[Adapted from Man, Economy and State with Power and Market, pp. 851–55.]
In the real world, there will be continual changes in the pattern of economic activity, changes resulting from shifts in the tastes and demands of consumers, in resources available, technological knowledge, etc. That prices and outputs fluctuate, therefore, is to be expected, and absence of fluctuation would be unusual. Particular prices and outputs will change under the impact of shifts in demand and production conditions; the general level of production will change according to individual time preferences. Prices will all tend to move in the same direction, instead of shifting in different directions for different goods, whenever there is a change in the money relation. Only a change in the supply of or demand for money will transmit its impulses throughout the entire monetary economy and impel prices in a similar direction, albeit at varying rates of speed. General price fluctuations can be understood only by analyzing the money relation.
Yet simple fluctuations and changes do not suffice to explain that terrible phenomenon so marked in the last century and a half — the “business cycle.” The business cycle has had certain definite features which reveal themselves time and again. First, there is a boom period, when prices and productive activity expand. There is a greater boom in the heavy capital-goods and higher-order industries — such as industrial raw materials, ma-chine goods, and construction, and in the markets for titles to these goods, such as the stock market and real estate. Then, suddenly, without warning, there is a “crash.” A financial panic with runs on banks ensues, prices fall very sharply, and there is a sudden piling up of unsold inventory, and particularly a revelation of great excess capacity in the higher-order capital-goods industries. A painful period of liquidation and bankruptcy follows, accompanied by heavy unemployment, until recovery to normal conditions gradually takes place.
This is the empirical pattern of the modern business cycle. Historical events can be explained by laws of praxeology, which isolate causal connections. Some of these events can be explained by laws that we have learned: a general price rise could result from an increase in the supply of money or from a fall in demand, unemployment from insistence on maintaining wage rates that have suddenly increased in real value, a reduction in unemployment from a fall in real wage rates, etc. But one thing cannot be explained by any economics of the free market. And this is the crucial phenomenon of the crisis: Why is there a sudden revelation of business error? Suddenly, all or nearly all businessmen find that their investments and estimates have been in error, that they cannot sell their products for the prices which they had anticipated. This is the central problem of the business cycle, and this is the problem which any adequate theory of the cycle must explain.
No businessman in the real world is equipped with perfect foresight; all make errors. But the free-market process precisely rewards those businessmen who are equipped to make a minimum number of errors. Why should there suddenly be a cluster of errors? Furthermore, why should these errors particularly pervade the capital-goods industries?
Sometimes sharp changes, such as a sudden burst of hoarding or a sudden raising of time preferences and hence a decrease in saving, may arrive unanticipated, with a resulting crisis of error. But since the eighteenth century there has been an almost regular pattern of consistent clusters of error which always follow a boom and expansion of money and prices. In the Middle Ages and down to the seventeenth and eighteenth centuries, business crises rarely followed upon booms in this manner. They took place suddenly, in the midst of normal activity, and as the result of some obvious and identifiable external event. Thus, Scott lists crises in sixteenth- and early seventeenth-century England as irregular and caused by some obvious event: famine, plague, seizures of goods in war, bad harvest, crises in the cloth trade as a result of royal manipulations, seizure of bullion by the King, etc.63 But in the late seventeenth, eighteenth and nineteenth centuries, there developed the aforementioned pattern of the business cycle, and it became obvious that the crisis and ensuing depression could no longer be attributed to some single external event or single act of government.
Since no one event could account for the crisis and depression, observers began to theorize that there must be some deep-seated defect within the free-market economy that causes these crises and cycles. The blame must rest with the “capitalist system” itself. Many ingenious theories have been put forward to explain the business cycle as an outgrowth of the free-market economy, but none of them has been able to explain the crucial point: the cluster of errors after a boom. In fact, such an explanation can never be found, since no such cluster could appear on the free market.
The nearest attempt at an explanation stressed general swings of “overoptimism” and “overpessimism” in the business community. But put in such fashion, the theory looks very much like a deus ex machina. Why should hardheaded businessmen, schooled in trying to maximize their profits, suddenly fall victim to such psychological swings? In fact, the crisis brings bankruptcies regardless of the emotional state of particular entrepreneurs. … [F]eelings of optimism do play a role, but they are induced by certain objective economic conditions. We must search for the objective reasons that cause businessmen to become “overoptimistic.” And they cannot be found on the free market.
- 63. Cited in Wesley C. Mitchell, Business Cycles, the Problem and ItsSetting (New York: National Bureau of Economic Research, 1927), pp. 76–77.
The Mises Institute exists to promote teaching and research in the Austrian school of economics, and individual freedom, honest history, and international peace, in the tradition of Ludwig von Mises and Murray N. Rothbard. These great thinkers developed praxeology, a deductive science of human action based on premises known with certainty to be true, and this is what we teach and advocate. Our scholarly work is founded in Misesian praxeology, and in self-conscious opposition to the mathematical modeling and hypothesis-testing that has created so much confusion in neoclassical economics. Visit https://mises.org