The Liberty Papers

When Ludwig von Mises first arrived in the United States after escaping from Nazi Europe, and pretty much up until the present day, he was essentially ignored by the mainstream economics community in the United States. It was only through the assistance of American businessmen that he was able to get a job teaching at New York University, and, even then, the work he did had nothing to do with official university activities because he was, effectively, shunned for his uncompromising defense of the free-market.

Earlier this week in The Wall Street Journal, though, Mises is given credit for being one of the few economists in the 1920s to foresee the impending Great Depression:

Mises’s ideas on business cycles were spelled out in his 1912 tome “Theorie des Geldes und der Umlaufsmittel” (“The Theory of Money and Credit”). Not surprisingly few people noticed, as it was published only in German and wasn’t exactly a beach read at that.

Taking his cue from David Hume and David Ricardo, Mises explained how the banking system was endowed with the singular ability to expand credit and with it the money supply, and how this was magnified by government intervention. Left alone, interest rates would adjust such that only the amount of credit would be used as is voluntarily supplied and demanded. But when credit is force-fed beyond that (call it a credit gavage), grotesque things start to happen.

Government-imposed expansion of bank credit distorts our “time preferences,” or our desire for saving versus consumption. Government-imposed interest rates artificially below rates demanded by savers leads to increased borrowing and capital investment beyond what savers will provide. This causes temporarily higher employment, wages and consumption.

Ordinarily, any random spikes in credit would be quickly absorbed by the system—the pricing errors corrected, the half-baked investments liquidated, like a supple tree yielding to the wind and then returning. But when the government holds rates artificially low in order to feed ever higher capital investment in otherwise unsound, unsustainable businesses, it creates the conditions for a crash. Everyone looks smart for a while, but eventually the whole monstrosity collapses under its own weight through a credit contraction or, worse, a banking collapse.

The system is dramatically susceptible to errors, both on the policy side and on the entrepreneurial side. Government expansion of credit takes a system otherwise capable of adjustment and resilience and transforms it into one with tremendous cyclical volatility.

(…)

We all know what happened next. Pretty much right out of Mises’s script, overleveraged banks (including Kreditanstalt) collapsed, businesses collapsed, employment collapsed. The brittle tree snapped. Following Mises’s logic, was this a failure of capitalism, or a failure of hubris?

Mises’s solution follows logically from his warnings. You can’t fix what’s broken by breaking it yet again. Stop the credit gavage. Stop inflating. Don’t encourage consumption, but rather encourage saving and the repayment of debt. Let all the lame businesses fail—no bailouts. (You see where I’m going with this.) The distortions must be removed or else the precipice from which the system will inevitably fall will simply grow higher and higher.

That was Mises’ argument in The Theory Of Money And Credit, but he did so much more than that. In Socialism, first published in 1921, Mises laid out in detail the reasons why the centrally planned economy of nations like the USSR could never produce a rational economy and were doomed to failure. He was, of course, proven right in that regard as we learned only twenty years ago. Mises’ magnum opus is Human Action: A Treatise on Economics and while it’s not easy reading it is well worth consuming for even the amateur student of economics.

Here’s hoping people will start taking Mises’ lessons to heart before we make the same mistakes all over again.