Money, Interest, And The Business Cycle

The banks very often expand credit for political reasons. There is an old saying that if prices are rising business is booming, the party in power has a better chance to succeed in an election campaign than it would otherwise. Thus the decision to expand credit is very often influenced by the government that wants to have “prosperity.” Therefore, governments all over the world are in favor of such a credit-expansion policy. credit expansion

On the market, credit expansion creates the impression that more capital and savings are available than actually are, and that projects which yesterday were not practical because of the higher interest rate are feasible today because conditions have changed. Businessmen assume that the lower interest rate signals the availability of sufficient capital goods. This means that credit expansion falsifies the businessman’s economic calculations; it gives the impression to him, to the nation, and to the world, that there are more capital goods than there really are. By credit expansion, you can increase the accounting concept of “capital”; what you cannot do is create more real capital goods. As production is necessarily always limited by the amount of capital goods available, the result of credit expansion is to make businessmen believe that projects are feasible which actually cannot be executed on account of the existing scarcity of capital goods. Thus credit expansion misleads businessmen, results in distorting production and causes economic “malinvestment.” When the credit expansion causes businessmen to undertake such projects, the result is called a “boom.”

We must not overlook the fact that all during the nineteenth and twentieth centuries there was always an obsession, unfortunately not against credit expansion, but at least against giving the government too much power in matters of credit expansion. The main object was to limit the government’s influence with regard to the central banks.

In the course of history, governments have used the central banks again and again for borrowing money. The government can borrow money from the public. For instance, a person who has saved one hundred dollars could hold them as dollars or invest them. But instead of doing either of these things he can buy a new government bond; this purchase doesn’t change the amount of money in existence; the money he pays for the bond passes from his hands to those of the government. But if the government goes to the central bank to borrow the money, the bank can buy government bonds and lend money to the government simply by expanding credit, in effect creating new money. Governments have a lot of good ideas as to how to carry out this borrowing.

There has always been a struggle between parliaments and the executive concerning the government’s influence on the central banks. Most of the European legislatures said very clearly that their central banks must be separate from the government, that they must be independent. And in this country, you know there is a continual conflict between the Federal Reserve Board and the U.S. Treasury. This is a natural situation caused by economic laws and government legislation. Some governments have found it very easy to violate the legislation without violating the letter of the law. The German government, for instance, borrowed from the public during World War I because the Reichsbank had promised to give it loans. Private individuals who bought German government bonds needed to pay out only 17 percent of the amount of the bond, and this 17 percent gave them a yield of 6 or 7 percent. Hence, 83 percent of the price of the bond was supplied by the Bank. This meant that when the government borrowed from the public, it was actually borrowing indirectly from the German Reichsbank. The result was that in Germany the U.S. dollar went from 4.20 Marks pre–World War I, to 4.2 billion Marks by the end of 1923.1

There has always been resistance to giving power to the central banks, but in the last decades this resistance has been by and large completely defeated in all countries of the world. The U.S. government has used the power of the central bank, the Federal Reserve, to borrow from it to obtain a considerable part of the money it needs to fund its expenditures. The consequences have been inflation and a tendency for prices and wage rates to rise.

There is no doubt that the credit expansion brings about a drop in the rate of interest. Why then does this not mean that the rate of interest can always remain low and that interest could really disappear completely? If it is true that the rate of interest is not a monetary phenomenon but a general phenomenon of the market, which reflects the fact that future goods are traded at a discount as compared with present goods, we must ask ourselves, “What is the nature of the process which, after the initial drop of the interest rate due to credit expansion, finally brings about step by step a return of the rate of interest to that level which reflects market conditions and the general state of affairs?” That is, if the rate of interest is a general category of human action, and yet if an increased supply of money and bank credit can bring about a temporary drop in the rate of interest, how does the interest rate return once more to the rate that reflects the discount of future goods over present goods?

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This essay is a selection from lecture 7 in Marxism Unmasked: From Delusion to Destruction.

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