The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money

This file is a short 1946 economic memorandum/essay by Ludwig von Mises. Its scope is a compressed statement of Austrian trade-cycle theory: cheap-money policy, by forcing interest below its market level through bank credit expansion, produces an artificial boom that must end either in monetary breakdown or in crisis and readjustment.

Mises begins by treating hostility to interest as a political and moral prejudice rather than an economic insight. Modern “easy money” policy, he argues, revives the old anti-usury impulse under scientific language. Against the view that low interest helps the poor against rich creditors, he insists that modern creditors include savers, bondholders, insurance beneficiaries, and holders of bank deposits. Thus cheap money often injures the very public that supports it.

The conceptual core of the essay is the distinction between real saved resources and bank-created purchasing power:

Every serious discussion of the problem of credit expansion must start from the distinction between two classes of credit: commodity credit and circulation credit.

Commodity credit transfers actual savings from savers to entrepreneurs; it is limited by abstention from consumption. Circulation credit, by contrast, is not grounded in prior saving but in new banknotes or deposits. Mises gives the stark Austrian formulation:

It is creation of credit out of nothing.

This distinction lets him frame the business cycle not as an accidental disturbance but as a consequence of falsified calculation. Interest, prices, and wages are not arbitrary obstacles to production; they are signals of scarcity and social valuation.

The rate of interest is a market phenomenon.

For Mises, market prices coordinate entrepreneurial plans with consumer preferences and available capital goods. If government or banks manipulate interest downward, entrepreneurs are induced to begin projects that only appear profitable. The error is not psychological optimism alone, but arithmetic based on distorted data.

Prices, wage rates and interest rates are only indices expressive of the degree of this scarcity.

The argument then moves from price theory to cycle theory. Cheap credit initiates a boom because projects formerly judged unprofitable now seem viable. But the real supply of capital goods has not increased. As entrepreneurs compete for factors of production, costs rise; continuing the boom requires further credit expansion. The prosperity is therefore fragile, dependent on continuing monetary falsification rather than genuine saving.

Thus, credit expansion unavoidably results in the economic crisis.

Mises presents two possible endings. If the banks continue expansion indefinitely, the public eventually flees from money into goods and the currency collapses, as in Germany in 1923. If the banks stop earlier, interest rates jump, inventories are liquidated, firms fail, and unemployment appears. In both cases the crisis is not caused by the cessation of expansion; it is the delayed revelation of malinvestment already created by the boom.

The artificial boom is not prosperity, but the deceptive appearance of good business.

One of the essay’s strongest moves is to reinterpret depression. Against popular opinion, Mises sees the slump not as the original evil but as the painful process by which the economy abandons projects unsupported by real savings. Recovery requires recognizing scarcity, liquidating malinvestments, and allowing interest to reflect genuine time preference.

The depression is thus the first step on the return to normal conditions, the beginning of recovery and the foundation of real prosperity based on the solid production of goods and not on the sands of credit expansion.

The final section gives the essay its political edge. Mises links the market rate of interest to “economic democracy”: consumers, by saving or consuming, determine how much investment society can sustain. A dictator may force saving by reducing consumption, but a market economy cannot evade public preferences through monetary tricks. The crisis is therefore the public’s eventual refusal to validate overextended investment plans.

The collapse of the house of cards is a manifestation of the democratic process of the market.

The memorandum’s relevance lies in its uncompromising warning against policies that promise investment without saving and prosperity without cost. Mises’s conclusion is deliberately austere: the harms of cheap money cannot be avoided by more cheap money. The only way to reduce the damage is to end expansion sooner, balance budgets, stop government borrowing from commercial banks, and let interest be determined by the market.

These means cannot be provided by printing banknotes or by loans on the bank books.