at different times and to different extents. For many businesses, rising prices of their products on the consumer market give the false appearance of real gains on their accounting ledgers.

Encouraged by these illusory gains, these businesses calculate that they can now afford to consume more, and they too contribute to the rising prices of consumer goods. Pro ducers prices are affected first and the most dramatically, but the rising prices of consumers goods reassure the businessmen that their capital expansion program will pay for itself in spite of the rising costs of production.

Von Mises was the first economist to realize how this whole process occurs. It gets a little bit complicated here, but I urge you to stick with this analysis, because

understanding it will help you avoid losing money by being fully invested at bull market tops.

In Von Mises terms, call p the amount of capital goods available on the eve of credit expansion, r the replacement capital which must be saved from the gross proceeds of production with p, and g the total amount of consumer goods that are produced from p. Further, assum e that the economic condition prior to the credit expansion was a progressive one that produced surplus capital (capital savings) of p, and p2 which, without the advent of the credit expansion, would have been employed to produce the incremental quantity g I of goods produced previously and the quantity 92 of newly developed goods.

Without the credit expansion, the result would be that p (the existing capital) would produce r + g (the necessary replacement capital plus the goods that p produced for consumpt ion) and capital savings of pi + p2 (new capital to increase existing production plus capital to invest in new projects). Growth would come from using pi + p2 to produce gl + 92 (more existing products plus new products), and technological innovation would accelerate the process. But instead of this happening, the central bank, trying to stimulate employment and production, puts money into the system creating additional credit availability.

Enticed by the credit expansion, entrepreneurs decide to produce an additional quantity, 93, of goods previously produced, and embark on new ventures designed to produce 94 of newly developed products. To produce 93 and 94, additional capital goods, p3 and p4, are needed. But as I already mentioned, the capital available for business expansion is limited to p, and p2; p3 and p4 dont even exist, they just seem to! The entrepreneurial decision to produce 93 and 94 is based on an illusion brought about by the credit expansion.

Looked at this way, the actual quantity of capital goods at the disposal of entrepreneurs for planning is p, + p2 + r, but the apparent capital available is p I + p2 + p3 + p4 + r. Entrepreneurs act as if they could produce gI + gz + 93 + 94 with the apparent capital available and, because of the lac of real capital available, a bidding war ensues for pi + p2 + r. Prices for producers goods rise and may, at first, outstrip the rise in consumers goods prices, causing originary interest to decline in the near term.

During this period, the increased interest in producing for the future may actually bring about the generation of real new wealth. But eventually, as the credit expansion continues, the rise in prices of consumers goods outstrips that for producers goods. The rise in wages and profits (la rgely apparent, not real) intensifies the demand for consumers goods before the capital is in place to provide them. Consumer prices rise. If consumer prices continue to rise, eventually people want to own consumer goods as soon as possible to avoid paying more for them in the future. In other words, there is a tendency to raise originary interest, which means there is a tendency toward increased consumption in the immediate term versus provisioning for the future. Capital, in the form of savings, is consu med. This often reaches the point where people like Donald Trump will borrow as much as possible to own items which they believe will cost more or be worth more in dollar terms in the near future.

From an arithmetic standpoint, interest rates may ris e as a result of the increased demand for loans. But the entrepreneurial and price premium components of the interest rate necessarily lag behind what is required for the "proper" allocation of capital. Banks assume that their higher rates are enough to compensate for the effects of changing prices, so they continue loaning to businessmen, confident that the business expansion will continue indefinitely.

In fact, however, their confidence is a false one because they fail to realize that they are fanning the flames of the bidding war for scarce capital. As entrepreneurs, judging that they can meet the increased costs of production through increased sales, continue to borrow money to expand production, interest

rates continue to rise, as do the prices of both producers and consumers goods. Only by a continued increase in the supply of money created by the banks can the boom continue.

But soon, even that is not enough. If banks continue their expansionist policies, eventually the public becomes aware of what is happening. They see that the real purchasing power of their money is on the decline and a flight to real goods begins-the originary interest in holding goods skyrockets and that of holding money plummets. It is at this stage that runaway inflation, such as that which until recently existed in Brazil and still exists in Argentina and other nations, takes hold. Von Mises calls this stage of credit expansion a "crack-up boom."

Normally, however, things never go quite this far. Consumers on fixed incomes cry to politicians about the rising cost of living. Politicians blame someone else and urge the central bank to put on the brakes. The central bank responds by restricting credit availability. Entrepreneurs, unable to afford the now scarce loans, abandon new projects as they realize that they are doomed to failure. Banks stop lending because they realize that they have already overextended themselves. Loans are called in. The monetary expansion stops.

At this, the turning point of the boom, prices begin to fall as businessmen, hungry for cash to service their debt, sell off inventories. In particular, the price of producers goods usually falls precipitously and to a greater extent than consumers goods, such as in 1929 to 1933, when retail sales dropped 15% whi le the sales of capital goods dropped about 90%. Factories close. Workers are laid off. And as confidence in the economy wanes, the entrepreneurial component of interest rates jumps to excessive heights which further accelerates the deflationary process. Accompanying this process is usually some kind of news which turns the already existing crisis into a panic, often reflected in a plunge of stock and commodity futures prices. The bust occurs.

Typically, after such a crash, economists decry the failure of capitalism and declare that "overinvestment" was the cause of the bust. This is a huge mistake and the most misunderstood aspect of the boom/bust cycle. It is not overinvestment, but what Von Mises calls "malinvestment" that causes both the boom and the bust. It is the fact that lowering the gross market rate of interest through credit expansion encourages entrepreneurs to attempt to employ p, + pZ + r (the actual capital) as if it were p, + p2 + p3 + p4 + r (the apparent capital) that causes the problem. It necessarily brings about investment and distribution of resources that is out of whack with the real available supply of capital goods.

It is like trying to build the foundation for a 5000 square foot house out of concrete sufficient for a 2500 square foot house-either you alter the plans or you spread the concrete so thin that it wont support the structure.

As I discussed in the last chapter, to increase wealth requires the savings of surpluses for investment in future production. Technological innovation accelerates the rate of growth of wealth but is possible only through the application of saved capital. Most often, during a credit expansion, part of p, + p2 + r is invested in innovations which accelerate the real rate of growth of wealth, offsetting some of the negative effects described above. But this is only a damper.

The nature of the distorted investments brought about by the credit expansion must sooner or later collapse, and wealth will be consumed. It may be true, and most often is, that by the end of the boom/bust cycle, the actual standard of living and overall wealth in the economy is greater than at the beginning. But it is certainly not greater than it would have been during the same period without the irresponsible credit expansion.

As a speculator participating in markets influenced by credit regulation by central banks, you must be able to identify the stages of the boom/bust cycle. To do this, you have to understand the different forms that credit expansions take. Specifically, you have to understand how both the Federal Reserve Board and the Treasury contribute to money and credit inflation. Since central banks in all nations operate in basically the same way, once you understand how the U.S. system works, you will have a grasp of how all central banks work. Then, you will have the basis to understand and potentially to predict the economic outcome of politicians attempts to coordinate both national and international monetary policy.

THE STRUCTURE AND ROLE OF THE FEDERAL RESERVE SYSTEM

In the title of this chapter, I posed the rhetorical question: "Who holds the pump, and who holds the needle?" In France during the Mississippi Scheme, the answer was John Law and the Duke of Orleans. In the United States today, the parallel answer is the The Federal Reserve Board and the Federal Open Market Committee (FOMC). These organizations monopolistically control the supply of money and credit in the entire Federal Reserve System which now includes, de facto, nearly all depository institutions in the country.

The economic power that they wield is absolutely mind boggling. It is so great that we have become a

nation of Fed watchers, clinging to the obtuse proclamations made by the Fed Chairman and other key

Board and FOMC members as we look for some indication of forthcoming policy. A single statement

made by the Fed Chairman can literally reverse the stock market trend, as happened on July 24,1984,

when then Chairman Paul Volcker announced, "The Feds [restrictive] policy was inappropriate." Th at

same day, the stock market made its low, and a new bull

Ironically, an agency which can literally swing the market with a sentence was established by the Federal Reserve Act of 1913 to stabilize the workings of the money and credit markets.

In the words of the legislation, the purpose of the Federal Reserve is to "give the country an elastic currency, to provide facilities for discounting commercial paper, and to improve the supervision of banking." By 1963, the Feds acknowledged objectives had expanded "to help counteract inflationary and deflationary movements, and to share in creating conditions favorable to a sustained, high level of employment, a stable dollar, growth of the country, and a rising level of consumption."g (Note the emphasis not on production but on consumption-pure Keynesianism.)

Today, the Fed is virtually another branch of govemment which attempts to coordinate its policies with Congress, the President and the Treasury, and the central banks of foreign govemments. But the primary function of the Fed is to act as the central bank of the United States. Lets first look at its operation in this role.

As the nations central bank, the primary function of the Federal Reserve is to:

... regulate the flow of bank credit and money. Essential to the performance of this main function

is the supplemental one of collecting and interpreting information bearing

on economic and credit conditions. A further function is to examine and supervise State

banks .... obtain reports of condition from them, and cooperate with other supervisory

authorities in the development and administration of policies .... 9

The Feds big stick is its power "to regulate the flow of bank credit and money," which means, plain and simple, to inflate or deflate the supply of money and credit.

Before I go on, let me briefly define what "the Fed" is. The Federal Reserve System has three basic components: the Board of Govemors, the Federal Open Market Committee (FOMC), and the Federal Reserve Banks. As an agency of the Federal govemment, the organization of The Federal Reserve System is mandated by law, but little else is. The Board and the FOMC-the seven board members occupy seven of the twelve seats on the FOMC unilaterally establish and implement the monetary policy of the United States. It is these two components that people generally refer to when they use the words, "The Fed."

The Board consists of seven Presidentially selected appointees, confirmed by the Senate, who serve 14-year terms. The terms are arranged such that one expires every even-numbered year, and a member may not be reappointed after serving a full term. The Federal Open Market Committee consists of the seven Board members plus five presidents from the twelve Federal Reserve District banks, one of