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et al., Banking and the Business Cycle, pp. 139ff.
36
The error of the followers stems from their failure to adopt the pure time-
preference theory of interest of Fetter and Mises, and their clinging to eclectic
productivity elements in their explanation of interest. See the references men-
tioned in footnote 5 above.
The Positive Theory of the Cycle 33
below the free-market rates? Only by expanding their credit! To
avoid the business cycle, then, it is not necessary for the banks to
be omniscient; they need only refrain from credit expansion. If
they do so, their loans made out of their own capital will not
expand the money supply but will simply take their place with
other savings as one of the determinants of the free-market inter-
est rate.37
Hayek believes that Mises s theory is somehow deficient
because it is exogenous because it holds that the generation of
business cycles stems from interventionary acts rather than from
acts of the market itself. This argument is difficult to fathom.
Processes are either analyzed correctly or incorrectly; the only test
of any analysis is its truth, not whether it is exogenous or endoge-
nous. If the process is really exogenous, then the analysis should
reveal this fact; the same holds true for endogenous processes. No
particular virtue attaches to a theory because it is one or the other.
Recurrence of Cycles
Another common criticism asserts that Mises s theory may
explain any one prosperity depression cycle, but it fails to explain
another familiar phenomenon of business cycles their perpetual
recurrence. Why does one cycle begin as the previous one ends?
Yet Mises s theory does explain recurrence, and without requiring
us to adopt the familiar but unproven hypothesis that cycles are
self-generating, that some mysterious processes within a cycle
lead to another cycle without tending toward an equilibrium con-
dition. The self-generating assumption violates the general law of
the tendency of the economy toward an equilibrium, while, on the
other hand, the Mises theory for the first time succeeds in inte-
grating the theory of the business cycle into the whole structural
design of economic theory. Recurrence stems from the fact that
37
Mises points out (Human Action, p. 789n.) that if the banks simply lowered
the interest charges on their loans without expanding their credit, they would be
granting gifts to debtors, and would not be generating a business cycle.
34 America s Great Depression
banks will always try to inflate credit if they can, and government
will almost always back them up and spur them on. Bank profits
derive mainly from credit expansion, so they will tend to inflate
credit as much as they can until they are checked.38 Government,
too, is inherently inflationary. Banks are forced to halt their credit
expansion because of the combined force of external and internal
drains, and, during a deflation, the drains, and their fears of bank-
ruptcy, force them to contract credit. When the storm has run its
course and recovery has arrived, the banks and the government are
free to inflate again, and they proceed to do so. Hence the contin-
ual recurrence of business cycles.
Gold Changes and the Cycle
On one important point of business cycle theory this writer is
reluctantly forced to part company with Mises. In his Human
Action, Mises first investigated the laws of a free-market economy
and then analyzed various forms of coercive intervention in the
free market. He admits that he had considered relegating trade-
cycle theory to the section on intervention, but then retained the
discussion in the free market part of the volume. He did so because
he believed that a boom bust cycle could also be generated by an
increase in gold money, provided that the gold entered the loan
market before all its price-raising effects had been completed. The
potential range of such cyclical effects in practice, of course, is
severely limited: the gold supply is limited by the fortunes of gold
mining, and only a fraction of new gold enters the loan market before
influencing prices and wage rates. Still, an important theoretical
38
Walker, The Science of Wealth, pp. 145ff.; also see p. 159.
[B]anks must be constantly desirous of increasing their loans, by issuing
their own credit in the shape of circulation and deposits. The more they
can get out, the larger the income. This is the motive power that ensures
the constant expansion of a mixed [fractional reserve] currency to its high-
est possible limit. The banks will always increase their indebtedness when
they can, and only contract it when they must.
The Positive Theory of the Cycle 35
problem remains: can a boom depression cycle of any degree be
generated in a 100 percent gold economy? Can a purely free mar-
ket suffer from business cycles, however limited in extent? One
crucial distinction between a credit expansion and entry of new
gold onto the loan market is that bank credit expansion distorts the
market s reflection of the pattern of voluntary time preferences;
the gold inflow embodies changes in the structure of voluntary time
preferences. Setting aside any permanent shifts in income distri-
bution caused by gold changes, time preferences may temporarily
fall during the transition period before the effect of increased gold
on the price system is completed. (On the other hand, time pref-
erences may temporarily rise.) The fall will cause a temporary
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