XX. Interest, Credit Expansion, and the Trade Cycle

0:00CHAPTER 20 INTEREST, CREDIT EXPANSION AND THE TRADE CYCLE 1. THE PROBLEMS In the market economy in which all acts of interpersonal exchange are performed by the intermediary of money, the category of originary interest manifests itself primarily in the interest on money loans. It has been pointed out already that in the imaginary construction of the evenly rotating economy, the rate of originary interest is uniform. There prevails in the whole system only one rate of interest. The rate of interest on loans coincides with the rate of originary interest as manifested in the ratio between prices of present and of future goods.

0:50We may call this rate the neutral rate of interest. The evenly rotating economy presupposes neutral money. As money can never be neutral, special problems arise. If the money relation, that is, the ratio between the demand for and the supply of money for cash holding, changes, all prices of goods and services are affected. These changes, however, do not affect the prices of the various goods and services at the same time and to the same extent. The resulting modifications in the wealth and income of various individuals can also alter the data determining the height of originary interest.

1:35The final state of the rate of originary interest to the establishment of which the system tends after the appearance of changes in the money relation is no longer that final state toward which it had tended before, thus the driving force of money has the power to bring about lasting changes in the final rate of originary interest and neutral interest. Then there is a second, even more momentous problem, which of course may also be looked upon as another aspect of the same problem. Changes in the money relation may under certain American Circumstances first affect the loan market in which the demand for and supply of loans influences the market rate of interest on loans, which we may call the gross money, or market rate of interest.

2:27Can such changes in the gross money rate cause the net rate of interest included in it to deviate lastingly from the height which corresponds to the rate of originary interest, that is, Can Events on the Loan Market Partially or Totally Eliminate Originary Interest? No economist will hesitate to answer these questions in the negative. But then a further problem arises. How does the interplay of the market factors readjust the gross money rate to the height conditioned by the rate of originary interest? These are great problems. These were the problems economists tried to solve in discussing banking, fiduciary media and circulation credit, credit expansion, gratuitousness or non-gratuitousness of credit, the cyclical movements of trade and all other problems of indirect exchange.

3:312. The Entrepreneurial Component in the Gross Market Rate of Interest The market rates of interest on loans are not pure interest rates. Among the components contributing to their determination, there are also elements which are not interest. The money lender is always an entrepreneur. Every grant of credit is a speculative entrepreneurial venture, the success or failure of which is uncertain. The lender is always faced with the possibility that he may lose a part or the whole of the principal lent. His appraisal of this danger determines his conduct in bargaining with the prospective debtor about the terms of the contract.

4:16There can never be perfect safety, either in money lending or in other classes of credit transactions and deferred payments. Payments. Debtors, guarantors and warrantors may become insolvent. Collateral and mortgages may become worthless. The creditor is always a virtual partner of the debtor, or a virtual owner of the pledged and mortgaged property. He can be affected by changes in the market data concerning them. He has linked his fate with that of the debtor, or with the changes Capital as such does not bear interest. It must be well employed and invested not only in order to yield interest, but also lest it disappear entirely.

5:07The dictum, money cannot beget money, is meaningful in this sense, which of course differs radically from the sense which ancient and medieval philosophers attached to it. Gross interest can be reaped only by creditors who have been successful in their lending. If they earn any net interest at all, it is included in a yield which contains more than merely net interest. Net interest is a magnitude which only analytical thinking can extract from the gross proceeds of the creditor. The entrepreneurial component included in the creditor's gross proceeds is determined and by all those factors which are operative in every entrepreneurial venture.

5:54It is, moreover, co-determined by the legal and institutional setting. The contracts which place the debtor and his fortune, or the collateral, as a buffer between the creditor and the disastrous consequences of malinvestment of the capital lent, are conditioned by laws and institutions. The creditor is less exposed to loss and failure than the debtor only in so far as this legal and institutional framework makes it possible for him to enforce his claims against refractory debtors. There is, however, no need for economics to enter into a detailed scrutiny of the legal aspects involved in bonds and debentures, preferred stock, mortgages and other kinds of credit transactions.

6:44The entrepreneurial component is present in all species of loans. It is customary to distinguish between consumption or personal loans on the one hand and productive or business loans on the other. The characteristic mark of the former class is that it enables the borrower to spend expected future proceeds. In acquiring a claim to a share in these future proceeds, The lender becomes an entrepreneur, as in acquiring a claim to a share in the future proceeds of a business. The particular uncertainty of the outcome of his lending consists in the uncertainty about these future proceeds. It is furthermore customary to distinguish between private and public loans, that is, loans to governments and subdivisions of governments.

7:37The particular uncertainty inherent in such loans concerns the life of secular power. Empires may crumble, and governments may be overthrown by revolutionaries, who are not prepared to assume responsibility for the debts contracted by their predecessors. That there is, besides, something basically vicious in all kinds of long-term government debts has been pointed out already. For all species of deferred payments hangs, like a sword of Damocles, the danger of government interference. Public opinion has always been biased against creditors. It identifies creditors with the idle rich and debtors with the industrious poor. It abhors the former as ruthless exploiters and pities the latter as innocent victims of oppression. It considers government action is designed to curtail the claims of the creditors as measures extremely beneficial to the immense majority at the expense of a small minority of hard-boiled userers.

8:44It did not notice at all that 19th century capitalist innovations have wholly changed the composition of the classes of creditors and debtors. In the days of Solon the Athenian, of ancient Rome's agrarian laws, and of the Middle Ages, The creditors were, by and large, the rich and the debtors the poor. But in this age of bonds and debentures, mortgage banks, savings banks, life insurance policies and social security benefits, the masses of people with more moderate income are rather themselves creditors. On the other hand, the rich, in their capacity as owners of common stock of plants, farms Creditors and real estate are more often debtors than creditors.

9:32In asking for the expropriation of creditors, the masses are unwittingly attacking their own particular interests. With public opinion in this state, the creditor's unfavorable chance of being harmed by anti-creditor measures is not balanced by a favorable chance of being privileged by anti-debtor measures. This unbalance would bring about a unilateral tendency toward a rise of the entrepreneurial component contained in the gross rate of interest if the political danger were limited to the loan market, and would not in the same way affect today all kinds of private ownership of the means of production. As things are in our day, no kind of investment is safe against the political dangers of a general expropriation of all private property.

10:25A capitalist cannot reduce the vulnerability of his wealth by preferring direct investment in business to lending his capital to business or to the government. The political risks involved in money lending do not affect the height of a regionary interest. They affect the entrepreneurial component included in the gross market rate. In the limiting case, that is, in a situation in which the impending nullification of all All contracts concerning deferred payments is generally expected. They would cause the entrepreneurial component to increase beyond all measure. 3. The price premium as a component of the gross market rate of interest.

11:13Money is neutral if the cash-induced changes in the monetary unit's purchasing power affect at the same time and to the same extent the prices of all commodities and services. With neutral money, a neutral rate of interest would be conceivable, provided there were no deferred payments. If there were deferred payments, and if we disregard the entrepreneurial position of the creditor and the ensuing entrepreneurial component in the gross rate of interest, we We must furthermore assume that the eventuality of future changes in purchasing power is taken into account in stipulating the terms of the contract. The principle is to be multiplied periodically by the index number, and thus to be increased or decreased in accordance with the changes that have come to pass in purchasing power.

12:08With the adjustment of the principle, the amount from which the rate of interest is is to be calculated changes too. Thus, this rate is a neutral rate of interest. With neutral money, neutralization of the rate of interest could also be attained by another stipulation, provided the parties are in a position to anticipate correctly the future changes in purchasing power. They could stipulate a gross rate of interest containing We may call this allowance the positive or negative price premium. In the case of a quickly progressing deflation, the negative price premium could not only swallow the whole rate of originary interest, but even reverse the gross rate into a minus quantity, a rate to to be passed on the debtor's account.

13:09If the price premium is correctly calculated, neither the creditor's nor the debtor's position is affected by intervening changes in purchasing power. The rate of interest is neutral. However, all these assumptions are not only imaginary, they cannot even hypothetically be thought of without contradictions. In the changing economy, the rate of interest can never be neutral. In the changing economy, there is no uniform rate of originary interest. There only prevails a tendency toward the establishment of such uniformity. Before the final state of originary interest is attained, new changes in the data emerge which divert anew the movement of interest rates toward a new final state.

13:59Where everything is unceasingly in flux, no neutral rate of interest can be established. In the world of reality, all prices are fluctuating and acting men are forced to take full account of these changes. Entrepreneurs embark upon business ventures and capitalists change their investments only because they anticipate such changes and want to profit from them. The market economy is essentially characterized as a social system in which there prevails an incessant urge toward improvement. The most provident and enterprising individuals are driven to earn profit by readjusting again and again the arrangement of production activities so as to fill in the best possible way the needs of the consumers, both those needs of which the consumers themselves are already be aware, and those latent needs of the satisfaction of which they have not yet thought themselves.

15:02These speculative ventures of the promoters revolutionize afresh each day the structure of prices, and thereby also the height of the gross market rate of interest. He who expects a rise in certain prices enters the loan market as a borrower, and is ready to allow a higher gross rate of interest than he would allow if he were to expect a less momentous rise in prices, or no rise at all. On the other hand, the lender, if he himself expects a rise in prices, grants loans only if the gross rate is higher than it would be under a state of the market in which less momentous or no upward changes in prices are anticipated.

15:48The borrower is not deterred by a higher rate if his project seems to offer such good chances that it can afford higher costs. The lender would abstain from lending and would himself enter the market as an entrepreneur and bidder for commodities and services if the gross rate of interest were not to compensate him for the profits he could reap this way. The expectation of rising prices thus has the tendency to make the gross rate of interest rise, while the expectation of dropping prices makes it drop. If the expected changes in the price structure concern only a limited group of commodities and services, and are counterbalanced by the expectation of an opposite change in the prices of other goods, as is the case in the absence of changes in the money relation, the two Two opposite trends by and large counterpoise each other.

16:47But if the money relation is sensibly altered and a general rise or fall in the prices of all commodities and services is expected, one tendency carries on. A positive or negative price premium emerges in all deals concerning deferred payments. The role of the price premium in the changing economy is different from that we ascribe in the hypothetical and unrealizable scheme developed above. It can never entirely remove, even as far as credit operations alone are concerned, the effects of changes in the money relation. It can never make interest rates neutral. It cannot alter the fact that money is essentially equipped with a driving force of its own.

17:37Even if all actors were to know correctly and completely the quantitative data concerning the changes in the supply of money, in the broader sense, in the whole economic system, the dates on which such changes were to occur and what individuals were to be first affected by them, they would not be in a position to know beforehand whether and to what extent the demand for money for cash holding would change, and in what temporal sequence Sequence, and to what extent the prices of the various commodities would change. The price premium could counterpoise the effects of changes in the money relation upon the substantial importance and the economic significance of credit contracts, only if its appearance were to precede the occurrence of the price changes generated by the alteration in the money relation.

18:33It would have to be the result of a reasoning by virtue of which the actors try to compute in advance the date and the extent of such price changes with regard to all commodities and services which directly or indirectly count for their own state of satisfaction. However, such computations cannot be established because their performance would require a A Perfect Knowledge of Future Conditions and Valuations The emergence of the price premium is not the product of an arithmetical operation which could provide reliable knowledge and eliminate the uncertainty concerning the future. It is the outcome of the promoter's understanding of the future and their calculations based on such an understanding.

19:23It comes into existence step by step as soon as first a few and then successively more and more actors become aware of the fact that the market is faced with cash-induced changes in the money relation, and consequently with a trend oriented in a definite direction. Only when people begin to buy or to sell in order to take advantage of this trend does as the price premium come into existence. It is necessary to realize that the price premium is the outgrowth of speculations having regard for anticipated changes in the money relation. What induces it, in the case of the expectation that an inflationary trend will keep on going, is already the first sign of that phenomenon which, later, when it becomes general, is is called Flight into Real Values and finally produces the crack-up boom and the crash of the monetary system concerned.

20:26As in every case of the understanding of future developments, it is possible that the speculators may err, that the inflationary or deflationary movement will be stopped or slowed down, and that prices will differ from what they expected. The increased propensity to buy or to sell, which generates the price premium, affects as a rule short-term loans sooner and to a greater extent than long-term loans. As far as this is the case, the price premium affects the market for short-term loans first, and only later, by virtue of the concatenation of all parts of the market, also the market for long-term loans.

21:11However, there are instances in which a price premium in long-term loans appears independently of what is going on with regard to short-term loans. This was especially the case in international lending in the days in which there was still a live international capital market. It happened occasionally that lenders were confident with regard to the short-term development of a foreign country's national currency. In short-term loans stipulated in this currency there was no price premium at all, or only a slight one. But the appraisal of the long-term aspects of the currency concerned was less favorable, and in long-term contracts a considerable price premium was taken into account.

22:00The result was that long-term loans stipulated in this currency could be floated only at at a higher rate than the same debtor's loans stipulated in terms of gold or a foreign currency. We have shown one reason why the price premium can at best practically deaden but never eliminate entirely the repercussions of cash-induced changes in the money relation upon the content of credit transactions. A second reason will be dealt with in the next section. The price premium always lags behind the changes in purchasing power because what generates it is not the change in the supply of money in the broader sense, but the necessarily later occurring effects of these changes upon the price structure.

22:52Only in the final state of a ceaseless inflation do things become different. The panic of the currency catastrophe, the crack-up boom, is not only characterized by a tendency for prices to rise beyond all measure, but also by a rise beyond all measure of the positive price premium. No gross rate of interest, however great, appears to a prospective lender high enough to compensate for the losses expected from the progressing drop in the monetary unit's purchasing power. He abstains from lending and prefers to buy himself real The gross rates of interest as determined on the loan market are not uniform.

23:44The entrepreneurial component which they always include varies according to the peculiar characteristics of the specific deal. It is one of the most serious shortcomings of all historical and statistical studies devoted to the movement of interest rates that they neglect this factor. It is useless to arrange data concerning interest rates of the open market or the discount rates of the central banks in time series. The various data available for the construction of such time series are incommensurable. The same central bank's rate of discount meant something different in various periods of time. The institutional conditions affecting the activities of various nations' central banks, their private banks, and their organized loan markets are so different that it is entirely misleading to compare the nominal interest rates without paying full regard to these diversities.

24:44We know a priori that, other things being equal, the lenders are intent upon preferring Preventing high interest rates to low ones, and the debtors upon preferring low rates to high ones. But these other things are never equal. There prevails upon the loan market a tendency toward the equalization of gross interest rates for loans for which the factors determining the height of the entrepreneurial component and the price premium are equal. This knowledge provides a mental tool for the interpretation of the facts concerning the history of interest rates. Without the aid of this knowledge, the vast historical and statistical material available would be merely an accumulation of meaningless figures.

25:32In a ranging time series of the prices of certain primary commodities, empiricism has at least an apparent justification in the fact that the price data dealt with refer to the same physical object. It is a spurious excuse, indeed, as prices are not related to the unchanging physical properties of things, but to the changing values which acting men attach to them. But in the study of interest rates, even this lame excuse cannot be advanced. Gross interest rates, as they appear in reality, have nothing else in common than those characteristics Economics which Catallactic Theory sees in them. They are complex phenomena and can never be used for the construction of an empirical or a posteriori theory of interest.

26:26They can neither verify nor falsify what economics teaches about the problems involved. They constitute, if carefully analyzed with all the knowledge economics conveys, invaluable documentation for economic history. They are of no avail for economic theory. It is customary to distinguish the market for short-term loans, money market, from the market for long-term loans, capital market. A more penetrating analysis must even go further in classifying loans according to their duration. Besides, there are differences with regard to the legal characteristics which the terms In short, the loan market is not homogeneous, but the most conspicuous differences arise from the entrepreneurial component included in the gross rates of interest.

27:24It is this that people refer to when asserting that credit is based on trust or confidence. The connexity between all sectors of the loan market and the gross rates of interest determined on them is brought about by the inherent tendency of the net rates of interest included in these gross rates toward the final state of originary interest. With regard to this tendency, catalactic theory is free to deal with the market rate of interest as if it were a uniform phenomenon, and to abstract from the entrepreneurial component, which is necessarily always included in the gross rates, and from the price premium, which is occasionally included.

28:10The prices of all commodities and services are at any instant moving toward a final state. If this final state were ever to be reached, it would show in the ratio between the prices of present goods and future goods the final state of originary interest. However, the changing economy never reaches the imaginary final state. New data emerge again and again and divert the trend of prices from the previous goal of their movement toward a different final state, to which a different rate of originary interest may correspond. In the rate of originary interest, there is no more permanence than in prices and wage rates.

28:57Those people whose provident action is intent upon adjusting the employment of the factors

29:32The interest plays in these deliberations of the planning businessman is obvious. It shows him how far he can go in withholding factors of production from employment for want satisfaction in nearer periods of the future, and in dedicating them to want satisfaction in remoter periods. It shows him what period of production conforms in every concrete case to the difference which which the public makes in the ratio of valuation between present goods and future goods. It prevents him from embarking upon projects, the execution of which would not agree with the limited amount of capital goods provided by the saving of the public. It is in influencing this primordial function of the rate of interest that the driving force of money can become operative in a particular way.

30:27Each induced changes in the money relation can, under certain circumstances, affect the loan market before they affect the prices of commodities and of labor. The increase or decrease in the supply of money, in the broader sense, can increase or decrease the supply of money offered on the loan market, and thereby lower or raise the gross market rate of interest, although no change in the rate of original interest has taken place. If this happens, the market rate deviates from the height which the state of originary interest and the supply of capital goods available for production would require. Then, the market rate of interest fails to fulfill the function it plays in guiding entrepreneurial decisions.

31:17It frustrates the entrepreneur's calculation and diverts his actions from those lines in in which they would in the best possible way satisfy the most urgent needs of the consumers. Then there is a second important fact to realize. If other things being equal, the supply of money in the broader sense increases or decreases and thus brings about a general tendency for prices to rise or to drop, a positive or negative price premium would have to appear and to raise or lower the gross rate of market interest. But if such changes in the money relation affect first the loan market, they bring about just the opposite changes in the configuration of the gross market rates of interest.

32:07While a positive or negative price premium would be required to adjust the market rates of Interest to the Changes in the Money Relation, gross interest rates are in fact dropping or rising. This is the second reason why the instrumentality of the price premium cannot entirely eliminate the repercussions of cash-induced changes in the money relation upon the content of contracts concerning deferred payments. Its operation begins too late. It lags behind the changes in purchasing power, as has been shown above. Now we see that under certain circumstances, the forces that push in the opposite direction manifest themselves sooner on the market than the price premium.

32:565. The Effects of Changes in the Money Relation upon Originary Interest Like every change in the market data, changes in the money relation can possibly influence the rate of originary interest. According to the inflationist view of history, inflation by and large tends to increase the earnings of the entrepreneurs. Commodity prices rise sooner and to a steeper level than wage rates. On the one hand, wage earners and salaried people, classes who spend the greater part of their income for consumption and save little are adversely affected, and must accordingly restrict their expenditures. On the other hand, the proprietary strata of the population, whose propensity to save a considerable part of their income is much greater, are favored.

33:52They do not increase their consumption in proportion, but also increase their savings. Thus, in the community as a whole, there arises a tendency toward an intensified accumulation of new capital. Additional investment is the corollary of the restriction of consumption imposed upon that part of the population which consumes the much greater part of the annual produce of the economic system. This forced saving lowers the rate of originary interest. that accelerates the pace of economic progress and the improvement in technological methods. It is important to realize that such forced saving can originate from an inflationary movement and actually often did so originate in the past.

34:42In dealing with the effects of changes in the money relation upon the height of interest rates, one must not neglect the fact that such changes can, under certain circumstances, really alter the rate of originary interest. But several other facts must be taken into account, too. First, one must realize that forced saving can result from inflation, but need not, necessarily. It depends on the particular data of each instance of inflation, whether or not the rise in wage rates lags behind the rise in commodity prices. A tendency for real wage rates to drop is not an inescapable consequence of a decline in the monetary unit's purchasing power. It could happen that nominal wage rates rise more than or sooner than commodity prices. Furthermore, it is necessary to remember that the greater propensity of the wealthier classes to save and to accumulate capital is merely a psychological and not a praxeological fact.

35:50It could happen that these people to whom the inflationary movement conveys additional proceeds do not save and invest their boon, but employ it for an increase in their consumption. It is impossible to predict with the apodictic definiteness which characterizes all theorems of economics in what way those profiting from the inflation will act. The Theory can tell us what happened in the past, but it cannot assert that it must happen in the future. It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption. One of its consequences is that it falsifies economic calculation and accounting.

36:37It produces the phenomenon of imaginary or apparent profits. If the annual depreciation quotas are determined in such a way as not to pay full regard to the fact that the replacement of worn-out equipment will require higher costs than the amount for which it was purchased in the past, they are obviously insufficient. If in selling inventories and products the whole difference between the price spent for their acquisition and the price realized in the sale is entered in the books as a surplus, Every error is the same. If the rise in the prices of stocks and real estate is considered as a gain, the illusion is no less manifest.

37:22What makes people believe that inflation results in general prosperity is precisely such illusory gains. They feel lucky and become open-handed in spending and enjoying life. They embellish their homes, they build new mansions and patronize the entertainment business. When spending apparent gains the fanciful result of false reckoning, they are consuming capital. It does not matter who these spenders are. They may be businessmen or stock-jobbers. They may be wage earners whose demand for higher pay is satisfied by the easy-going employers who think that they are getting richer from day to day. They may be people supported by taxes, which usually absorb a great part of the apparent Gains.

38:11Finally, with the progress of inflation, more and more people become aware of the fall in purchasing power. For those not personally engaged in business and not familiar with the conditions of the stock market, the main vehicle of saving is the accumulation of savings deposits, the purchase of bonds and life insurance. All such savings are prejudiced by inflation. Thus, saving is discouraged and extravagance seems to be indicated. The ultimate reaction of the public, the flight into real values, is a desperate attempt to salvage some debris from the ruinous breakdown. It is, viewed from the angle of capital preservation, not a remedy, but merely a poor emergency measure.

39:00It can, at best, rescue a fraction of the savers' funds. The main thesis of the champions of inflationism and expansionism is thus rather weak. It may be admitted that in the past inflation often, but not always, resulted in forced saving and an increase in capital available. However, this does not mean that it must produce the same effects in the future too. On the contrary, one must realize that under modern conditions the forces driving toward and capital consumption are more likely to prevail under inflationary conditions than those driving toward capital accumulation. At any rate, the final effect of such changes upon saving, capital and the originary rate of interest depends upon the particular data of each instance.

39:54The same is valid with the necessary changes with regard to the analogous consequences Signs and Effects of a Deflationist or Restrictionist Movement.