Why we have recessions

Inflation has, of course, many other bad effects, much more grave and painful than is realized by most people who have not lived through a serious inflation. But the effect that is most devastating, and at the same time the least understood, is that in the long run inflation inevitably produces extensive unemployment.

– Friedrich A. Hayek  1979

The United States has always had booms and recessions: good times and bad. These ups and downs in production are called “business cycles”. During the booms, we often have steep rises in prices and many wage increases. During the recessions there are widespread bankruptcies; millions of people become unemployed for many months, or even years.

Ever since 1800, there have been periodic up and down swings of national production, prices, and employment in the United States, and most of the developed world. Some of these swings have been related to major wars. In this country, there were economic swings during the Civil War, the two World Wars, the Korean War, the Vietnam War, plus many other international conflicts. With the growth of trade between nations, a boom or a recession in one country tends to spread to the nations it trades with.  When things are tough here, we tend to buy less imports. That hurts the economies of the nations that export to us.

Downturns in the United States used to be called “panics”. There were panics in 1819, 1837, 1857, 1873, 1893, and 1907. In more recent times, there were major downturns in 1913, 1921, 1924, 1927, 1930-39, 1946, 1949, 1954, 1974, 1980, 1982 and 1990. This graph illustrates some of the business cycles that have taken place since 1923:

On this chart you can see some patterns in the massive shifts in U. S. production. The depression in 1920 after the end of World War I has been almost forgotten today, but it was a major shock to everyone when it happened. Fortunately, it did not last long. Because of that drop, many people expected a similar downturn after the end of World War II. There was a drop, but nothing as significant as before.

There are other events shown here that do not appear to be related to warfare: the panic of 1893, 1907 (not shown on the graph) and the Nixon and Carter Recessions. What caused them?

Business Cycle Theories

For the past 200 years, economists have dreamed up dozens of theories to explain these shifts, few of which have proved widely persuasive.  One we can discount right away: the over-investment cycle.

According to this theory, entrepreneurs spot an opportunity for profit: a shortage of office buildings, the invention of personal computers, discovery of oil in Alaska, opening up of copper mines in Utah. They rush like lemmings to invest in these opportunities. It takes many years from the beginning of these projects until they can bring the products to market. When they finally do, they discover that there is too much investment, resources are too expensive, and output selling prices are lower than they thought. Profits disappear. Businesses go bankrupt, and the results ricochet throughout the economy, sending shock waves of further bankruptcy and unemployment. It is a good theory, but it does not really happen that way.

In fact, the interactions of entrepreneurs, investors and consumers in the market are much more complex and responsive than this theory would have us believe. Production decisions are generally reached not by any estimation of the actual size of the total demand, but by the prices available in the market. As long as the market is free from outside disturbances — warfare or government interference with the money supply — the interactions of participants will always move towards an equilibrium based on the profits to be made from exploiting the differences between the prices of factors of production (land, labor and capital) and the prices of final goods.

For every entrepreneur seeing a profit in one opportunity, there will be two or three others who see profits in something else — which may be contrary to the first one’s theory. There is no reason why all investors should suddenly move in the same direction all at once: if they did, the prices of the factors of production needed would go up so rapidly that most of them would quickly sense a lack of profits, and would stop their mistaken investment.  No guiding hand is needed here.

Imagine hundreds of cars speeding down a four lane super highway. Suppose all the motorists got the idea at once that the left lane was the fastest. All try to shift to that lane. Of course, traffic would quickly come to a halt. But, in fact, what happens is that as soon as motorists perceive a slowdown in one lane, they quickly shift to another. Without anyone telling them to, independently, they seek the lane which moves them ahead fastest at that particular moment. The market is like that.

What is missing from the over investment theory is the real cause of business cycles: changes investment patterns caused by a deliberate government change in the money supply.

How Interest Rate Shifts Cause Business Cycles

Suppose you are an entrepreneur seeking to make a profit. You have spotted an opportunity to manufacture an industrial robot which may take four years to realize.

You decide not to invest.

Then a dramatic drop in interest rates occurs. Rates go from 12% to 8%. Your interest charges drop from $1,000,000 to $666,667. Your profits go from -0- to $333,333. Your robot project is now a winner.

At the same time that you see this opportunity, thousands of other entrepreneurs are investing in their new projects, since interest rate reductions usually apply to everyone. The rush to invest is on.

Because of the low interest rates, thousands of enterprises borrow money, begin to hire workers and bid for scarce resources: tubular steel, computer chips, plastic dies, and construction crews. Prices of factors of production rise, wages rise, and a boom is in the making.

Your robot project, and the others, is a valid investment. The profit is there. It may be less than you first calculated, because the cost of your inputs is rising rapidly. But as long as the interest rates remain low, you will probably still make a profit. If the rates should go back up to the old rates, you will be wiped out along with thousands of others.

In time, that is exactly what happens. Interest rates do rise back up for the same reason that they came down: some central authority is causing them to move. Governmental monetary authorities deliberately inflate the money supply causing interest rates to fall, and then, later, deflate it causing interest rates to rise. The result is a business cycle. Why these authorities should make the money supply go up and down is the central story in this article.

Why they are called cycles

Before we go further, let’s understand the common language used for these movements in business activity. The reason that these ups and downs are called business cycles is that on a graph they have the appearance of a sine wave, or cycle:

On this graph, there is shown a long term upward trend of the Gross Domestic Product which has been relatively steady for the past 200 years at about 2% per year. Periodically, there is a boom, with high employment, rising production and prices. This is followed by a panic, crash, recession or depression — where GDP goes down, unemployment goes up, and prices may (or may not) go down. This recession continues until it “bottoms out” at a trough, and starts back up again in what is called a “recovery”.  In the 1800′s and early 1900′s these downturns used to be called panics, principally because many banks failed, and people rushed to take their money out before they lost everything.

The politician’s word for the panic of 1929-1940 was a depression, so called because it sounded better. It conveyed the impression that eventually things would improve (a depression is just a dip in the road). The depression took so long to end, and was so severe that politicians had to come up with a new word, which they did: a recession was what the downturn was called in the Eisenhower administration. The new word has stuck.

In the typical cycle, a boom is followed by a recession in which bankruptcies and unemployment increase. The GDP goes down for several months, or years, until it “bottoms out” in a “trough”. Then economists say “the recession is over!”, even though there are millions of unemployed, and will be for many more months or years. The recovery begins, which eventually turns into a boom, and the process starts all over again.

It is important to realize that no one knows for sure at any time where we are on the cycle. When the economy is headed downward you will hear many authorities announce that “we have bottomed out”, only to learn that there is still more recession ahead. No one knows. There is no way of knowing how long the recession will last, or how high the boom can go before it bursts. Economists are not astrologers. Many will look at previous booms and recessions, and assume that this one will be just like the last one. They could be right. And they could be wrong.

Business Cycles are not inevitable

In the absence of external events like wars or money supply changes, it is unlikely that there would ever be any serious business cycles. The natural interaction of millions of individual entrepreneurs in the market creates a kind of equilibrium. Some enterprises are making high profits, while others are going under. Overall, the profit seeking of millions means that too many are never going all at once in the same direction.

To understand business cycles, we must define inflation and deflation.


The meaning of the term inflation is often confusing. Its original and proper meaning is an excessive increase in the quantity of money, leading in turn to an increase in prices. A general rise in prices, for instance one brought about by a shortage of food caused by bad harvests, is not inflation. It is the increase in the money supply, and not the price rise, which is the real meaning of inflation.

Inflation in the money supply can come about from the printing and distributing of increased amounts of paper money by the government, or banks, or by permitting banks to hold a lower fraction of their deposits as reserves (which results in increasing the money supply by a multiplied amount.

If the money supply increases faster than the supply of goods and services then prices will tend to go up. “Too much money chasing too few goods”, is the way it is often described. Deflation is the opposite: a drop in the supply of money.

For the last seventy-five years, Keynesian economists have used a different definition of inflation. They define it as “a time of generally increasing prices”. They maintain that gradual annual increases in prices and wages are good for the economy because they help create high employment and investment. Their theories have led most western governments, including our own, to inflate their currency year after year, expecting the process to produce prosperity.  As one leading Keynesian economist said in 1976[i]:

“An increase in prices is usually associated with high employment. In mild inflation the wheels of industry are initially well lubricated, and output is near capacity. Private investment is brisk, jobs are plentiful.  Such has been the historical pattern.”

Economic thinking such as this has led to the great expansion in the money supply which has occurred almost every year since 1946, and consequent price rises. It has led to the growth in the activities of the Federal Reserve System (the major means by which the money supply is expanded). Inflation of the money supply has become central to government policy in the past sixty-five years.

Free market economists today reject this theory and the definition that goes with it. There is growing acceptance of the idea that money supply increases are the proper definition of inflation; and that inflation of the money supply is one of the chief causes of the periodic recessions which produce widespread unemployment.

I use the original definition of inflation: Inflation is an increase in the money supply. Such inflation does not necessarily increase prices. If the production of goods is going up by 3% per year, and the money supply increases by a corresponding amount, there would not necessarily be a general rise in all prices. The effects of inflation are felt differently by different sectors of the economy.

What Causes Inflation

Inflation (increase in the supply of money) can come about from many causes:

  • Banks print and issue increased amounts of dollar bills. Banks were permitted to do this from the founding of our country up until 1935. Since that time, only the federal government (now the Federal Reserve System) is authorized to issue paper money.
  • The Treasury prints money and uses it to pay their bills. In the Revolutionary War the individual Colonial governments issued their own currency. In the Civil War, the Federal Government printed “Greenbacks” to finance the war. While the same thing could happen today, it is unlikely. All national currency in circulation today is issued by the Federal Reserve System, rather than by the Treasury.
  • The Federal Reserve System can print money and issue it in exchange for bonds or other assets. This happens on a daily basis. It is how banks get the brand new currency which enters the money supply (in exchange for old rumpled money which is constantly being turned in and burned). In fact, however, this process does not necessarily lead to inflation. The amount of paper money in circulation is relatively fixed, and determined by the public that decides how much to keep in their wallets versus their bank accounts. If the Fed printed billions more bills than the public wanted, the Fed would be stuck with the money in its vaults — just as a shoe manufacturer would be stuck with surplus shoes in his warehouse if he manufactured more than the public wanted to buy.
  • The Treasury can print bonds and sell them to the Federal Reserve System.  The Treasury Department maintains its checking accounts with the Federal Reserve. The Treasury prints an average of six billion dollars’ worth of bonds every business day. Most of these are sold to investors and institutions in the New York bond market. These do not cause inflation — because the money to pay for the bonds is surrendered by the new owners of the bonds, in exchange for the certificates.
  • Some of these bonds, however, are sold to the Federal Reserve System. In exchange, the Fed increases the Treasury’s bank account by the value of the bonds. The Treasury writes checks on their account to pay their bills. The result is an increase in the money supply — by a multiplied amount. Why multiplied? Because the recipients of this new money (the people that the government pays with the checks — government employees, farmers, defense contractors, welfare recipients, etc.) spend the money, in such a way that it ultimately ends up deposited in the banking system. The banks can loan up to 80% (or a higher percentage) of the amount on deposit. The result, therefore, of the Treasury selling bonds to the Federal Reserve is that the money supply increases by about five times the total amount of the bonds purchased.
  • The Federal Reserve can buy bonds from private citizens and banks on the open market. This, too, happens on a daily basis. Each time the Fed does this, it also has the effect of increasing the money supply by a multiplied amount. Of course, the Fed also sells bonds back to the public, which reduces the money supply. If they buy more than they sell, the money supply increases.
  • From the above it should be clear that the control of the money supply is, today, strictly in the hands of the Federal Reserve. They can create inflation (by buying bonds) or deflation (by selling bonds).

Why inflate the money supply?


Inflation today, therefore, is the result of the deliberate actions of the Federal Reserve Board of Governors. Why do they create it?

While the Fed’s actions are never the result of any single factor, a study of their decisions shows that they operate on the theory that a little inflation will help to produce prosperity. The reasoning goes this way:

  • If the money supply is fixed, and the production of goods and services increases, then prices would have to fall. For example, if the quantity of money is fixed, and the number of potatoes produced and eaten grows every year, eventually the price of potatoes (and everything else) would have to fall or there wouldn’t be enough money to buy them.
  • Falling prices mean that real wages would increase. Let’s see why this is so. Most employees and employers are very unwilling to cut anyone’s wage or salary if they are doing a good job. Employers are afraid their good employees would leave them. Employees, faced with fixed mortgages, insurance premiums and other debts are very unwilling to accept a reduction in their money wages. As a result, wages and salaries are seldom reduced, unless a company is in serious financial trouble.
  • But if prices of consumer goods are coming down, while wages are not, then each worker’s real income must be going up. Workers can buy more and more goods with the same salary. So falling prices result in increases in real wages.
  • If real wages increase, businesses will seek to replace workers with capital equipment (which, like everything else, would be falling in price and cheaper than the now expensive workers.) Employers will do this, not because they don’t care about their employees, but because competition will force them to replace workers. If their competitors are turning out products at lower cost because they have installed modern machinery, companies will have to do the same thing, or they will be forced out of business.
  • Replacement of workers by capital equipment is always going on, of course, and results in higher productivity and more efficiency. But rapid replacement due to falling price levels will soon become a hot political issue. Many workers will be laid off. Unemployment will grow.

It is this type of scenario that motivates the Federal Reserve to constantly inflate the money supply.

Targets for Deliberate Inflation

There are three possible targets for deliberately planned inflation. Increase the money supply:

  • Slower than the growth of production;
  • The same rate as production growth, or
  • Faster than production growth.

Many people would favor the middle course: have the money supply keep up with production. In that way prices would be kept fairly steady with no increases and no decreases. Unfortunately, there is no way that price levels can be stabilized by manipulating the money supply. Prices are constantly shifting because of changing demands, and changing technologies. When the price of potatoes falls, is that because of reduced demand of potatoes, an over-supply, new technology, imports from Canada, or not enough increase in the money supply? No one can be sure.

If there are pockets of new unemployment, is that because of a reduction in the demand for some product, increase in demand for a competing product, governmental regulations, decreased capital investment, or not enough inflation? There is no simple answer to these questions.

The Federal Reserve Board of Governors is supposed to be above the political process. But they live in the real world. If price levels get too high, they clamp down on inflation. If unemployment increases, they create inflation. Overall, for the years from 1970 through 2010, they created a lot more inflation than would have been necessary to keep prices stable, principally because they were worried about unemployment.

Historically the Federal Reserve has consistently inflated the money supply by an amount far larger than the growth in production. In many years, inflation is double or triple the growth of the GNP. Major recessions (negative dips in the GNP) always follow major inflationary rises — but after a few years, not right away. Are these dips in GNP related to the inflation of the money supply? This relationship — between deliberate inflation, and recessions is the central theme of this analysis.

What is the effect of inflation?

When the Federal Reserve increases the money supply, the increased money goes, originally, to the Federal Government (if they sell bonds to the Federal Reserve) or to the banks (if the Federal Reserve buys bonds on the open market).

The next group of people who are affected by the money supply increases are the people who receive the federal payments, and the people who borrow money from the banks. This includes both consumers and businesses. These people, generally, spend the money they receive on goods and services.  This spending is likely, in a short time, to cause price increases. Why should this be?

Before the new money was created, let us assume that there was an equilibrium of some sort between the money in the system and the goods in the system. $3.00 bought 10 lbs of potatoes. Now there is more money, but the same amount of potatoes. As a result, it is likely that in a little while, it will take $3.10 to buy the same 10 lbs of potatoes. This type of price rise will occur in the goods and services that are generally purchased by the original receivers of the new, increased money.  The increased money in the hands of the buyers enables them to buy more goods and services. This increased demand increases the prices of the things they buy.

Money Supply Effect on Interest Rates

Increased money supply also affects interest rates. Interest rates exist for one reason only. People prefer to have resources (capital goods, or consumer goods) today rather than wait for them some time in the future. This time preference may occur because the people are businessmen who can put the resources purchased with borrowed money to work right now producing more output than they could without the resources. Many consumers also want things sooner, rather than later. They would rather own and live in a house today, than wait thirty years until they have saved up enough to buy the house with cash. Interest, thus, is the premium that borrowers pay to lenders to get them to provide resources now, rather than having to wait. Interest exists because people have different subjective time preferences in regard to money. A house today is more valuable to a newlywed couple than a house many years later. On the other hand, the banker who lends them the money to buy the house would prefer to give up the use of his money today in return for getting it paid back with interest at some time in the future.

People who save money in a bank or pension fund are really lending that money (through intermediaries) to other unknown people who have a more urgent need for money today than they do. The level of interest rates results from the interaction of the subjective time preferences of savers and borrowers. If few people are willing to save, then interest rates will be very high, and entrepreneurs will find it difficult to begin or expand their projects; consumers will find it difficult to buy houses or automobiles. If many people are willing to save, interest rates will come down; borrowing will be easier.

The overall market rate of interest is a composite of the subjective time preferences of millions of individuals some of whom want resources right now and will pay a premium to get them, and others who have no immediate need for resources, but are willing to lend their resources to others in exchange for a return in the future.

When the Federal Reserve increases the money supply, it results in the reserves held by member banks. These banks have more money on hand than they need. They will want to make more loans.  Why? Because their revenue comes from interest payments on loans that they make. They don’t make any revenue from idle deposits on their books.

When the money supply increases, the bank managers have to find a way to make more loans. They take out ads in newspapers, on the radio, and on television, telling people that this is a great time to buy a new house, a car, or go on a vacation. They call up their business contacts, telling them that the big loan they have been discussing can now be approved. They want people to borrow money.

The problem with money supply increases created by the Fed, is that almost all banks will have increased reserves at the same time. They are all trying to increase their loans at once. Persuasive advertisements are usually not enough. The banks will have to drop their interest rates if they want to loan out all their new money. The bidding war for interest rates that takes place between banks reduces the interest rates pretty rapidly.

Commercial borrowers are usually much more alert to the changes in interest rates than the general public. Corporations that borrow money have employees whose job it is to find out what interest rates are available every day — sometimes on an hourly basis! If they are borrowing a million dollars short term at 4.25%, they may switch lenders immediately if they find someone offering 4.125%. These commercial borrowers really make the market. They act as arbitrageurs: finding opportunities and taking immediate advantage of them. They, not the general public, are the ones that really make interest rates move in response to money supply changes.

Effect of interest rate changes on the Structure of Production

Interest rate changes affect various industries in the structure of production in different ways. Consumers, and businesses that supply consumers, are only indirectly affected by interest rates. If you need a new car, you will probably buy one, even if the interest rates go up. Car dealers have to pay interest on their inventory. If interest rates go up from 8% to 10%, few car dealers would say, “These rates are too high. I won’t stock my show room with cars.”

If they were to say that, they would be unlikely to make any sales. Their business would suffer. They have to get an inventory of cars to sell if they want to remain in business — regardless of the interest rates.

But a higher order industry, such as an aluminum producer, or a steel mill, faces a different situation. He is deciding whether to make a major investment that will increase his output, or reduce his costs. Most investments in higher order industries take several years from the time they are started until the project is completed and producing results.

For example, suppose that a steel mill wants to modernize an old plant that is very inefficient. They plan on an investment program that costs $200 million. It will take eight years to complete, and will cut their costs of output by 20%. Given their expected rate of production, the project is estimated to provide a profit of $32 million per year when it is finished in eight years. The market rate of interest is 8%. Should they undertake the investment?

Let’s see how they do the computation.

An investment that produces an annual return of $32 million is worth $400 million if the interest rate is 8%.

Value = Annual yield / market rate of interest

V = Y / r

V = $32 / .08

V = $400

How long will it be before interest charges on the $200 million will have increased the cost of the original investment up to $400 million?

The formula for the cost of interest payments after a number of years is:

C = I(1+r)n

I = the investment ($200 million)

r = the rate of interest (8%)

n = the number of years

C = maximum cost of construction (the value of the project)

Solving this formula for n, it becomes:

n = Log(C/I) / Log(1+r)

n = Log(400/200) / Log(1+.08)

n = 9 years.

Result: The project is just barely worthwhile, since when the steel mill begins production in eight years, it will still be worth more than it cost to build it.

But look what happens when the interest rates go up: the numbers change. Suppose that the interest rates go up to 9% instead of 8%.

In this case, the value of the steel mill is less:

V = $32 million / .09

V = $356 million.

Solving for the number of years, we get these numbers:

n = Log(C/I) / Log(1+r)

n = Log(356/200) / Log(1+.09)

n = 6.7 years.

If the interest rates rise to 9%, the steel mill has only 6.7 years to get into operation before the project costs more than it is worth. Since the construction period is scheduled for 8 years, they cannot afford the modernization.

Clearly, to a higher order producer, interest rates are very important, indeed. If interest rates rise, many projects become economically impossible. But, when interest rates go down, many alternatives open up.

The effect of a money supply increase on higher order industries is as follows:

Money supply increase results in an Interest rate reduction. Therefore, many new investment projects are started.

At first glance, this might seem like a very good thing. Investment and modernization of our higher order industries should be in the national interest, right? The Federal Reserve Board of Governors should be commended for inflating the money supply, if it results in starting these worthwhile projects.

Unfortunately, the results are not as beneficial as they might seem at first. Here is why:

Sound investments result from saving.

When people save their money in the bank, instead of spending it, they are not using the money to buy goods and services. Instead, the bank loans their money to borrowers, and they buy the goods and services. It is as if a whole lot of consumers were saying to a steel company: “Here is the money you need to modernize. Pay us back later.”  The capital projects started with this money do not normally result in major price increases, because the money for the projects comes from saving (people deliberately postponing their spending of their money).  When a steel mill starts spending to build their new plant, the money is paid to workers and materials suppliers. These people spend their income on consumer goods. Since this money came from saving (from consumers who are not using it to buy consumer goods), it does not increase the total amount of spending. A certain percentage of the money reaches the savers who will save it in the banks where it will be loaned out for more investment projects.  As long as saving is equal to total investment, there is no danger of excessive general price increases.

Investment based on money supply inflation is unsound.

When there has been no increase in saving, but only an artificial inflation of the money supply by the Fed, the higher order industries cannot tell the difference. All they know is that interest rates have come down, and that this is a good time to invest. When their invested funds are spent, however, the result is a net increase in the total spending for goods and services. There are no savers who postponed their spending to provide this money.

The spent money goes to people who have a high time preference: they do not save it. Instead they spend it on consumer goods, instead of saving it. This increased demand for consumer goods will raise prices, and ultimately lead to wage increases. Wages rise because both consumer goods industries and higher stage industries are competing for workers at the same time. The competition for workers raises wages.

The increase in prices and wages eventually gets serious enough to worry the Federal Reserve officials who were responsible for inflating the money supply. They bring the inflation to a halt: they stop increasing the money supply.

When this happens, there is no longer money available for continuing the higher order projects. New projects are postponed. Half-finished ones are scrapped as worthless. Many firms go bankrupt, and thousands are laid off.

Why false investments hurt the economy

Investment is spent for capital goods which are usually useful only to the company that produced them. When the $400 million Kennecott Copper Mine was shut down in 1985, it was a total loss. It could not be broken up and sold to other companies. This situation is not unusual. It is normal. For this reason, anything that leads businesses to undertake mistaken investments wastes national wealth.


How inflation led to a recession

To illustrate the relationship between inflation in the money supply and recessions, the period from 1981 to 1992 provides a perfect textbook example.

From 1981 to 1986, the Federal Reserve made unusually large annual increases in the money supply. The country was undergoing a recovery from a recession caused by inflation in the 1970′s.  The Fed authorities believed that they could blunt the impact of the recession by inflating the money supply — and, indeed, they did.

As a result of the money supply increases after 1981, many higher stage producers embarked on major capital expenditure programs. From 1981 to 1985 US Steel invested $300 million over four years to modernize its Pittsburgh California mill. Timken invested $500 million in a new plant at Canton, Ohio. Tuscaloosa Steel built a new $75 million rolling mill in Alabama. Great Lakes Steel spent $200 million to modernize its plant in Michigan. Wheeling Pittsburgh, in bankruptcy, began construction on a $50 million plant in West Virginia. Standard Oil of Ohio invested $400 million to modernize Kennecott’s Utah Copper Division. Many of these higher stage producers took out large bank loans to finance these long term projects.

Beginning in 1981, the Federal Reserve started a massive increase in the money supply: an average of about 9.6% per year. This lowered the cost of borrowing money, and induced higher order industries to borrow for long term capital investments. Iron and steel industries and primary metals embarked on major investments due to the lower interest rates. For instance, long term bank loans by iron and steel industries totaled $1,832 million in 1981. By 1982 these long term loans had grown to $5,453 million. In primary metals, long term bank loans increased from $4,010 million in 1981 to $7,597 million in 1982.

The loans by these higher stage industries were not at all the same as long term bank loans by all manufacturing industries. Industries other than iron and steel and primary metals, did not show the same amount of expansion from 1981 to 1985. Why not? Because these other industries do not rely as much on a favorable interest rate climate to finance their investment projects. It is the higher stage industries that have very long term investments are mainly stimulated by the availability of credit.

The Effect of Stimulation of Investment Projects

The investment which was stimulated by the money supply increases from 1981 to 1986 produced a boom in these higher order investing industries. Workers were hired and prices of materials increased. As iron and steel workers, and the construction workers engaged on the primary metals projects began to spend their new wages, consumer prices began to rise, and consumer goods industries were stimulated. By 1986 a boom was underway, caused by the spending of the money supply increases by higher order industries.

Of course, the entire boom was false: built not on the savings of individuals, but the creation of artificial money by the Federal Reserve. When the boom led to serious inflationary signs late in 1986, the Federal Reserve cut back drastically on their annual increases in the money supply. This unilateral government decision is completely different from what savers would have done. Ask yourself: “Would savers all at once have decided to stop saving because prices went up?”  The answer clearly is no.

Federal Reserve Action: Disaster for Iron and Steel

The result was disaster for the higher stage industries. By 1986, many iron and steel producers found themselves over-extended in massive projects with no hope of a profit. Several declared bankruptcy. Others closed down their projects, took the loss, and laid off their workers.

These higher stage disasters were not noticed by the general public since most higher stage activity is not included in the GDP as it is counted by government statistics – based on Keynesian economics.   The GDP seemed to continue to grow since the earlier spending had stimulated consumer goods industries. As a result, the recession which began in primary industries spread downward silently and unnoticed.  By 1990, the recession reached all parts of the economy, and millions were thrown out of work.

Why Consumer Goods Industries Are Not Affected by changes in interest rates.

While higher stage industries are expanding and contracting, quite the opposite is normally happening in consumer goods industries. During the expansionary period, consumer goods industries do not usually expand as fast. There are two reasons for this:

  1. Expansion of consumer goods industries is dependent more on consumer demand than on interest rate levels and
  2. Consumer demand is seldom strong in the early years of a recovery, before the majority of the unemployed workers have found jobs.

The expansion of the higher stage producer’s projects puts people to work. The income builds consumer spending which gradually fires up the lower level industries. These lower stage industries don’t borrow money just because the interest rates have decreased. They borrow because the demand for their products has increased, and they need more warehouses, stores, and manufacturing facilities to meet it. Consumer demand did not pick up in 1981 through 1985. It only got going in a big way after 1986, when the expansion of higher order industries put a lot of spending money into the economy.

Once the boom had started, these lower order industries began to increase their bank borrowing. Interest rates were going up, at this point, and money was harder to borrow. But these industries borrowed anyway. Why? Because they had to expand to meet the consumer demand. They were willing to pay higher rates — because most of their projects could be built in a year or two, so interest rates were not as important to them.

By 1986 both higher and lower level industries were competing for labor, and for other factors of production. Prices began to rise.  If the Federal Reserve wanted to keep interest rates low at this point, they would have to have taken vigorous action to inflate the money supply, since intense borrowing was driving rates higher and higher.

Price rises, however, were now becoming serious. The value of money was declining. Continued inflation was seen as a cause of the price increases which were tending to disrupt the market and get out of hand. The Federal Reserve realized that it must act decisively to cut the price increases, by reducing their inflationary activities.

As soon as the Federal Reserve stopped inflating the money supply at the previous rate (about 9.6% per year), interest rates, already high, moved much higher.  Higher stage industries, dependent on low cost financing to complete their projects, found themselves ruined. They shut down or, in some cases, went bankrupt.

The recession dropped demand for iron and steel output in 1982. It was a body blow, and demand was not to recover to 1981 levels during the next ten years (if ever). The industry didn’t know that, however, and kept expanding capacity by heavy investments because of the availability of cheap investment funds.  When the Federal Reserve pulled the plug in 1986, iron and steel prices began a long downward slide (while all other prices were going up!). One by one, iron and steel industries went bankrupt. Why? Because they had overexpanded due to the false interest rate signals sent by the Federal Reserve from 1981 to 1986.

Lower stage industries, however, continue to expand and prosper after 1986. They were driven not by interest rates, but by consumer demand which, at this point, was vigorous. Lower stage industries borrowed more money, and expanded their facilities.

The final stage of the business cycle was now at hand. With higher stage industries ruined, interest rates increasing, and spreading unemployment in capital goods industries, consumer demand began to flag. Without the stimulation of government inflation, the boom ran out of gas and collapsed. Lower stage industries, seeing the fall in consumer demand, cut back their investments which put still more people out of work. The recession became general with millions of unemployed, and production in all levels at a standstill.

The Keynesian solution to the business cycle.

In 1936, John Keynes produced a book that said that recessions were caused by consumers saving their money instead of spending it. The solution, he announced, was increased government spending to make up for the failure of consumer demand.  This theory has dominated economic thinking ever since.

Unfortunately, Keynes never explained why millions of consumers decide all at once to start saving their money. In fact, these mysterious savers have never been located. Most people who stop spending money in recessions are those who have just lost their jobs, or fear that they soon will. To accuse these people of causing the recession begs the question: why did they lose their jobs?

Keynesian economics underlies the fiscal policies of most western governments today. It is written into the Full Employment Act of 1946, and the Humphrey-Hawkins Act of 1976. Following Keynes’s ideas, our government has created huge deficits, inflated the money supply, and increased the peacetime national debt from $1 trillion in 1982 to $14 trillion in 2011, on the assumption that such government spending would produce full employment and prosperity. The massive increase in the money supply from 2008 – 2011 and the $867 billion stimulus bill in 2009 did not work. .

Despite this experience, most economists today do not understand the cause of recessions: inflation of the money supply which sends false signals to higher order industries, and causes them to make mistaken investments.

The reason why the inflation in the money supply has not been identified as the culprit long ago is that it always takes time for the inflation to cause unemployment. In the case of the recession of 1990, the money supply increase that caused it took place from 1981 to 1986. Few people realized in 1990 that the problem they were facing really was caused by something that happened nine years earlier.

The major recession which will occur in the coming years will be caused by the Federal Reserve inflation of the money supply from 2009 to 2012.

Almost all of the inflation (expansion of the money supply) since World War II is the result of deliberate Federal Reserve policy action designed to “fine tune” the economy to produce full employment. None, of course, was designed to produce unemployment. But the facts do support the theory that the unemployment was an unintended consequence of the money supply expansion. For example:

The recession of 1990 was preceded by the inflation of 1982-86.

The recession of 1980 was preceded by the inflation of 1975-77.

The recession of 1974 was preceded by the inflation of 1971-72.

The recession of 1946 was preceded by the inflation of 1940-45 (war years).

The depression of 1930 was preceded by the inflation of 1923-25.

Can we say that these inflations caused the subsequent downturns? Not absolutely. But they certainly seem like the most likely suspects.

Do international conditions cause recessions?

The United States is part of the global economy. For many years economies in Europe and Latin America which consistently export a high percentage of their output have found their economies tied to the fortunes of America. When we have good times, so do they. When we are going through a recession, they do also. Which is causing which?

The answer has to lie in an analysis of the types of imports and exports. If a country exports luxury goods or expensive consumer items, they can expect that during a recession, American consumers will reduce their purchases of these items. On the other hand, if the country exports basic commodities, such as coffee, bananas or crude oil, they can expect a relatively constant export trade with the United States, in good years and bad.

What should we do to avoid booms and recessions?

If government initiated inflation is not a practical long run solution to business cycles, what is the correct answer? It seems that there are several true statements that can be derived from what we have learned thus far:

Saving is the key to wealth. Investment that is based on saving is the royal road to prosperity. Savers do not make policy shifts that bankrupt higher order producers and throw thousands out of work. Investment based on saving does not lead to massive price rises.

Government cannot create prosperity by inflating the money supply.  Imagine an island where everyone is working to produce investment goods and consumer goods for everyone else. Introduce a government which inflates the money supply and uses the newly created money to redistribute income to the poorest residents — or to certain industries. How will the actions of the government increase the wealth of the island?

If you think about it, there is no way that such inflation can result in the production of any more investment or consumer goods. In all likelihood, it will produce less goods than are already being produced. Why? Because the artificial money supply increase will divert production into false investments which will be based on the continuation of the inflation. Once the inflation is brought to an end, the industries dependent on it will collapse, and much of the hard work that went into creating their capital will be shown to have been wasted.  The lesson: inflation increases employment in the short run, and leads to much bigger unemployment in the long run.

Since the current recession began in 2008, the Federal Reserve has been expanding the money supply far faster than the rate of growth of production. This type of money supply growth, according to Keynesian theory, should have stimulated production. But look at what actually happened. The GDP has stalled at very low levels. Conclusion: you can’t raise long run production with money supply stimulation. All you can do is create business cycles that create unemployment and industrial dislocation in the long run.

An expanding money supply is not essential to prosperity.

Money is a medium of exchange. It has no use value of itself. Any expansion of the money supply tends to favor some sectors, and hurt other sectors. There are good arguments for why it should not be held rigidly at a fixed amount, but few good arguments for the kind of high levels of inflation which the Fed has created in the 1980′s, 1990′s and since 2008. Perhaps the best approach would be for the Federal Reserve to establish a target which roughly approximates the expected growth of the GDP during the coming decade, and hold all inflation to that level, year after year, without the huge ups and downs that have characterized their inflation and deflation of recent decades. If inflation of the money supply were to be held to a fixed amount such as three percent per year, without change, in good years and bad, the major cause of business cycles would be virtually eliminated.


  1. There are two definitions of inflation: an increase in the money supply, and rising prices. I use the earlier definition: an increase in the money supply.  Such money supply increases may or may not increase prices. Keynesians define inflation as rising prices.
  2. Inflation in the money supply has come about in the past from banks or the Treasury printing money. Today, it occurs because the Federal Reserve buys government bonds from the Treasury or the general public. Both actions have the effect of increasing the money supply by a multiplied amount because the banking system loans out the bulk of all new deposits received. Inflation, therefore, is completely under the control of the Federal Reserve Board of Governors.
  3. The Federal Reserve acts to create a certain amount of inflation every year on the theory that it will produce prosperity. They believe that if they do not inflate the money supply, the result will be unemployment; if they inflate it too much, prices will increase. They seek to steer a middle course. In fact, however, in the past three decades, they have always inflated the money supply by much more than the growth of production of goods and services.
  4. The effects of inflation are spread throughout the economy by government spending and banks who loan out the new money. The increased spending usually results in higher prices and higher wages as consumers and businesses compete for scarce capital goods, raw materials, and employees.
  5. Inflation also reduces interest rates as banks hasten to loan out their new deposits. Banks reduce their interest rates in a bidding war with other banks, most of whom also have new money to lend. The new money can increase consumer borrowing, but is most likely to increase borrowing by commercial borrowers who are alert to any shift in interest rates.
  6. Lowering interest rates affects higher stage industrial producers more than final goods producers. This is because their long term projects take many years to complete. When market interest rates are high, many long term projects cannot be carried out because the interest payments would cost more than the project would return in profits. Lower stage industries — such as an automobile dealer — will borrow money to maintain inventories regardless of the interest rates.
  7. When interest rates drop, higher stage producers begin costly long term projects. These projects can continue only as long as the money supply inflation continues, and interest rates continue at a low level.
  8. Spending on these long term projects results in increased demand for consumer goods and higher wages. Soon the entire economy is stimulated by the inflation.
  9. When prices rise, the government authorities that are responsible for causing the inflation begin to worry about the effects of their actions. They eventually call a halt to the inflation. They stop increasing the money supply. The effect of their action is to raise interest rates, and put a end to many major investment projects.
  10. In higher stage industries, plants are shut down, projects abandoned, workers laid off. The recession which begins in the higher stages eventually spreads to lower stages — although it may take several years to do so.
  11. Inflation, therefore, causes a false prosperity which can last only so long as the inflation continues. When it is ended, billions of dollars of investments become worthless, and millions are thrown out of work. Sound expansion must come from saving, not from inflation. Investment built from saving does not produce the same price rises, and does not collapse all at once.
  12. A textbook example of a business cycle is provided by the inflation of the money supply from 1981 to 1986. The money supply increased by an average of 9.6 percent per year during that period. As a result many long term investment projects were undertaken by higher stage producers. In 1986, price rises forced the Federal Reserve to drastically reduce their money supply inflation. As a result, many investment projects were ruined. Many higher stage producers declared bankruptcy. Plants were closed. Workers were laid off. The recession of 1990 was created.
  13. Business cycles (periodic ups and downs in production) have occurred with regularity since the early 1800′s. They were called “panics” before 1914, since they usually involved panic runs on the banks. There were at least eleven serious downturns from 1921 to 1990. No one has been entirely sure why they occur.
  14. Since 1936, Keynesians have held that recessions come about because consumers decide to save their money instead of spending it. They recommend government deficits as a method of permanent prosperity.
  15. Pursuit of this idea has had two results: very large peacetime government deficits and growth of the national debt to unprecedented levels ($14 trillion dollars by 2011). Recessions, however, continue to occur with increasing frequency. In other words, the present policy is not working well.
  16. Increasing attention today is focused on a more likely cause of business cycle downturns: inflation which sends false signals to higher stage industries, leading them to engage in mal-investments which collapse as soon as the inflation is terminated, causing a recession, and putting millions out of work.
  17. The reason why inflation was not identified as the cause of business cycles long ago is that it seems to help the situation by putting people to work. The fact that the projects are false, and likely to collapse when the inflation is ended is not known by anyone involved (workers or investors). When the inflation is brought to a halt, and the false projects begin to collapse, no one identifies the previous inflation as the cause, but, in fact, blames the deflation for the predicament.
  18. In theory, business cycles could be caused by increases and decreases in U.S. export sales abroad. In fact, exports represent a small percentage (10%) of the U. S. GDP. The movement of export trade tends to lag the U. S. business cycle by a couple of years, rather than to lead it. So far, exports are not a major factor in U. S. business cycles.
  19. To avoid recessions in the future, we must recognize that there is only one true road to national wealth: private saving which is used for investment. Savers are useful in two ways: their saving tends to reduce consumer spending, and hence keep prices down; and their continued saving provides a steady flow of funds for investment, not likely to be turned off rapidly (as is government inflation).
  20. Government cannot create prosperity by inflating the money supply. This inflation wastes resources by stimulating false investments many of which must ultimately be scrapped as useless.
  21. A partial solution to business cycles would be for the Federal Reserve to hold the inflation rate of the money supply to a fixed amount, such as three percent per year, in good years and bad, without change. This should eliminate a major cause of the business cycles.

[i] Samuelson, Paul (1975) Economics New York, McGraw Hill.

About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
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