Lesson 1 of 7
The resources never there
The constraint a credit boom runs into, stated by Mises and worked through by Hayek. It is not a failure of confidence and not a decision by a lender.
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 binding constraint is real, not financial: the consumable output needed to carry workers through the longer processes was never released, because nobody abstained.
- Mises states the endpoint directly. A moment must come when the means of subsistence are used up while the capital goods started are not yet finished.
- Continuing the credit expansion postpones the moment and enlarges it. Mises's conclusion is that the only choice is whether the crisis comes sooner or later.
Nothing in this account requires a bank to lose its nerve, a government to act, or a mood to change. The boom ends because it was running on something that was not there.
What runs out, and when
- 1Longer processes startedFinanced by created credit, not by abstention
- 2Workers paid and spendingBidding for consumer goods that were never freed up
- 3Consumers' goods prices riseThe squeeze becomes visible as a price, not as a shortage
- 4Early-stage margins closeCosts rise, the spread that justified the long process disappears
- 5The long processes stopHalf-finished, with the complementary goods bid away
Mises's statement of the limit
In The Theory of Money and Credit he puts it without diagrams. Despite there having been no increase in intermediate products and no possibility of lengthening the average period of production, a rate is established in the loan market that corresponds to a longer period, so a lengthening looks profitable for a time.
A time must necessarily come, he writes, when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. Because production and consumption are continuous, this does not appear as a sudden absence of goods. It appears as a reduction in the quantity available for consumption, which shows up as a price.
He adds that the moment arrives sooner than it otherwise would, because a lower rate weakens the motive to save.
Hayek's version of the same corner
Hayek describes consumption continuing for a while after the longer processes have started, because goods already well down the chain keep arriving. When the reduced output of the stages that lost their factors finally matures, the scarcity shows up and consumers' goods prices rise.
He then says that this necessity will be resisted, which is the sentence the whole contraction hangs on. Wage earners' incomes are rising because of the money being invested, and in the face of rising consumer prices those incomes will be spent on consumption, driving the prices up faster.
Why continuing does not help
Because continuing means adding more of the same. Hayek notes that the banks could keep the long processes going by expanding further, and that at first they will, because rising consumers' goods prices offer temporary extra profits and borrowers are willing.
But the demand it has to outrun is itself fed by the new money, so each round has to be larger than the last. Hayek's reply to his critics works through this: a constant rate of credit expansion is not enough to maintain a constant rate of forced saving, because the competing demand from consumers rises in proportion to the previous injection.
Mises draws the conclusion the tradition has kept. There is no means of avoiding the final collapse of a boom brought about by credit expansion, and the alternative is only whether the crisis comes sooner from a voluntary stop or later.
Check yourself
What is the binding constraint, on this account?
- The banking system's reserve requirement
- The consumable output needed to carry the economy through the longer processes, which was never released because nobody abstained
- A loss of business confidence
Show the answer
Answer: B.
Mises states it as the means of subsistence being used up before the capital goods have matured into consumption goods.Why does continuing the expansion fail to prevent the end?
- Because banks are legally capped
- Because the consumer demand it has to outrun is itself fed by the new money, so each round must be larger than the last
- Because interest rates cannot fall below zero
Show the answer
Answer: B.
Hayek's reply to Hansen and Tout argues that a constant rate of credit expansion cannot maintain a constant rate of forced saving.What does Mises say the choice is?
- Between a deep crisis and no crisis
- Between a crisis sooner, from stopping the expansion, and later, from continuing it
- Between inflation and unemployment
Show the answer
Answer: B.
He states there is no means of avoiding the final collapse of a boom brought about by credit expansion, which is a claim about the alternative, not a schedule.Sources
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part three, chapter 5, section 4, for the rate corresponding to a longer period of production than is practicable, for the exhaustion of the means of subsistence before the capital goods mature, for the effect appearing as a restriction of consumption and a rise in consumers' goods prices, and for the weakening of the motive to save.
- Mises, Human Action, 1949, chapter XX, section 8, for the conclusion that the final collapse cannot be avoided and that the only alternative is sooner or later.
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture III, section 7, for consumption continuing for a time and then the scarcity appearing, and for the resistance to the involuntary retrenchment.
- Hayek, 'Capital and Industrial Fluctuations: A Reply to a Criticism', published in Econometrica in April 1934 and reprinted as the appendix to the second edition of Prices and Production, 1935, for the argument that a constant rate of credit expansion cannot sustain a constant rate of forced saving.
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 twelve hundred workers and the three-year projects are invented and describe nothing.
- That the constraint binds in the way described is the theory's claim, not an established finding. What would count against it is set out in the last lesson of the boom course.