InCognito

When Ludwig von Mises first expounded his theory of the business cycle in 1913, itself a wedding of Wicksell’s natural rate hypothesis and Bohm Bawerk’s capital theory, central bank coordination was not a problem. The Bank of England played a leading role in determining policy and by doing so promoted international monetary stability (Eichengreen 1987; Bordo and Macdonald 2005). This allowed Mises to formulate a theory of the business cycle within a closed national economy.

Mises begins his formulation by arguing business cycles were the result of the fluctuations in credit monies issued by private banks practicing a fractional reserve policy. By concentrating on private banks, Mises is able to connect his business theory upon Wicksellian foundations and lead naturally into Bohm-Bawerk’s capital theory:

If it is possible for the credit issuing banks to reduce the rate of interest on loans below the rate determined by the whole economic situations (Wicksell’s natürlicher Kapitalizins or natural rate of interest), then the question arises of the particular consequences of a situation of this kind. . . A reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. . . . But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. . . . Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available. . . The market prices of consumption goods rise and those of production fall. (1953, 359-362)

Nominal changes in money and money prices affect the structure of production, and thereby the real economy because relative prices, including the interest rate – the price of money across time– have been distorted.

But can competing firms generate a business cycle on their own and what is the range of systematic distortion that the process of private credit expansion is able to promote? Here Mises’s argument fits well, though not perfectly with the general old monetarist tradition (Hawtrey 1913,76)[1]. The interest rate is a lagging indicator of the real economy, so overinvestment in apparently profitable sectors is unavoidable. Overinvestment that results from private ordering occurs within bounds as “every bank is obliged to regulate its interest policy in accordance with that of the others (Mises 1953, 373).” Cycles occur, but they are limited in amplitude. Much in the same way that a flag is in stasis as it flaps in the wind, “the money market must be subject to fluctuations (Hawtrey 1913, 76-77).” Economic fluctuations are an inherent, yet constrained, aspect of markets.

The scenario is complicated by the introduction of a central bank. A private bank can lower interest rates for as long as it remains solvent. Losses, or the threat thereof, limit the extent to which banks can allow the market rate of interest to differ from the natural rate. Central banks can lower reserve ratios and the rate of interest charged on loans for a longer period of time than private banks because they face different kinds of liquidity restraints. Only when authorities find that expansion has generated gold losses that threaten target gold reserve ratios or worry that it has fueled too much speculation, is contraction necessitated (Mises 1953, 390).

With a central bank, booms grow stronger and busts grow deeper as a result of manipulation of the base money stock, but mechanisms for transmitting the boom are essentially the same. An increase in the money stock distorts relative prices and arbitrarily increases the length of the structure of production. With a central bank, however, the distortion is not an emergent, uncoordinated phenomena. It is a systematic distortion resulting from the central banks privilege to create base money creation.