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The wavelike movement affecting the economic system, the recurrence of periods of boom whi ch are followed by periods of depression (recession), is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The altemative is only whether the cnsis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.


Since the mid to late eighteenth century, the debate has raged as to what causes broad cyclical fluctuations in the market economy. In the context of this book. I want to answer that question so you can make money, not only during market upswings, but also in the downswings when many businessmen and most investors are losing money or are at least giving back a large part of previous gains.

I started this chapter with the quote from von Mises because I have never read a more accurate and well-formulated answer to the question of what causes the business cycle than his. In spite of his rather obtuse style, his answer is simple. But like Einsteins simple formulation, E = mc2, there is a lot of knowledge underlying the statement.

If you can understand the content of von Mis es statement with all its subtleties

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and apply it to the U.S. and world system of money and credit, you will be better equipped to foresee major market tuming points than, say, 90% of speculators in the markets.

In the statement, von Mises implies that to understand the business cycle, you have to understand the relationship of money, interest, credit, and the effects of credit expansion on the economy. THE NATURE OF THE BUSINESS CYCLE

Almost everyone knows the nature of pyramid schemes such as chain letters, and most of us dont participate in them because we rightly assume that either the founders of the schemes are crooked or that there is a good chance of ending up at the top of the pyramid with everything to lose and nothing to gain. The business cycle is like an extremely elaborate pyramid scheme that repeats itself over and over again, introduced not necessarily by intention, but through widely accepted errors in economic thinking.

The phenomenon known as the business cycle didnt really begin until the middle of the eighteenth century. Before that, there were depressions, but their causes were easily discemable. A king would need money to wage a war or simply to fill his purses and would send out his marshalls to confiscate money (taxes). Naturally, this would cause a slump in commerce because it deprived people of their ability to cany on "business as usual"

Or perhaps during war, one nation would deprive another of an essential resource, the way the North deprived Britain of cotton during the American Civil War, and cause a slump in industries dependent on that item, leading to a general economic decline. Whatever the source, it was relatively easy to identify the event which caused the economic downtum. Without these extemal, or exoge nous, events, economic activity went along in more or less a straight line with steady but moderate growth.

Starting in about 1750, however, there emerged a recurring cyclical fluctuation in the economic

Booms and Busts: Who Holds the Pump and Who Holds the Needle?

activity of industrialized nations that wasnt so easy to explain. There were two coincident developments during this period of history: the industrial revolution, which began in England and spread throughout the western world; and the rise of central banking, specifically, central fractional reserve banking controlled by govemment regulators. Since these were the only new significant economic developments, political economists began to explore the possibility that one or the other of these two factors were responsible for the business cycle.

Two basic schools of thought emerged. One group, the mercantilists, assumed that there was something inherent, or endogenous, in the market economy which caused cyclical fluctuations in business activity. For this group, their focus was to find these causes and then use govemment control to eliminate them and provide a stable environment for business expansion. The other group, led by the classical economist, David Ricardo, explained the business cycle by analysis of the effects of paper money and credit expansion on trade.

In their terms, the business cycle is caused by the exogenous factor of govemment intervention in the money and credit markets. Unfortunately, the endogenous school triumphed, culminating in the economics of John Maynard Keynes, which in variant forms still dominates world economic thought today. Consequently, central banks, operating on the fractional reserve system, exist in every major industrial nation in the world-and so do booms and busts.

I realize that it is not enough to say that because central banks exist and booms and busts exist, that central banks are the cause. But before I explain exactly how central bank expansion of money and credit causes the boom/bust cycle, let me give an example from history, an example which repeats over and over again, just with different players.

Although the business cycle didnt develop until the mid-eighteenth century, central banking began in 1692 with the foundation of the Bank of England. Almost simultaneously, in The Royal Commonwealth of Massachusetts, the first fiat money was issued (money with no redeemable value in the precious metals). Obviously, even this early in banking history, some govemment advisors had recognized the short-term benefits of credit expansion and fractional reserve banking. Perhaps the best illustration of this is the so-called Mississippi Scheme, which occurred in France in the early eighteenth century.2

During his long and lavish reign from 1643 to 1715, King Louis XIV put the finances and economy of France into total disarray. After a period of prosperity (centered primarily in Paris and the immediately surrounding regions) brought about by extravagant royal spending, by the time of Louis XIVs death in 1715, both domestic and foreign commerce were on the decline, and the solvency of the French govemment was in question.

The national debt was 3 billion livres3 (in the forms of billets detat, or govemment securities), the tax revenue was 145 million, and the govemment budget was 143 million, excluding the interest on the outstanding 3 billion debt. There was a debate whether the govemment should just declare bankmptcy and start from scratch, but the politicians of the time feared revolution and looked instead for a more expedient solution.

The govemments first feeble attempt to remedy the problem was to devaluate the currency through a recoinage, depreciating the currency by 20%. New coins were issued weighing 5 of the old coin, but with the same face value, and the populace was ordered by law to make the exchange. T he net effect was to bring 72 million livres into the state treasury and to throw the commerce of the nation into a state of further disarray and economic depression.

To calm the public outcry which arose in response to the devaluation, the govemment slightly cut taxes and launched a reform program to eliminate widespread corruption among tax collectors. These measures drew public attention away from the crisis state of the countrys finances but did little to bring the govemment into a state of solvency.

There emerged onto this scene a wandering Scotsman named John Law. An avid gambler and ladies man. Law had fled from Scotland to the European continent after killing a man in a duel over a woman. In Europe, he found a home for

both his gambling skills and his twentieth century ideas about money, credit, and govemment finance.

Law was a firm believer that an entirely metallic currency system, unaided by paper currency, was inadequate for the commercial needs of a country and actually limited economi growth. In other words, like John Maynard Keynes, Law believed that prosperity could be bought through carefully managed credit expansion and inflation of the currency. (I have to wonder if some of the wild oats that Law was reputed to have sown ended up in the Keynes family tree.)

Law lobbied the Duke of Orleans, his friend and the regent of France, and convinced him of the need for a private central bank to employ his currency and credit theories and bring France back to the fore as an economic power.

In 1716, the regent issued a royal edict authorizing Law and his brother to establish a bank, under the name of Law and Company, to be capitalized through the sale of 12,000 shares at 500 livres each, purchasable one-fourth in specie and the remainder in billets detat. The regent authorized Laws bank to issue bank notes instead of coin and decreed the notes as acceptable, at full face value, for payment of taxes (in effect, they were declared legal tender in a limited sense).

Law was no neophyte to banking. The son of a Scottish banker and an avid student of money, credit, and trade. Law knew that he had to establish public confidence in his banks notes for the entire scheme to work. He immediately announced that all notes from his bank were payable on sight in the coin current at the time of issue. The public, reasonably fearing further devaluation of the coin, naturally favored holding Laws bank notes to coin and, almost immediately, the notes sold at a premium to the precious metals.

Public confidence in Law and his bank notes grew rapidly, the notes trading as high as a 15% premium to the metal coin, and branch bank offices were opened in five major French financial centers. During the same period, the billets detat were trading at a discount of 78.5% or more.

At this point, one could reasonably argue that Laws actions were based on sound economic principles. Above all, what France needed at the time was to restore confidence in the currency and credit of the nation. Laws fully backed paper currency did just that.

In effect, he offered his depositors an insurance policy against devaluation of the coin. As long as people believed in the credibility of Laws bank and his ability to redeem his notes in specie, his notes were literally "as good as gold." With confidence restored in the currency, both foreign and domestic commerce enjoyed a resurgence. Taxes were paid with greater regularity, and the debt of the nation was slowly but surely being retired.

But the Duke of Orleans, who really didnt understan d what was happening, thought that paper currency was the magic cure for all of Frances economic woes. Seeing what he thought was an opportunity to quickly retire the overwhelming govemment debt, the regent made two fatal errors in 1717.

First, he authorized Law to form a company with exclusive trading privileges in the Louisiana Territory along the entire west bank of the Mississippi River, which was thought to be rich with deposits of gold and silver. The company was

capitalized through the sale of 200,000 shares with a par value of 500 livres each, which could be purchased with billets detat at face value, even though they were trading at roughly 16% of their original value at the time.

Second, the regent made Laws bank public, declaring it the Royal Bank of France. Totally blind to the consequences of his policies, the Duke then caused, over a period of a few years, the issue of over one billion livres in paper currency. Whether Law agreed with this policy is not known, but when the bank was operating under his authority, the paper issue had never exceeded 60 million livres.

The billion livres werent just handed out on street comers throughout France; they were given out as loans. In other words, there was a huge and rapid credit expansion resu Iting in an inflation of the paper currency. In addition, in a further attempt to retire the still outstanding billets detat, another recoinage was ordered in which 5000 livres of a new and smaller coin were exchanged for 4000 of the old coins plus 1000 livres in the billets detat at their full face value.

The immediate consequence of the credit expansion was a speculative boom. Businesses and merchants that borrowed money bought domestic and foreign goods, domestic production was expanded, imports increased, and constmction (especially around Paris) picked up. Leading the way in this boom was Laws Mississippi Company. The Duke of Orleans granted the company the exclusive

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