II. The Credit Controversy A. The Banking Principle

Some economists of the “Banking School” ventured to deny flatly that changes in the quantity of money available can affect prices and interest rates. They introduced into their reasoning the idea of monetary “hoards” as a deus ex machina. The amount of money kept in these mythical hoards changes in such a way as to neutralize automatically changes in the quantity of money. A surplus of money is swallowed by these hoards; a deficiency of money is made good by a restriction of the amount hoarded. This fable has long since been abandoned.

The bulk of the older Banking School economists and all contemporary representatives of this school do not deny that an increase in the quantity of money (metallic money, government paper money, irredeemable bank notes, and deposit currency) must — other things being equal — result in a general rise of prices. The core of their teachings is: Short-term credits granted by commercial banks in the form of bank notes or deposits created for this purpose do not affect prices and interest rates, provided they do not exceed “the needs of trade.” Such loans provide the debtor with the funds required for the production and the marketing of goods. They are self-liquidating. If the purchased raw materials are made up and sold, or if the buyer of products settles his balance, the loan is paid off, and the bank notes or deposits disappear again. An actual need has brought them into existence. With the cessation of this need, they go off the stage. The amount of credit of this type which the market can absorb is determined by the volume of production and business activity. It is beyond the power of the banks to alter this volume. No credit expansion is to be feared if the banks strictly abide by the rule to limit their lending to satisfy the demand of producers or merchants for short-term credit.

The reasoning of the Banking School misses the essential problem. It is obvious that no credit expansion takes place if the banks keep the total amount of their lending at the same level. But if a new bank enters the field or if an existing bank embarks upon the granting of additional credit above the amount of its previous credits, credit expansion results.

It is not true that the volume of credit that the banks are in a position to grant, if strictly abiding by the aforementioned rules, is independent of the bank’s policy. The market is always in a position to absorb a surplus of credit supply. An increase in the supply of credit brings about a tendency toward a lowering of the rate of interest. With the lower rate of interest, many projects appear attractive that did not appear so with a higher rate. The lowering of the rate of interest encourages the expansion of precisely those business activities that — according to the banking doctrine — are viewed as proper instances for the granting of bank credit. Thus the credit expansion automatically increases the “needs of trade.” It stimulates business activities because it cheapens the exchange of future purchasing power for present purchasing power. While the supply of capital goods remained unaltered, there is now a greater demand for them on the part of business. Prices must, consequently, rise. A boom starts.

B. The Currency Principle

The “Currency School” intended to provide an explanation of the recurrence of economic crises. Its proponents first observed that the root cause of the depression is the preceding boom and substituted for the study of crises the study of the trade cycle.

Their reasoning ran this way: If the British banks expanded credit while conditions in the other countries remained unchanged, British prices would begin to rise, and these on the world market would lag behind them. Consequently, there would be an excess of British imports over exports. As the surplus of imported goods could not be paid for by shipping bank notes, the importers would have to export gold. Hence, gold would be withdrawn from the banks; their reserves would dwindle. This “external drain” would force upon the banks a restriction of their lending activities. The artificial boom would come to an end and give way to a depression.

The main fault of the Currency School was that it dealt with bank notes only and did not realize that deposits subject to check are only technically different from bank notes, while their economic significance is equal to that of bank notes. This failure vitiated the British Bank Act of 1844. But it is easy to rectify this error by a simple extension of the theory.

C. Austrian Theory of the Trade Cycle

Currency theory did not consider the problem of the consequences of credit expansion within an isolated country or of a synchronous credit expansion in all countries. It did not enter into a discussion of the way in which the market and the whole apparatus of production and distribution react to credit expansion. This task was accomplished by Austrian theory.

The rate of interest established on a market not hampered by credit expansion, says Austrian theory, separates those business projects that can be carried out under the existing state of the supply of capital goods and consumers’ preferences from those that cannot. With the lowering of the rate of interest brought about by credit expansion, the entrepreneurs embark upon projects for the realization of which the available amount of factors of production does not suffice.[2] They are deceived by the appearance of a nonexistent richness in the supply of material factors of production. They behave like a master builder who has overestimated the amount of building material available, has used up too much for the foundations and cannot complete his plan on account of a lack of material. Some of the new projects will never be finished; others, when finished, will be useless for lack of the plants producing the required complementary producers’ goods; others will not yield an adequate return on the capital invested.

It is true, the banks (or the governments) are in a position to prolong the boom for some time by injecting progressively increasing quantities of bank notes and deposits into the market. But the artificially created prosperity cannot last forever. Sooner or later it must come to an end. There are only two alternatives:

1. The banks do not stop and go on expanding credit at a progressively accelerated pace. But the spell of inflation breaks once the public has the conviction that the banks and the authorities are resolved not to stop. If no limit of the inflation and, consequently, of the general rise of prices can be foreseen, a general Flucht in die Sachwerte starts. Everybody becomes aware of the fact that to hold cash and deposit balances with the banks involves loss, and that he does better to buy and store goods. Everybody is anxious to get rid of money and to exchange it for some other commodities, no matter how much he must pay for them. Prices are running away, and the purchasing power of the monetary unit drops to zero. The national currency system cracks up.

2. As a rule, the banks do not let things go so far. They stop sooner by restricting credit. Then the day of reckoning dawns. The illusions disappear, people begin again to see reality as it is. The blunders committed in the boom become visible.

In every case, the slump is unavoidable. There is no means to make permanent a boom created by credit expansion and inflation.

The slump does not destroy values, but merely illusions. It does not make people poorer, it merely makes them aware of the impoverishment brought about by the malinvestment of the boom. It is not the depression that is an evil, but the preceding boom. The depression is the process of adjustment of economic conditions to the real market state-of-affairs. The fall in prices and wage rates is the preliminary step toward recovery and future real prosperity. He who wants to prevent the recurrence of economic crises must prevent the resumption of credit expansion.

In short, credit expansion is doomed to failure at any rate. There is no means to substitute fictitious capital created by monetary and credit manipulation for nonexisting capital goods. The only method to increase a nation’s wealth and income is to save and to accumulate more real capital goods.

The rate of interest is a market phenomenon. In the long run, its height does not depend on the supply of money and credit. It is determined by the difference in the valuation of present goods and future goods. An increase in the supply of money and credit only temporarily lowers the rate of interest. In bringing about malinvestments, it finally results in a reduction in the amount of capital goods available. The economy has to pay heavily for the orgy of the artificial boom.

D. The Socialists’ Rejection of Austrian Theory

In the eyes of the socialists, there is no such thing as a scarcity of material factors of production. Mankind could enjoy a life in plenty. Scarcity is merely an outcome of the capitalist mode of production and distribution. Economic crises are an evil inherent in capitalism. They have nothing at all to do with the endeavors to expand credit and to lower the rate of interest by bank manipulation.

The consistent supporters of these tenets blithely assert that interest is a purely monetary phenomenon that could not exist in a barter economy. (Such were, for instance, the ideas of Silvio Gesell, the minister of finance of the short-lived communist Soviet regime in Munich; Lord Keynes is full of praise for Gesell and calls him an “unduly neglected prophet.”) Others are less outspoken and cling to a more cautious language. But a faulty doctrine does not gain anything from the fact that its advocates lack the courage to profess frankly all the conclusions which must be drawn logically from the principles they have espoused.

Whoever does not share the opinion that the rate of interest is only a monetary phenomenon is under the necessity to demonstrate the mechanism by which that level of the rate of interest, which corresponds to the whole structure of market conditions, reestablishes itself when temporarily disarranged by an easy money policy. The only solution of this problem provided up to now is that of the Austrian theory.

All those economists who want to explain the trade cycle as being caused by factors other than credit expansion must admit that no boom could arise if the amount of money and credit available were not increased. This implies that they cannot help admitting the fundamental thesis of Austrian theory.

E. Salvation Through Credit Manipulation

Consistent supporters of the doctrine that the rate of interest is a monetary phenomenon only and that there is no harm in the endeavors to abolish it by credit manipulation cannot help approving plans to establish the millennium by a reform of the monetary and banking system. The best known of the older projects of this type was that of the French socialist Proudhon, the man who coined the phrase “Property is theft.”

Such ideas are very popular with many successful businessmen. The Belgian Ernest Solvay advocated “social compatabilism,” a system hardly distinguished from that of Proudhon. More than twenty years ago, Thomas A. Edison and Henry Ford suggested that the construction of roads be financed by the issue of additional paper money in order to avoid the payment of interest to the banks or the public.

The present-day variety of this old superstition is embodied in the doctrine of unbalanced budgets and government spending. As far as the government procures the means required for spending by taxing the citizens and by borrowing from the public, its spending curtails individuals’ capacity to invest to the same extent that it increases that of the government. As far as the government borrows from the commercial banks or issues additional paper money, it embarks upon credit expansion and inflation.

In the early stages of every instance of credit expansion and inflation, there is always optimism. People do not want to pay attention to the warning voices of economists. They stubbornly insist that their present situation has nothing in common with the boom periods of the past, and that the theorists are wrong in predicting the breakdown of the “prosperity.” But when the crisis comes, people become desperate; then they impeach not the faulty monetary and credit policies but the capitalist system as such.