This talk was delivered at the 2013 Jeremy Davis Mises
Circle in Houston, Texas.
In December it will be 100 years since Congress authorized the
creation of the Federal Reserve System. Throughout that century the Fed has
enjoyed broad bipartisan support. Thats another way of saying the Fed
never appeared on the political radar until Ron Paul broke the rules by
actually campaigning against it in 2007.
The Fed was supposed to provide stability to the financial sector and
the economy at large. We are supposed to believe it has been a wonderful
success. A glance at the headlines over the past five years renders an unkind
verdict on this rarely examined assumption.
Last year we observed another important centenary the
100-year anniversary of the publication of Ludwig von Misess pathbreaking book, The Theory of Money and Credit,
written when the great economist was just 31. The end of an era was
approaching as that book reached the public. A century of sound money, albeit
with exceptions here and there, was drawing to a close. It had likewise been
a century of peace, or at least without a continent-wide war, since the
Congress of Vienna. Both of these happy trends came to an abrupt end for the
same reason: the outbreak in 1914 of World War I, the great cataclysm of
It was as though Mises had one eye to the
past, speaking of the merits of a monetary system which
while not perfectly laissez-faire had served the world so well for
so long, and another eye to the future, as he warned of the consequences of
tampering with or abandoning that system. Mises
carefully dismantled the inflationist doctrines that were to ravage much of
the world during the twentieth century.
That book covered the whole expanse of monetary theory, including
money and its origins, interest rates, time preference, banking, credit,
inflation, deflation, exchange rates, and business cycles.
Most important for our topic today was Misess
warning to the worlds monetary authorities not to
suppress the market rate of interest in the name of creating prosperity. The
failure to heed Misess advice,
indeed the full-fledged ignorance or outright defiance of that advice, is the
monetary story of the twentieth century.
The single most arresting economic event of the Feds
century was surely the Great Depression. This was supposed to have
discredited laissez-faire and the free economy for good. Wild speculation was
said to have created a stock market bubble, and the bust in 1929 was what the
unregulated market had allegedly wrought. Other critics said the problem had
been the free markets unfair distribution of wealth:
the impoverished masses simply couldnt
afford to buy what the stores had for sale. In later years, even so-called
free-marketeers would blame the Depression on too
little intervention into the market by the Federal Reserve. (With friends
like these, who needs enemies?)
Ludwig von Mises offered a different
explanation, as did F.A. Hayek, Lionel Robbins, and other scholars working in
the Austrian tradition in those days. Murray N. Rothbard,
in turn, would devote his 1962 book Americas Great Depression to
an Austrian analysis of this misunderstood episode.
The study of business cycles differs from the study of economic hard
times. Economic conditions can be poor because of war, a natural disaster, or
some other calamity that disrupts the normal functioning of the market.
Business cycle research is not interested in those kinds of conditions. It
seeks to understand economic boom and bust when none of these obvious factors
Mises referred to
his own approach as the Circulation Credit theory of the business cycle. For
our purposes, we can describe it in brief.
On the free market, when people increase their saving, that increased
saving has two important consequences. First, it lowers interest rates. These
lower interest rates, in turn, make it possible for entrepreneurs to pursue a
range of long-term investment projects profitably, thanks to the lower cost
of financing. Second, the act of saving and thus abstaining from spending on
consumer goods, releases resources that these entrepreneurs can use to
complete their new projects. If consumer-goods industries no longer need
quite so many resources, since (as we stipulated at the start) people are
buying fewer consumer goods, those released resources provide the physical
wherewithal to carry out the long-term production projects that the lower
interest rates encouraged entrepreneurs to initiate.
Note that it is decisions and actions by the public that provide the
means for this capital expansion. "If the public does not provide these
means," Mises explains, "they cannot be
conjured up by the magic of banking tricks."
But "banking tricks" are precisely how the Fed tries to
stimulate the economy. The Fed lowers interest rates artificially, without an
increase in saving on the part of the public, and without a corresponding
release of resources. The public has not made available the additional means
of production necessary to make the array of long-term production projects
profitable. The boom will therefore be abortive, and the bust becomes
In short, interest rates on a free market reflect peoples
willingness to abstain from immediate consumption and thereby make resources
available for business expansion. They give the entrepreneur an idea of how
far and in what ways he may expand. Market interest rates help entrepreneurs
distinguish between projects that are appropriate to the current state of
resource availability, and projects that are not, projects that the public is
willing to sustain by its saving and projects that
they are not.
The central bank confuses this process when it intervenes in the
market to lower interest rates. As Mises put it:
The policy of artificially lowering the rate of interest below its
potential market height seduces the entrepreneurs to embark upon certain
projects of which the public does not approve. In the market economy, each
member of society has his share in determining the amount of additional
investment. There is no means of fooling the public all of the time by
tampering with the rate of interest. Sooner or later, the publics
disapproval of a policy of over-expansion takes effect. Then the airy
structure of the artificial prosperity collapses.
None of these cycles will be exactly like any other. Roger Garrison
says the artificial boom will tend to latch on to and distort whatever the
big thing at the time happens to be tech stocks in the 1990s, for
example, and housing in the most recent boom.
With this theoretical apparatus as a guide, Mises
became convinced as the 1920s wore on that the seeds of a bust were being
sown. This was not a fashionable position. Irving Fisher, a godfather of
modern neoclassical economics and the man Milton Friedman called the greatest
American economist, could see nothing but continued growth and prosperity in
his own survey of economic conditions at the time. In fact, Fishers
predictions in the late 1920s, even in the very midst of the crash, are
On September 5, 1929, Fisher wrote: "There may be a recession in
stock prices, but not anything in the nature of a crash
possibility of which I fail to see."
In mid-October, Fisher said stocks had reached a "permanently
high plateau." He expected "to see the stock market a good deal
higher than it is today within a few months." He did "not feel that
there will soon, if ever, be a fifty- or sixty-point break below present
On October 22 Fisher was speaking of "a mild bull market that
will gain momentum next year." With the stock market crashing and values
plummeting all around him with declines far more severe
than Fisher had been prepared to admit were even conceivable Fisher
on November 3 insisted that stock prices were "absurdly low." But
they would go much lower, ultimately losing 90 percent of their peak value.
What had gone so horribly wrong? Fisher and his colleagues had been
blinded by their assumptions. They had been looking at the "price
level" and at economic growth figures to determine the health of the
economy. They concluded that the 1920s were a period of solid, sustainable
economic progress, and were taken completely by surprise by the onset and persistence
of the Depression.
Mises, on the other
hand, was not fooled by the 1920s. For Mises and
the Austrians, crude aggregates of the kind Fisher consulted were not
suitable for ascertaining the condition of the economy. To the contrary,
these macro-level measurements concealed the economy-wide micro-level
maladjustments that resulted from the artificial credit expansion. The
misdirection of resources into unsustainable projects, and the expansion or
creation of stages of production that the economy cannot sustain, do not show up in national income accounting figures. What
matters is that interest rates were pushed lower than they would otherwise
have been, thereby leading the economy into an unsustainable configuration
that had to be reversed in a bust.
Thus Mises wrote in 1928:
It is clear that the crisis must come sooner or later. It is also
clear that the crisis must always be caused, primarily and directly, by the
change in the conduct of the banks. If we speak of error on the part of the
banks, however, we must point to the wrong they do in encouraging the
upswing. The fault lies, not with the policy of raising the interest rate,
but only with the fact that it was raised too late.
Once the crisis hit, Mises showed how his
theory of business cycles accounted for what was happening. If people could
understand how the crash had come about, Mises
hoped, they would be less likely to exacerbate the problem with
counterproductive government policy.
"The Causes of the Economic Crisis" was the title of an
address Ludwig von Mises delivered in late February
1931 to a group of German industrialists. It was unknown to English-speaking
audiences until 1978, when it was published as a chapter in a collection of Misess essays called On the Manipulation of Money and
Credit. The Mises Institute
published a new edition of these essays in 2006 under the title The Causes of the Economic Crisis:
And Other Essays Before and After the Great Depression.
In that essay Mises was characteristically
blunt in describing the causes of the Great Depression, as well as in his
warnings that such crises would recur as long as the authorities continued to
pursue the same destructive courses of action.
The crisis from which we are now suffering is
outcome of a credit expansion. The present crisis is the unavoidable sequel
to a boom. Such a crisis necessarily follows every boom generated by the
attempt to reduce the "natural rate of interest" through increasing
the fiduciary media [in other words, through creating credit out of thin air]
As we have seen at this event today, the crisis whose wreckage we see
all around us right now, a crisis that began in 2008, originated from the
same interventions Mises warned against a century
ago. Mises would not have been surprised by the
Panic of 2008. In 1931 he warned of a recurrence of boom-bust cycles if the
policy of artificially low interest rates was not abandoned:
The appearance of periodically recurring economic crises is the
necessary consequence of repeatedly renewed attempts to reduce the "natural"
rates of interest on the market by means of banking policy. The crises will
never disappear so long as men have not learned to avoid such pump-priming,
because an artificially stimulated boom must inevitably lead to crisis and
All attempts to emerge from the crisis by new interventionist measures
are completely misguided. There is only one way out of the crisis
Give up the pursuit of policies which seek to establish interest rates, wage
rates, and commodity prices different from those the market indicates.
In the 1920s as now, fashionable opinion could see no major crisis
coming. Then as now, the public was assured that the experts at the Fed were
smoothing out economic fluctuations and deserved credit for bringing about
unprecedented prosperity. And then as now, when the bust came, the free
market took the blame for what the Federal Reserve had caused.
It is fitting that a century of the Federal Reserve should come to an
end at a moment of economic crisis and uncertainty, with the central banks
leadership confused and in disarray after the economys
failure to respond to unprecedented doses of monetary intervention. The
century of the Fed has been a century of depression, recession, inflation,
financial bubbles, and unsound banking, and its legacy is the precipice on
which our economy now precariously rests.
Faced with a slow-motion train wreck they feel helpless to stop,
people often ask what they can do.
There are no easy answers, to be sure. But one thing is certain: there
will be no progress without the spread of knowledge.
I hope youll be
a part of the crucial and historic moment that lies before us.
Thanks in large part to Ron Paul, recent years have seen a spectacular
revival of interest in the Austrian School of economics and in particular its
theory of the business cycle. This is a deeply significant and most welcome
development. Until recently, even supporters of the free market had by and
large ignored the Federal Reserve, or even thought of it as a potentially
stabilizing force in a capitalist economy. The possibility that its
interventions into the market may actually have been destabilizing, and
actually have been the cause of the boom-bust cycle, was hardly to be heard
anywhere. Were you to say such a thing at an ostensibly free-market
conference, chances were slim that you would appear on the following years
For more than 30 years, however, the Mises
Institute has been dedicated to the pursuit of economic science in the
Austrian tradition. Weve
warned against the economic damage caused by central banking at a time when
that message couldnt have been
less fashionable. Youve
already seen some of the results of our work here this weekend: three of our speakers Peter Klein, Bob Murphy, and Tom
Woods came through the Institutes
programs during their college years.
But now, with the vastly increased demand for what we offer, we want
to step things up. Way up.
One of our primary goals is to carry out what we are calling Operation
Ron Paul. We want to equip the masses of young people drawn to the Austrian
School by Rons heroic work with the skills, resources, and
knowledge theyll need in order to keep the
Austrian School and Rons message vital and growing.
We are also setting up an Economic Crisis Project, to be ready now and
when the next event hits, with the scholarly and popular explanations of what
happened, and what to do about it.
What is attractive about the market economy is not simply what it
accomplishes materially: ever-higher standards of living, prosperity for the
masses that the most exalted monarchs of yore could scarcely have imagined
for themselves, and the ability to support far larger populations than anyone
centuries ago could have dreamed. This is all great cause for celebration, to
be sure. But what the beautiful order of the market shows is
the staggering, near-miraculous achievements of mankind by means of
voluntary cooperation, and without state violence or an exalted leader
ordering people around.
Set against this marvelous spectacle, the government-privileged
central bank is a grotesque anomaly. To say that we need a politically
created monopoly to create money, the commodity that constitutes one-half of
every non-barter transaction, is to say that the market economy is not really
so impressive or effective after all. If we must conjure a specially
privileged monopoly to create this most essential commodity, and if that
monopoly is likewise given the task of managing the economy to maximize
employment and output, then we are in principle abandoning the whole case for
the free market and conceding the value of central planning.
do not need any such monopoly, as the work of the Austrian economists makes
clear, and we do not need any form of central planning. We need the free
market, which is another way of saying we need to let people make their own
decisions, enter into the agreements of their choice, and be secure in their
The Austrian School is enjoying its most spectacular surge in growth
in its entire history. A generation of smart young people
are reading everything they can find on Austrian economics. The
Austrian diagnosis of the economic crisis is so widespread that even
establishment writers and economists have been forced to engage with it.
Let’s make sure this surge doesnt
fizzle out. If we build on these early successes, if we carry forward the
message of the Austrian School relentlessly and courageously, we can
make the next hundred years a Misesian century of
peace, sound money, and liberty. Please join us.