Mainstream economics--by which I mean, the sort of economics that is taught in universities and promulgated in the mainstream press--is clearly in a grievous state and has been so for many decades now. One of the most serious deficiencies of academic economists is their incorrigible obtuseness concerning the business cycle. Despite all their theories about how business cycles come about and all the statistical evidence they have compiled detailing what happens when an economy goes into its inevitable malaise, they are still at sea when it comes to prognostication. Nor is it simply a matter of not being able to say precisely when an economy will rise or fall. Exact predictions in economics are impossible. But at least one would expect economists to have a rough idea of where the economy is likely to go. Even in respect to this very modest goal, mainstream economists fail more often than not. In June 1990, to take one example, 88% of economists polled predicted a continued economic expansion. [Prechter, The Crest of the Wave, 19] A month later, the economy promptly nose-dived into the worst recession in a decade. Economists really ought to do better if they expect any intelligent man to take them seriously.
Their grasp of the financial side of things is little better. Mainstream economists were just as clueless about the nineties' stock market as they were about the economy as a whole. "Economists are as perplexed as anyone by the behavior of the stock market," Stanford economics professor Robert Hall confessed. To the question, "Is the Stock Market too high?" Berkeley economics professor J. Bradford De Long answered, "No one knows." Is this not incredible? What good are all their graduate and postgraduate degrees, all their mathematical and empirical training, all their models and analysis, if they cannot explain something so simple as the behavior of the stock market?
Now as long as the economy is humming along at a good pace and most people are doing just fine, the fact that the overwhelming majority of professional economists are clueless about business cycles provokes little interest. Why should any of us care, as long as the paychecks keep flowing into our bank accounts and our credit card debt is manageable? But as soon the economy begins to flounder and we find ourselves facing unemployment and crushing debts, we are likely to take a different attitude towards the intellectual malfeasance of mainstream economists. Their ignorance now seems to be implicated in our misfortune. Perhaps if they knew something more about business cycles than do palmists and tarot card readers, we could turn to them for guidance in time of crisis. But given their track record, this would clearly not be a very wise thing to do.
Who, then, in a time of economic crisis, should we turn to? Is there anyone at all who understands these mysterious fluctuations in economic activity that lead so inevitably to booms and busts? Or is the science of economics, and especially of business cycle research, one vast and perpetual morass of unintelligibility?
To know nothing is to be in a lamentable to state. But even worse is to think one knows when one is actually quite ignorant. Mainstream economists may appear ignorant to those who observe them from the outside and can hardly fail to notice how often they are wrong concerning the direction of the economy. But this is not how they perceive the matter. In their own eyes, they are great interpreters of economic fact, men whose understanding and wisdom soars well above the common herd. Icarus had his wings, all wax and feathers, and economics its "science," all mathematics and intellectual pretense; yet neither, I fear, can hold fast under the bright warm glare of truth. Economists have compiled all sorts of theories to try to explain the business cycle, none of which, alas, are all that convincing or can be counted on in the practical matter of guiding fiscal and monetary policy. Consider, as one example, perhaps the most influential business cycle theory within the economics profession today, the Keynesian theory, as expounded by the pundit-master of liberal economics himself, Paul Krugman. "As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple," Krugman smugly assures us. "A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time." [Slate, 1998]
This explanation, like so many propagated by Lord Keynes and his followers, raises more questions than it answers. Business cycles, we are told, happen when, for some inexplicable reason, a whole lot of people suddenly decide to increase their cash holdings. But why should such a thing ever occur in the first place? Why would so many people, at the very same time, decide to start stuffing their mattresses with cash? How can we explain so singular an occurrence? Is it mere coincidence? A malignant conjunction of the planets? Or is it perhaps a wave of temporary hoarding insanity that spreads through the population like a vulgar fashion or a bad cold? It is very odd that a man of Krugman's stamp, who is so sure that he alone is right and that everyone who disagrees with him is a complete dunce, should offer up so ridiculous a theory. For it should be clear that Krugman's Keynesian theory of recessions suffers from an egregious superficiality. Imagine if some medical researcher had written an editorial in the New York Times insisting that the common cold is caused by a sore throat! Yet Krugman's statement is no more credible. Increased cash reserves is merely a symptom of a recession, not its cause. If you cannot provide a coherent explanation of why a large part of the private sector increases its cash reserves at the commencement of an economic crisis, you will never explain why recessions happen.
If mainstream economics cannot provide us with an adequate explanation of the business cycle, who on earth can? Has any progress at all been made in explicating this great mystery? Well, yes, some progress has been made. Not in mainstream economics, but on fringes, a few economists can give you at least a rough idea of the how and why of recessions. The best theories are those that arose at the turn of the century out of Austria. Two men in particular deserve mention: Ludwig von Mises and Joseph Schumpeter. In 1911, they each published a book introducing a new theory of the business cycle. Mises' theory, introduced in his classic The Theory of Money and Credit, is known as the Austrian theory of the trade cycle, because it relies heavily on the work of the two great founders of the so-called "Austrian school" of economics, Carl Menger and Eugen Böhm-Bawerk. Schumpeter's theory, which, due to its unique and heterodox nature, has no special name of its own and belongs to know particular school (though it dovetails nicely with certain aspects of the Austrian theory), was first introduced to the world in the pathbreaking The Theory of Economic Development. While neither of these theories is fully adequate, they both provide the essential groundwork for grasping the inner workings of the business cycle.
Mises theory begins with an examination of the interest rate. Mises' teacher, Böhm-Bawerk, had argued that the phenomenon of interest could only be accounted for on the basis of what he called a "time-preference." The interest rate, this theory claims, stems from the fact that people prefer present spending over future spending. If a man borrows $100 for one year at 10 per cent, this is tantamount to saying that he would rather have a $100 now than $110 a year from now. [Hazlitt, The Failure of the "New Economics", 204] In the words of Mexican economist Faustino Ballvé: "If the entrepreneur obtains money, he is able to have today what he could otherwise not have until tomorrow. When he obtains a loan, he buys time: the interest that he pays is the price of the advantage he obtains from having at his disposal immediately what he would otherwise have to wait for." [Essentials of Economics, 205]
With this theory of time-preference well in hand, Mises proceeds to analyze what happens when the banks (usually at the behest of the government) seek to stimulate the economy by "artificially" lowering the interest rate. What happens is that when the interest rate falls, it falls below the level that would have been determined by the time-preference of the general public. This means that the new interest rate fails to express what is really going on in the economy. A "genuine" decrease in the interest rate would mean that the public's time-preference had changed: most people would prefer to save now and spend later. This in turn would bring about an increase of savings and more money for the banks to loan to entrepreneurs. But when the interest rate is lowered artificially, there exists no corresponding increase in savings. Instead, the banks merely create money by expanding credit. The bank, for examples, lends money to Peter. Peter pays off Paul, his contractor, and Paul deposits the money back in the bank. Then the bank turns around and lends Paul's savings-deposits to someone else. Through this process the bank expands credit well beyond its original reserves. A bank with $100,000 in savings deposits can quickly multiply its credit to well over a million dollars. The only restraint on this process is what is called a reserve requirement. Banks have to keep a certain percentage of a customer's savings-deposits as a reserve, so that they will always have cash on hand to pay depositors who want to take money out of their accounts. But these reserves are usually a very small percentage-sometimes as low as three per cent. The capacity to expand credit is therefore potentially significant.
Now according to Mises' trade cycle theory, when banks lower interest rates by expanding credit, entrepreneurs suddenly find that they can safely invest in lengthy and time-consuming projects which, on the basis of the original interest rates, would never have been profitable. Mises argues that in assuming this, the entrepreneurs have committed a major error. Herein lies the problem; for it turns out that these new projects are not really profitable, because there exists no real savings to fund them. The time-preference of the public has not really changed. The average Joe still wants to spend as much of his money on consumer goods as he did before. But if Joe continues to spend the same proportion on consumption goods as before, this means that there exists no real money to spend on investment goods, since the pool of investment goods remains the same. The entrepreneur's investment is based on a mirage. The amount of capital goods, of machines and tools, remains the same. All that has changed is that there is more money to spend on such items. The inevitable result of this state of affairs is a rise of prices within the capital goods industry. Entrepreneurial projects suddenly become more expensive. The entrepreneur, thinking that, with the decrease in the interest rates, he can afford new investments in capital goods, has been fooled. All his calculations have proved futile. He failed to anticipate that the price of capital goods would rise before he could carry out his entrepreneurial investment all the way through. "Business had been seduced by the governmental tampering and artificial lowering of the rate of interest [into acting] as if more savings were available to invest than were really there," is how Austrian economist Murray Rothbard, in his exposition of Mises' theory, explained the process. "As soon as the new bank money filtered through the system,it became clear that there were not enough savings to buy all the producers' goods, and that business had misinvested the limited savings available. Business had overinvested in capital goods and underinvested in consumer products." [The Austrian Theory of the Trade Cycle, 84]
Although this theory is certainly preferable to anything found in contemporary mainstream economics, there are still a number of things seriously wrong with it. To begin with, the theory is clearly motivated by an ideological prejudice against any kind of state intervention in the market. The Austrian school has largely been infiltrated by partisans of laissez-faire who dogmatically believe that all government interference in the economy is always bad. But the economist must not allow his ideological biases to influence his conclusions. What the economist should be endeavoring to discover is what is actually happening in economic reality, irrespective of policy implications. Policy implications are the province of ideologues-that is, of those who have already made up their minds ahead of time and have no interest in the truth.
If we look at the Austrian theory impartially, without the biases engendered by a political or ideological point of view, we will find a number of serious shortcomings. The Austrian vision, although so clear in some directions, is clouded in others by a fog of wishful thinking and ideological presumption. At the very commencement of their theory, we find them lapsing into error. The interest rate, they claim, is a product of "time-preference." But is this really true?
While this view of the matter may have a certain amount of logical plausibility, it fails to account for several important empirical realities, the most critical of which involves the question of motivation. Do lenders really charge interest rates because they would rather spend more money now than later? No, not quite. Their motivation is really a great deal more complicated than that. Very few people with money to lend stops to think of how much the money is going to be "worth" to them a year from now. The fact is, they don't really know how much the money will be worth to them in a years time. The future is a realm of great uncertainty-so much so that it is very unlikely that time-preference plays an important part in the calculations of more than a handful of lenders. And it probably plays an even smaller role in the calculations of savers and borrowers. People save for a variety of motives that have little if anything to do with time-preference. The most common motive is uncertainty about the future. The proverbial "save for a rainy day" falls under this category. Or people save because they don't have enough money to buy what they want right now. While there is an element of time-preference in such saving, to regard it solely as the consequence of time-preference is naive, because that is not how people think. Most people do not think in terms of time-preference, and so if you want to predict their behavior, you better not overemphasize the time-preference factor.
The economist Frank Knight had a much better grasp of this issue than anybody within the Austrian camp. He wrote in his classic work Risk, Uncertainty, and Profit: "The saving of capital seems to us to be in fact the result mainly of two or three motives of which the desire for increased consumption of goods in the future is only one and probably one of the less important. Like other acts of man in society, it is largely a mere matter of established custom, good form, the thing to do, the mores. Then we must emphasize the impulse to create. Probably the greatest single source of saving is the putting of income back into a business, because of sheer interest in the business and the desire to make it grow. That the desire for the increased income is not the dominant motive in much of this is proved by the fact that men invest as desperately in an enterprise never likely to be profitable as they do in the most prosperous concern, and by the further fact that much of the reinvestment in society is made by directors of corporations who will not get the fruits of the work for themselves at all. The truth is, we believe, that the real motives of human life, at least of those people who do big things, are idealistic in character. The business man has the same fundamental psychology as the artist, inventor, or statesman. He has set himself at a certain work and the work absorbs and becomes himself. It is the expression of his personality; he lives in its growth and perfection according to his plans." [162-163]
Knight's analysis suggests that there is something else wrong with the Austrian theory: namely, that it is too rationalistic. It places too much faith on rationalistic calculation, when, as a matter of fact, in real life, a great deal of motivation arises from idealistic and (let us be scrupulously honest with ourselves) irrational impulses. Even more important is Knight's allusion to "established custom" and "mores." The Austrian theory tends to regard individuals as mere rationalistic profit-maximizers, when, as a matter of fact, they are often nothing of the sort. Many an individual who becomes rich does so not because he aimed for riches but through mere accident, through following his private vision instead of the bottom line. Many small business owners seek only to make enough money to get by, that is, to keep their measly enterprises afloat. From a purely monetary standpoint, they might be much better off as an employee in some massive corporation. But because they prefer working for themselves to making more money, they choose to stick with a business that barely produces enough revenue to keep itself in the black.
The Austrian theory, because of its rationalist naiveté concerning human motivation, runs afoul of the facts in other areas of their business cycle speculations. According to the Austrians, as soon as the interest rates fall, entrepreneurs flock to banks looking for loans to fund projects which, at a slightly higher rate, would be judged unfeasible. But is this really what happens in the real world? Perhaps in some instances this happens. But does it happen in all instances? I don't think so. Since not all entrepreneurs are profit-maximizers eager to expand their businesses at the first opportunity, we have no right to conclude that a fall in interest rates will always trigger enough entrepreneurial borrowing to bring about the kind of malinvestments in the capital goods industries predicted by the Austrian theory. In some instances, perhaps it may. But in others, perhaps it won't. And if it cannot explain all instances, then the Austrian theory cannot be regarded as a complete theory applying to all cyclical theories.
Yet this is not all that is wrong with it. Another shortcoming in the Austrian theory involves its underestimation of the profound effect of uncertainty. By uncertainty, I don't mean merely a failure to guess what is going to happen. The Austrian theory obviously stresses the role that misperceptions about the true state of the economy play in savings and investment. Businessmen, the Austrians contend, are led to misperceive the true state of the capital market by the artificial lowering of interest rates. But this assumes that, in the absence of interest rate manipulations, businessmen would not have misperceived the true state of the capital market. Is this a plausible assumption?
No, as a matter of fact, it isn't, because it fails to take into account the radical uncertainty of economic life. The fact of the matter is, there are certain things about the future we simply do not know and can't even guess. This is precisely what is meant by uncertainty. In a fluxing economy, where consumers tastes are often changing and some businesses are emerging while others are lapsing into bankruptcy or finding themselves gobbled up by stronger competitors, no one knows precisely what products consumers will demand by the time a projected good reaches the market or, ipso facto, how capital should be optimally allocated in capital goods industries. It's all a matter of guesswork, shrewd prophecy and luck.
Businesses, in their effort to come to grips with the uncertainty of economic life, devise various methods of increasing their control over consumer wants, to make them less unpredictable. Hence the important role that advertising, in which consumer demand is manipulated by vulgar appeals to gross appetite, plays in the economic farce. "One of the most fundamental weaknesses of the market system is the use of persuasive influence by sellers upon buyers and a general excessive tendency to produce wants for goods rather than goods for the satisfaction of wants," observed Frank Knight. [Freedom and Reform, 39] Businesses are eager to create demand for their products. But since in a competitive economy there will be a vast multitude of retailers trying to create demand for their wares, there is always going to exist a great deal of uncertainty as to who will succeed in the game of consumer manipulation. With so many goods vying for the attention of the consumer, it is difficult to know which combination of goods and advertising manipulation will succeed in triggering the appropriate spike in consumer demand.
The Austrian theory, by ignoring this element of consumer demand, falls prey to several errors, the most serious of which is its overestimation of the factor of consumer sovereignty. "On the market of a capitalistic society the common man is the sovereign consumer whose buying or abstention from buying ultimately determines what should be produced and in what quantity and quality," explained Ludwig von Mises in his brief polemical work, The Anti-Capitalist Mentality. "Big business always serves-directly or indirectly-the masses." [1-2]
Mises strongly disapproves of the opposing view which claims that consumers are brainwashed by corporations through sophisticated advertising techniques. "It is a widespread fallacy that skillful advertising can talk the consumers into buying everything that the advertiser wants them to buy," he wrote in his magnum opus, Human Action. "The consumer is, according to this legend, simply defenseless against 'high-pressure' advertising. If this were true, success or failure in business would depend on the mode of advertising only. However, nobody believes that any kind of advertising would have succeeded in making the candlemakers hold the field against the electric bulb, the horsedrivers against the motorcars, the goose quill against the steel pen and later against the fountain pen. But whoever admits this implies that the quality of the commodity advertised is instrumental in bringing about the success of an advertising campaign. Then there is no reason to maintain that advertising is a method of cheating the gullible public." [321]
Mises argument, though perfectly sound as far as it goes, nevertheless spreads more confusion on the subject than light. The question in advertising is not whether businesses could ever use propaganda techniques and hypnotic suggestion to sell candles in place of lightbulbs or horse and buggies in place of automobiles. No, what is at stake involves a far more subtle point. Left-wing critics of capitalism who believe consumers are so gullible that they can be manipulated by multi-national corporations into buying anything are clearly guilty of gross exaggeration. But this does not mean that the exact opposite view is any more tenable. That most corporate advertising is suggestive and manipulative, rather than informative and objective, no disinterested observer would ever deny, as even some of Mises' own followers have admitted. Consider the following remark courtesy of the Austrian economist Wilhelm Roepke: "It is undeniable that the 'sovereignty of the consumer'is seriously impaired by the suggestions which advertising puts out in an attempt to replace his true needs by imaginary ones. At the same time advertising becomes a dangerous instrument of monopoly ('monopoly of opinion') and of big business." [The Social Crisis of Our Time, 143]
The point I am trying to make, however, is not so much a moral as it is a psychological one. Central to the Austrian theory is the notion that the efficiency of economic processes is largely evaluated by how well it serves the desires of consumers. Any intervention in the market that thwarts consumer sovereignty is regarded by Austrians as a waste of precious resources. From this premise, Austrians conclude that intervention in the credit markets leading to lower interest rates and expansion of credit must always lead to lower economic efficiency. Investments based on expanded credit are always, according to this theory, "malinvestments." But is this really always the case?
Let us think about this for a moment. Suppose the banking system, under prompting from the Federal Reserve, dramatically increases credit. What will happen? Well, a large chunk of this expanded credit will be invested by businesses in new production goods, that is, in machinery, factories, transportation, warehouses, etc. This, in turn, will drive up the price of investment goods. This is the inevitable result of expanding the money supply (since the expansion of credit is tantamount to an expansion of money, credit being merely a form of money). Whenever the money supply is expanded, there will be price inflation wherever the money is first spent. But even if we adjust for the inflation in production goods triggered by the credit expansion, it still remains true that, at the end of the day, there will be more production goods than there would have been had no credit expansion ever taken place. Is this necessarily a bad thing? Yes, say the Austrians, because the capital will have been "malinvested." But how can this be true? Isn't any increase of capital a good thing? Consider the following point made by none other than Mises himself: "There is only one way that leads to an improvement of the standard of living for the wage-earning masses, viz., the increase in the amount of capital invested." [Planning for Freedom, p. 152]
If increase in capital invested leads to higher standard of living for the masses, why should Mises object to the increase of capital brought about by credit expansion? Why is he so adamant that all investment brought about through credit expansion must lead by grim necessity to malinvestment? He explains his position in Human Action as follows: "What [economics] has in mind when asserting that impoverishment is an unavoidable outgrowth of credit expansion is impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom. The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living. The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by malinvestment and overconsumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning; it appears impoverished only when compared with the potentialities which existed for a still better state of satisfaction." [564-565]
Mises introduces this theory in order to address what would otherwise appear, from an Austrian point of view, as an anomaly: namely, the fact that, historically, business cycles have occurred hand-in-hand with rapid economic progress. The sharpest and most severe and frequent cyclical activity in American economic history occurred in the very period that witnessed the most rapid economic growth (i.e., the second half of the nineteenth century). In order to explain away this inconvenient fact, Mises assumes that, in the absence of credit expansion and the ensuing trade cycle, consumers must have been better served. But here Mises seems to be arguing in a circle. He is assuming that all market prices, including interest rates, always register precisely what consumers want. So any market "interference," even if engineered by non-governmental market participants (e.g., the banks), will always lead to a loss of consumer satisfaction.
But do consumers really know what will give them the greatest satisfaction? That is hardly likely. They may know what they want in terms of basic necessities, but in an advanced capitalist society, economic activity is only partially directed towards "basic necessities." The greater part is devoted to "quality of life" consumption-that is, to luxuries, VCRs, computers, CDs, garden tools, cameras, camping gear, etc. etc. Between such items there does not necessarily exist any great difference in consumer satisfaction. If, for instance, credit expansion led to over-investment in technological goods at the expense of investment in camping gear and sportswear, would this inevitably lead to a loss of consumer satisfaction amounting to impoverishment? No, not at all. Technological goods, like TVs, computers, stereos, and VCRs would merely be less expensive, in relative terms, than tents, sleeping bags, and jogging shorts. Consumers, prompted by lower prices and advertising, would merely watch more videos and play more computer games and spend less time in the woods or on jogging trails. Who's to say that they would be any less happy or less satisfied? It is possible that a few might be; but given the fact that most people really are not exactly sure what they want anyway, it hardly seems to matter that they might have been steered by economic development into one sphere of activity rather than another. Consumer satisfaction is obviously impaired only in extreme cases, as when consumers have to settle for bread and water instead of meat and wine, or bikes and go-carts instead of cars and motorcycles. But when the comparison is between boats and campers, or lobster and sushi, arguments over consumer satisfaction and the thwarting of consumer sovereignty lose a great deal of their polemical force.
If we then factor in the element of advertising into the equation, it becomes even less clear how consumer sovereignty arguments can be used to support the malinvestment view of credit expansion. Although advertising cannot create consumer wants and consumer satisfactions out of thin air, they can nonetheless "educate" the consumer to prefer whatever products are most favored by production. And so if credit expansion really has seriously distorted the production process, especially within the capital good industries, then there seems little reason to doubt that advertising can be used to readjust consumers tastes to fit the new structure of production. While such readjustments will never be absolutely perfect, it is unlikely they would have been perfect even if there had been no credit induced "malinvestment" in the first place. For we cannot reasonably believe that all "malinvestment" is caused by credit expansion. Investors make unwise decisions all the time, irrespective of the monetary manipulations of the Federal Reserve. Nor is it true, as the Austrian theory implies, that all (or even most) investments are motivated by considerations of economic efficiency (that is, by concern for profits). Many people go into certain lines of business, not because they are looking to get rich, but because they feel specially called. A man may seek to become a contractor, not because market prices indicate to him that there is a high demand for such work, but because he feels a special aptness for directing construction projects.
I fear that, in some respects at least, Austrians misinterpret what is essential to the market process. Their emphasis on consumer sovereignty, rather than entrepreneurial innovation, constitutes one of the greatest weaknesses in their theory. Consider, as an example of this, Mises description of the entrepreneur in Human Action: "Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers." [290]
The entrepreneur is here regarded as a mere agent or lackey of the consumer, whose role goes no further than to administer the needs of his customers. But is this really an accurate description of the entrepreneur? Is the entrepreneur really nothing more than the lickspittle of consumer appetite? If so, how can we explain the dynamic, innovative, progressive quality of the capitalist achievement? If the "titans of industry" are simply the sycophants of consumer taste, how can we account for their roles as leaders of economic development? Could someone who is merely concerned with satisfying the petty needs of his customers possibly be the very same person who, by introducing utterly new and disturbing innovations, completely overturns and renders obsolete all the old, customary and approved ways of doing things? It would seem hardly likely that the timid personage of Mises' description and the bold, innovative entrepreneur of capitalist history could be one in the same personage. Serving the needs and whims of consumers is all fine and good as far as it goes. But it seems more than probable that the entrepreneur can hardly be explained on so slender a basis.
The Austrian account of the business cycle fails precisely because it does not sufficiently take account of the role that entrepreneurial innovation plays in the capitalist system. Capitalism is not a static system. What separates capitalism from all previous systems of political economy is its dynamic, ever-progressing, innovative nature. It is the innovation in technology and methods of production that has served as the basis of the extraordinary transformation of society brought about by the capitalist engine of production.
Mises is also misguided in his suggestion that capitalist progress is simply a matter of an "increase in the amount of capital invested." Innovation-by which is meant the introduction into the economy of new, more "efficient" methods of production-may involve no increase in actual capital, but instead, a more felicitous use of existing capital. As Joseph Schumpeter explained: "The slow and continuous increase in time of the national supply of productive means and of savings is obviously an important factor in explaining the course of economic history through the centuries, but it is completely overshadowed by the fact that development consists primarily in employing existing resources in a different way, in doing new things with them, irrespective of whether those resources increase or not. In the treatment of shorter epochs, moreover, this is even true in a more tangible sense. Different methods of employment, and not saving and increases in the available quantity of labor, have changed the face of the economic world in the last fifty years. The increase of population especially, but also the sources from which savings can be made, was first made possible in large measure through the different employment of the then existing means." [Theory of Economic Development, p. 68]
Schumpeter's great insight into the nature of capitalist enterprise will help us draw a far more convincing portrait of the business cycle than the one provided to us by Mises and other "orthodox" Austrian theorists. The key to capitalist development and progress, Schumpeter asserted, is entrepreneurial innovation, which involves combining the resources of production in new and economically progressive ways. The entrepreneur is that individual in the economic system who has the "initiative," "authority," and "foresight" to carry out "new combinations" in production. His central task, as Schumpeter puts it, is to lead "the means of production into new channels." [92]
Schumpeter places special emphasis on the role that entrepreneur's play in introducing "new combinations" into the economy. Society often resists new innovations. Businesses that feel threatened by a new innovation may act to stifle it. Consumers may feel reluctant to try a new product, especially if it violates some rooted moral prejudice of the community. But even in the face of determined and hostile opposition, the entrepreneur perseveres. For this reason, the entrepreneur, according to Schumpeter, is the principle catalyst and leader of economic progress: "It isthe producer who as a rule initiates economic change, and consumers are educated by him if necessary; they are, as it were, taught to want new things, or things which differ in some respect or other from those which they have been in the habit of using." [65]
But perhaps the most significant source of resistance to entrepreneurial innovation comes from the investment community, which may look askance at a proposed innovation because of its unproven economic potential. Under ordinary conditions, investors will usually prefer lending to established businesses whose products have stood the test of time. Although any investment contains an element of risk, entrepreneurial investments are the most precarious of all, because they have no track record that would enable the creditor to calculate the risk involved in making the loan. No one can tell whether a new method of production involving, in many cases, entirely new products, will ever succeed. The outcome of any economic innovation always contains a large element not merely of risk, but of uncertainty, that is, of incalculable risk. If investors were perfectly rational, they would never lend money to entrepreneurs seeking to introduce new combinations into the economy. It is much safer to stick with established businesses that have proved the worth of their products and their methods of production over time.
How, then, do entrepreneurs find the capital necessary to fund their innovations? Who can they turn to lend them the necessary money? Do they have to rely entirely on "irrational" investors? Or is there some other method that will enable them to, in effect, "take" capital from the established businesses and put it into their own daring schemes?
There is, in fact, one important method which entrepreneurs and the investment community resort to in order to redirect capital from proven, established businesses to boldly innovative firms specializing in new methods of production. This is the method of credit expansion. Credit is created quite literally out of thin air and then lent to entrepreneurs, who use it to buy the production goods necessary to carry out their innovations. Schumpeter even goes so far as to say that credit creation is the only method by which "entrepreneurs' demand capital can be met. [Essays, 39] I don't believe this is altogether true, since historically, entrepreneurs have used other methods (often bordering on downright larceny) to raise the purchasing power necessary to fund their projects. But that credit creation is the most important source of capital for entrepreneurial development can hardly be denied by the impartial observer.
Orthodox Austrians would argue that it is not credit creation, but savings that are necessary to support entrepreneurial innovation. While this is true to some extent, it nonetheless fails to grasp the main point at issue. It would be naive to suppose that the very segment of the community most eager to save would also be those most likely to invest in risky new production schemes. It would appear that, on this issue at least, the Austrians have been led astray by their time-preference theory of savings. Not everybody saves money because they want to be able to spend more at a future date. Many save money as a hedge against uncertainty: that is to say, they save because they are afraid of future contingencies that will imperil their financial position. Still others save because they believe it is the right thing to do.
Now anyone who would save for these reasons would probably shrink from being involved in any risky schemes such as those proposed by some daring entrepreneur, eager to direct capital into new, untried ventures. Such timid souls will seek to place their savings in financial institutions that promise safe investments, which in this context means: investments backed with collateral and "tested" methods of production and sale. This would appear to rule out any investments in entrepreneurial innovation from the very start. In the capitalist system, an impasse is created between the saver and the entrepreneur that can only be bridged through credit expansion (and other forms of economic skullduggery). By expanding credit, banks and other financial institutions can divert savings from "safe" investments involving established methods of production into the hands of innovators eager to try new combinations. In essence, what is happening is that economic resources are being transferred into the hands of those most fit to make good use of them. More than anything else, economic progress depends on diverting capital into the hands of those who will put it the capital to best use. Of all economic systems, historical capitalism has enjoyed the most success in achieving this goal.
There is another factor related to the whole problem of savings versus entrepreneurial investment that also needs to be noted. In the early stages of capitalism, limitation of consumption is absolutely essential to produce the funds necessary for capital investment. Without frugality and thrift, capitalism could never take its first steps. What the sociologist Max Weber called "worldly asceticism" is the necessary moral foundation of early capitalism, at least among the business class. But as capitalism progresses from one triumph of production to another, it soon finds itself confronted by a serious dilemma. The aim of capitalism is production through savings. But a point is soon reached when production, taken as an end in itself, becomes self-defeating. In order for the entrepreneur or the capitalist to make a profit, he must sell his products. But if worldly asceticism is the dominant morality, it is clear that production through savings will soon prove self-defeating. At some point along the line, consumers have to become spenders. And businesses, in order to turn profit, will do everything in their power to encourage the transition from worldly asceticism to consumerist prodigality. Using manipulative advertising techniques, they will try to induce consumers to buy their products. These products, they will suggest, can vastly improve the quality of the consumer's life, especially the quality of his (or her) sex life.
In tandem with this shameless psychological manipulation, businesses develop methods that make it easier for consumers to buy their products. Retailers sell on the "installment plan" or issue "credit cards" to facilitate consumption. The end result of this is that the entire capitalist engine, on the retail side, becomes thoroughly consumer-orientated, so much so that a consumerist ethic is born and material acquisition increasingly becomes one of the most important indicators of social status.
The consumerist orientation of modern capitalism can easily be verified by statistics on personal savings. In 1990, Americans saved 7.8% of their disposable personal incomes. By 1995, that figure had fallen to 5.6%; by 1999, it had fallen to 2.4%. With personal savings so low, where on earth is the fledgling entrepreneur ever to find the capital necessary to fund his projects?
Established businesses fund the lion's share of their capital expenditures out of their own profits. An entrepreneur whose only capital is some idea or innovation obviously can't rely on such a source for expenditures. Where, then, is he to raise the capital necessary to put his innovations into effect?
Here again we find ourselves confronted with the importance of credit expansion to entrepreneurial innovation and economic progress. While credit expansion does not in itself create any new production goods, if the bulk of it is used for capital expenditures, it will bring about shift in the economy from consumer goods to capital goods. More production goods will be created than would otherwise have been the case. Mises referred to this sort of increase in capital through credit creation as "forced savings" (erzwungenes Sparen).
There are, then, two reasons why credit creation facilitates entrepreneurial innovations: (1) it helps divert capital from established businesses into entrepreneurial ventures; and (2) it creates additional savings from which to fund capital that might not otherwise exist due to the excessive consumerism of mature capitalism. If these were the only effects of credit expansion, there would be no reason why banks shouldn't go on inflating credit ad infinitum. However, this conclusion, embraced by so many mainstream economists under the influence of Keynes and other palpable economic quacks, constitutes a serious misjudgment. For like so many things in life, credit expansion leads to both "good" and "bad" consequences. The "good" consequences are the aforementioned facilitation of entrepreneurial innovation. The "bad" consequences run along the lines predicated by the Austrian theory.
The Austrians, as will be recalled, argued that credit expansion must inevitably lead to "malinvestment" in production goods. While many of the theoretical constructs upon which this theory is based can be called into question, the basic contention seems more or less sound. Malinvestment is a necessary consequence of credit inflation, especially when the inflation is prolonged. This is true regardless of the number of successful innovations introduced into the economy by entrepreneurs as a result of the credit expansion. The innovations will lead to greater total output in the long run and a more efficient use of resources; but they cannot, in and of themselves, prevent the serious dislocations in the economy brought about by the sustained expansion of credit. For despite the beneficial consequences of credit expansion, it still remains true that, fundamentally, any inflation of credit must be regarded as financially unsound.
Why does credit expansion lead inevitably to malinvestment? The Austrians would have us believe that dislocations in the "temporal" structure of production are the main culprits in the business. As explain earlier in this essay, credit expansion creates the "illusion" that there exists more investment capital than is justified by the actual supply of savings. "This means, however, that entrepreneurs will make their decisions about the volume of their investments, i.e., about the quantities of consumers' goods they will produce at various dates, as if the present distribution of monetary demand between consumer goods and investments corresponded to the way in which the consumers divide their income between consuming and saving. The result of this must be that the proportion in which entrepreneurs will divide their resources between production for the near future and production for the distant future will be different from the proportion in which consumers' in general want to divide their current income between current consumption and provision for consumption at a later date." [Readings in Business Cycle Theory, p. 357]
While this theory is certainly plausible and may in fact correctly describe at least one aspect of credit expansion and the subsequent business cycle, there is too much that it leaves out. For this reason alone, if for no other, it must be regarded as insufficient. As has already been stated, it overestimates the importance of "consumer sovereignty" and underestimates the importance of entrepreneurial innovation. And since no theory of economic cycles can possibly succeed without reference to the progressive effects of innovation on the economy and the leadership role of entrepreneurs in forming consumer taste, the Austrian theory is clearly in need of being reformulated.
To understand why this is so, we need to take a closer look at the phenomenon of entrepreneurial innovation. What happens when an entrepreneur successfully introduces a new, more efficient method of production or a new, more "satisfying" product? Schumpeter notes at least three important consequences. To begin with, entrepreneurial innovation leads to "new methods by which more of a product already produced before can be got out of them save quantity of labor and natural agents." [Essays, 38] More products at less cost mean a deflationary impetus, that is, a tendency towards lower prices, as we see, for example, in the computer industry, where better products are continually being offered at lower prices.
The second important consequences of entrepreneurial innovation is what happens to established businesses producing rival goods. At the start of the boom capital is diverted from old firms to new via credit expansion. This means, in practical terms, that capital costs rise for established firms, which leads to reduced revenues. Later on, the revenues of these older businesses suffers additional curtailment as new, innovative firms seize control of the market. If these older firms fail to adapt to the new circumstances, they will go out of business. Their factories, machines, and production methods may all have to scrapped. This process by which innovation renders obsolete whole industries Schumpeter called "Creative Destruction." "The history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today-linking up with elevators and railroads-is the history of revolutions," wrote Schumpeter in Capitalism, Socialism, and Democracy. "So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace, or the history of the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mailcoach to the airplane. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation-if I may use that biological term-that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating the new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in." [83]
The third consequence of entrepreneurial innovation is that it tends to spawn swarms of imitators or entrepreneurial wannabes. Again, to quote Schumpeter: "Sinceentrepreneurial qualification is something which, like many other qualities, is distributed in an ethnically homogenous group according to the law of error, the number of individuals who satisfy progressively diminishing standards in this respect continually increases. Hence, neglecting exceptional cases,the successful appearance of an entrepreneur is followed by the appearance not simply of some others, but of ever greater numbers, though progressively less qualified." [Theory of Economic Development, 228-229, italics added]
The appearance of less qualified entrepreneurs is one of the critical factors in the business cycle. Keep in mind that, initially, the entrepreneur tends to rely very heavily on credit creation to fund the capital necessary to introduce his innovation into the economy. If innovation succeeds, this, along with the inflationary impetus brought about by credit expansion, leads to widespread optimism in business and financial circles. Investors and aspiring entrepreneurs, captivated by the enormous profits earned by the first wave of entrepreneurs, rush into the market in the hope of getting a piece of the action. At the same time, bankers and investors, noticing how profitable entrepreneurial innovation has suddenly become, are also eager to join the feeding frenzy. The consequence is that on the one side you have investors who are more and more desirous of loaning additional funds to entrepreneurs and on the other entrepreneurs who are less and less qualified to use those funds in profitable ways. This will inevitably lead to the accumulation of bad debt. Here we find one of the primary sources of the "malinvestment" which Austrians regard as so conspicuous a feature of the trade cycle.
But it gets worse as the behavioral logic of the situation plays itself out. As I mentioned earlier, economic action is profoundly affected by the radical uncertainty of life. Now while it may be possible to predict the consequences of some entrepreneurial innovations, others have ramifications that nobody can guess. Who in 1990 could have predicted what the Internet would be like in the year 2000? Only a handful of visionaries had any notion of the Internet's possibilities. Well into the nineties, many leaders in the business community, including the estimable Bill Gates, regarded the Internet as a mere plaything with limited commercial possibilities. Then sentiment turned completely around. In the late nineties, investors greatly overestimated the Internet. In the first years of twenty-first century, investors are finally beginning to acquire a more realistic understanding of both the possibilities and limitations e-commerce.
Because entrepreneurial innovations represent, in many instances, entirely new products or methods of production, it can be very difficult to estimate their long-range effect on the economy. The very fact that an innovation is new and has no history means there is no empirical evidence about its probable effects. When an entrepreneur introduces some "new combination" into the economy, he and his investors are entering upon completely uncharted waters. Under such circumstances, there is no guarantee of success. In at least some instances, the investors are likely to lose all their money.
We touched upon this issue earlier in relation to the problem of entrepreneurial investment. Because entrepreneurial innovations are inherently risky, they do not represent a safe investment bet. Investors, if they were completely rational, would avoid them, preferring established businesses with "proven" track records. Credit expansion, by giving an illusion of plentiful investment capital, changes the mentality of the investor. Keynes satirically described this aspect of the psychology of investment when he wrote: "Most, probably, of our decisions to do something positivecan only be taken as a result of animal spirits-of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative probabilities." [General Theory, p.161] "Animal spirits" might be putting it too strongly. But it is certainly true that credit expansion encourages risk-taking. If taken to excess, it can lead to reckless speculation across the board, especially in stocks and real estate.
Most things in life are neither all good nor all bad, but a mixture of the two. This is true of credit expansion. While it helps facilitate the diversion of capital from old methods of doing business to new methods, it also helps facilitate the diversion of capital to entrepreneurial schemes that never amount to anything. Good judgment on the part of investors can help mitigate this sort of "malinvestment," but since there is no sure way to distinguish a successful innovation from a disastrous one short of giving both a chance to prove themselves in the market, the value of an economic innovation can only be determined through a process of trial and error. Business cycles are necessary evils. In their absence, it is not clear how entrepreneurs would ever be able to test their innovations on the market.
With this insight in hand, the character of the business cycle takes on a whole new significance. Instead of regarding the business cycle as merely a period of reckless credit expansion that inevitably leads entrepreneurs to misread the desires of consumers, it should be seen as a great facilitator of entrepreneurial experimentation. And just as experimentation is the very touchstone of progress in science, so it is of economic progress. Economic booms are periods of innovation precisely because the "animal spirits" they engender in the investment community makes entrepreneurial experimentation on a grand scale feasible. But it also paves the way for the inevitable bust.
The expansion phase of the business cycle can be seen as the trial period for entrepreneurial innovation. Judgment on the value of these innovations is rendered in the "bust" period. Those innovations that prove their economic worth survive the recession and live to see the subsequent boom. Those innovations that prove infelicitous are "liquidated" by the very recession they help bring about.
This view of the business cycle, which, despite a few changes here and there, comes pretty close to the theory espoused by Schumpeter in his Theory of Economic Development, still needs a few details added before it can make any kind of pretense to even a loose approximation of actual facts. Specifically, we need to examine more closely some of the other effects of credit expansion beyond what has been attributed in the realm of entrepreneurial investment. Only a very naive economist could believe that all the credit manufactured through "banking operations" and other financial chicanery winds up in the hands of entrepreneurs. Much of it probably does, either directly or indirectly, but some of it almost certainly winds up in the hands of speculators and other non-entrepreneurial investors, while the remainder is eventually pocketed and spent by consumers. The importance of this can hardly be underestimated. When excess credit flows into the hands of speculators, the consequence is almost inevitably some sort of market bubble, usually in asset prices and real estate. The process goes as follows: the first injection of excess credit drives up the prices in a given investment market, while this, in turn, leads to further investment in the same market, as investors seek to get in while the going is good. The market is thus driven up further and further, until a full-fledged bubble emerges. This is in essence what happened to the stock market in both the twenties and the nineties. Credit excesses fueled a speculative bubble market in stocks. That such bubbles cannot be maintained ad infinitum hardly needs proof. Sooner or later, they must burst, sending waves of financial devastation throughout the economy.
The effect of credit expansion on consumer spending is no less fraught with unpleasant consequences. At first, the impetus to consumption triggered by fresh injunctions of credit into the hands of consumers serves only to heighten the general level of prosperity throughout the economy. To put it in Keynesian terms, credit expansion, when used to fund consumption, serves to increase "effective demand." The problem is (and this is precisely where Keynesians go astray), there is no way to maintain this effective demand without continual increases of "manufactured" credit. And, as in the case of speculative bubbles, it is simply impossible to keep manufacturing credit ad infinitum. Private individuals can only take on so much consumer debt. Sooner or later a breaking point is reached and further credit expansion becomes unfeasible. This is often what triggers the recessionary phase of the trade cycle. When the banks reach the point where they can no longer expand credit, consumer spending declines and businesses find themselves unable to sell all their products. In order to cut their losses, they curtail production. Workers lose their jobs. This causes an additional curtailment in consumer demand. A period of retrenchment commences in which the economy cleanses itself of all the untenable debt accumulated during the expansion phase.
There is a widespread belief, even among professional economists, that the expansion phase of the trade cycle could be prolonged indefinitely merely by maintaining a policy of continual credit expansion. Consider once again Paul Krugman's explanation for the trade cycle, quoted earlier: "A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time," Krugman wrote. "Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the [view that recessions are inevitable]. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money?"
Like so many mainstream economists, Krugman is clueless about the nature of credit expansion. In a modern industrial economy, increasing the money supply almost always means expanding credit. But any expansion of credit involves a concomitant expansion of debt, since debt is merely the other side of credit. This, in a nutshell, is the key to understanding why credit expansion must ultimately lead to a recession. When you expand credit, you expand debt; and eventually a point is reached where the amount of debt becomes so onerous, that it becomes impossible to expand it any further.
Although this seems pretty obvious, there will be still be some who will wonder why expansion cannot be carried out indefinitely. To fully grasp why this is impossible, it is necessary to take account of a critical fact-namely, that even during periods of great prosperity and economic expansion, there are businesses that will struggle. This is especially true of businesses dependent on outmoded methods of production or obsolete consumer goods. These businesses, if they cannot adapt to new circumstances, will find themselves in serious trouble. The economist Wesley Mitchell understood this aspect of the trade cycle as well as anyone: "As prosperity approaches its height," wrote Mitchell, "a sharp contrast develops between the business prospects of different enterprises. Many, probably the majority, are making more money than at any previous stage of the business cycle. But an important minority, at least, face the prospect of declining profits. The more intense prosperity becomes, the larger grows this threatened group. It is only a question of time when these conditions, bred by prosperity, will force some radical adjustment."
Mitchell continues: "Now such a decline of profits threatens worse consequences than the failure to realize expected dividends, for it arouses doubt concerning the security of outstanding credits. Business credit is based primarily upon the capitalized value of present and prospective profits, and the volume of credits outstanding at the zenith of prosperity is adjusted to the great expectations which prevail when the volume of trade is enormous, when prices are high, and when men of affairs are optimistic.Cautious creditors fear lest the shrinkage in the market rating of the business enterprises which owe them money will leave no adequate security for repayment; hence they begin to refuse renewals of old loans to the enterprises which cannot stave off a decline of profits, and to press for settlement of outstanding accounts."
And Mitchell concludes on this ominous note: "Thus prosperity ultimately brings on conditions which start a liquidation of the huge credits which it has piled up. And in the course of liquidation, prosperity merges into crisis." [Readings in Business Cycle Theory, 56] Again, I want to emphasize the point that credits are merely debts looked at from the other side of the ledger, so that Mitchell could have just as easily written that prosperity leads to a liquidation of the enormous debts which it has accumulated. I suspect that the word credit, because of its benign associations, has misled many economists. If instead of using the term "credit expansion," economists were in the habit of calling it "debt expansion," perhaps the ominous implications of this whole process, especially when it is allowed to proceed without check for years on end, would be more generally appreciated. But the universal tendency toward euphemism in speech has made credit the preferred term in describing this economic phenomenon.
(We find the same tendency toward euphemism in regard to those little pieces of plastic used to incite consumerism known as "credit cards." But strictly speaking, they are no such thing. They are debt cards. Every time an individual uses them, he accumulates not credit, but debt. There is nothing "creditable" about these little plastic cards except for the companies that issue them.)
The accumulation of debt during the expansionist phase would be unpropitious even in the best of circumstances. But as a result of the economic optimism engendered by the boom phase of the cycle, lenders lose their sense of caution and loans are made without regard to sound principles of finance. This, in one sense, is good, because, as pointed out earlier, it enables unproved entrepreneurs to raise the necessary funds for their pathbreaking innovations. But in another sense, it is very bad. It inevitably leads to the accumulation of bad debt, backed, if backed at all, by inflated assets or bogus real estate values. The consequences of such unsound lending practices should be obvious. At some point, there must be a day of reckoning, a period of recession where the economy attempts to expel all the bad debt from its system.
Krugman has suggested that, if the financial system is inundated with bad loans, why not "junk the bad investments and write off the bad loans?" As a once in a lifetime solution, this might be a way out of an impossible situation, but if it became a routine policy, it would almost certainly undermine the financial integrity of the economy and bring about a serious decline in savings and capital. We cannot simply keep writing off all the bad debts we accumulate and still expect people and businesses to save their money.
We have but one more aspect of the trade cycle to examine before these notes can be drawn to a close. It involves one of the most salient characteristics of the trade cycle-namely, the fact that production goods industries are usually the first to be hit by a recession and that they invariably find themselves hit harder than anyone else. One of the reasons why Mises and other Austrian economists emphasize malinvestment in producer goods is to explain this aspect of the trade cycle. Credit expansion, they contend, leads businessmen to invest more in capital and producer goods than is warranted by the preferences of consumers. I regard this theory as inadequate because it fails to appreciate the role that entrepreneurial innovation plays in the business cycle farce. But if the Austrian explanation proves inadequate, then how are we to explain the intensification of the trade cycle among production good industries? If it is not caused by malinvestment, then what does cause it?
The economist John Maurice Clark in an article he wrote as long ago as 1917 provided the best explanation. Clark pointed out that all producers of industrial equipment must meet two separate demands of their customers: first, they need to maintain the industrial equipment already in use, and second, they must furnish any new equipment needed for expanded production. "Both these demands come ultimately from the consumer," wrote Clark, "but they follow different laws." [Readings in Business Cycle Theory, 238] Demand for replacement equipment tends to be steady, because equipment wears out at a predictable rate. But demand for new equipment arises out of shifts in consumer demand. If suddenly demand increases for a particular product, businesses have to increase the number of machines on hand to increase the supply of the product in question. The industry that constructs the new machines enjoys a period of increased production. But since machines are fairly durable and can be used for years before they need to be replaced, once the new machines are made, there is no need to add additional equipment, except those required to replace worn-out machines. This means that once the machine industry satisfies the increased demand for new equipment, demand for new machines must fall. The machine industry will suddenly find itself in a recession. Thus any change in consumer demand must always lead to a recession within some sector of the production goods industry. The larger the shift in consumer demand, the greater the fluctuation in production goods.
Clark illustrates this principle by imagining "a town which grows rapidly up to the size at which its industrial advantages are fully utilized and beyond which its normal production can expand but slowly. When the point of transition is reached from rapid to slow expansion, the town may find that it has outgrown itself by the number of people engaged in the extra construction work involved in the process of growing. Houses to take them in, stores to feed and clothe them, trucks to haul the materials they work with, offices, etc., all will be demanded, and thus a boom may be created which is none the less temporary for being based on tangible economic needs. The experience of the boom town has been common enough in the growth of our western country, and the blame need not be laid entirely upon the vagaries of mob psychology." [242]
Nor need it be blamed entirely on credit expansion, in the manner of the Austrians. Of course, credit expansion will certainly intensify this phenomenon of the trade cycle, and malinvestment will make it even worse. Thus the element of truth in the Austrian diagnosis. But it is an error to blame the whole phenomenon on entrepreneurial error brought about by easy money policies. For even if every last dollar of the credit expansion were invested in entrepreneurial innovations that ultimately prove their worth in the market, there would still be an intense fluctuation within the producer goods industries. Only in a static economy could the Austrian diagnosis ever hope for complete vindication. In a dynamic, progressive economy, where consumer demand is always being created anew by the introduction of pathbreaking innovations, shifts in demand are endemic. A progressive economy must for this very reason find itself pray to fluctuations. The business cycle is the price we pay for economic progress. Even if we could have progress without credit expansion (which is unlikely), we would still not be able to rid ourselves of the trade cycle altogether. Without the distortions introduced by credit expansion, the fluctuations of the business cycle would not be as sharp, but they would still occur. The trade cycle is rooted within the very nature of the market system. It is a product of capitalism's inherently dynamic, and hence unstable, constitution.
I have titled this essay "Notes Toward a Theory of the Business Cycle" to stress the provisional character of what is offered here. I regard this theory merely as a well-informed conjecture that probably contains some element of truth, but may also, for all I know, contain significant errors as well. Empirical research will be needed to determine whether, and to what extent, this theory accords with reality.
But before any research is conducted, certain limitations of the theory must be understood, lest it should be tested upon circumstances where it clearly doesn't apply. This theory, it should be realized, is not valid for all forms of capitalism. It holds good (if it holds good at all) only for the sort of industrial capitalism that flourishes best in Europe and North America. It is does not hold for most Third World economies or for Communist or Post-Communist regimes, because these economies lack the requisite entrepreneurial base. Before credit expansion can spur economic innovation, there must exist an entrepreneurial class capable of leading the economy in new and revolutionary directions. In most Third World countries and Post-Communist nations, this entrepreneurial class does not exist. The attempt, therefore, to create economic progress through credit expansion in such countries is bound to lead to failure. It will, in fact, lead to all the results predicted by the Austrians-malinvestment and spoliation on a grand scale.
Economic action, as conducted in the real world of fact (as opposed to how it works in textbooks) is always characterized by a certain element of spoliation. This is true regardless of the economic system involved, whether predominantly capitalist or socialist in nature. As Vilfredo Pareto noted, "Societies which admit private propertyoffer men two essentially different ways of acquiring wealth. One is by producing it directly or indirectly through the work and services of the capital they possess. The other is by acquiring the wealth thus produced by others. These two methods have at all times been employed, and it would be rash to believe that they will cease to be employed in the foreseeable future. But because the second method is generally under moral reproof, people willingly close their eyes to its employment, holding it to be something sporadic and incidental. In fact it is a general and enduring phenomenon." [Sociological Writings, p. 139]
Quite so. But not all forms of spoliation are created equal. It depends on who is bagging the plunder and what they are doing with it once they get control of it. The tremendous wealth of the capitalist West did not arise merely because capitalists are better at spoliation than non-capitalists, but because capitalists have made much better use of whatever loot they have pilfered. Feudal aristocracies squandered whatever wealth they had expropriated from the labor of others on stupid luxuries. Communists spent their expropriations on military projects. But capitalists devoted the lion's share of their ill-gotten gains to business investment. Thus theft was used to help raise the capital that made nations like America and Great Britain rich and powerful.
With this in mind, we can state the conditions under which credit expansion (which is a form of spoliation) leads to economic progress. Two conditions, in particular, must be met: first, there must exist in society a class of entrepreneurs willing and eager to redirect capital into promising new innovations; and second, this class of entrepreneurs must be among the principle beneficiaries of the credit expansion. If the newly created credits wind up in the hands of timid men or the idle rich or the lazy and thriftless poor, it would be as if all the newly created money had been flushed down a massive toilet. You will simply have runaway inflation and the gradual impoverishment of all decent and hard-working men.
The key to civilization and prosperity is the spontaneous development of methods whereby the vices of human nature are made to work for society instead of against it. Spoliation works for society when it helps transfers capital into the hands of those most fit and willing to make good use of it. How spoliation is made to work in this way is anyone's guess. One thing is for sure: it is not something that can be legislated or "intended." It arises spontaneously, out of the mores. Either a given society has the mores and institutions that allow spoliation to work for the good of the country, or it doesn't. At the present state of our knowledge, that is about the most that can be said about it.