Wednesday, 20 March 2013

The Illusion of Wealth: Ludwig von Mises on the Business Cycle

Just as the economic bust we’re now enduring is the inevitable flipside of the earlier (credit-induced) boom, so too is Cyprus-style bank theft the inevitable flipside of the debts built up by governments during and after the credit boom--inevitable because, as their spending continues to increase even while the bust refuses to go away, governments are increasingly desperate to find money (by any means necessary!) with which to pay back that debt.

Both bust and theft are inevitable results of the earlier boom, that illusion of wealth created by the unlimited credit expansion produced by banks licenced to turn debt into currency.

Can we stop this never-ending cycle? Are the boom and bust of the business cycle inevitable? Economist Ludwig Von Mises reckons not.  Here’s a quick “twelve-minute” summary of his argument as it appears in the new book The Illusion of Wealth: Ludwig von Mises on the Business Cycle, edited by Robert P. Murphy:

imageLudwig von Mises: Real vs. Paper Wealth
Ludwig von Mises (1881–1973) is the economic theorist who did more than
anyone to sweep away the mystical view that business cycles just happen
to us, like bad weather and aging. He brought scientific logic to bear on the
problem. He drew on the fields of money, interest, capital theory, and international
capital flows to map out a general theory of what causes business
cycles, the parameters of how they play out in the real world, and how they
might be ended.

With an economy addicted to credit expansion and absurdly low interest rates
(not even Mises could have foreseen zero or negative rates!), we all wonder
what is real and what is not. The book gives us the tools to make that discerning

Mises’s general idea is that cycles begin with loose credit provided by a banking
system that is protected from facing the economic consequences of unsound
lending by the existence of the central bank. The boom turns to bust when the
resources to sustain it go missing.

In a market, banks want to lend; they are restrained by risk. Government guarantees
encourage risky lending. Artificially low interest rates — always cheered
by indebted governments — signal to borrowers that there are more savings in
the system than really exist. Business in particular expands production in a way
that is unsustainable. This loose money policy creates a boom — the illusion of
wealth — that is not justified by economic fundamentals. The correction takes
place when the illusion of wealth is revealed in the course of time, kicked off by
tightening credit or when the boom times are tested by reality.

In the 1920s and the first half of the 1930s, Mises’s view came to be almost
commonplace in the English-speaking world, mentioned and discussed by
the mainstream as the top contender. After World War II, the theory ended up
being stamped out by the newfound faith in macroeconomic planning, with
John Maynard Keynes as its leading profit.

Today, that faith in macroeconomic management is now at another low point,
but the baseline assumption that business cycles have a psychological origin
is still with us. As Robert Murphy explains in the introduction, the goal of this
book is to provide the most coherent possible explanation of the entire theory
from its roots to its conclusions.

Mises begins with a discussion of money. It is not neutral to every transaction,
affecting all prices in all places the same way. Changes in purchasing power of
money are a feature of normal market activity. There is no such thing as perfect
stabilization. Prices changes as human valuations change. Money is nothing
but a medium of this interpersonal exchange. Prices are objective, but value is
subjective, an expression of people’s eagerness to acquire goods and services.

imageMoney makes possible economic calculation. This is the ability to assess and truly measure the economic merit and viability of anything. All the technology, all the discoveries, all the laboratories and manufacturing in the world are useless without the ability to calculate profit and loss. The capacity to calculate and assess the relative merits of various production paths is the key to unlocking every innovation and making it real. Without the ability to calculate, society itself would crash and burn. This is the social function of prices. Nothing can substitute for them (not central planning or engineering or intuition). Prices are building blocks
of civilization and require private property and markets for their emergence.

Increasing the amount of money in an economy does nothing to brush away the problem of economic scarcity. Money is merely a tool for calculation. Producing more of it only changes its purchasing power and distorts decision-making. It does nothing to make speculation or
entrepreneurship more or less successful.

Appearances to the contrary (“This whole generation is great at investing!”), the
seeming prosperity is illusory and indicates a false boom. New money only ends
up hiding incompetency and delaying the day that it is revealed. The only vehicle
for authentic economic progress is the accumulation of additional capital goods
through saving and improvement in technological methods of production.

In a market, entrepreneurs can profit or they can take losses. Errors result
in losses and success results in profits. There is, in a market economy, no
systematic tendency for one tendency to prevail over others. False prices
are checked by competition. Errors are never general and social. They are
specific and cleared away when discovered. “The market process is coherent
and indivisible,” writes Mises. “It is an indissoluble intertwinement of action
and reactions, of moves and countermoves.” But there is no such thing as a
general under-consumption in markets, as Keynesians like to believe.

Conventional economic modelling cannot capture the time horizons of millions
of capitalist investors and producers. The real-world structure of production
includes production plans of one day or 50 years or several generations. What
allows coordination between these many plans are markets with free-floating
prices and interest rates that respond to real savings and the actual plans of
entrepreneurs and capitalists. Interest rates themselves reflect the time horizons
of the public. They fall when people save and rise when people prefer
consumption over saving. The loan markets reflect these varying plans.

When the central bank lowers rates, it creates “forced saving” — the appearance,
but not the reality. Forced saving causes an inflow of resources to capital goods
industries, because investors make longer-term plans. It looks like capital expansion.
It is really what Mises calls “malinvestment” — meaning bad investment in
lines of production that would not otherwise take place.

The reality is that all credit expansion tends toward capital consumption. It falsifies
economic calculation. It produces imaginary or only apparent profits. People
begin to think they are lucky and start spending and enjoying life. They buy large
homes, build new mansions, and patronize the entertainment business. These
activities all amount to capital consumption.

imageCredit expansion also raises wage rates in a way that is not sustainable. Entrepreneurs become addicted to expansion in order to enlarge the scale of their production. This requires ever more infusions of credit. The boom can last only as long as the system expands credit at an ever-increasing pace. When this
ends, the plans stop too and business starts selling off inventory, wages fall, and the economy begins to fall into recession. Mises describes this as the collapse of an “airy castle” — something beautiful that has no substance.

Artificial credit expansion doesn’t always produce price inflation. When it does happen, inflationary expectations can cause a general tendency to buy as much as can be bought. That can lead to the crackup of the whole of the economy. At the same time, the effects of
inflation can be disguised as rising stock prices or increasing home values.
But it always leads to relative impoverishment.  It always makes people
poorer than they otherwise might be. But Mises specifies something very
important here. It doesn’t mean society will revert exactly to the state
it was in before the boom. The pace of capitalistic expansion is so great
that it has usually outstripped the “synchronous losses” caused by
malinvestment and overconsumption.

10 Takeaways

  1. Economic calculation is indispensable to the creation of society and civilization;
    it is what unlocks and applies all-over knowledge discoveries.
  2. Prices are true and functioning only in a market economy with private
    property and competitive markets.
  3. Production processes take place over time, with each capitalist forming
    a different time horizon and configuring plans based on that.
  4. Artificial increases in the money supply, released through the banking
    system, lower the rate of interest. This is akin to forced savings.
  5. Forced savings accelerate the pace of economic progress and the improvement
    in technology, but this is unsustainable.
  6. Credit expansion makes some people richer and some people poorer, but
    it can never raise the standard of living of the whole of society. It causes
    people overall to be poorer than they would otherwise be.
  7. There is nothing wrong with falling prices. That is the natural state of
    the market.
  8. The “wavelike movement” of the economy is the unavoidable
    outcome of the attempt to lower the market rate of interest by
    means of credit expansion.
  9. All present-day governments are fanatically committed to an easy
    money policy.
  10. The moral ravages of credit expansion are worse than the economic ones.
    It creates feelings of envy towards those who receive “first use” of the easy
    credit, despair and frustration among the victims of the crash, and discourages
    people who would otherwise be excellent inventors, workers, and investors.

Why does a good theory of the business cycle matter? Understanding the
process as it unfolds helps reveal the source of the problem, which is not in
our heads or hearts or in some other strange force of history, but more specifically
in the government-protected banking cartel. In short, it is not the market
that deserves the blame, but the interventions in the market. This theory helps
in assessing whether reforms are geared toward fixing the problem or making
more problems. For example, further regulation of the monetary and banking
systems is not likely to do much toward addressing the underlying cause of
the business cycle.

Mises’s theory predicts that a society addicted to artificial credit stimulus would
probably enjoy unusual amounts of technological progress, but relentlessly
declining real income. It would depend on increasing rates of technological
improvement, but this would never be enough to raise incomes and prosperity
over the long term. Mises was writing before the age of the fiat dollar, but
he foresaw precisely what we have today: advances in technology, declines in
standards of living, and endless waves of boom and bust with no increases in
the capital and savings that make long-term prosperity possible.

Ludwig von Mises (1881–1973) was an Austrian economist who enjoyed
enormous fame in Europe before the Great Depression. The rise of the Nazis forced
his emigration, first to Geneva in 1934 and then the U.S. in 1940. His first
decade in the U.S. was spent as an unemployed writer trying to restart
life. He ended up teaching a private seminar at New York University that
taught a new generation. Instead of being the last of a great line of economists,
he sparked a revival of free-market thought. Today, many hundreds
of thousands count themselves among his students and followers.

This summary is part of a new series of 12-Minute Executive Summaries produced for the Laissez Faire Book Club.


  1. Cyprus, am I misunderstanding the matter, the option is to let the banks fail in which case all 100% (or close to it) of the deposits will be lost, or the depositors basically take a "haircut" in the same way that Greek Bond holders had to take the same recently to avoid default. And since the Cyprus Banks' troubles are very much interwoven with the Greek Bond haircut, it's a valid comparison.

    Or are we arguing that there was a full amount deposit insurance scheme operating, and that such a contract has been violated.

    Because without either a funded deposit insurance scheme (and those are usually limited to a certain value) or relying on some other group like German taxpayers, depositors in a failing back will lose money. Frankly, let them fail a la Iceland and be done with it.

  2. This is a good article. Has what needs to be explained. People ought to listen to him more.

    The two quotes in boxes to the side of the article are surprises, especially the first one of them but I was surprised to learn both of them.

    I know that some technology went backwards as well. My father used to go from New York City to London and back again in a supersonic airlinee on his business. Now it is only possible to do it much slower in twice the time. Slow. That good technlogy is gone and nothing new is coming in. Also there are no more hovercraft in the English Channel any more. Also there are no hydrofoils for commuting in Hong Kong any more. Slow old boats is what is now. But even with all this going wrong you still have to admit that there is lots more technology around at the moment. There are all these PEDs, special TVs, game boxes, medicine processes and machines, computers on everything and awesome printers and sound systems and money changing machines and EFTPOS and smartcards, robots and memory metal even.

    Those two quotes are shocking for me and they make me think about where this is all heading and what is going on. Mises knew so much. It is sad he is not with us any more.

    Does anyone want to discuss or explain details about the two quotes? they are important I think.



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