Mises Built His Business Cycle Theory on the Currency School’s Doctrines Even Though He Had to Correct Its Many Defects

Throughout his writings, Mises recognized and lauded the lasting contributions of the Currency School to monetary and business cycle theory and policy. In his first complete presentation of the Austrian theory of the business cycle, published in 1928, Mises (2006, pp. 101, 128) stated:

Of all the theories of the trade cycle, only one has achieved and retained the rank of a fully-developed economic doctrine. That is the theory advanced by the Currency School, the theory which traces the cause of changes in business conditions to the phenomenon of circulation credit [that is, the issue of fiduciary media]. . . . Every advance toward explaining business fluctuations to date is due to the Currency School. We are also indebted to this School alone for the ideas responsible for policies aimed at eliminating business fluctuations.  

In his earlier treatise, The Theory of Money and Credit, Mises credited the Currency School as the main inspiration for the development of modern business cycle theory. There Mises (1981, pp. 282–83) commented that the Currency School “propounded a theory, complete in itself, of the value of money and the influence of the granting of credit on the prices of commodities and the rate of interest.” While noting that the school’s doctrines were based on the erroneous value theory of the classical school and a mechanical version of the quantity theory, Mises yet maintained, “Within its own sphere of investigation,” the Currency School “was extremely successful.” “This fact,” he observed, “deserves grateful recognition from those who, coming after it, build upon the foundations it laid.”

Mises, however, did not allow his admiration for the Currency School to blind him to the two key errors it committed. In fact he was eager to expose and correct these errors because they were the reason that the currency principle failed on the policy level when it was implemented in Great Britain by the Bank Act of 1844, more popularly known as Peel’s Act. The first error was an analytical one. Unlike the opposing and inflationist Banking School, the Currency School failed to recognize that bank deposits were perfectly interchangeable with bank notes in exchange and, as such, were part of the money supply. Consequently, the currency principle’s rigid restriction on the creation of fiduciary media was tragically weakened because Peel’s Act applied only to bank notes, while banks were left free to create new, unbacked demand deposits ad libitum.

The second, practical flaw in the program of the Currency School was its insistence that power to enforce the currency principle be centralized in a bank with monopolistic legal privileges—in this case the Bank of England. Th is quasi-central bank, in which most of the system’s gold reserves were held, would then have the means and the power to enforce the currency principle for the banking system as a whole. In effect, the authors of Peel’s Act unwittingly created the template for the modern inflationary and crisis-prone monetary and financial system. In the modern system, a central bank such as the Fed is legally empowered to issue its own fiat notes and deposits which serve as the reserves for the commercial banks. The commercial banks, in turn, are permitted to create fiduciary media by pyramiding their own bank deposits on these Fed liabilities.

—Joseph T. Salerno, “Ludwig von Mises as Currency School Free Banker,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 103-104.

Mises Distinguishes “Commodity Credit” (Healthy Kind) from “Circulation Credit” (Unhealthy Kind)

In order to understand the ABCT it is necessary to grasp a distinction between two different kinds of credit first introduced by Ludwig von Mises himself. The first one, commodity credit, is, in Mises’s opinion, the healthy kind of credit. Somebody saves out of his income and transfers the savings to somebody else, mainly by means of financial intermediaries. As this kind of credit necessitates savings, it involves an exchange of present goods for future goods. In the words of Mises, credits of this kind are

characterized by the fact that they impose a sacrifice on that party who performs his part of the bargain before the other does—the foregoing of immediate power of disposal over the exchanged good.

In short, before commodity credit can be granted, somebody must have saved up goods or money that can now be lent to the debtors. The sacrifice of the savers is the necessary condition for this kind of credit.

The second kind of credit Mises calls circulation credit. In his opinion, it constitutes the unhealthy kind of credit. It does not stem from anybody’s savings, but from the power of banks to lend additional money into existence. It is not necessary to go into the details of fractional reserve banking here. That this kind of banking is able to create additional credit via lending out its own banknotes (in earlier times) or demand deposits that are at any time convertible into money is generally accepted by economists. The phenomenon is called the money multiplier. Mises’s point is that this kind of credit creation does not presuppose savings and therefore causes nearly no costs to either the issuing bank or anybody else. This

group of credit transactions is characterized by the fact that in them the gain of the party who receives before he pays is balanced by no sacrifice on the part of the other party.

According to Mises’s definition, what he calls circulation credit is not a proper credit transaction from an economic point of view. “[T]he essential element, the exchange of present goods for future goods, is absent.” No savings and no sacrifices are necessary:

If a creditor is able to confer a loan by issuing claims which are payable on demand, then the granting of the credit is bound up with no economic sacrifice for him.

—Eduard Braun, “The Subsistence Fund in Ludwig von Mises's Explanation of the Business Cycle,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 194-195.