Credit Expansion and Inflation¹

The money supply is unstable because governments can create fiat money at will and banks create uncovered money substitutes, meaning banks keep less than 100% reserves.  Those who receive the new money first, before the PPM has adjusted to the new supply, benefit.  They can trade over-valued money for goods until the new supply/demand equilibrium is reached.  People living on savings or a fixed income are hurt the worst as their costs rise but their nominal wealth remains constant.  Their real share of the money supply decreases.

Bank credit expansion, extending loans not backed by 100% reserves, is, like the creation of fiat money, a form of wealth redistribution.  Credit expansion can have worse consequences than money creation, and the problems often appear far after the act.  The benefits, however, quickly become manifest.

Inflation, including both credit expansion and fiat money creation, produce winners and losers as a new PPM equilibrium is established, depending on when each person receives the new money.  Permanent winners and losers are also created by the new equilibrium.  Each person has a unique spending pattern.  The uneven distribution of the new money, both in space and time, will cause permanent changes in relative goods prices.  This will cause permanent changes in many individuals’ consumption/investment proportions, and some will have to either buy goods which are relatively more expensive or will change their goods purchased.

Credit expansion lowers the loan rate of interest as more savings appear to be available to borrow.  This would seem to reflect a lowering of societal time preferences.  In fact, time preferences have not changed, and the loan rate and natural rate diverge.  The inflationary credit expansion has negative consequences apart from setting off the business cycle, which will be described below.  Savings, which appear to have grown, are actually hurt as savers, creditors, are repaid in devalued money.  Inflation causes capital consumption as businesses believe profits have risen and under-invest in terms of the new PPM.  These profits will appear to have risen most in the most capital-intensive businesses, since the greatest proportion of investment has been done under the old PPM but the profits appear in inflated money.  Real profits remain unchanged, but nominal profits, appearing high, attract new investment into these sectors.  Apart from investing in production above demand, investment is diverted from production which is demanded by society.  This is not understood at the time, which leads to the next step in the development of the business cycle.

Saving, Investment, and Interest Rates in the Free Market

In the free market, as the investment to consumption ratio goes up due to lowered time preferences, the prices of consumer goods fall and producer goods rise.  Goods of the lowest orders fall the most and those of the highest orders rise the most.  The structure of production is lengthened and efficiency increases as investment flows to the higher stages of production, along with labor and non-specific factors of production.  The lengthening of the production process entails more stages of production.  At the same time, the price differentials between these stages narrow.  A lower return per stage is earned in more stages of production.  This means that the natural rate of interest decreases, and this leads to a decrease in the loan rate as well.

This increase in investment, made possible by actual lowered societal time preferences and the resultant increase in available savings on the loan market, allows for a more efficient production process.  This efficiency eventually pays off in the form of more and cheaper consumer goods on the market.  Everyone’s real income increases.

There is no room for a business cycle to develop in the case just described.  Investment has been coordinated by capitalists and entrepreneurs with the information coming from the loan market.  This is turn has been a reflection of the natural rate of interest and lowered societal time preferences.  Credit expansion, while providing similar signals at first, leads to a very different scenario.

The Start of the Business Cycle

As banks extend loans not backed by reserves, the money supply increases and interest rates fall.  This fall is not, however, due to a lowering of societal time preferences.  Businesses borrow at the new, lower rates and buy capital goods and factors of production.  These resources are put to use in the higher stages of production, narrowing the price differentials between stages.  As in the first case, prices rise the most in the highest stages of production.  The difference now is that the lower interest rate which has led to the increased investment has not been matched by lower time preferences and higher savings.  Total money income was unchanged in the first case as the higher spending on the higher stages of production was offset by lower spending in the lower stages.  Also, the lengthened production structure was offset by the narrowed price differentials between stages.  Here, however, total money income increases as newly created money enters the production structure.  The lengthened production structure is not accompanied by a narrowing of the price differentials between stages because spending on consumer goods has not decreased and caused a fall in the prices of lower order goods.

The receivers of the newly created money allocate their spending based on their time preferences.  Businesses have over-invested in the higher stages of production and under-invested in the lower stages.  They were misled by the lower interest rates.  Societal time preferences and the new investments don’t match.  The savings required for sustaining the new production structure are not actually there.  The consumption/investment allocations of the public remain unchanged from where they were before the credit expansion, and the loan rate of interest is pulled back up toward the natural rate.

The prices of the goods used in the higher stages fall and the goods used in the lower stages rise back towards their levels seen before the credit expansion as the consumer demand for the new production structure is seen to not exist.  Time preferences are actually higher than the credit expansion led borrowers to believe.  The savings were never really there.  The credit expansion did not increase capital investment, it simply shifted investment to a longer production structure which was not matched by societal preferences.  The newly created money simply transferred purchasing power to the borrowers from everyone else.  The investment was financed via wealth transfer, not real, voluntary savings.

To summarize, consumers, who eventually receive the newly created money, spend according to their time preferences, which are higher than the credit expansion loan rates would make them appear.  Consumer goods prices rise as the new money is spent purchasing them, and the producer goods begin to fall as soon as there are no new loans based on credit expansion to bid them up.  The old spreads between higher and lower order goods return, and the new investment is seen to be a mistake.  Prices have risen for all goods as the PPM has decreased, but the relative prices return to pre-inflation levels, with some changes as described in the previous section on the PPM.  Societal time preference has also been altered due to the change in the PPM, but the new equilibrium approaches the old.  The business cycle elucidates the nature of the relation between the money supply and interest rates and how their manipulation affects the economy.  An increase in the money supply through credit expansion cannot permanently lower interest rates; it can only do so temporarily and at the cost of economic distortion.

Some Other Effects of the Credit Expansion

The downturn and depression phase of the cycle is really the beginning of the recovery from the harm caused during the boom.  Any actions that government may take to lessen the depression’s effects would only lead to its prolongation.  Only further credit expansion can prolong the boom period, and the further it is prolonged, the worse its effects will be.  The longer the credit expansion phase lasts, the worse the economic distortion and the resulting correction will be.  Scarce resources are misdirected during the boom, and society becomes poorer, though the opposite seems true at the time.

The expanding money supply and decreasing PPM will lower the demand to hold money, and people will begin buying goods in anticipation of continued rising prices.  If the dishoarded money flows to higher order goods, then profits will be lowered as the differentials between higher and lower stages become smaller.  This will further lower the loan rate below the natural rate, and the correction phase will be worse.

Deflation often occurs during the correction as credit contraction sets in.  This will allow for prices between goods of different orders to widen and return to levels in accordance with the natural rate of interest.  But whereas during the boom phase businesses were fooled by inflation into believing their profits were higher than they actually were, the same accounting error leads them to believe that profits are lower than they really are during deflation.  This will lead to more saving than would otherwise occur, which will help lessen the effects of the capital consumption that happened during the inflationary period.

1.  See Chapter 12, Section 11 in Rothbard’s Man, Economy, and State.

In a barter economy with no money, it is easy to see how value and purchasing power come about:  a person must produce or acquire something, whether a good or service, that someone else would want to exchange another good or service for.  This is explained by Say’s Law.

Interest is evident in a barter economy as the ratio of current goods demanded to future goods.  This is the result of time preference, and shows that interest is not a monetary phenomenon but is the result of scarcity both in goods and time.

The situation is complicated by the use of commodity money in an economy, and even more so when fiat money is used that is not restricted in quantity by anything but government discretion.

What Kind of Good is Money?¹

Is money a production or consumption good?  The loss or gain of a production or consumption good makes society worse or better off than before, but an increase or decrease in the supply of money cannot change society’s welfare, since it will only decrease or increase the purchasing power of existing money and will leave the overall value of all money unchanged.

No part of production or consumption is dependent on money, despite the fact that money greatly increases the ease of exchange.  The laws governing production and consumption goods are different than those governing money; they share only the basic laws of value.  Economic goods should therefore be divided into means of production, objects of consumption, and media of exchange.  These definitions will help to answer the question of whether or not money is capital, and help to elucidate the relation between the equilibrium (which is determined only by individuals’ time preferences) and money rates of interest.

What is the connection between private capital and money?  Private capital is the aggregate of products that are used to acquire other goods.  Money on loan bears interest, but produces nothing per se otherwise.  The borrower of money, however, exchanges it for economic goods, as do other holders of money.  Money is then part of private capital insofar as it is used as a means to obtain other capital goods.

Social capital is the aggregate of goods intended for use in further production, and money cannot be included since it is not a productive good.  The fact that the rate of interest is determined by the quantity of economic goods and not the quantity of money means that money is not a productive good.

Commodity Money²

The differences in money and commodities become obvious when looking at money’s objective exchange value, or purchasing power.  While money ultimately derives its value from the subjective valuations of people, as do all commodities, its subjective value is strongly affected by its objective exchange value, and is not so strongly affected by its objective use value and its place in the hierarchy of human needs as other goods are.

Subjective use and exchange values coincide in money since both are derived from its objective exchange value and money has no other use than in obtaining other economic goods.  The subjective use-values of commodities must be taken for granted and left to the psychology of each individual, but the analysis of money begins where the analysis of commodities stops, since money has no subjective value apart from its exchange value, and this comes from the subjective valuations of the goods for which money can be exchanged.  It is important to note that the exchange value discussed here, and which is derived from the individual subjective values placed on them, is not the same as the value theory of Smith and Ricardo and the Classical School, which took value in exchange as the starting point and which is derived from labor cost or cost of production (Marx used Smith’s labor theory of value to show the exploitation of the workers).

The price of money then is the amount of goods which money can be exchanged for.  Commodity values are explained by subjective use-value, but money only has value insofar as it can be exchanged for goods, and therefore has an objective exchange value, or price.  The objective and subjective values of money are linked.

Producers of goods focus on the exchange values of goods rather than on their use-values, which are subjective.  It is, however, the sum of the use-values placed on goods by all people in the market for those goods which determines the exchange values of those goods.

Money, however, cannot be traced back to any underlying aggregate use-values which are not tied to its own objective value which is in turn tied to the values of all the goods for which the money can be exchanged.

It was thought that the value of money depended on the economic use of the material of which it was made, but this cannot account for fiat money or credit money.  Monetary theory must remove all determinants of value which are tied to the money’s material, since these determinants make money indistinguishable from commodities.  Only the objective exchange value is important in monetary theory, as the economic value of its material can be explained by the standard tools of economics.

What gives money its value?  Fundamentally, it is the fact that market participants accept it as a medium of exchange; without this its value would collapse.  But given its acceptance, it has value as a medium through which the value of labor and goods are transferred between people.  A currency increases in value when more labor is undertaken in exchange for that currency and more goods denominated in that currency are traded.  An example is the desire of the US government to continue the pricing of international crude oil trading in dollars.  A less known example is the benefit to the dollar from having most illegal drugs priced in dollars worldwide.  Both of these increase the demand for dollars and therefore its value.  Holding supply constant for a currency, a greater amount of economic activity denominated in that currency increases its value.

Fiat Money

If the creator of the fiat currency, the government, decides to create more, it can essentially steal a proportion of the stored economic activity in that currency.  It can use the new money at the current value, before its market value decreases due to the increased supply.  Those connected to the government, who receive the money first, also benefit, as does everyone, with decreasing benefit, who acquires the money before it attains its new price based on the new supply.  This is the primary benefit of fiat currencies to governments and their partners.

The Demand for Money³

The demand for money is comprised of exchange demand and reservation demand, which gives the holder of reserves optionality.  Speculative demand exists when the PPM is expected to change.  The increase or decrease of money held hastens the change in the PPM to its expected value.

A growing economy will experience a long run increase in the demand to hold money as more exchanges and investments are made available.  Growing economies also develop clearing and credit mechanisms, which decrease the demand to hold money.

An individual’s time preference is shown in his allocation of money to consumption, investment, or to increasing his cash balance.  The proportion of money to consumption versus investment is a reflection of time preference.  An addition from income to the cash balance, or increased hoarding of cash, need not change the proportion devoted to consumption versus investment and therefore does not necessarily alter time preference or the rate of interest.  A change in the demand for money leads to a change in the PPM, while a change in time preference leads to a change in interest rates.

Interest as Time Preference⁴

A proper understanding of the nature of interest rates is fundamental to understanding the business cycle, which is itself caused by a divergence between the real and loan rates of interest.  This divergence, caused by an expansion of credit not backed by real savings, distorts the information provided by interest rates to entrepreneurs.  The phenomenon of interest results from the real economy as a result of time preference, which causes, all else equal, a higher price for goods now than in the future.  The pure rate of interest is the difference in value between present goods and future goods.  In the production process, interest is calculated as the difference in the final good and the sum of the factors of production, which are discounted to the final goods price due to time preference.  Productivity theories of interest ascribed the earning of interest to the productivity of the various factors of production.  In actuality, the prices of the capital goods are based on their productivity, but the discount of their prices to the final goods they help produce is due to time preference and is the pure rate of interest.

The classical economists called profit, or interest, the return to capital, rent the return to land, and wages the return to labor, but all three are really the result of time preference and their prices are calculated from their discounted products.  For example, without time preference and discounting, productive land prices would be infinite.

The pure rate of interest explains why shorter, less productive methods of production might be chosen over longer, more productive techniques.  Time preference often proves a stronger force than achieving more production per input.

Contrary to some theories, interest is not determined by the supply of and demand for capital goods on the market, but determines them, along with how much of the current stock of capital goods will be saved or consumed.  Interest does not cause saving, but aggregates the various individual time preferences of market participants and signals to borrowers a hurdle rate with which to analyze potential projects, and to potential savers what are the opportunity costs of consumption.  So the interest rate, as a manifestation of the goods economy and individual time preferences, serves as a signal from the real economy to the money loan market and brings its interest rates in line with the aggregated time preferences of a society.

Interest in a Monetary Economy⁵

The natural rate of interest is the market rate of return to economic production, also known as the marginal efficiency of capital.  The loan rate is simply a reflection of the natural rate and depends on the various expectations and decisions which economic actors make on the loan markets, stock markets, and other financial markets.

The natural rate is composed of the pure rate, which is due to time preference; the rates of return specific to various lines of production, which differ in risk, etc.; a purchasing power component which corrects for changes in the PPM during the time lag in the production process; and a terms of trade component due to the non-neutrality of money and the resulting different speeds of price change between factors of production and final goods.  Only the pure rate would exist in a world without uncertainty.

The relationship between interest rate changes and price changes will be analyzed in two parts:  first under the assumption of neutral money, and then allowing for non-neutrality of money.

A rise or fall in prices, meaning a fall or rise in the PPM, will cause nominal and real returns to deviate due to the time lag between the purchase of the factors of production and the sale of the final product.  In a world of rising prices, rates of return will appear higher than they are.  The decrease in the PPM will show that the apparent rise in profits was illusory.  Because of this deviation between the nominal and real return, the natural rate of interest contains a purchasing power component which corrects for actual changes in the PPM during the production process.  The purchasing power component would not exist if changes in the PPM were fully anticipated since market activity would quickly align the current PPM with the anticipated future PPM.

Changes in the PPM are never neutral, meaning they affect different goods differently.  The changes alter the hypothetical array of goods which measures the PPM.  Because of this, factors of production and final goods change at different speeds when the PPM changes and different factors change at different speeds, which changes the terms of trade in a production process.  When product prices rise faster than factor prices, a positive terms of trade component exists in the natural rate of interest and will be reflected in the loan rate.

Changes in the PPM⁶

A change in the money relation, which is the demand for and supply of money, is non-neutral, meaning, for example, that a doubling of the supply of money will not result in a doubling of all prices.  The new equilibrium between the money relation and goods will be different than the old equilibrium, apart from higher prices, and the path to that new equilibrium will not be predictable.  The relative prices between goods will also be changed.  Some people will gain and some people will lose.  Those whose selling prices rise faster than their buying prices will gain, as will those who receive the new money before goods prices have adjusted to the new money relation.  The new money will enter the economy at some points and will diffuse throughout the economy until individual prices have adjusted and a new equilibrium has been reached.

There is no gain in social utility from the new money relation resulting from a doubling of the money supply, only a transfer of some peoples’ PPM to others.  There are some who gain and some who lose, and there is a possibly destabilizing path to a new equilibrium.  Time preferences could also be changed since the winners will have different preferences than the losers.

The Money Supply and Goods Prices⁷

The exchange demand for goods is equal to the supply of money minus the reservation demand for money.  The total demand for goods is equal to the supply of money minus the reservation demand for money plus the reservation demand for all goods.  These are general and obvious relations, and it can be seen that any change in the money supply will have unpredictable consequences for the demand for any particular goods.

The exchange demand for money is equal to the supply of all goods minus the reservation demand for all goods.  All of these relations are pointing to the same thing, which is the PPM.  A rise in the supply of goods or the reservation demand for money cause the PPM to increase and a rise in the stock of money or the reservation demand for goods cause the PPM to decrease.  An increase in demand for any particular good will cause a decrease in demand for one or more other goods absent a decrease in the reservation demand for money.  A change in any specific demand for a good will not change the PPM if there is no change in the reservation demand for money.

PPM Stabilization⁸

All economic laws are qualitative.  Mathematical descriptions of economic laws obscure the fact that there are no constants in human action.  Mathematics relies on simplifications which cannot describe the level of uncertainty in the ever-changing magnitudes and correlations inherent in human economic activity.  For this reason the quantitative methods used to stabilize or control the PPM are dubious and often harmful.  These actions rely on indices which are supposed to measure a typical basket of goods available to the average consumer.  This average consumer, however, has constantly changing value scales and utilities of money and goods.  The attempt to stabilize the PPM through controlling the money supply will alter each individual’s value scales and will change the relative utilities of goods and the utility of money.  The PPM can and should change as the utility of money relative to each available good changes.  A stable PPM is actually destabilizing as it masks the natural changes taking place between money and each good and between the relative prices of all goods.  Individuals holding or spending money is socially useful as it is a reflection of individual value scales.  A fluctuating PPM is a natural result and reflection of this utility.  Useful economic information is distorted.  This fact will take on more importance when business cycles are studied.

1.  See Chapter 5 of Mises’ Theory of Money and Credit.

2.  See Chapter 7 of Mises’ Theory of Money and Credit.

3.  See Chapter 17 of Mises’ Human Action and Chapter 11 of Rothbard’s Man, Economy, and State.

4.  See Chapter 19 of Mises’ Human Action.

5.  See Chapter 6 in Rothbard’s Man, Economy, and State.

6.  See Chapter 11, Section 7 in Rothbard’s Man, Economy, and State.

7.  See Chapter 11, Section 8 in Rothbard’s Man, Economy, and State.

8.  See Chapter 11, Section 14 in Rothbard’s Man, Economy, and State.