rights to trade in India, China, and the South Seas, and to all the possessions of the French East India Company. The name of the company was changed to The Company of the Indies, and Law promptly arranged the sale of 50,000 new shares at 500 livres per share to be bought 100% with billets detat at their nominal value, while promising a 200-livre per year dividend to all stockholders.

There was an immediate speculative frenzy for the new stock issue. Believing Law to be a financial miracle worker, thousands of people filled the streets outside Laws residence, trying to get shares of the stock that was increasing in value daily. The regent saw an opportunity to retire the entire remaining national debt and authorized another issue of 300,000 shares to be sold at 5000 livres each, again payable in billets detat.

You might think that such an enormous increase in the stock issue would have quelled the frenzied speculation. It didnt. The credit expansion simply fanned the fire and soon the price of the stock was rising as much as 10 or 20% in the course of a few hours. Stableboys and housema ids became rich overnight, and the general sentiment was that the magical source of prosperity would never end. Amazingly, the paper currency maintained its integrity for several years, but slowly and surely, the gold and silver which supposedly backed the paper began to drain out of France into foreign countries.

As with all credit driven booms, the paper inflation caused prices in France to increase, making foreign products cheap relative to domestic products. As imports increased, specie payments to fore ign governments also increased, creating a drain on the nations stock of gold and silver. In addition, people who knew that gold and silver reserves at the Royal Bank were but a fraction of the paper circulation quietly began converting paper to coin and transporting the coin to foreign banks.

By 1720, the scarcity of coin was so great that it was becoming impossible to carry out foreign trade, which was carried out with hard currency. In an effort to stop the run on gold and silver, coin was decreed depreciated first to 5% below, and then to 10% below the paper, and specie payments at the bank were limited to 100 livres in gold and 10 in silver.

These stopgap measures held back the coming storm until Law made a fatal error in February of 1720. At his suggestion, a decree was issued forbidding anyone to hold more than 500 livres in coin, and also forbidding people from buying up precious stones, jewelry, silver settings, and so forth, under penalty of a heavy fine and confiscation of the holdings. The decree encouraged the public to inform on lawbreakers by providing an incentive reward of one-half the recovered amount. Rather than restore public confidence in the paper currency, this measure totally destroyed it and brought the country to the brink of revolution.

By May 27,1720, the bank was forced to stop making payments in specie and the price of Laws stock was tumbling. The bubble burst, and the pyramid tumbled in what I believe was the first recorded stock crash in history. The stock of the India Company plummeted and the value of the paper currency depreciated relative to gold and silver in spite of every effort by the govemment to achieve the opposite. Commerce was in total disarray, and every measure the govemment took aggravated and prolonged the problem. Law, once a national hero recognized as the savior of the glory of France, became the scapegoat for the entire problem and was nearly murdered by angry crowds. He eventually left the country, carrying with him virtually nothing of the vast fo rtune he had amassed.

A council was formed to restore order to Frances financial system. Their audit found that rather than being diminished, the govemment debt had risen to 3.1 billion livres. The corruption they found within the govemment financial offices was unbelievable, and some of the guilty were sentenced to life imprisonment at the Bastille. Eventually, order and solvency were restored to some degree, but as history shows, the same mistakes were made again and again, contributing to the impoveri shment of the people and the growing division between the landed aristocracy and the working man. Eventually, these and other problems led to the abortive French Revolution and the eventual reign of Napoleon.

This story is such a wonderful microcosm of the effects of credit expansion on an economy that I couldnt help but tell it. Every boom/bust cycle in market history follows a similar, but not as dramatic or condensed, pattem. The pattem goes something like this. After a period of economic decline -a bust-economic activity is sluggish and there is a social clamor for the govemment to "do something." While the market is in the process of a necessary adjustment, some ingenious economic gum links up with the govemment and offers a plan for recovery.

Invariably, the plan calls for an end to inflation, a balancing of the budget, decreasing govemment

deficits (if they exist), and stabilization of the currency relative to foreign currencies. BUT (and there always is a but), the policies to achieve these noble ends always involve some form of interference in the workings

of the free market and eventually amount to little more than a new credit expansion that results, sooner or later, in another boom and bust cycle.

Why does central bank credit expansion necessarily cause a boom/bust cycle? Simply put, it results in a misallocation of resources and confuses economic cal culation to such a degree that either, like a drug addict, higher and higher doses of credit expansion are required to stay one step ahead of the inevitable consequences, or the economy goes into cold turkey-a recession or depression. But to fully understand what happens, you have to go back to the economic fundamentals; you have to understand the effect that credit expansion has on origin ary interest.

Recall from the last chapter that Von Mises defined otiginary interest as the ratio of the valuation of present goods to the valuation of future goods, or "the discount of future goods as against present goods." 5 It is originary interest, as expressed by individuals exchanging in the marketplace, that determines the level of spending on consumer goods versus the level of plain and capital savings. In other words, originary interest determines how much of the available supply of goods in the marketplace is to be devoted to immediate consumption versus provisioning for the future. Its expression in the market is as a component of the market rate of interest.

The market rate of interest tends toward the level of originary interest held by a predo minance of market participants. It is important to realize, however, that in the continuing operation of the market there is no fixed, constant level of originary interest. Rather, it varies from person to person, market to market, and within each market according to changes in valuations brought about by changing conditions and opinions. But there is a tendency, brought on by the competition of entrepreneurs, to drive originary interest to a uniform level.

To understand how credit expansion causes the boom/bust cycle, you have to understand the distinction between originary interest and the gross market rate of interest. The gross market rate of interest has three components: originary interest, an entrepreneurial component, and a price premium. The entrepreneurial component is the portion of interest which gives the creditor incentive to lend money for investment. In effect, the entrepreneurial component entitles the creditor to a portion of profits gained through the investment of his money. The price prem ium is an allowance, either positive or negative, for anticipated changes in the purchasing power of money. To put it in somewhat oversimplified terms, originary interest is the subjective value that the market places in consuming now versus consuming later, the entrepreneurial component is a premium which varies according to the creditors confidence in getting his retums, and the price premium varies according to the creditors assessment of the purchasing power of money in the future versus the present.

All three components of the gross market rate of interest operate in every credit transaction; they are all constantly changing, and they all affect one another. As with any other market, the final determinant of the nominal interest rate on each loan is supply and demand. In a free market, entrepreneurs and promoters attempt

to make profits by selling products at a price exceeding production costs plus the gross market interest rate. The role of the gross market rate of interest is to show entrepren eurs and promoters how far they can go in withholding the factors of production from immediate consumption for the purpose of creating more products in the future. The market rate of interest guides entrepreneurs to make the best use of the limited amount of capital goods available, which are provided by the savings of market participants.

Credit expansion by central banks, under certain conditions, can completely reverse this role. Assume for the moment that the credit expansion takes the form of making mo re money available for banks to lend, as happened in France during the Mississippi Scheme fiasco. In cases like this, money has a driving force of its own, and the loan market is directly affected before any changes occur in the prices of commodities and labor.

At first, no change in originary interest occurs, but the entrepreneurial component of the gross

market rate of interest rate drops due to the apparent availability of new capital for investment. Although no additional capital actually does exist, when entrepreneurs put pencil to paper, the increase in the supply of money available makes it appear that it does exist. Previously unfeasible projects now appear to be feasible. In the early stages of a credit expansion, there is no way for the entrepreneu r to distinguish between money available and capital available-the whole basis for economic calculation is distorted.

Artificially lowering the market rate of interest has no real relationship to the supply of capital goods available or to the current level of originary interest. But because of the distortion of increased credit availability, decisions are made as if they were directly related. As a result, capital goods are diverted away from their best use, encouraging poor investments and eventual capita 1 consumption.

In addition, the role of the price premium component of interest rates in economic calculation is totally subverted. Because the money supply expansion directly affects the loan market before it affects prices, there is a lag time before the price premium can possibly reflect the inevitable rise in prices which will occur as a result of the money supply expansion. Consequently, the price premium component of the gross market rate of interest is artificially low in the early stages of the cred it expansion and creditors unknowingly make loans at too low an interest rate.6

In a fractional reserve banking system,? credit expansion always causes an inflation in the money supply, as I will discuss in detail shortly. Advocates of an inflationary expansion argue that the price increases which occur from money supply inflation affect commodities before they affect wage rates. Consequently, they say, producers costs go up, consumer prices go up, and the wage earners and salaried people, who have less tendency and ability to save than other classes in the market, are forced to restrict expenditures, and savings are made available for capital expansion.

On the other hand, they say, entrepreneurs and businesses, who have a greater tendency to save, enjoy the benefits of higher prices and increase their savings in greater proportion than consumption. As a result, there is a general tendency toward

an intensified accumulation of new capital paid for by the diminished consumption of wage earners and salaried people. This forced savings lowers the rate of originary interest (lowers interest in immediate consumption) and therefore, because of an increase in capital investment, accelerates the pace of economic progress and technological innovation.

While this may be true at times, and indeed has happened at certain times in the past, it is an argument that overlooks several important facts. First, it is not necessarily true that wage rates always lag commodity prices. Labor unions in the 70s, for example, caug ht on to the effects of inflation and bargained for real increases in wage rates above and beyond the rise in the Consumer Price Index (CPI)-the so-called "wage-price spiral." There is also no guarantee that entrepreneurs and businesses will always necessarily save more than wage earners and salaried people. But perhaps the most important fact that this argument overlooks is that inflation introduces forces in the market that tend toward capital consumption.

Inflation-an increase in the money supply caused by central bank credit expansionfalsifies economic calculation and accounting. When the central bank makes a greater supply of money available on the credit market, it makes additional loans available that otherwise would not have been. The nominal interest rate-the actual average percentage interest rate-might not change, but because more money is available in the loan market, the gross market rate of interest is lowered. Consequently, loans are made that would not have been made prior to the expansion. T his is exactly what the Fed is trying to accomplish now (91).

To entrepreneurs, who deal and think only in dollar terms, the availability of credit makes formerly unfeasible projects appear feasible. For them, credit is a claim on unconsumed goods to be invested in new projects. As more and more entrepreneurs embark on new projects, business activities are stimulated and a boom begins. But there is an inherent problem from the outset of the boom. At any point in time, the goods and labor available for business expansion are finite, or scarce. The increased demand for these scarce items caused by the credit expansion creates a tendency for a rise in the prices of producers goods and the rates of wages.

With the increase in wage rates, there is a corresponding increase in demand for consumer goods, and their price begins to rise as well. This happens in stages, affecting different sectors of the economy