Book Excerpt: Money, Banking, and the Business Cycle

by | Sep 21, 2014 | Economics, Money & Banking

An excerpt from the introduction of Money, Banking, and the Business Cycle.

I have recently completed a two-volume book titled Money, Banking, and the Business Cycle. Here is an excerpt from the introduction of volume two describing the contents of the book.

In the first volume, I provide the theoretical foundations of ABCT [Austrian business cycle theory]. As a part of that task, I discuss the nature of money, banking, and inflation, with insights on these topics that will be new to many. I also show in volume one how the government’s manipulation of the supply of money and credit creates the cycle. Here is a brief summary of that discussion. When the government increases the money supply at an accelerating rate, it temporarily reduces interest rates and increases spending, revenues, and profits in the economy. When the latter increase unexpectedly, businesses expand their activities and produce more in an attempt to take advantage of the unexpectedly profitable times. This is the essence of the expansion phase of the business cycle. The contraction ensues when the government decreases the money supply or does not increase it sufficiently. At this point, spending, revenues, and profits fall or fail to rise sufficiently (especially relative to expectations). Interest rates also rise due to the decrease or insufficient increase in the money supply.

In volume one, I also explain the role the fractional-reserve checking system plays in causing the business cycle. Because of this system, most of the new money enters the economic system as additional supplies of credit. This increased credit is what keeps interest rates low, especially relative to the rate of profit, during the expansion phase of the cycle. Likewise, the correspondingly reduced supply of credit brought about by the fractional-reserve checking system during the contraction causes interest rates to rise relative to the rate of profit during that phase. The movements in interest rates and the rate of profit provide two incentives for businesses to expand and contract during those respective phases of the cycle. During the expansion phase, since the rate of profit is high, businesses have an incentive to invest more. At the same time, low interest rates give them the incentive and ability to borrow more to expand. . . . During the contraction, the low rate of profit gives businesses the incentive to contract. Likewise, high interest rates make it more expensive to maintain their existing activities and provide a motivation to take on investment projects of shorter duration.

. . . [T]he next task I undertake in volume one is to defend the theory from criticisms. I show that ABCT is consistent with “rational expectations” (as contemporary economists use that term), that the theory is not overly complex, that it does not exaggerate the role interest rates play in the cycle, and that the creation of mal-investment during the cycle does not depend on the existence of fully employed resources at the beginning of the expansion phase of the cycle. I defend ABCT from many other criticisms as well.

In addition, I extensively apply ABCT in volume one by performing a historical analysis of the business cycle in America from the beginning of the twentieth century up through 2012. I also go back to eighteenth-century France and the Mississippi Bubble to demonstrate the explanatory power of the theory. In my analysis, I show how fluctuations in the rate of change of the money supply drive changes in the velocity of circulation of money, the rate of profit, interest rates, output, and other variables. I do this by presenting and analyzing extensive amounts of data for the period pertaining to America. For the period in France, I use what data are available, as well as historical accounts of the period, to show how ABCT explains that episode.

Where data are available, my analysis in volume one employs a more comprehensive measure of output, as compared to gross domestic product (GDP), to provide a more complete picture of what events are taking place during the cycle. The more comprehensive measure is known as gross national revenue. GDP is deficient as a measure of spending and output because it mainly only measures spending on consumers’ goods. It fails to include most spending by businesses.

In addition, my analysis in volume one utilizes a better understanding of inflation to explain the cycle. It focuses on inflation as an undue increase in the money supply or, equivalently, an increase in the money supply by the government, instead of mere increases in prices. This focus allows for a deeper understanding of the causes of the cycle. Many more insights based on this better understanding of inflation will also be made in the current volume [volume two].

My analysis in volume one reveals that variables fluctuate as predicted by ABCT. The data also show changes in the structure of production during the cycle that ABCT predicts. That is, output in industries that are more sensitive to interest rates fluctuates more than output in industries that are less sensitive to interest rates. Through an integration of theory and practice, volume one clearly and convincingly demonstrates the validity of ABCT.

In addition, as a part of my analysis in volume one, I discuss other factors that contributed to specific episodes of the cycle. These include the government controls imposed by Presidents Hoover and Roosevelt during the Great Depression. Such controls took the economy down to unprecedented depths and made the recovery from that devastating episode much more difficult. For example, Hoover’s White House Conferences, where he used the presidency as a bully pulpit to (among other things) get businesses to keep wages high, sent unemployment to levels far above any that have been seen before or since.

. . . My analysis shows that far from being incompatible with ABCT, these other factors are complementary to ABCT in explaining specific episodes of the cycle. However, my analysis also shows that ABCT identifies the primary drivers of the cycle: the drivers that exist in each cycle. The other factors are merely adjuncts to ABCT that appear occasionally in different forms for some cycles.

In volume one, I also address other attempts to explain specific episodes of the cycle. I show that these other attempts do not provide valid explanations. For instance, I show that the Arab oil embargo of the 1970s did not cause the recession that occurred in the mid-1970s. Reductions in the supply of a commodity do not cause changes in the amount of spending that occur in the economy during the cycle and they do not cause the right pattern of fluctuations in industries. For example, ceteris paribus, an oil embargo would create a boom for oil companies not involved in the embargo, as prices rose, and a contraction in industries that use oil as an input. This is not the pattern of fluctuations we see during the cycle.

. . . The task of this volume [volume two] is to complete the case for ABCT. To do this, I show that other, prominent theories of the business cycle, such as real business cycle theory and the Keynesian “sticky price theory” of the cycle, do not provide valid explanations of the cycle. This task is undertaken in part one of this volume.

In part two, I show how government interference in the economy is responsible for the existence of fiat money and fractional-reserve banking. I also show what a free market in money and banking will look like and what it will lead to. The basic result will be a much more stable monetary and banking system. In addition, I provide an investigation into the types of monetary and banking systems that have existed in a number of countries around the world during the last 300 years or so. While not an exhaustive study—whole books have been written on this subject—by analyzing some of what are considered to be the freer episodes in money and banking, I show that a free market in money and banking has not existed. In fact, governments interfered early on in the history of money and banking (even much farther back than the periods I investigate). They did so mainly to finance their own spending.

In the next-to-last chapter, I discuss the benefits of a gold standard and 100-percent reserve banking. I also show that criticisms of gold and 100-percent reserves are not valid. Gold and 100-percent reserves have the ability to essentially eliminate the business cycle and help lead to much higher rates of economic progress. They lead to greater progress because of the stable financial environment they create. Finally, in the last chapter, I show how to transition to a free market in money and banking. The transition can be completed smoothly, without a depression or even a minor financial contraction. As a part of this last topic, I analyze a number of alternative plans to transition to a gold standard.*

The book is published by Palgrave Macmillan. A link to volume one is here. A link to volume two is here.

*Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 2: Remedies and Alternative Theories (New York: Palgrave Macmillan, 2014), pp. 2-5. Reproduced with permission of Palgrave Macmillan.

Brian P. Simpson is an economics professor and chair of the Department of Accounting, Finance, and Economics in the College of Professional Studies at National University in La Jolla, CA. He is the author of A Declaration and Constitution for a Free Society, and the two-volume work on Austrian business cycle theory titled Money, Banking, and the Business Cycle (Palgrave Macmillan, 2014) and the book Markets Don’t Fail! (Lexington Books, 2005). Visit his website brian-simpson.com.

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