[This talk was delivered on January 26, 2013, at the Jeremy S. Davis Mises Circle in Houston, Texas.]
In December, it will be 100 years since Congress authorized the creation of the Federal Reserve System. Throughout that century the Fed has enjoyed broad bipartisan support. That’s another way of saying the Fed never appeared on the political radar until Ron Paul broke the rules by actually campaigning against it in 2007.
The Fed was supposed to provide stability to the financial sector and the economy at large. We are supposed to believe it has been a wonderful success. A glance at the headlines over the past five years renders an unkind verdict on this rarely examined assumption.
Last year we observed another important centenary—the 100-year anniversary of the publication of Ludwig von Mises’s pathbreaking book, The Theory of Money and Credit, written when the great economist was just 31. The end of an era was approaching as that book reached the public. A century of sound money, albeit with exceptions here and there, was drawing to a close. It had likewise been a century of peace, or at least without a continent-wide war, since the Congress of Vienna. Both of these happy trends came to an abrupt end for the same reason: the outbreak in 1914 of World War I, the great cataclysm of Western civilization.
It was as though Mises had one eye to the past, speaking of the merits of a monetary system which—while not perfectly laissez-faire—had served the world so well for so long, and another eye to the future, as he warned of the consequences of tampering with or abandoning that system. Mises carefully dismantled the inflationist doctrines that were to ravage much of the world during the twentieth century.
The book covered the whole expanse of monetary theory, including money and its origins, interest rates, time preference, banking, credit, inflation, deflation, exchange rates, and business cycles.
Most important for our topic today was Mises’s warning to the world’s monetary authorities not to suppress the market rate of interest in the name of creating prosperity. The failure to heed Mises’s advice, indeed the full-fledged ignorance or outright defiance of that advice, is the monetary story of the twentieth century.
The single most arresting economic event of the Fed’s century was surely the Great Depression. This was supposed to have discredited laissez-faire and the free economy for good. Wild speculation was said to have created a stock-market bubble, and the bust in 1929 was what the unregulated market had allegedly wrought. Other critics said the problem had been the free market’s unfair distribution of wealth: the impoverished masses simply couldn’t afford to buy what the stores had for sale. In later years, even so-called free-marketeers would blame the Depression on too little intervention into the market by the Federal Reserve. (With friends like these, who needs enemies?)
Ludwig von Mises offered a different explanation, as did F.A. Hayek, Lionel Robbins, and other scholars working in the Austrian tradition in those days. Murray N. Rothbard, in turn, would devote his 1962 book America’s Great Depression to an Austrian analysis of this misunderstood episode.
The study of business cycles differs from the study of economic hard times. Economic conditions can be poor because of war, a natural disaster, or some other calamity that disrupts the normal functioning of the market. Business cycle research is not interested in those kinds of conditions. It seeks to understand economic boom and bust when none of these obvious factors are present.
Mises referred to his own approach as the circulation credit theory of the business cycle. For our purposes, we can describe it in brief.
On the free market, when people increase their saving, that increased saving has two important consequences. First, it lowers interest rates. These lower interest rates, in turn, make it possible for entrepreneurs to pursue a range of long-term investment projects profitably, thanks to the lower cost of financing. Second, the act of saving and thus abstaining from spending on consumer goods, releases resources that these entrepreneurs can use to complete their new projects. If consumer-goods industries no longer need quite so many resources, since (as we stipulated at the start) people are buying fewer consumer goods, those released resources provide the physical wherewithal to carry out the long-term production projects that the lower interest rates encouraged entrepreneurs to initiate.
Note that it is decisions and actions by the public that provide the means for this capital expansion. "If the public does not provide these means," Mises explains, "they cannot be conjured up by the magic of banking tricks."
But "banking tricks" are precisely how the Fed tries to stimulate the economy. The Fed lowers interest rates artificially, without an increase in saving on the part of the public, and without a corresponding release of resources. The public has not made available the additional means of production necessary to make the array of long-term production projects profitable. The boom will therefore be abortive, and the bust becomes inevitable.
In short, interest rates on a free market reflect people’s willingness to abstain from immediate consumption and thereby make resources available for business expansion. They give the entrepreneur an idea of how far, and in what ways, he may expand. Market interest rates help entrepreneurs distinguish between projects that are appropriate to the current state of resource availability, and projects that are not, projects that the public is willing to sustain by its saving and projects that they are not.
The central bank confuses this process when it intervenes in the market to lower interest rates. As Mises put it:
The policy of artificially lowering the rate of interest below its potential market height seduces the entrepreneurs to embark upon certain projects of which the public does not approve. In the market economy, each member of society has his share in determining the amount of additional investment. There is no means of fooling the public all of the time by tampering with the rate of interest. Sooner or later, the public’s disapproval of a policy of over-expansion takes effect. Then the airy structure of the artificial prosperity collapses.
None of these cycles will be exactly like any other. Roger Garrison says the artificial boom will tend to latch on to and distort whatever the big thing at the time happens to be—tech stocks in the 1990s, for example, and housing in the most recent boom.
With this theoretical apparatus as a guide, Mises became convinced as the 1920s wore on that the seeds of a bust were being sown. This was not a fashionable position. Irving Fisher, a godfather of modern neoclassical economics and the man Milton Friedman called the greatest American economist, could see nothing but continued growth and prosperity in his own survey of economic conditions at the time. In fact, Fisher’s predictions in the late 1920s, even in the very midst of the crash, are downright embarrassing.
On September 5, 1929, Fisher wrote: "There may be a recession in stock prices, but not anything in the nature of a crash … the possibility of which I fail to see."
In mid-October, Fisher said stocks had reached a "permanently high plateau." He expected "to see the stock market a good deal higher than it is today within a few months." He did "not feel that there will soon, if ever, be a fifty- or sixty-point break below present levels."
On October 22 Fisher was speaking of "a mild bull market that will gain momentum next year." With the stock market crashing and values plummeting all around him—with declines far more severe than Fisher had been prepared to admit were even conceivable—Fisher on November 3 insisted that stock prices were "absurdly low." But they would go much lower, ultimately losing 90 percent of their peak value.
What had gone so horribly wrong? Fisher and his colleagues had been blinded by their assumptions. They had been looking at the "price level" and at economic growth figures to determine the health of the economy. They concluded that the 1920s were a period of solid, sustainable economic progress, and were taken completely by surprise by the onset and persistence of the Depression.
Mises, on the other hand, was not fooled by the 1920s. For Mises and the Austrians, crude aggregates of the kind Fisher consulted were not suitable for ascertaining the condition of the economy. To the contrary, these macro-level measurements concealed the economy-wide micro-level maladjustments that resulted from the artificial credit expansion. The misdirection of resources into unsustainable projects, and the expansion or creation of stages of production that the economy cannot sustain, do not show up in national income accounting figures. What matters is that interest rates were pushed lower than they would otherwise have been, thereby leading the economy into an unsustainable configuration that had to be reversed in a bust.
Thus Mises wrote in 1928:
It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.
Once the crisis hit, Mises showed how his theory of business cycles accounted for what was happening. If people could understand how the crash had come about, Mises hoped, they would be less likely to exacerbate the problem with counterproductive government policy.
"The Causes of the Economic Crisis" was the title of an address Ludwig von Mises delivered in late February 1931 to a group of German industrialists. It was unknown to English-speaking audiences until 1978, when it was published as a chapter in a collection of Mises’s essays called On the Manipulation of Money and Credit. The Mises Institute published a new edition of these essays in 2006 under the title The Causes of the Economic Crisis: And Other Essays Before and After the Great Depression.
In that essay Mises was characteristically blunt in describing the causes of the Great Depression, as well as in his warnings that such crises would recur as long as the authorities continued to pursue the same destructive courses of action.
The crisis from which we are now suffering is … the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the "natural rate of interest" through increasing the fiduciary media [in other words, through creating credit out of thin air].
As we have seen at this event today, the crisis whose wreckage we see all around us right now, a crisis that began in 2008, originated from the same interventions Mises warned against a century ago. Mises would not have been surprised by the Panic of 2008. In 1931, he warned of a recurrence of boom-bust cycles if the policy of artificially low interest rates was not abandoned:
The appearance of periodically recurring economic crises is the necessary consequence of repeatedly renewed attempts to reduce the "natural" rates of interest on the market by means of banking policy. The crises will never disappear so long as men have not learned to avoid such pump-priming, because an artificially stimulated boom must inevitably lead to crisis and depression. …All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis. … Give up the pursuit of policies which seek to establish interest rates, wage rates, and commodity prices different from those the market indicates.
In the 1920s as now, fashionable opinion could see no major crisis coming. Then as now, the public was assured that the experts at the Fed were smoothing out economic fluctuations and deserved credit for bringing about unprecedented prosperity. And then as now, when the bust came, the free market took the blame for what the Federal Reserve had caused.
It is fitting that a century of the Federal Reserve should come to an end at a moment of economic crisis and uncertainty, with the central bank’s leadership confused and in disarray after the economy’s failure to respond to unprecedented doses of monetary intervention. The century of the Fed has been a century of depression, recession, inflation, financial bubbles, and unsound banking, and its legacy is the precipice on which our economy now precariously rests.
Faced with a slow-motion train wreck they feel helpless to stop, people often ask what they can do.
There are no easy answers, to be sure. But one thing is certain: there will be no progress without the spread of knowledge.
I hope you’ll be a part of the crucial and historic moment that lies before us.
Thanks in large part to Ron Paul, recent years have seen a spectacular revival of interest in the Austrian School of economics and in particular its theory of the business cycle. This is a deeply significant and most welcome development. Until recently, even supporters of the free market had by and large ignored the Federal Reserve, or even thought of it as a potentially stabilizing force in a capitalist economy. The possibility that its interventions into the market may actually have been destabilizing, and actually have been the cause of the boom-bust cycle, was hardly to be heard anywhere. Were you to say such a thing at an ostensibly free-market conference, chances were slim that you would appear on the following year’s program.
For more than 30 years, however, the Mises Institute has been dedicated to the pursuit of economic science in the Austrian tradition. We’ve warned against the economic damage caused by central banking at a time when that message couldn’t have been less fashionable. You’ve already seen some of the results of our work here this weekend: three of our speakers—Peter Klein, Bob Murphy, and Tom Woods—came through the Institute’s programs during their college years.
But now, with the vastly increased demand for what we offer, we want to step things up. Way up.
One of our primary goals is to carry out what we’re calling Operation Ron Paul. We want to equip the masses of young people drawn to the Austrian School by Ron’s heroic work with the skills, resources, and knowledge they’ll need in order to keep the Austrian School and Ron’s message vital and growing.
We are also setting up an Economic Crisis Project, to be ready now and when the next event hits, with the scholarly and popular explanations of what happened, and what to do about it.
What is attractive about the market economy is not simply what it accomplishes materially: ever-higher standards of living, prosperity for the masses that the most exalted monarchs of yore could scarcely have imagined for themselves, and the ability to support far larger populations than anyone centuries ago could have dreamed. This is all great cause for celebration, to be sure. But what the beautiful order of the market shows is the staggering, near-miraculous achievements of mankind by means of voluntary cooperation, and without state violence or an exalted leader ordering people around.
Set against this marvelous spectacle, the government-privileged central bank is a grotesque anomaly. To say that we need a politically created monopoly to create money, the commodity that constitutes one-half of every non-barter transaction, is to say that the market economy is not really so impressive or effective after all. If we must conjure a specially privileged monopoly to create this most essential commodity, and if that monopoly is likewise given the task of managing the economy to maximize employment and output, then we are in principle abandoning the whole case for the free market and conceding the value of central planning.
We do not need any such monopoly, as the work of the Austrian economists makes clear, and we do not need any form of central planning. We need the free market, which is another way of saying we need to let people make their own decisions, enter into the agreements of their choice, and be secure in their private property.
The Austrian School is enjoying its most spectacular surge in growth in its entire history. A generation of smart young people are reading everything they can find on Austrian economics. The Austrian diagnosis of the economic crisis is so widespread that even establishment writers and economists have been forced to engage with it.
Let’s make sure this surge doesn’t fizzle out. If we build on these early successes, if we carry forward the message of the Austrian School relentlessly and courageously, we can make the next hundred years a Misesian century of peace, sound money, and liberty. Please join us.
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