16. Credit Expansion and the Trade Cycle

CHAPTER

SIXTEEN

Credit Expansion and the Trade Cycle

Now what is credit expansion? Credit expansion is inflation also. The reason for making a distinction between credit expansion and simple inflation is because of the different effects that an additional quantity of money has upon entering the economic system by the two different routes. In simple inflation, the new money enters by spending on the part of government. The government spends additional sums created, for instance, for the purpose of carrying on a war. The effect of this spending is that prices of the things the government buys go up and consumers start to hoard. With credit expansion the additional quantities of money enter the economic system, not through government spending, but through loans of newly created credit to businessmen by the banks. So the prices of the things businesses buy go up. This brings about a “boom” in business. If this boom is not stopped in time, it develops into a great economic crisis. This is the trade cycle, the most interesting phenomenon of the capitalistic system.

The trade cycle is due to the fact that banks expand credit and this credit expansion brings about an expansion of business. But as the quantities of producers’ goods, capital goods, are not increased, there is an overexpansion of some businesses, but not a general over-investment, as it is called by some finance brokers, throughout the whole economy. The significant characteristic of the boom is this over-expansion by the artificial lowering of the interest rate in order to create the credit expansion. This misleads businessmen into thinking that there is a greater amount of capital goods available than actually exists, and that certain projects are now possible which would have been impossible with a higher rate of interest. In fact the only thing that is newly available is an increased amount of credit created precisely for this purpose. This system, this “boom,” goes on until finally it breaks down when it becomes apparent that the so-called “over-investment” is actually mal-investment or over-expansion in some areas of the economy.

Nevertheless, we have a situation now in which each of the leading countries of the world wants to expand, to have a lower rate of interest. People have always been hostile to interest as such, considering it “usury.” The idea has long prevailed that the interest rate is something that can be manipulated ad libitum [at will] by government and the banks. The reason for this attitude is a misunderstanding of the whole modern economic system. What makes very great problems is the wish of all countries, or let us say of the inflationists of all countries, to have a lower rate of interest. What I am concerned with at this time is the effects this tendency on the part of each country has on market prices, savings and investment.

If the countries have an international currency, or if they have national currencies which are free from gold, people will be in favor of increasing the quantity of money. Few people are in favor of decreasing the quantity of money and falling prices. If a government wants to become popular, it will try to raise the prices for the benefit of the consumers, for the benefit of the producers, and especially for the benefit of the unions. There will, therefore, be a tendency toward an increase in the quantity of money. An increase in the quantity of money brings about higher prices. And if there is a tendency toward higher prices there is also necessarily a tendency for interest rates to go up. Recently a columnist wrote in a leading weekly that we have tamed the business cycle. Perhaps you read his column—I read it just an hour before leaving for this meeting. But really, there is nothing to tame unless it be the inflationists, those who want to hold interest rates low and expand credit artificially, those who do not think that conditions, as determined by the savings of people, are satisfactory.

Interest rates must go up when there is a general tendency for prices to go up because, if you buy commodities instead of lending money and hold the commodities, you make an extra profit in such a situation by the increase in the prices of the commodities you have bought. Therefore, people will prefer not to lend money to anybody if there is not an indemnification in the rate of interest which they are receiving for the profit they could make by buying commodities or stocks themselves and keeping them for a time until their prices went up. Therefore, the state of affairs in which prices are going up is necessarily a state of affairs in which the rate of interest will go up also, because under such conditions the rate of interest must contain an element which I have called the “price premium,” that is an indemnification for the profit the money lender could earn himself by buying commodities instead of giving a loan.

Now when the rates of interest are going up, people will say that what is needed to fight the high rate of interest is to increase the quantity of money. But the situation is precisely the opposite. The only method to have lower interest rates is not to have inflation, to remove from the power of the government the problem of increasing or decreasing the quantity of money. The government will always be in favor of inflation, because governments always want to spend more. Therefore, there will be general disagreement about policies.

The beginnings of the inflation are always characterized by the fact that those who are favored by the inflation are the first to declare that conditions are very good and that they want the government to continue. The government wants to be able to say to the voters, to the people, “You never had such a wonderful time as you are enjoying now.” And such a wonderful time can very easily be brought about for a very short time by inflation, you know. Only later do people discover what the results are. And only later do they discover that this means, at the same time, the destruction of the savings of all those people who are not themselves owners of some real property or some enterprise.