David Glasner, ed., Business Cycles and Depressions
      New York: Garland Publishing Co., 1997, pp. 440-42

     
     
     

    Ludwig Edler von Mises

    by Roger W. Garrison

    A central figure of the Austrian School, Ludwig Edler von Mises (1881-1973) contributed broadly to both theoretical and applied economics. Dating from 1902, his writings developed into a comprehensive treatment of economic principles set forth in Human Action, a treatise which first appeared as Nationalökonomie [1940]. His economic thought is presented as an integral part of a "praxeological" system—a logic of action in the context of human purpose and the passage of time.
            Though widely known for denying the possibility of rational central planning and as a life-long critic of interventionism, Mises also contributed importantly to monetary and business-cycle theory. In his Theory of Money and Credit, originally published in 1912 as Theorie des Geldes und der Umlaufsmittel, Mises demonstrated that the value of money, no less than that of other goods, is based on its marginal utility. Building upon this early integration of value theory and monetary theory, Mises sought to explain how both market forces and bank policy affected the purchasing power of money. He also provided a clear account, in this first major work, of the credit-induced boom and subsequent bust. An extended treatment of what came to be known as the Austrian Theory of the Business Cycle is provided in his "Monetary Stabilization and Cyclical Policy" and in Human Action. To formulate a theory of boom and bust, Mises drew insights from three sources: Eugen von Böhm-Bawerk of the early Austrian School, Knut Wicksell of the incipient Swedish School, and Lord Overstone and others of the British Currency School.
            From Böhm-Bawerk, Mises adopted the conception of a production economy whose temporally sequenced stages of production employ capital goods and other resources. This capital-theoretic framework, in which some production processes are more time-consuming, or "roundabout," than others, features a trade-off between the amount and the timeliness of economic output. In an economy unhampered by perverse bank policy, the economy's intertemporal structure of production is governed by the rate of interest, which reflects the "time preferences" of consumers. That is, the interest rate brings into balance the marginal productivity of roundaboutness with consumers' marginal utility of goods now as compared to goods later. Mises' treatment of intertemporal resource allocation did not differ substantively from Böhm-Bawerk's. Original with Mises was his use of the Austrian theory of capital and interest as a basis for a theory of business cycles.
            From Wicksell, whose Interest and Prices was published in 1898, Mises borrowed the idea that the bank rate of interest sometimes diverges from the "natural" rate of interest, so called by Wicksell. The natural rate, which excludes all monetary influences, was taken by Mises to be the interest rate consistent with consumers' time preferences; the bank rate, which is subject to monetary manipulation, was taken to be the focus of bank policy. Holding the bank rate below the natural rate requires a continuous expansion of bank credit. The divergence of the two rates of interest was of concern to Wicksell primarily because of its effect on the general level of prices. Wicksell acknowledged that bank policy might also affect the allocation of resources, but any such allocational effects were reduced to "tendencies only" by his simplifying assumptions and thus were no part of his formal theory.
            Mises, in effect, relaxed Wicksell's simplifying assumptions in order to investigate the allocational effects of bank policy. He was specifically concerned with credit expansion in the context of time-consuming, capital-using production processes. Tracing the effects of bank policy on production activity furthered the integration of monetary and value theory and identified the ultimate consequences of a cheap-credit policy. Since the natural rate is the rate of interest that reconciles intertemporal production activities with the time preferences of consumers, credit expansion, by keeping the bank rate below the natural rate, induces a fundamental inconsistency. A cheap-credit policy distorts business calculations causing the production of consumer goods to be reduced and production processes in general to be excessively roundabout. Mises used the term "forced savings" to describe the policy-induced reduction in consumption and the term "malinvestment" to describe the intertemporal misallocation of resources induced by artificially cheap credit.
            Mises transformed his insights about forced saving and malinvestment into a theory of the business cycle by recognizing the unsustainability of production activities that are based upon a low bank rate. But the idea that the market's responses to credit expansion contain the seeds of their own undoing is older than either the Austrian or the Swedish School. A self-reversing process triggered by bank policy had been identified early in the nineteenth century by members of the Currency School. So similar in form was Mises' theory to the "Circulation Credit Theory of the Trade Cycle," as exposited by Lord Overstone and others, that Mises considered his own theory an extension of the circulation-credit theory rather than a uniquely Austrian theory.
            However, Mises found the formulation of the Currency School to be inadequate in two respects. First, it gauged bank policy too narrowly in terms of the quantity of banknotes, ignoring the equally if not more significant volume of demand deposits. Secondly, and more importantly, it failed to identify any domestic market forces that might counteract the initial effects of credit expansion. The unsustainability of the boom in the Currency School's formulation derived exclusively from international repercussions. As an expansion of banknotes drove domestic prices upward, exports would fall while imports rose. The trade imbalance would drain gold, the redemption medium, from the expanding banks eventually requiring the banks to contract. It is this specie-flow mechanism, in the Currency School's view, that limits the ability of any one country to maintain a cheap-credit policy.
            Mises' formulation advanced the circulation-credit theory by showing that credit expansion is unsustainable even in a closed economy—or in an open one in which the banks of all countries expand together. In the early phase of a credit expansion, workers receive income from production activities undertaken on the basis of a low bank rate of interest, but those same individuals, as consumers, spend their income at a rate corresponding to the higher natural rate of interest. This consumer spending eventually counteracts the initial effects of credit expansion. The rise of consumer-good prices, which demonstrates the true strength of consumers' preferences for goods now over goods later, discourages the relatively more roundabout production processes that cheap credit initially encouraged. Attempts by the central bank to reinforce the credit expansion will also reinforce the market's "countermovements," as termed by Mises. As market forces continuously counteract bank policy, the artificial boom is eventually brought to an end. Some production processes that were initiated during the period of cheap credit can be completed only at a loss, while others must be liquidated. Even apart from international considerations, the credit expansion contains the seeds of its own undoing.
            In sum, Mises saw the boom as a consequence of unenlightened bank policy, a period of artificial and unsustainable expansion, in which capital and other resources are committed to excessively roundabout production processes, and he saw the bust as the inevitable consequence of the credit-induced boom. In the end, the pattern of consumer spending wins out over the pattern of bank lending. Mises saw the recovery as the period during which malinvestments are liquidated and production activities are again reconciled with actual consumer preferences. Mises recognized, as did Wicksell, that enlightened bank policy would avoid credit expansion, thus minimizing the divergence between the bank rate and the natural rate. Believing, however, that central bank policy as formulated by government officials would be ideologically biased towards cheap credit, Mises favored institutional reform in the direction of free banking.
            Mises' theory underwent substantial development by F. A. Hayek, whose Prices and Production influenced many British theorists, and remains a part of the research agenda of the modern Austrian School. But the Austrian theory of the business cycle has not been incorporated into mainstream macroeconomic theory. Several factors have inhibited a broader acceptance of Mises' views. First, mainstream macroeconomics since the Keynesian revolution has developed with no grounding in capital theory of the sort that underlies Austrian business-cycle theory. Thus, a capital-theoretic account of the unsustainability of a credit-induced boom, when grafted onto a macroeconomic theory that is otherwise free of such considerations, appears ad hoc and unduly complex. Second, because of fundamental difficulties in measuring capital and roundaboutness, especially in the context of artificial booms and consequent busts, the empirical—largely episodic—support for the Austrian theory does not conform well to the econometric procedures for model evaluation that have come to characterize modern empirical economics. And third, the implied policy of avoiding artificial booms as the only way of avoiding the otherwise inevitable bust, is unattractive to policy activists committed to the goal of initiating and perpetuating economic booms.
     

    BIBLIOGRAPHY:

    Bohm-Bawerk, Eugen. Capital and Interest. 3 vols. [originally published in German in 1884, 1889, and 1909], South Holland, IL: Libertarian Press, 1959.

    Hayek, Friedrich A. von. Prices and Production. 2nd ed. New York: Augustus M. Kelley, Publishers, [1935] 1967.

    Mises, Ludwig von. The Theory of Money and Credit [originally published in German in 1912]. New Haven, CT: Yale University Press, 1953.

    ________. "Monetary Stabilization and Cyclical Policy," in Mises. On The Manipulation of Money and Credit. Edited by Percy L. Greaves, Dobbs Ferry, NY: Free Market Books, 1978.

    ________. Human Action: A Treatise on Economics. 3rd rev. ed. Chi cago: Henry Regnery and Co., 1966.

    Mises, Ludwig von et al. The Austrian Theory of the Trade Cycle and Other Essays. Auburn, AL: Ludwig von Mises Institute

    Overstone, Samuel Jones Loyd (Lord). Tracts and Other Publications on Metallic and Paper Currency. London: Longmans, 1858.

    Wicksell, Knut. Interest and Prices. Translated by R. F. Kahn. London: McMillan, 1936 [originally published in 1898].