by Alasdair Macleod, GoldMoney:

The greatest strength of a truly free market economy, where money is sound and does not corrupt prices, is the absence of cyclical action. With sound money, and consumers deciding for themselves their wants and satisfactions, having to choose between this or that instead of deploying unbacked credit to have this and that, there can be no cycle of credit, and no credit-driven business cycles.

Central bank manipulation of money is intended to force everyone to act the same way at the same time. Central banks direct the quantity of money and credit to encourage us en masse to spend money we do not have, supplanting the randomness of Schumpeter’s “creative destruction” with a synchronised destruction, deferred to the end of the credit cycle.

The constructive and continually evolving process of reallocation of capital from uneconomic projects to more productive uses is ruined by unsound money. To this damage can be added extensive regulation, promoted by governments as being in the public interest, but more accurately, designed to protect established businesses from competition. You cannot sell ice cream without a license, and even then, its composition is regulated by the state.

Economic progress brought about by technology has always been despite government economic planning. Horse power was replaced by the internal combustion engine, but all the muck-shifters, coachmen and blacksmiths found re-employment in other trades. Drudgery in the home was replaced by labour-saving equipment, and domestic servants gained other employment and a higher level of personal freedom. Computers have automated all the things we want to automate.

These advances have been driven by enormous shifts in consumer demand, but the individual investments in new, up-and-coming industries still have their successes and failures, and in free markets these successes and failures are just as non-cyclical as in any other line of business. That is why we can describe economic activity in free markets with sound money as essentially non-cyclical and therefore random. But government bureaucrats don’t do random. It goes against their controlling nature. This is why repeating cycles in the economy have their origin in government intervention and will continue, as will unsound money, until the fiat money system collapses.

Even under the gold standard money was unsound, because banks were free to expand unbacked credit at will, formalised by the 1844 Bank Charter Act, which endorsed fractional reserve banking. Not long after the creation of the Federal Reserve Board, central banks colluded with each other to manipulate the quantity of money. Central banks have been generally free from criticism of their actions, arguing that evolution of monetary policy renders the past irrelevant. To combat this nonsense, the few critics left standing can only use reasoned theory, which given the general disinterest in monetary affairs, is an uphill struggle.

However, the logic that in a sound-money economy credit-driven cycles do not exist, is irrefutable, because it takes unbacked credit expansion to get economic actors to abandon random activity and act in concert. The question then to be answered is can there be any other source of cycles? The answer must address human behaviour itself, which is undoubtedly prone to being driven by fads and fashion. But in the absence of easy credit, a person buying into the latest fashion must divert funds from buying something else, or compromise personal cash liquidity. He or she cannot have both. We can therefore assume that while ephemeral shifts in the use of money and savings can take place in a sound money environment, they are bound to be more limited without the expansion of unbacked credit.

Booms and busts that have their origin in human behaviour rather than credit have occurred. The South Sea Bubble, which popped in 1720, could be cited as an example. The lure of easy profit tempted people living in London, or within a day or two’s coach ride, to divert their gold and silver from other uses into speculating in the stock market. The same had happened with the tulip mania in Holland in 1636. We cannot say these events were totally free of unbacked credit, debased or clipped coinage, but they were relatively so. In the absence of freely available unbacked credit, these speculative booms are too rare to be called cyclical. Rather, they are instances of the extraordinary popular delusions and madness of crowds that drive them, as Charles Mackay aptly described it.

The Mississippi bubble in France was different, because it’s architect, John Law, used a combination of money-printing and share issuance to fuel it. Eight decades later, France made the same error of debasing money by issuing assignats as a means of paying down the royal debts. This currency collapsed rapidly, as did the mandats currency that followed the revolution. Even this was not cyclical: true cyclicality only came with the validation of bank credit in the 1844 Bank Charter Act in England.

The origins of modern credit cycles

We must accept the possibility of mass speculation in an economy based on sound money, but any tendency towards regularly repeating human behaviour requires the rocket-fuel of unbacked money and credit. We are now addressing formalised bubbles: the 1844 Act led to a repeating cycle of bank credit increasing in good times, leading to speculative excess, banking crises, slumps, then recovery. This was the pure credit-driven business cycle. The Bank of England first developed the modern function of lender of last resort in the years following the 1844 Act, to rescue failing banks central to this cycle of credit.

After the Fed was established in 1913, a dialog with the BoE gradually developed, which in the 1920s grew into a close working relationship between Benjamin Strong, Chairman of the Fed, and Montague Norman, Governor of the BoE. Their cooperation over monetary policy, expanding credit while maintaining the gold standard, fuelled industrial production in the 1920s with restrained price inflation. This was followed by the greatest credit bust in history, apart, that is, from the Mississippi bubble. The legacy of global unemployment in the 1930s hung over politics until the 1980s, and changed mainstream economic thinking to this day.

The twenties boom and thirties bust were made more violent and prolonged by cooperation between the two central banks, which were the issuers of the most important currencies at the time. The natural randomness of the free markets of the two greatest nations had been fatally compromised.

Following WW2, a new cycle of intervention commenced, comprising greater government involvement in Britain and Europe, supported by monetary expansion. In the US, the government stimulated the economy through defence spending and the expansion of American corporations, paid for by exporting dollars, which were guaranteed under the Bretton Woods Agreement, as well as expanding domestic bank credit. A new super-cycle of US dollar credit was created, whereby it was expanded without the consequences of runaway price inflation, that is until the Bretton Woods Agreement failed in 1971. Subsequently, prices began to rise despite attempts to restrain them.

The Bank of England was forced to increase interest rates in November 1973 sufficiently to create a slump in the economy, though they didn’t peak until 1979. The Fed finally ended the dollar’s post-war credit cycle by raising the Fed funds rate to over 20% in 1981.

The 1945-1980 period was something of a super-cycle, where Keynesian intervention ameliorated end-of-cycle crises, leaving distortions to accumulate from one credit cycle to another. Since then, the world has embarked on a new super-cycle of credit, this time fuelling asset prices, while the production of goods in America entered a long-term decline. Commodity prices have been suppressed by the expansion of artificial supply through paper derivatives. Cheaper production in emerging markets and the suppression of raw material prices have kept price inflation below where it would otherwise be, allowing the creation of fiat currency and unbacked credit to continue for a prolonged period. The focus of credit expansion, particularly after the regulatory changes in the mid-eighties, has been debt-fuelled consumption and speculative investment.

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