Lesson 1 of 8
The whole claim, once
Credit expands, the rate falls, the structure lengthens, and the resources are not there. Six steps, in order, with the author who added each one.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The sequence is six steps: credit is created, the rate falls below the natural rate, longer projects look profitable, resources are drawn away from consumption, consumers push back, and the longer projects become unprofitable.
- Mises supplied the interest step in 1912 and the conclusion that the collapse cannot be avoided by continuing. Hayek supplied the account of what happens to relative prices between stages.
- The claim is about direction and sequence, not about timing or magnitude, and this course is careful never to let it become more than that.
Here is the whole thing in one place, before the lessons that take the steps apart. Read it once now and once again after the eighth lesson.
The sequence, and who added each step
Six steps
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Credit is created without saving. Banks lend by creating deposits, not by passing on somebody's abstention. Mises, The Theory of Money and Credit, 1912.
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The market rate falls below the natural rate. The new supply clears at a lower price, and the gap opens. Wicksell's distinction, 1898, applied to bank credit by Mises.
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Longer projects clear the lower rate. A fall in the cost of waiting makes processes worth starting that were not worth starting before. Bohm-Bawerk's roundaboutness, 1889, supplies the reason.
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Resources move to the earlier stages. Prices of producers' goods rise, non-specific factors are bid away from work near consumption, and consumption is squeezed without anybody choosing it. Hayek, Prices and Production, 1931.
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Consumers push back. The new money reaches wages and rents, incomes rise, and people restore the proportion of their spending they wanted all along. Hayek, same work.
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The longer processes become unprofitable. Prices of consumers' goods rise relative to producers' goods, the margins that justified the long processes close, and the specific capital committed to them falls in value. Mises, 1912, and Hayek, 1931.
What each author actually added
Mises put interest at the centre. His chapter on money, credit and interest sets out the divergence between the natural rate and the money rate as the thing to be explained, and states the conclusion the tradition has kept: there is no way to avoid the collapse of a boom brought about by credit expansion, and the only choice is whether the crisis comes sooner from stopping or later from continuing.
Hayek supplied the middle. His own note in the third lecture of Prices and Production says that Mises's work contained little more on the price mechanism than the few sentences he quotes at the head of that lecture, and that what people found hardest was Mises's short statement that the rise in the prices of consumers' goods is the cause of the crisis. Hayek's stated aim in that lecture is to clear that up.
Bohm-Bawerk supplied the reason a lower cost of waiting changes anything: that longer methods can yield more, and by diminishing amounts.
What the sequence is not
It is not a schedule. Nothing in it says how long any step takes, how large the effect is, or which industries move first in any particular episode.
It is not a claim that credit expansion always produces a visible boom, and it is not a claim about the price level. Mises is explicit that the general rise in prices and the change in the structure are two different things.
And it is not a claim about anybody's competence. The next two lessons are about why careful people would do this.
Check yourself
What happens at step two of the sequence?
- The central bank announces a target
- The market rate falls below the natural rate, because supply in the loan market rose without anyone abstaining
- Consumers save more
Show the answer
Answer: B.
Wicksell supplied the distinction in 1898 and Mises applied it to credit created by banks in 1912.What does Mises say about avoiding the collapse of a credit boom?
- That it can be avoided by raising rates early enough
- That there is no means of avoiding it, and the only choice is whether the crisis comes sooner from stopping or later from continuing
- That it depends on the banking system's reserve ratio
Show the answer
Answer: B.
He states it in the chapter of Human Action on the circulation credit theory, and the same conclusion is already in the 1912 book.What did Hayek say his own contribution was?
- The discovery of the natural rate
- Clearing up the price mechanism, in particular Mises's short statement that a rise in consumers' goods prices causes the crisis
- The measurement of the money supply
Show the answer
Answer: B.
He says in a note to the third lecture of Prices and Production that Mises's work contained hardly more than a few sentences on this, and that people found the claim unintelligible without Bohm-Bawerk's theory of interest.Sources
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part three, chapter 5, sections 3 to 5, on the equilibrium rate against the money rate, the effect of an artificially reduced rate on the length of production processes, and credit and economic crises.
- Mises, Human Action, 1949, chapter XX, section 8, on the circulation credit theory of the trade cycle and on there being no means of avoiding the final collapse of a credit boom.
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture III, sections 1 and 7, for his statement of what Mises had left unexplained and for the sequence of relative price changes.
- Bohm-Bawerk, The Positive Theory of Capital, German original 1889, English translation by Smart, book II, chapter II, for the greater productiveness of indirect methods and the diminishing return to lengthening.
- Wicksell, Interest and Prices, German original 1898, English translation 1936, chapter 8, for the distinction the second step rests on.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The firm and the two discount rates are invented round figures chosen to show a decision flipping. No company is described.
- Presenting the mechanism as six numbered steps is a teaching device. The authors do not number them, and the steps overlap in time.
- Every step of this sequence has been disputed. The eighth lesson of this course states the claim in testable form and the course on the case against the theory sets out the objections at full strength.