Austrian Business Cycle Theory, by Jesús Huerta de Soto

Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, Second Edition.

Chapter 5 : Bank Credit Expansion and Its Effects on the Economic System

The term first-order economic goods has traditionally referred to those consumer goods which, in the specific, subjective context of each action, constitute the goal pursued by the actor in performing the action.

The achievement of these goals, consumer goods, or first-order economic goods, is necessarily preceded by a series of intermediate stages represented by “higher-order economic goods” (second, third, fourth, etc.). The higher the order of each stage, the further the good is from the final consumer good.

This picture might help in better understanding the concept. On the left we have the early stages of production, or stages furthest from consumption. On the right we have the final stages of production, or stages closest to consumption.

Capital and Capital Goods

We may use the term capital goods to designate the intermediate stages of each action process, subjectively regarded as such by the actor. Or to put it another way, each of the intermediate stages in an actor’s production process is a capital good. […]

Moreover capital goods arise from the union of three essential elements: natural resources, labor and time, all of which are combined in entrepreneurial action conceived and processed by human beings. The sine qua non for producing capital goods is saving, or the relinquishment or postponement of immediate consumption. […]

To illustrate this important concept, we will use the example given by Böhm-Bawerk to explain the process of saving and investment in capital goods carried out by an individual actor in an isolated situation, such as Robinson Crusoe on his island.

Let us suppose that Robinson Crusoe has just arrived on his island and spends his time picking berries by hand, his only means of subsistence. Each day he devotes all of his efforts to gathering berries, and he picks enough to survive and can even eat a few extra daily. After several weeks on this diet, Robinson Crusoe makes the entrepreneurial discovery that with a wooden stick several meters long, he could reach higher and further, strike the bushes with force and gather the necessary berries much quicker.

The only problem is that he estimates it could take him five whole days to find a suitable tree from which to take the stick and then to prepare it by pulling off its branches, leaves, and imperfections. During this time he will be compelled to interrupt his berry picking. If he wants to produce the stick, he will have to reduce his consumption of berries for a time and store the remainder in a basket until he has enough to survive for five days, the predicted duration of the production process of the wooden stick. After planning his action, Robinson Crusoe decides to undertake it, and therefore he must first save a portion of the berries he picks by hand each day, reducing his consumption by that amount. This clearly means he must make an inevitable sacrifice, which he nevertheless deems well worth his effort in relation to the goal he longs to achieve.

So he decides to reduce his consumption (in other words, to save) for several weeks while storing his leftover berries in a basket until he has accumulated an amount he believes will be sufficient to sustain him while he produces the stick.  […]

Once Robinson Crusoe has saved enough berries, he spends five days searching for a branch from which to make his wooden stick, separating it from the tree and perfecting it. … at the end of five days he will have the stick (a capital good), which represents an intermediate stage removed in time (by five days of saving) from the immediate processes of the berry production (by hand) which up to that point had occupied him. With the finished stick Robinson Crusoe can reach places inaccessible to him by hand and strike the bushes with force, multiplying his production of berries by ten.

[…] there is also no doubt that the process of berry production using the stick is a more lengthy one in terms of time (it includes more stages) than the production process of berry picking by hand. Production processes tend to increase in length and duration (i.e., to become more complex and include more stages) as a result of the saving and entrepreneurial activity of humans; and the longer and more time-consuming these processes become, the more productive they tend to be. […]

Unlike in the example of Robinson Crusoe, production processes in a modern economy are extremely complex, and in terms of time, very lengthy. They incorporate a multitude of stages, all of which are interrelated and divide into numerous secondary processes that humans employ in the innumerable action projects they constantly launch.

For instance the process of producing a car consists of hundreds or even thousands of productive stages requiring a very prolonged period of time (even several years) from the moment the car company begins to design the vehicle (the stage furthest from final consumption), orders the corresponding materials from its suppliers, runs these materials through the different assembly lines, orders the different parts for the motor and all accessories, etc., until it arrives at the stages closest to consumption, such as transport and distribution to dealers, the development of advertising campaigns and the presentation and sale of the car to the public. […]

At all times each of the stages coexists with the others and therefore some people spend their time designing vehicles (the cars which will be available to the public in ten years), while others simultaneously order materials from suppliers, others work on assembly lines, and others devote their efforts to the commercial field (very close to final consumption), promoting the sale of vehicles that have already been produced. […]

In other words, wear on capital equipment is not only physical, but technological and economic as well (obsolescence).

[…] entrepreneurs must repair existing capital goods; and, even more importantly, they must constantly produce new capital goods to replace the old ones they are in the process of consuming. … A certain minimum level of saving is essential in order to compensate for depreciation by producing the capital goods necessary to replace ones that have worn out or depreciated. […]

As a general rule capital goods are difficult to convert, and the closer they are to the final stage of consumption, the more difficult is their convertibility. […]

While capital goods are difficult to convert, investors manage to provide them with considerable “mobility” through the juridical institutions of property and contract law, which regulate the different forms of transferring such goods. Thus the (extremely complex and prolonged) productive structure permits the constant mobility of investors, through the exchange and sale of capital goods in the market.

The Interest Rate

We will use the term “interest rate” to denote the market price of present goods in relation to future goods. […]

Indeed the market of present and future goods, in which the interest rate is determined, consists of society’s entire structure of productive stages, in which savers or capitalists give up immediate consumption and offer present goods to owners of the primary or original factors of production (workers and owners of natural resources) and to owners of capital goods, in exchange for the full ownership of consumer (and capital) goods of a supposedly higher value once the production of these goods has been completed in the future. If we eliminate the positive (or negative) effect of pure entrepreneurial profits (or losses), this difference in value tends to coincide with the interest rate. […]

Here owners of the original means of production (labor and natural resources) and capital goods act as demanders of present goods, and savers act as suppliers of them. […]

In fact it is entirely possible to conceive of a society in which no loan market exists, and all economic agents invest their savings in production directly (via internal financing and retained earnings through partnerships, corporations, and cooperatives). Although in this case no interest rate would be established in a (nonexistent) loan market, an interest rate would still be determined by the ratio at which present goods are exchanged for future goods in the different intermediate stages in production processes. […]

Thus the more plentiful the savings, i.e., the greater the quantity of present goods sold or offered for sale, other things being equal, the lower their price in terms of future goods; and consequently, the lower the market rate of interest. This indicates to entrepreneurs that more present goods are available, which enables them to increase the length and complexity of the stages in their production processes, making these stages more productive. […]

In short the interest rate conveys to entrepreneurs which new productive stages or investment projects they can and should embark on and which they should not, in order to keep coordinated, as much as humanly possible, the behavior of savers, consumers, and investors, and to prevent the different productive stages from remaining unnecessarily short or becoming too long. […]

Indeed if the interest rate one can obtain by advancing present goods in some stages (for example, those closest to consumption) is higher than that one can obtain in other stages (for example, those furthest from consumption), then the entrepreneurial force itself, driven by a desire for profit, will lead people to disinvest in stages in which the interest rate or “rate of profit” is lower, relatively speaking, and to invest in stages in which the expected interest rate or “rate of profit” is higher.

The Structure of Production

Indeed if we begin at the first stage in our example, consumers spend 100 m.u. on consumer goods, and this money becomes the property of the capitalists who own the consumer goods industries. One year earlier, these capitalists had advanced from their savings 80 m.u. corresponding to the services of fixed capital goods and to circulating capital goods produced by other capitalists in the second stage of the production process.
The first capitalists also pay 10 m.u. to the owners of the original means of production (labor and natural resources) which they hire directly in the last stage, corresponding to the production of consumer goods (this payment to the owners of the original means of production is represented on our chart by the vertical arrow that begins to the right of the last step [100 m.u.] and extends to the upper right-hand box containing 10 m.u.).

Since the capitalists of the consumer goods stage advanced eighty m.u. to the owners of the capital goods of the second stage, and ten m.u. to workers and owners of natural resources (a total of 90 m.u.), at the end of one year when these capitalists sell the consumer goods for 100 units, they obtain an accounting profit or interest derived from having advanced 90 m.u. from savings a year earlier. This difference between the total amount they advanced, 90 m.u. (which they could have consumed, yet they saved and invested it), and the amount they receive at the end of a year, 100 m.u., is equal to an interest rate of approximately 11 percent per year (10:90 = 0.11). […]

We can follow the same reasoning with respect to the rest of the stages. Hence for example, the capitalists who own the intermediate goods of the third stage advanced at the beginning of the period 40 m.u. in payment for capital goods produced in the fourth stage, as well as 14 m.u. to owners of the original means of production (labor and natural resources). In exchange for the 54 m.u. they have advanced, the capitalists become owners of the product which, once it is finished, they sell to capitalists of the second stage for 60 m.u., earning a differential of six m.u., which is their accounting profit or interest; it is also close to 11 percent.

Some Additional Considerations

Ludwig von Mises very clearly states that …

The length of time expended in the past for the production of capital goods available today does not count at all. These capital goods are valued only with regard to their usefulness for future satisfaction. The “average period of production” is an empty concept. (Mises, Human Action, p. 489)

[…] Furthermore it has been demonstrated that as the economy evolves and prospers, these stocks [of intermediate goods] become more important because they enable different businesses to minimize the ever-latent risk of unexpected shortages or “bottlenecks” which prolong delivery periods. … Hence one manifestation of the lengthening of production processes is precisely a continual increase in inventories or stocks of intermediate goods.

[…] durable consumer goods satisfy human needs over a very prolonged period of time. Therefore they simultaneously form a part of several stages at once: the final stage of consumption and various preceding stages, according to their duration. […] The years the owner spends caring for and maintaining his durable consumer good so that it will continue to perform consumer services for him in the future correspond to the stages which appear above and are increasingly distant from consumption: stage two, three, four, etc. Thus one of the manifestations of the lengthening of production processes and of the increase in their number of stages consists precisely of the production of a larger number of durable consumer goods of increasing quality and durability.

[…] In the market there exists a trend (driven by the force of entrepreneurship) toward the equalization of the “rate of profit” in all economic activities. This occurs not only horizontally, within each production stage, but also vertically, between stages. Indeed when there are disparities in profits, businessmen will devote their effort, creative capacity and investment to those activities which generate relatively higher profits, and they will stop devoting these things to activities which yield lower profits. […]

Indeed capital goods “flow downward,” i.e., from the stages furthest from consumption to the stages closest to it, and money “flows” in the opposite direction. In other words, m.u. are first used to pay for final consumer goods, and from that point they gradually move up the scale of productive stages until they reach those stages furthest from consumption.

Criticism of the Measures used in National Income Accounting

For example, the traditional definition of “gross national product” (GNP) contains the word “gross,” yet in no way reflects the true gross income spent during the year on the entire productive structure.

[37] For instance as Ramón Tamames indicates, the gross national product at market prices …

“can be defined as the sum of the value of all the final goods and services produced in a nation in one year. I speak of final goods and services because intermediate ones are excluded to avoid the double computation of any value.”

Indeed GNP incorporates the value of the sales of fixed or durable capital goods, such as real estate, industrial vehicles, machinery, tools, computers, etc., which are finished and sold to their final users during the year, and thus are considered final goods. However it in no way includes the value of circulating capital goods, intermediate non-durable products, nor of capital goods which are not yet finished or if so, pass from one stage to another during the process of production. These intermediate goods are obviously different from the similar ones included in final goods (for instance, the carburator produced as an intermediate product is not the same carburator included in the car sold as a final product.) In contrast, our gross output figure from Table V-2 incorporates the gross production of all capital goods, whether completed or not, fixed, durable or circulating, as well as all consumer goods and services produced during the financial year.

[…] To get an idea of the amounts involved, it suffices to consider that the gross output (calculated according to our criterion) of an advanced country like the United States is equal to more than twice the country’s official GNP. [38]

[38]. Skousen, in his book, The Structure of Production, pp. 191–92, proposes the introduction of “gross national output,” a new measure in national income accounting. With respect to the possible gross national output of the United States, Skousen concludes the following:

First, Gross National Output (GNO) was nearly double [Gross National Product] (GNP), thus indicating the degree to which GNP underestimates total spending in the economy. Second, consumption represents only 34 percent of total national output, far less than what GNP figures suggest (66 percent). Third, business outlays, including intermediate inputs and gross private investment, is the largest sector of the economy, 56 percent larger than the consumer-goods industry. GNP figures suggest that the capital-goods industry represents a minuscule 14 percent of the economy.

2) The Effect on the Productive Structure of an Increase in Credit Financed Under a Prior Increase in Voluntary Saving

The Issue of Consumer Loans

It could be argued that sometimes loans are not granted to entrepreneurs of productive stages, to enable them to lengthen their production processes through investment, but are instead granted to consumers who purchase final goods. […] It is only possible to conceive of a consumer loan in the credit market, which as we know plays a subsidiary role and is secondary to the total market where present goods are offered and purchased in exchange for future goods. Second, in most cases consumer loans are granted to finance the purchase of durable consumer goods, which as we saw in previous sections, are ultimately comparable to capital goods maintained over a number of consecutive stages of production, while the durable consumer good’s capacity to provide services to its owner lasts.

The Effects of Voluntary Saving on the Productive Structure

First: The Effect Produced by the New Disparity in Profits Between the Different Productive Stages

Chart V-2 shows that before the increase in saving, 100 m.u. of net income were spent on final consumer goods produced by companies which first incurred expenses totaling 90 m.u. Of this amount, 80 m.u. corresponded to the purchase of capital goods from the stage immediately preceding, and 10 m.u. were paid for original means of production hired or purchased in the last stage (labor and natural resources). […]

Immediately following the rise in saving, we see that the monetary demand for final consumer goods decreases from 100 to 75 m.u. in each time period. … On the contrary, in their account books these companies record unchanged expenditures of 90 m.u. Just as in the previous case, 80 m.u. of this amount is spent on capital goods from the preceding stage (machinery, suppliers, intermediate products, etc.) and 10 m.u. are paid to the owners of the original means of production (workers and the owners of natural resources).

As a result of this increase in saving, companies devoted to the final stage (consumption) suffer an accounting loss of 15 m.u. … Therefore we could conclude that all increases in saving cause considerable relative losses to … the companies which operate closest to final consumption.

… accounting losses occur in the final stage does not immediately affect the stages prior to consumption …

Instead, accounting losses take effect after a long period of time, and decrease (or cancel) as we “climb” to productive stages furthest from consumption. As a result, entrepreneurs disinvest in stages of production closest to consumption (less profitable) for the benefit of stages furthest from consumption (more profitable).

In the consumer goods sector an accounting loss follows from the upsurge in saving, while the industries of the fifth stage, which are further from consumption […] continue to enjoy profits roughly equal to 11 percent of the capital invested […]

Indeed entrepreneurs from the fifth stage increase their investment in original factors and productive resources from 18 m.u. to 31.71 m.u., a figure nearly double their initial outlay.

Although the narrowing of the stages of production close to consumption is followed by a reduction in the supply of consumer goods, prices do not rise precisely because of the reduced demand for consumer goods due to the rise in savings.

Moreover the increase one might expect to observe in the prices of the factors of production (capital goods, labor and natural resources) as a result of the greater demand for them in the fifth stage does not necessarily occur (with the possible exception of very specific means of production). In fact each increase in the demand for productive resources in the stages furthest from consumption is mostly or even completely neutralized or offset by a parallel increase in the supply of these inputs which takes place as they are gradually freed from the stages closest to consumption, where entrepreneurs are incurring considerable accounting losses and are consequently obliged to restrict their investment expenditure on these factors.

Second: The Effect of the Decrease in the Interest Rate on the Market Price of Capital Goods

Capital goods already in use will undergo a significant rise in price as a result of the drop in the interest rate and will be produced in greater quantities, bringing about a horizontal widening of the capital goods structure (that is, an increase in the production of pre-existing capital goods). […] Hence the second effect of a decrease in the interest rate caused by an increase in voluntary saving is the deepening of the investment goods structure, in the form of a vertical lengthening involving new stages of capital goods increasingly distant from consumption. […]

Fluctuations in the value of capital goods, which arise from variations in saving and the interest rate, also tend to spread to the securities which represent these goods, and thus to the stock markets where they are traded.

In other words, an increase in savings, through lower interest rates will boost stock prices among companies operating in stages producing capital goods, and generally, the price of all financial securities representing such capital goods. The further these goods are from final consumption, the higher the market prices of the correspondent financial securities will be. This explains why the price of equities of companies operating in stages close to consumption will decline temporarily.

Only securities which represent the property of the companies closest to consumption will undergo a temporary, relative decline in price, as a result of the immediate, negative impact of the decrease in the demand for consumer goods that is generated by the upsurge in saving. Therefore it is clear that, contrary to popular opinion […] the stock market does not necessarily reflect mainly companies’ profits. In fact, in relative terms with the capital invested, the accounting profits earned by the companies of the different stages tend to match the interest rate. Thus an environment of high saving and low relative profits (i.e., with a low interest rate) constitutes the setting for the greatest growth in the market value of securities representing capital goods.

Third: The Ricardo Effect

As one might expect, changing the production structure alters relative wages. The (shrinking) stages close to consumption saw their wages decline, while (expanding) stages further from consumption saw their wages increase.

If, as generally occurs, the wages or rents of the original factor labor are initially held constant in nominal terms, a decline in the prices of final consumer goods will be followed by a rise in the real wages of workers employed in all stages of the productive structure. With the same money income in nominal terms, workers will be able to acquire a greater quantity and quality of final consumer goods and services at consumer goods’ new, more reduced prices.

This increase in real wages, which arises from the growth in voluntary saving, means that, relatively speaking, it is in the interest of entrepreneurs of all stages in the production process to replace labor with capital goods. […] This constitutes a third powerful, additional effect tending toward the lengthening of the stages in the productive structure.

… Ricardo concludes that …

“every rise of wages, therefore, or, which is the same thing, every fall of profits, would lower the relative value of those commodities which were produced with a capital of a durable nature, and would proportionally elevate those which were produced with capital more perishable. A fall of wages would have precisely the contrary effect.”

… Hayek offers a very concise explanation of the “Ricardo Effect” when he states that …

“with high real wages and a low rate of profit investment will take highly capitalistic forms: entrepreneurs will try to meet the high costs of labour by introducing very labour-saving machinery — the kind of machinery which it will be profitable to use only at a very low rate of profit and interest.”

[…] Furthermore the consumer goods and services left unsold as a result of the rise in voluntary saving play a role remarkably similar to that of the accumulated berries in our Robinson Crusoe example … [and] … fulfill the important function of making it possible for the different economic agents (workers, owners of natural resources and capitalists) to sustain themselves during the time periods that follow.

Conclusion: The Emergence of a New, More Capital-Intensive Productive Structure

Chart V-3 reveals that final consumption has fallen to 75 m.u. This reduction has also affected the value of the product of the second stage (the previous stage closest to consumption), which has dropped from 80 m.u. in Chart V-1 to 64.25 m.u. in Chart V-3. A similar decrease occurs in the third stage (from 60 m.u. to 53.5 m.u.), though this time the reduction is proportionally smaller. However beginning in the fourth stage (and upward, each stage further from consumption than the one before it), the demand in monetary terms grows.
The increase is gradual at first […] in the fifth stage, where the value of the product grows from 20 m.u. to 32.25 m.u., as we saw in Chart V-2. Furthermore two new stages, stages six and seven, appear in the area furthest from consumption. […]

The net income received by the owners of the original means of production (workers and owners of natural resources) and by the capitalists of each stage, according to the net interest rate or differential, amounts to 75 m.u., which coincides with the monetary income spent on consumer goods and services.

Tables V-3 […] We see that the supply of and demand for present goods rests at 295 m.u., i.e., 25 m.u. more than in Table V-1. This is because gross saving and investment have grown by precisely the 25 m.u. of additional net saving voluntarily carried out.

… as Table V-4 shows […] even though the gross national output is identical in monetary terms to its value in the last example, it is now distributed in a radically different manner: over a narrower and more elongated productive structure (that is, a more capital-intensive one with more stages).

Hence we see that the voluntary increase in saving provokes the following effects:

First: a deepening of the capital goods structure. This outcome manifests itself as a vertical “lengthening” of the productive structure via the addition of new stages […]

Second: a widening of the capital goods structure, embodied in a broadening of the existing stages (as in stages four and five).

Third: a relative narrowing of the capital goods stages closest to consumption.

Fourth: … Given that the monetary demand for [consumer] goods is invariably reduced, and given that these two effects (the drop in consumption and the upsurge in the production of consumer goods) exert similar influences, the increase in production gives rise to a sharp drop in the market prices of consumer goods. Ultimately this drop in prices makes it possible for a significant real rise in wages to occur along with a general increase in all real income received by owners of the original means of production. [55]

[55] Moreover the consumer price index falls, since it merely reflects the effect the reduced monetary demand has on consumer goods stages, yet no index adequately records the growth in prices in the stages furthest from consumption.

[57] … it is perfectly feasible for an entrepreneur of consumer goods to earn money even when his sales do not increase and even decrease, if the entrepreneur reduces his costs by substituting capital equipment for labor.

The Case of an Economy in Regression

If society as a whole decides to save less … the industries … of the stages closest to consumption will tend to grow dramatically, which will drive up their accounting profits. … these events … lead to a “flattening” of the productive structure, since productive resources will be withdrawn from the stages furthest from consumption and transferred to those closest to it. … Moreover the drop in saving will push up the market rate of interest and diminish the corresponding present value of durable capital goods, deterring investment in them.

Finally a reverse “Ricardo Effect” will exert its influence: growth in the prices of consumer goods and services will be accompanied by an immediate decline in real wages and in the rents of the other original factors, which will encourage capitalists to replace capital equipment with labor, now relatively cheaper.

The Effects of Credit Expansion on the Productive Structure

[…] the generation of loans ex nihilo (i.e., in the absence of an increase in saving) raises the supply of credit to the economy […] This lowering of the interest rate in the credit market does not necessarily manifest itself as a decrease in absolute terms. […] the reduction is even compatible with an increase in the interest rate in nominal terms, if the rate climbs less than it would have in an environment without credit expansion (for instance, if credit expansion coincides with a generalized drop in the purchasing power of money).

[…] the lowering of the interest rate gives the appearance of profitability to investment projects which until that point were not profitable, giving rise to new stages further from consumption.

Savings are deferred consumption, in the sense that it finances future consumption. Conversely, the loan finance immediate consumption in the sense that it involves the sacrifice of future consumption (repayment of the loan). When loans exceed savings, we have a deficit in the financing of future consumption, while entrepreneurs increasingly invest in factors of production. It is easy to guess why such an extension of the production structure, based on this model, is untenable.

[65] In either case, the additional plants require the investment of additional factors of production. But the amount of capital goods available for investment has not increased.

[…] In the case of an upsurge in voluntary saving … the real resources that were saved and not consumed made the preservation and lengthening of the productive structure possible. […]

[68] Lionel Robbins, in his book, The Great Depression (New York: Macmillan, 1934), lists the following ten characteristics typical of any boom: first, the interest rate falls in relative terms; second, short-term interest rates begin to decline; third, long-term interest rates also drop; fourth, the current market value of bonds rises; fifth, the velocity of the circulation of money increases; sixth, stock prices climb; seventh, real estate prices begin to soar; eighth, an industrial boom takes place and a large number of securities are issued in the primary market; ninth, the price of natural resources and intermediate goods rises; and last, tenth, the stock exchange undergoes explosive growth based on the expectation of an uninterrupted increase in entrepreneurial profits (pp. 39–42).

We must consider that the adoption of a production model (more or less capital-intensive) always requires a sound compensation, as all life situations usually require. The lengthening of the structure of production requires a sacrifice of the present prosperity (short term) in favor of a prosperous future (long term). All cannot increase at the same time. In reality, with increased savings the economy will be more productive, allowing prices to decline, instead of rising.

However, a lengthening of the production structure without prior savings only leads to a boom, where everything seems to increase at the same time (consumption, investment, profit, etc.), generating an excess of optimism. And from that moment, only, financial markets begin to boil, and bubbles inflate (then explode). Nothing to do with the lame theory of “animal spirits” so dear to Keynes, where the excessive optimism emerges “out of thin air”. Yes, just like a magic trick.

And keep in mind that without credit expansion, the increasing demand for loans will rise the interest rates, which prevent bubble from developing.

The following charts et tables “should only be valued insofar as they illustrate and facilitate understanding of the fundamental economic argument”.

[70] Our intention is to warn readers of the error which threatens anyone who might attempt to make a strictly theoretical interpretation of the charts we present. Nicholas Kaldor committed such an error in his critical analysis of Hayek’s theory, as was recently revealed by Laurence S. Moss and Karen I. Vaughn, for whom :

“the problem is not to learn about adjustments by comparing states of equilibrium but rather to ask if the conditions remaining at T1 make the transition to T2 at all possible. Kaldor’s approach indeed assumed away the very problem that Hayek’s theory was designed to analyze, the problem of the transition an economy undergoes in moving from one coordinated capital structure to another.”

When we compare it with Chart V-1 … we see that final consumption remains unchanged at 100 m.u., in keeping with our supposition that no growth in net saving has taken place. However new money is created … and enters the system through credit expansion and the relative reduction in the interest rate … necessary to persuade economic agents to take out the newly-created loans.

Therefore the rate of profit … now drops from the 11 percent shown in Chart V-1 to slightly over 4 percent yearly.

Table V-5 … We see that the supply of present goods increases from the 270 m.u. shown in Table V-1 to slightly over 380 m.u., which are in turn composed of the 270 m.u. (m.u. originating from real saved resources) plus slightly over 113 m.u. which banks have created through credit expansion without the backing of any saving.

It is interesting to compare Chart V-6 to V-4. A clear difference emerges : no contraction of nominal demand in stages closest to consumption occurs. All shaded areas from stage n°2 to n°7 totalled exactly 113.75 mu (i.e. the amount of additional credit granted by 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, namely, only insofar as they are raised by the rise in wages. Thus the tendency toward a fall in the rate of interest on loans that originates in the policy of the banks is at first strengthened. But soon a countermovement 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, The Theory of Money and Credit, pp. 362-363)

It is worthwhile to recall that the interest rate is “just” a price for present goods (savings). To focuse on the possibility of mutiple interest rates is somewhat irrelevant. Saying that the existence of multiplicity of interest rates disproves the ABCT is like saying that the amount of savings can’t determine the amount of money the bank could loan. If the different prices for present goods tend to fall, this is only due to a lower time preference. That’s the core of ABCT. See the Sraffa-Hayek debate.

The Market’s Spontaneous Reaction to Credit Expansion

Some microeconomic factors can halt the process of exaggerated optimism and unsustainable growth.

1. The rise in the price of the original means of production.

The first temporary effect of credit expansion is an increase in the relative price of the original means of production (labor and natural resources). … On the one hand, capitalists from the different stages in the production process show a greater monetary demand for original resources, and this growth in demand is made possible by the new loans the banking system grants.

[…] when credit expansion takes place without the backing of a prior increase in saving, no original means of production are freed from the stages closest to consumption […] Therefore the rise in the demand for original means of production in the stages furthest from consumption and the absence of an accompanying boost in supply inevitably result in a gradual increase in the market price of the factors of production. Ultimately this increase tends to accelerate due to competition among the entrepreneurs of the different stages in the production process.

2. The subsequent rise in the price of consumer goods.

Sooner or later the price of consumer goods begins to gradually climb, while the price of services offered by the original factors of production starts to mount at a slower pace (in other words, it begins to fall in relative terms). […]

(a) First, growth in the monetary income of the owners of the original factors of production. Indeed if, as we are supposing, economic agents … continue to save the same proportion of their income, the monetary demand for consumer goods increases as a result of the increase in monetary income received by the owners of the original factors of production … this effect would only explain a similar rise in the price of consumer goods if it were not for the fact that it combines with effects (b) and (c).

(b) Second, a slowdown in the production of new consumer goods and services in the short- and medium-term, a consequence of the lengthening of production processes […] This … derives from the fact that original factors of production are withdrawn from the stages closest to consumption …

(c) … In fact entrepreneurs tend to calculate their costs in terms of the historical cost and purchasing power of m.u. prior to the inflationary process. However they compute their earnings based on income comprised of m.u. with less purchasing power. All of this leads to considerable and purely fictitious profits, the appearance of which creates an illusion of entrepreneurial prosperity and explains why businessmen begin to spend profits that have not actually been produced …

[75] The additional demand on the part of the expanding entrepreneurs tends to raise the prices of producers’ goods and wage rates. With the rise in wage rates, the prices of consumers’ goods rise too.

[…] When there is no prior growth in saving, and therefore consumer goods and services are not freed to support society during the lengthening of the productive stages and the transfer of original factors from the stages closest to consumption to those furthest from it, the relative price of consumer goods inevitably tends to rise.

3. The substantial relative increase in the accounting profits of the companies from the stages closest to final consumption.

The price of consumer goods escalates faster than the price of original factors of production, and this results in relative growth in the accounting profits of the companies from the stages closest to consumption … in the stages furthest from consumption the price of the intermediate goods produced at each stage does not show a major change, while the cost of the original factors of production employed at each stage climbs continuously, due to the greater monetary demand for these factors […]

Hence companies operating in the stages furthest from consumption tend to bring in less profit, an accounting result of a rise in costs more rapid than the corresponding increase in income. […] it gradually becomes evident throughout the productive structure that the accounting profits generated in the stages closest to consumption are higher in relative terms than the accounting profits earned in the stages furthest from it. […]

[77] Sooner or later, then, the increase in the demand for consumers’ goods will lead to an increase of their prices and of the profits made on the production of consumers’ goods. […] The prices of consumers’ goods would always keep a step ahead of the prices of factors. That is, so long as any part of the additional income thus created is spent on consumers’ goods (i.e., unless all of it is saved), the prices of consumers’ goods must rise permanently in relation to those of the various kinds of input.
(Hayek, The Pure Theory of Capital, pp. 377–78)

4. The “Ricardo Effect.”

… the more-than-proportional growth in the price of consumer goods with respect to the rise in factor income drives this income, particularly wages, down in real terms, providing entrepreneurs with a powerful financial incentive to substitute labor for machinery or capital equipment, in keeping with the “Ricardo Effect.”

In other words, the reversal of the Ricardo effect, following a decline in real wages due to a rise in prices of consumer goods, leads to a flattening of the production structure; entrepreneurs use more labor with the existing machinery, by using outworn, obsolete, less expensive and less durable machines.

This results in a relative drop in the demand for the capital goods and intermediate products of the stages furthest from consumption, which in turn further aggravates the underlying problem of the fall in accounting profits (even losses) which begins to be perceived in the stages furthest from consumption.

5. The increase in the loan rate of interest. Rates even exceed pre-credit-expansion levels.

… when the pace of credit expansion unbacked by real saving stops accelerating … interest rates will climb to their previous level … They will even exceed their pre-credit-expansion level … as a result of the combined effect of the following two phenomena:

(a) … credit expansion … will tend to drive up the price of consumer goods, i.e., to reduce the purchasing power of the monetary unit. Consequently if lenders wish to charge the same interest rates in real terms, they will have to add (to the interest rate which prevails prior to the beginning of the credit expansion process) a component for “inflation,” …

(b) … entrepreneurs who have embarked upon the lengthening of production processes despite the rise in interest rates will, to the extent that they have already committed substantial resources to new investment projects, be willing to pay very high interest rates […] this phenomenon will last as long as the belief that the production processes can be completed.

6. The appearance of accounting losses in companies operating in the stages relatively more distant from consumption: the inevitable advent of the crisis.

It has now become obvious that certain investment projects are unprofitable, and entrepreneurs must liquidate these and make a massive transfer of the corresponding productive resources, particularly labor, to the stages closest to consumption […] numerous investment projects launched in error are paralyzed, and many workers are laid off.

This lean period could resemble to the situation in which Crusoe would end up if, after a miscalculation, his basket of berries is exhausted after five days while the manufacture of his stick has no reached completion. Crusoe must suspend the manufacture of his capital good, and devote his efforts to pick berries.

[89] … Mark Skousen indicates that in the recession phase the price of goods from the different stages undergoes the following changes: first, the most serious decreases in price and employment normally affect the companies operating furthest from consumption; second, the prices of products from the intermediate stages fall as well, though not as dramatically; third, wholesale prices drop, yet less sharply in comparison; and fourth and last, the prices of consumer goods also tend to decline, though much less noticeably than the rest of the above goods. Moreover if stagflation occurs the price of consumer goods may even rise instead of declining. See Skousen, The Structure of Production, p. 304.

As the chart makes clear, the new productive structure is flatter and contains only five stages, since the two stages furthest from consumption have disappeared.

Furthermore Table V-6 demonstrates that although the gross income for the year is identical to that reflected in Table V-5 (483.7 m.u.), the distribution of the portion allocated to the direct demand for final consumer goods and services and to the demand for intermediate goods has varied in favor of the former.

Note that monetary demand for consumer goods is now one-third higher than the amount appeared in Table V-5, while monetary demand for intermediate goods has diminished from 383 to 351 mu.

[…] the productive structure which remains following the necessary readjustment … cannot continue to match the structure that existed prior to credit expansion. […] Heavy inevitable losses of specific capital goods have been incurred to the extent that society’s scarce resources have been channeled into investments that cannot be restructured and therefore are devoid of economic value. This gives rise to […] a decline in capital equipment per capita, resulting in a decrease in the productivity of labor, and consequently, a further reduction in real wages.

According to Fritz Machlup :

(1) Many capital goods are specific, i.e., not capable of being used for other purposes than those they were originally planned for …
(2) Capital values in general — i.e., anticipated values of the future income — are reduced by higher rates of capitalization; the owners of capital goods and property rights experience, therefore, serious losses.
(3) The specific capital goods serviceable as “complementary” equipment for those lines of production which would correspond to the consumers’ demand are probably not ready; employment in these lines is, therefore, smaller than it could be otherwise.
(4) Marginal-value productivity of labour in shortened investment periods is lower, wage rates are, therefore, depressed.
(5) Under inflexible wage rates unemployment ensues from the decreased demand prices for labour.

Chapter 6 : Additional Considerations on the Theory of the Business Cycle

1) Why No Crisis Erupts When New Investment is Financed by Real Saving (and Not by Credit Expansion)

Indeed if a sustained rise in voluntary saving triggers the process … there is no increase in the price of the original means of production.

[…] if the loans originate from an upsurge in real saving, the relative decrease in immediate consumption … frees a large volume of productive resources in the market of original means of production. These resources become available for use in the stages furthest from consumption and there is no need to pay higher prices for them. In the case of credit expansion we saw that prices rose precisely because such expansion did not arise from a prior increase in saving, and therefore original productive resources were not freed in the stages close to consumption, and the only way entrepreneurs from the stages furthest from consumption could obtain such resources was by offering relatively higher prices for them.

Otherwise, if the lengthening of the production structure is driven by real savings, we will see a decrease in consumer goods prices, because savings involve a drop in consumption, at least in short-term.

Hence there will be no relative increase in the accounting profits of the industries closest to consumption, nor a decrease in the profits, or even an accounting loss, in the stages furthest from consumption.

2) The Possibility of Postponing the Eruption of the Crisis: The Theoretical Explanation of the Process of Stagflation

The arrival of the economic recession can be postponed if additional loans unbacked by real saving are granted at an ever-increasing rate […]

In any case credit expansion must accelerate at a rate which does not permit economic agents to adequately predict it, since if these agents begin to correctly anticipate rate increases, the six phenomena we are familiar with will be triggered. Indeed if expectations of inflation spread, the prices of consumer goods will soon begin to rise even faster than the prices of the factors of production. Moreover market interest rates will soar, even while credit expansion continues to intensify (given that the expectations of inflation and of growth in the interest rate will immediately be reflected in its market value).

Hence the strategy of increasing credit expansion in order to postpone the crisis cannot be indefinitely pursued, and sooner or later the crisis will be provoked by any of the following three factors, which will also give rise to the recession:

(a) The rate at which credit expansion accelerates either slows down or stops, due to the fear, experienced by bankers and economic authorities, that a crisis will erupt and that the subsequent depression may be even more acute if inflation continues to mount. …

(b) Credit expansion is maintained at a rate of growth which, nevertheless, does not accelerate fast enough to prevent the effects of reversion in each time period. … Hayek revealed that the increasing speed at which the rise in the monetary income of the factors of production pushes up the demand for consumer goods and services ultimately limits the chances that the inevitable eruption of the crisis can be deferred via the subsequent acceleration of credit expansion. Indeed sooner or later a point will be reached at which growth in the prices of consumer goods will actually start to outstrip the increase in the monetary income of the original factors …

(c) … the banking system at no time reduces the rate at which it accelerates credit expansion, and instead does just the opposite … In this case, the moment economic agents begin to realize that the rate of inflation is certain to continue growing, a widespread flight toward real values will commence, along with an astronomical jump in the prices of goods and services, and finally, the collapse of the monetary system …

[5] Mark Skousen correctly indicates that, in relative terms, stagflation is a universal phenomenon, considering that in all recessions the price of consumer goods climbs more (or falls less) in relative terms than the price of the factors of production. Widespread growth in the nominal prices of consumer goods during a phase of recession first took place in the depression of the 1970s, and later in the recession of the 1990s. It sprang from the fact that the credit expansion which fed both processes was great enough in the different stages of the cycle to create and maintain expectations of inflation in the market of consumer goods and services even during the deepest stages of the depression …

Beginning at that point, wages will begin to decline in relative terms, and entrepreneurs will find more advantageous to substitute labor for machinery.

3) Consumer Credit and the Theory of the Cycle

It is first necessary to point out that most consumer credit is extended by banks to households for the purchase of durable consumer goods. We have already established that durable consumer goods are actually true capital goods which permit the rendering of direct consumer services over a very prolonged period of time. Therefore from an economic standpoint, the granting of loans to finance durable consumer goods is indistinguishable from the direct granting of loans to the capital-intensive stages furthest from consumption. In fact an easing of credit terms and a decline in interest rates will provoke, among other effects, an increase in the quantity, quality and duration of so-called “durable consumer goods,” which will simultaneously require a widening and lengthening of the productive stages involved, especially those furthest from consumption.

If the entire portion of the new credits is devoted to financing not durable consumer goods but current consumption, which is insignificant in practice, then …

… a trend toward the flattening of the productive structure is established without a prior expansionary boom in the stages furthest from consumption. Therefore the only modification to be made to our analysis is the following: if consumption is directly encouraged through credit expansion, the existing productive structure furthest from consumption clearly ceases to be profitable in relative terms, creating a trend toward the liquidation of these stages and the general flattening of the productive structure.

More precisely, if new loans finance immediate consumption exclusively (as opposed to consumption of durable goods) then instead of adding new stages of production, such as stage n°6 and n°7, the credit expansion will destroy pre-existing stages, such as stage n°4 and n°5.

4) The Self-Destructive Nature of the Artificial Booms Caused by Credit Expansion: The Theory of “Forced Saving”

The additional credits are not evenly distributed among all individuals. Some individuals temporarily enjoy greater purchasing power, given that they possess more money (thanks to the flow of new credits) while the prices of goods and services have not yet risen. When they spend this new money, prices begin to rise, but not homogeneously. This phenomenon is called : Cantillon Effect.

Hence the process gives rise to a redistribution of income in favor of those who first receive the new injections or doses of monetary units, to the detriment of the rest of society, who find that with the same monetary income, the prices of goods and services begin to go up. “Forced saving” affects this second group of economic agents (the majority), since their monetary income grows at a slower rate than prices, and they are therefore obliged to reduce their consumption, other things being equal. […]

At any rate the inflationary process unleashes other forces which impede saving: inflation falsifies economic calculation by generating fictitious accounting profits which, to a greater or lesser extent, will be consumed.

Furthermore, as interest rates diminish, individuals’ propensity to save has been reduced. Weak interest rates induce people to consume more, to borrow more. To prevent the malinvestment process, an increase of voluntary saving, at least equal to the amount of new credits, must immediately occur, which is practically impossible.

5) The Squandering of Capital, Idle Capacity, and Malinvestment of Productive Resources

[…] many capital goods will lose all of their value once it becomes clear there is no demand for them, they were manufactured in error and they should never have been produced. It will be possible to continue using others, but only after spending a large amount of money redesigning them. The production of yet others may reach completion, but given that the capital goods structure requires that the goods be complementary, they may never be operated if the necessary complementary resources are not produced.

[14] As a general rule, the closer a capital good is to the final consumer good, the more difficult it will be to convert. […] a house built in error is an almost irreversible loss, while it is somewhat easier to modify the use of the bricks if it becomes obvious during the course of the construction that using them to build a specific house is a mistake.

In the words of Hayek (Prices and Production, pp. 95–96) :

These engineers and also those economists who believe that we have more capital than we need, are deceived by the fact that many of the existing plant and machinery are adapted to a much greater output than is actually produced. What they overlook is that durable means of production do not represent all the capital that is needed for an increase of output and that in order that the existing durable plants could be used to their full capacity it would be necessary to invest a great amount of other means of production in lengthy processes which would bear fruit only in a comparatively distant future. The existence of unused capacity is, therefore, by no means a proof that there exists an excess of capital and that consumption is insufficient: on the contrary, it is a symptom that we are unable to use the fixed plant to the full extent because the current demand for consumers’ goods is too urgent to permit us to invest current productive services in the long processes for which (in consequence of “misdirections of capital”) the necessary durable equipment is available.

7) National Income Accounting is Inadequate to Reflect the Different Stages in the Business Cycle

As Mark Skousen has pointed out :

Gross Domestic Product systematically underestimates the expansionary phase as well as the contraction phase of the business cycle. For example, in the most recent recession, real GDP declined 1–2 percent in the United States, even though the recession was quite severe according to other measures (earnings, industrial production, employment). . . . A better indicator of total economic activity is Gross Domestic Output (GDO), a statistic I have developed to measure spending in all stages of production, including intermediate stages. According to my estimates, GDO declined at least 10–15 percent during most of the 1990–92 recession.

In fact, GNP excludes all intermediate capital goods “which at the end of the measurement period become available as inputs for the next financial year” from his figures.

[20] … In modern economies this sector [of consumer goods] usually accounts for 60 to 70 percent of the entire national income, while it does not normally reach a third of the gross domestic output, if calculated in relation to the total spent in all stages of the productive structure.

[21] … Mark Skousen, in his (already cited) article presented before the general meeting of the Mont Pèlerin Society of September 25–30, 1994 in Cannes, showed that in the United States over the preceding fifteen years the price of the goods furthest from consumption had oscillated between a +30 percent increase and a –10 percent decrease, depending on the year and the stage of the cycle; while the price of products from the intermediate stages had fluctuated between +14 percent and –1 percent, depending on the particular stage in the cycle, and the price of consumer goods vacillated between +10 percent and –2 percent, depending on the particular stage.

8 ) Entrepreneurship and the Theory of the Cycle

However, entrepreneurs cannot refrain from participating in the widespread process of discoordination bank credit expansion sets in motion, even if they have a perfect theoretical understanding of how the cycle will develop. This is due to the fact that individual entrepreneurs do not know whether or not a loan offered them originates from growth in society’s voluntary saving. In addition though hypothetically they might suspect the loan to be created ex nihilo by the bank, they have no reason to refrain from requesting the loan and using it to expand their investment projects, if they believe they will be able to withdraw from them before the onset of the inevitable crisis.

9) The Policy of General-Price-Level Stabilization and its Destabilizing Effects on the Economy

If the banking system brings about credit expansion unbacked by real saving … but just enough to maintain the purchasing power of money (or the “general price level”), then does the recession we are analyzing in this chapter follow ?

This is quite conceivable if new technologies and entrepreneurial innovations produce productivity gains, stabilizing the general price level, and therefore, hiding the increasing distortion of the production structure.

The American economy faced such a situation throughout the 1920s, when dramatic growth in productivity was nevertheless not accompanied by the natural decline in the prices of consumer goods and services. […]

In fact in the 1929 crisis, the relative prices of consumer goods (which in nominal terms did not rise and even fell slightly) escalated in comparison with the prices of capital goods (which plummeted in nominal terms). […] the factors which typically trigger the recession (relative growth in profits in consumption and a mounting interest rate), including the “Ricardo Effect,” are equally present in an environment of rising productivity, insofar as increased profits and sales in the consumer sector … reveal the decline in the relative cost of labor in that sector.

[28] … In fact in the 1920s the general price level in the United States was very stable: the index went from 93.4 (100 in the base year, 1926) in June 1921, to 104.5 in November 1925, and fell again to 95.2 in June 1929. However during this seven-year period, the money supply grew from 45.3 to 73.2 trillion dollars, i.e., more than 61 percent.

In the face of increasing productivity, the relative prices of consumer goods must fall in order to keep the production structure sustainable. Otherwise, producers would have nominal revenues exceeding their nominal outlays :

“the entrepreneurs would be led on by the double inducement of (1) reduced costs [without reduced revenues] and (2) interest rates falsified by the increase in the volume of money to undertake capital improvements on too large a scale” (Haberler, cited by Selgin, 1988, chapter 7).

10) How to Avoid Business Cycles: Prevention of and Recovery From the Economic Crisis

The boom and the beginning of the readjustment are naturally followed by a drop in the interest rate. This drop arises from the reduction and even the disappearance of the premium based on the expectation of a decrease in the purchasing power of money, and also from the increased relative saving the recession provokes.
The slowing of the frantic pace at which goods and services from the final stage are consumed, together with the rise in saving and the reorganization of the productive structure at all levels, furthers the recovery.
Its effects initially appear in stock markets, which are generally the first to undergo a certain improvement. Moreover the real growth in wages which takes place during the stage of recovery sets the “Ricardo Effect” in motion, thus reviving investment in the stages furthest from consumption, where labor and productive resources are again employed. […]

The answer is simple if we remember the origin of the crisis and what the crisis implies: the need to readjust the productive structure and adapt it to consumers’ true desire with regard to saving, to liquidate the investment projects undertaken in error and to massively transfer factors of production toward the stages and companies closest to consumption, where consumers demand they be employed.

[34] Rothbard also provides us with a list of typical government measures which are highly counterproductive and which, in any case, tend to prolong the depression and make it more painful. The list is as follows:

(1) Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.
(2) Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government “easy-money” policy prevents the market’s return to the necessary higher interest rates.
(3) Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. . . .
(4) Keep prices up. Keeping prices above the free-market levels will create unsalable surpluses, and prevent a return to prosperity.
(5) Stimulate consumption and discourage saving. . . . More saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved capital even further. . . .
(6) Subsidize unemployment. Any subsidization of unemployment . . . will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.
(America’s Great Depression, p. 19)

(b) […] Thus it is impossible for a government policy of spending and credit expansion to successfully protect all current jobs if workers spend their income, originating from credit expansion and artificial demand from the public sector, in a way that requires a different productive structure, i.e., one incapable of keeping them in their current jobs. […] Hence the only labor policy possible is to facilitate the dismissal and rehiring of workers by making labor markets highly flexible.

(c) […] any policy aimed at restoring the status quo with respect to macroeconomic aggregates should also be avoided. Crises and recessions are by nature microeconomic, not macroeconomic, and thus such a policy is condemned to failure, to the extent it makes it difficult or impossible for entrepreneurs to review their plans, regroup their capital goods, liquidate their investment projects and rehabilitate their companies.

In short, during a recession, the “fiscal stimulus” tends to distort relative prices, leading to a change in private demand, which will distort further an already obsolete production structure. If the “fiscal stimulus” boosts demand for final consumer goods, the increase in their relative prices will deteriorate the stages further from consumption, once again. It’s not a problem of aggregate demand, but a discoordination between time preference and the current production structure left after the boom.

Moreover if these works or “investments” are financed through the mere creation of new money, generalized malinvestment also takes place, in the sense that, if workers employed through this procedure dedicate most of their income to consumption, the price of consumer goods tends to rise in relative terms, causing the delicate situation of companies from the stages furthest from consumption to deteriorate even further. […]

Furthermore there is no guarantee that by the time governments diagnose the situation and decide to take the supposedly remedial measures, they will not err with respect to the timing or sequence of the different phenomena and tend with their measures to worsen rather than solve the maladjustments.

11) The Theory of the Cycle and Idle Resources: Their Role in the Initial Stages of the Boom

In fact Mises demonstrated from the beginning that the unemployment of resources was not only compatible with the theory he had developed, but was actually one of its essential elements. In market processes in which entrepreneurs undertake plans that involve the production of heterogeneous and complementary capital goods, errors are continually committed and due to “bottlenecks,” not all productive factors and resources are fully employed. Thus the necessity of a flexible market conducive to the exercise of entrepreneurship, which tends to reveal existing maladjustments and restore coordination in a never-ending process. Indeed the theory explains how bank credit expansion interrupts and complicates the coordinating process by which existing maladjustments are remedied.

[…] contrary to opinions expressed by many critics of the theory, full employment is not a prerequisite of the microeconomic distortions of credit expansion. When credit expansion takes place, economic projects which are not actually profitable appear so, regardless of whether they are carried out with resources that were unemployed prior to their commencement. The only effect is that the nominal price of the original means of production may not rise as much as it would if full employment existed beforehand. […]

Another possible effect of the use of previously-idle resources is the following: apart from the fact that their price does not increase as rapidly in absolute terms, they may make a short-term slowdown in the production of consumer goods and services unnecessary. Nonetheless a poor allocation of resources still takes place, since resources are invested in unprofitable projects, and the effects of the cycle eventually appear when the monetary income of the previously-unemployed original means of production begins to be spent on consumer goods and services.

12) The Necessary Tightening of Credit in the Recession Stage: Criticism of the Theory of “Secondary Depression”

We now analyse three types of deflation :

(a) Indeed the [forced] reduction in the quantity of money initially brings about a decline in loan concession and an artificial increase in the market interest rate, which in turn leads to a flattening of the productive structure, a modification forced by strictly monetary factors (and not by the true desires of consumers).

Due to the shortening process of the production structure, the most capital-intensive sectors experience great losses. Furthermore in all sectors the decline in costs (income of the owners of the original means of production) is slower than the decline in prices.

(b) […] the rise in the demand for money tends to push up the purchasing power of the monetary unit (in other words, it tends to push down the “general price level”). However this type of deflation differs radically from the former in the sense that it does make a contribution, since it originates from an increase in the saving of economic agents, who thus free resources in the form of unsold consumer goods and services. This provokes the effects we studied in chapter 5, where we considered a rise in voluntary saving.

(c) […] the massive repayment of loans and the loss of value on the assets side of banks’ balance sheets, both caused by the crisis, trigger an inevitable, cumulative process of credit tightening which reduces the quantity of money in circulation […] this sort of deflation … facilitates and accelerates the liquidation of the investment projects launched in error during the expansionary phase.

But more interesting is the effect of a credit deflation on relative incomes : it consists in a reversal of the Cantillon Effect.

Now, in the stage of credit tightening, this forced redistribution of income reverses in favor of those who in the expansionary stage were the first harmed, and thus people on a fixed income (savers, widows, orphans, and pensioners) will gain an advantage over those who most exploited the situation in the earlier stage.

But also, credit deflation tends to diminish entrepreneurial profits, inducing them “to save more and distribute less in the form of dividends (exactly the opposite of what they did in the expansionary phase).”

“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.”
(Mises, Human Action, p. 567)

The decline, provoked by the tightening of credit, in the quantity of money in circulation undoubtedly tends to drive up the purchasing power of the monetary unit. An inevitable drop in the wages and income of the original means of production follows, though at first this decrease will be more rapid than the reduction in the price of consumer goods and services, if such a reduction takes place.
Consequently, in relative terms, the wages and income of the original means of production will decline, leading to an increased hiring of workers over machines and a massive transfer of workers toward the stages closest to consumption. It is essential that labor markets be flexible in every aspect, in order to facilitate the massive transfers of productive resources and labor.

But a policy of maintaining wages, such as minimum wage, would deepen the recession.

The recovery will be characterized by a restoration of the relative price of the original means of production, i.e., by a decrease in the price of consumer goods and services. This reduction in the price of consumer goods and services will be greater, in relative terms, than the drop in wages, due to an increase in society’s general saving, which will again stimulate growth in the capital goods stages.

14) The Influence Exerted on the Stock Market by Economic Fluctuations

In an economy which shows healthy, sustained growth, voluntary savings flow into the productive structure by two routes: either through the self-financing of companies, or through the stock market. Nevertheless the arrival of savings via the stock market is slow and gradual and does not involve stock market booms or euphoria. … this [monetary] inflow … is rapidly absorbed by the new securities issued by companies with an aim to finance their new investment projects.

With credit expansion, the limitless availability of funds allows the ever-increasing purchases of security. Otherwise, the interest rates will rise and immediately stop the developing bubble. As Fritz Machlup explains:

If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, the boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted.

The significant capital gains earned on the stock market during the boom, to the extent that economic agents consider capital gains as a surplus of wealth and spend them by purchasing consumer goods and services, involve a substantial capital consumption, depleting society.

“The most probable result in this case is a quick recession of security prices. For higher stock prices will invite a new supply of securities, and the corporations, which want to take advantage of the higher prices in order to draw funds from the stock exchange and use them for real investment, will find that there are no additional funds to be had.” (Machlup, The Stock Market, Credit and Capital Formation, p. 90)

The fall in stock market prices reveals that the most serious entrepreneurial errors have been committed in the higher stages :

Other things being equal, indexes corresponding to the securities of companies that operate in the stages furthest from consumption reflect a more dramatic fall in market prices than those which represent companies that produce consumer goods and services.

The Roaring Twenties and the Great Depression of 1929

Murray N. Rothbard calculates that the money supply in the United States grew from $37 billion in 1921 to over $55 billion in January 1929. These figures closely approximate the estimates of Milton Friedman and Anna J. Schwartz, according to whom the money supply increased from over $39 billion in January 1921 to $57 billion in October 1929. (see Robert Murphy)

Thus the price of securities increased four-fold in the stock market, and while the production of goods for current consumption grew by 60 percent throughout the period, the production of durable consumer goods, iron, steel, and other fixed capital goods increased by 160 percent.

Another fact which illustrates the Austrian theory of the cycle is the following: during the 1920s wages rose mainly in the capital goods industries. Over an eight-year period they increased in this sector by around 12 percent, in real terms, while they showed an average of 5 percent real growth in the consumer goods industries. In certain capital goods industries wages rose even more. For instance, they increased by 22 percent in the chemical industry and by 25 percent in the iron and steel industry.

The Economic Recessions of the Late 1970s and Early 1990s

Grim reality sank in with the arrival of severe recession in the 1970s, when stagflation undermined and discredited Keynesian assumptions. Moreover the 1970s and the emergence of stagflation actually marked the rebirth of interest in Austrian economics, and Hayek received the 1974 Nobel Prize in Economics precisely for his studies on the theory of the business cycle. […]

Particularly in the four-year period between 1987 and 1991, the Japanese economy underwent enormous monetary and credit expansion which, as theory suggests, affected mainly the industries furthest from consumption. In fact although the prices of consumer goods rose only by around 0 to 3 percent each year during this period, the price of fixed assets, especially land, real estate, stocks, works of art and jewelry, escalated dramatically. Their value increased to many times its original amount and the respective markets entered a speculative boom.

Some Empirical Testing of the Austrian Theory of the Business Cycle

Wainhouse first empirically tests the proposition that changes in the supply of voluntary savings are independent of changes in bank credit. He uses statistical series which date from January 1959 to June 1981 and finds that in all cases but one the empirical evidence confirms this first proposition. Wainhouse’s second proposition is that modifications in the supply of credit give rise to changes in the interest rate, and that the two are inversely related. Abundant empirical evidence also exists to support this second proposition. Wainhouse’s third proposition states that changes in the rate at which loans are granted cause an increase in the output of intermediate goods, an idea he believes is also corroborated by the evidence he analyzes.

The last three propositions Wainhouse empirically tests are these: that the ratio of the price of intermediate goods to the price of consumer goods rises following the beginning of credit expansion; that in the expansion process the price of the goods closest to final consumption tends to decrease in relation to the price of intermediate goods; and lastly, that in the final stage of expansion the price of consumer goods increases more rapidly than that of intermediate goods, thus reversing the initial trend. Wainhouse also believes that in general these last three propositions agree with the empirical data, and he therefore concludes that the data supports the theoretical propositions of the Austrian School of economics. […]

Ramey has developed an intertemporal model which breaks down into different stages the inventories which correspond to: consumer goods, wholesale goods, manufactured equipment goods, and intermediate manufactured products. Ramey draws the conclusion that the price of inventories oscillates more the further they are from the final stage of consumption. The inventories closest to consumption are the most stable and vary the least throughout the cycle.

Chapter 7 : A Critique of Monetarist and Keynesian Theories

A Brief Note on the Theory of Rational Expectations

In fact even if they understand the dangers of lengthening the productive structure without the backing of real savings, they can easily derive large profits by accepting the newly-created loans and investing the funds in new projects, provided they are capable of withdrawing from the process in time and of selling the new capital goods at high prices before their market value drops, an event which heralds the arrival of the crisis.

Keynes’s Three Arguments on Credit Expansion

Jacques Rueff has pointed out that in an economy on a pure gold standard [or any “metallic standard”], an increase in the demand for money (or “hoarding”) does not push up unemployment at all. In fact, in accordance with the price system, it channels a greater proportion of society’s productive resources (labor, capital equipment, and original means of production) into the mining, production, and distribution of more monetary units.

These monetary units may be precious metals (gold, silver, bronze, platinum, etc…) or non-metal monetary units (tea bricks, or else).

The So-Called Marginal Efficiency of Capital

Hayek has conclusively demonstrated that the entire Keynesian doctrine of the “marginal efficiency of capital” as the determining factor in investment is acceptable only if we assume that there is absolutely no shortage of capital goods, and hence that any quantity can be acquired at a constant, set price. […]

In real life at least some of the complementary goods necessary to produce a capital good will always become relatively scarce at some point, and entrepreneurs, in keeping with their profit expectations, will increase the amount they are willing to pay for the good in question until the marginal efficiency or productivity of capital becomes equal to the interest rate.

In other words, as Hayek indicates, competition among entrepreneurs will ultimately lead them to push up the cost or offering price of capital goods to the exact point where it coincides with the present value (the value discounted by the interest rate) of the marginal productivity of the equipment in question. Hence the “marginal efficiency of capital” will always tend to coincide with the interest rate.

Criticism of the Keynesian Multiplier

( … Indeed first he asserts that the interest rate is determined by the demand for money or liquidity preference, and then he states that the latter in turn depends on the former.)
Another considerable shortcoming of Keynesian doctrine is the assumption that economic agents first decide how much to consume and then, from the amount they have decided to save, they determine what portion they will use to increase their cash balances and then what portion they will invest.
Nevertheless economic agents simultaneously decide how much they will allot to all three possibilities: consumption, investment and the increase of cash balances.
Hence if there is a rise in the amount of money each economic agent hoards, the additional amount could come from any of the following: (a) funds previously allocated for consumption; (b) funds previously allocated for investment; or (c) any combination of the above. It is obvious that in case (a) the interest rate will fall; in case (b) it will rise; and in case (c) it may remain constant.
Therefore no direct relationship exists between liquidity preference or demand for money and the interest rate.

See also :
The Fatal Flaw of the Keynesian Multiplier Theory
Debunking the Keynesian Accelerator Theory

4) The Marxist Tradition and the Austrian Theory of Economic Cycles: The Neo-Ricardian Revolution and the Reswitching Controversy

On the reswitching paradox, Hayek, in The Pure Theory of Capital (1941, pp. 388-389), mentioned that phenomenon, pointing out that what matters is not interest rates but prices changes, as he writes “will depend not on the rate of interest at which money can be borrowed but on the relations between different prices and the shape of the profit schedule (or investment demand schedule) as determined by these price differences”. And here again :

It is only via price changes that we can explain why a method of production which was profitable when the rate of interest was 5 per cent should become unprofitable when it falls to 3 per cent. Similarly, it is only in terms of price changes that we can adequately explain why a change in the rate of interest will make methods of production profitable which were previously unprofitable.

And de Soto as well made it clear that the non-monotonic association of these two variables, interest rates and production methods, is not a threat to the ABCT. The argument reads :

The jump between two alternate production techniques, an occurrence which may accompany continuous variations in the interest rate, and which has quite dismayed neoclassical theorists, presents no difficulties whatsoever for the Austrian theory of capital. In fact an increase in saving, and thus a decrease in the interest rate, always manifests itself in a change in the temporal perspective of consumers, who begin to view their actions in terms of a more distant future. Hence the productive structure is lengthened regardless of whether changes or even reswitching occur with respect to the different specific production techniques. In other words, within the Austrian School model, if, at a drop in the interest rate, a former technique is revived in connection with a new investment project, this occurrence is merely a concrete sign, in the context of a particular production process, that this process has become longer as a result of the rise in saving and the fall in the interest rate.

[92] … An increase in saving (and thus a decrease in the interest rate, other things being equal) may result in the replacement of a certain technique (the Roman plow, for instance) by a more capital-intensive one (the tractor). Even so, a subsequent drop in the interest rate may permit the reintroduction of the Roman plow in new production processes formerly prevented by a lack of saving (in other words, the established processes are not affected and still involve the use of tractors). Indeed a new lengthening of production processes may give rise to new stages in agriculture or gardening that incorporate techniques which, even assuming that production processes are effectively lengthened, may appear less capital-intensive when considered separately in a comparative static equilibrium analysis.

Apart from the complete description and Huerta de Soto’s defense of ABCT, some additional remarks can be added.

It is sometimes assumed that the higher stages of production will experience a rise in costs (due to the higher demand for capital goods) along with a rise in profits (due to the money newly created). But this hypothesis neglects the existence of a ‘lag’ between the rising costs and rising revenues due to money creation. This prevents the costs to catch up the artificial rise in profits :

Money and Capital : A Reply (Friedrich A. Hayek)

Every individual entrepreneur can increase his real capital only by spending more on capital goods and less on labour used in current production (or, what amounts to the same thing, more on labour which is invested for a relatively long period). He can, however, spend more on capital goods than on wages only so long as wages have not risen in proportion to the additional money which has become available for investment. Ultimately, incomes must rise in that proportion, since even the money used for the purchase of new capital goods must ultimately be paid out to the factors which make these new capital goods. But they will rise to the full extent only when all the new money has passed backwards through the successive stages of production until it is finally paid out to the factors. There will, therefore, always be a considerable ‘lag’ between the increase in the money used for productive purposes and the corresponding increase in the incomes of the factors – and consequent increase in the demand for consumers’ goods. And, so long as money keeps on increasing […] the demand for producers’ goods will be increased relative to the demand for consumers’ goods.

What Drives Profits? (Kel Kelly)

But money and credit do in fact have a tremendous affect on nominal profits: as the money supply is increased, profits increase because revenues rise faster than costs. […] the monetary value of revenues is usually greater than the monetary value of corresponding costs, since most costs were incurred when there was less money existing […] Thus, credit expansion increases the spread between revenues and costs, thereby increasing profit margins.

How the Stock Market and Economy Really Work (Kel Kelly)

The same concept would apply to the stock market: if there were a constant amount of money in the economy, the sum total of all shares of all stocks taken together (or a stock index) could not increase. Plus, if company profits, in the aggregate, were not increasing, there would be no aggregate increase in earnings per share to be imputed into stock prices. […] By contrast, in our world today, most stocks — good and bad ones — rise during inflationary bull markets and decline during bear markets. The good companies simply rise faster than the bad.

Some economists, like Bryan Caplan and many others theorized that the entrepreneurs are able to anticipate the manipulations of the interest rates. Brian J. Stanley exposes the countless problems with this hypothesis, in addition to those already exposed above.  Basically, the argument is that entrepreneurs have other things to do and to think about :

Why Don’t Entrepreneurs Outsmart the Business Cycle?

The entrepreneur, then, pursuant to the argument under consideration here, must not only sweep away the fog of years of past interventions, he must also predict what the Fed will do in the future and when it will do it — all while the Fed tries to anticipate what the entrepreneurs will do.
It seems that any entrepreneur who attempts to undertake such investigations would have little time for things such as serving his customers, improving his product and responding to his customers’ preferences.
[…] there would be those who would knowingly borrow at the below-market rates and take the risks associated with the loans. These companies would be those that were undercapitalized, perhaps startups or companies in trouble. In short, they would be the companies that had nothing to lose.

Another criticism is the one made by Sraffa. He argues that there may be “at any one moment as many “natural” rates of interest as there are commodities”. The existence of multiple interest rates is irrelevant for the very fundamentals of the ABCT. The interest rate is “just” a price for present goods (savings). If the “different” prices of present goods tend to fall, this is only due to a lower time preference. Saying that the existence of multiplicity of interest rates disproves the ABCT is like saying that the amount of savings can’t determine the amount of money the bank could loan. Whether there is one or several interest rates, it remains that the less people consume and the more people save, the more banks loan money, and the more the production structure lengthens. So the very fundamentals of the ABCT are valid.

Sraffa and Hayek on Multiple Interest Rates

“The case would, however, be different if the actual supply of wheat were not changed, but if, under the mistaken impression that the supply of wheat would greatly increase, wheat dealers sold short greater quantities of future wheat than they will actually be able to supply. This is the only case I can think of where, in a barter economy, anything corresponding to the deviation of the money rate from the equilibrium rate could possibly occur.”
(Money and Capital: A Reply – by Hayek)

The Cambridge Capital Controversy (CCC) is sometimes cited as one of the strongest refutation of the Austrian Business Cycle Theory. Actually, Zonghie Han and Bertram Schefold (2005) show that the “reswitching technique” is not a common phenomenon. Roger Garrison made the same point.

Theoretically, Guido Hülsmann, in “The structure of production reconsidered”, had investigated the issue. He explains that the interest rate and the production structure are not necessarily negatively related (i.e., a lower interest rate is related to a lenghtening of the structure of production) even though the interest rate still affects relative spending, as theorized by austrians. He proposes to develop and enrich the theory of the structure of production. He lists 8 possible scenarios, each of them having different implications; interestingly, the scenarios implying a drop of the PRI also involve higher relative spending toward the upstream stages. He finally investigates the implication of the consumer credit and the variation of monetary conditions. The former simultaneously thins and lengthens the structure of production. The latter has no systematic impact on the structure of production.

Further reading :
Austrian Business Cycle Theory : The Empirical Evidence