Reading
“Daniel Kuehn on the Austrian Business Cycle Theory,” December 5, 2013.

“John Hicks on Hayek’s Business Cycle Theory,” July 18, 2014.

“A Candid Admission from Hayek?,” Sunday, July 20, 2014.

External Links
David Glasner, “Hayek on the Unsustainability of Inflation-Fed Booms,” Uneasy Money, August 30, 2012.

David Glasner, “Two Problems with Austrian Business-Cycle Theory,” Uneasy Money, October 3, 2012.

Robert Murphy, “David Glasner Needs to Re-Read Mises,” Free Advice, 9 October, 2012.

David Glasner, “On the Unsustainability of Austrian Business-Cycle Theory, Or How I Discovered that Ludwig von Mises Actually Rejected His Own Theory,” Uneasy Money, October 10, 2012.

Philip Pilkington, “Tyler Cowen and Daniel Kuehn Miss the Point of the Austrian Business Cycle Theory,” Fixing the Economists, December 6, 2013.

BIBLIOGRAPHY
Hayek, F. A. von, 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Hayek, F. A. von, 1939. Profits, Interest and Investment. Routledge and Kegan Paul, London

Mises, L. von. 1912. Theorie des Geldes und der Umlaufsmittel. Duncker & Humblot, Munich and Leipzig.

Mises, L. von. 1924. Theorie des Geldes und der Umlaufsmittel (2nd edn). Duncker & Humblot, Munich.

Mises, L. von. 1934. The Theory of Money and Credit (trans. H. E. Batson from 2nd German edition of 1924). J. Cape, London.

Mises, L. von. 1949. Human Action. A Treatise on Economics. Yale University Press, New Haven, CT.

Mises, L. von. 1953. The Theory of Money and Credit (enlarged, new edn). Yale University Press, New Haven.

Mises, L. von. 2009 [1953]. The Theory of Money and Credit (enlarged, new edn). Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson). Mises Institute, Auburn, Ala.