How To Prevent the Boom-Bust Business Cycle

I recently wrote about how the Federal Reserve has made the economy of the United States much worse than it would have been without their bureaucratic central planning over the past century.

While the Fed’s disastrous track record is widely acknowledged even by Fed apologists, they point out that life was not perfect before the Fed either. They correctly note that there were business cycles before the creation of the Fed. So, even though inflation has been much higher with the Fed and the Fed helped cause the Great Depression and Great Recession, the US would still have had economic crises without the Fed.

That is true. However, the Fed has distorted the economy so significantly over the past century that business cycles and inflation are much worse than they were before. Instead of helping to solve the problem of the boom-bust business cycle, the Fed has made the problem even worse.

In this article, I will discuss what causes the boom-bust business cycle, highlight some business cycles before the Fed was created, and explain the simple way to eliminate these boom-bust business cycles in the future—without the Fed.

The Cause of the Boom-Bust Business Cycle

As Ludwig von Mises explained over a century ago, the recurring boom-bust business cycle is caused by fractional-reserve banks creating money out of thin air when they make loans.

This new money artificially lowers interest rates and encourages new borrowing and new investment projects, which causes the “boom” phase of the business cycle. Eventually, money supply growth slows, interest rates rise, and many of these new investment projects are shown to be unsustainable, which causes the “bust” phase.

Thus, as long as fractional-reserve banks create new money out of thin air, there will be boom-bust business cycles.

Business Cycles before the Fed

In his masterful money and banking treatise Money, Bank Credit, and Economic Cycles, Spanish economist Jesús Huerta de Soto detailed major business cycles that occurred before the Fed was founded in 1913.

In his book, Huerta de Soto discusses early fourteenth-century Florence, the center of financial and trade activity in the Mediterranean due to a significant economic boom resulting from the substantial credit expansion through Florentine banks. However, a series of events—including bankruptcy in England, the withdrawal of funds in Naples, and the crash of Florentine treasury bills—triggered widespread bank failure and a strong tightening of credit in the market (also known as mancamento della credenza) and resulted in a massive destruction of wealth. “Real estate prices, which had skyrocketed, plummeted to half their former value, and even such a reduction in price was insufficient to attract enough buyers. . . . It took thirty years (from 1349 to 1379) for a recovery to begin.”

By the 1560s, the Florentine economy was again booming and boosted by credit euphoria, including credit expansion. However, a severe squeeze in liquidity affected the entire banking system to the point that bankers “only paid in ink.” The crisis reached its peak in the mid-1570s, with deflation and a tightening of credit. This led to rapidly shrinking trade and frequent bankruptcies, causing the Florentine economy to fall into a long process of decline.

Other credit expansions that led to subsequent economic crises include the Medici bank failure in 1492, the sixteenth-century bank failures in Spain that affected all of Charles V’s bankers in the Seville square, and the major depression in eighteenth-century France resulting from John Law’s speculative and financial expansion.

In the United States, many of the crises followed a similar pattern.

The Panic of 1819: In the early nineteenth century, the newly created Bank of the United States produced a great artificial economic expansion, including “an expansion of credit and of the money supply, both in the form of bank bills and of loans, neither of which were backed by real saving.” However, in 1819, the bank ceased the credit expansion and demanded payment for the bank bills it possessed. This tightening of credit led to a panic and a deep, widespread economic depression that halted many investment projects and increased unemployment.

The Panic of 1873: Following the Civil War and its high costs, an expansion of credit was initiated in the US, which dramatically enlarged the railroad network as well as pushed the iron and steel industries to undergo intensive development. This expansion spread worldwide; in Europe, industrial sector securities soared due to tremendous stock market speculation. In May 1873, crisis hit the Continent first, followed quickly by the US in the summer. One of the great American banks, Jay Cook and Co., failed during this recession. France, however, escaped this panic and depression due to abstaining from the prior credit expansion.

The Crisis of 1882: France joined the US in credit expansion in 1878. In France, “the issuance of industrial shares soared and an ambitious public works program was introduced.” Banks attracted family savings and granted massive loans to industry. In 1882, however, the Union Générale failed. The Crédit Lyonnais—also on the verge of failure—faced a massive withdrawal of deposits (around half). In the US, four hundred banks failed (out of a total of 3,271 banks).

The Panic of 1907: Following a previous crisis that ended in 1896, credit expansion was again initiated. However, instead of railroads, these new loan funds—created ex nihilo—were invested in electric power, telephones, subways, and shipbuilding, as well as both the chemical and nascent automobile industries. Crisis hit in 1907, which was particularly severe in the US, and many banks again failed.

More details on US business cycles before the Fed was created in 1913 can be found in this brief article.

The key takeaway is that all of these financial crises and business cycles were caused by banks creating new money out of thin air, something mere mortals like us are not legally allowed to do.

The Solution to the Business Cycle Problem

As Murray N. Rothbard explained, the purpose of the Fed is to increase the profits of big banks. They do this by cartelizing the banking system and encouraging the creation of money out of thin air in order to make loans in good times and create more money out of thin air to bail out banks in bad times.

It’s much easier to create money out of thin air and earn more money by lending this money out than it is to earn money by creating new goods and services. That’s why banks love to do it. Also, they love having the government come to the rescue whenever they have problems.

Since the boom-bust business cycle is caused by banks creating money out of thin air, the solution is to not enable them to create even more money out of thin air with the help of the Fed!

This money creation is what has led to the dollar losing most of its value since 1913 as well as the unprecedented economic disasters of the Great Depression and Great Recession, plus whatever disaster the Fed is creating right now with their aggressive hiking of interest rates.

No, the solution to the business cycle is to legally prevent banks from creating money out of thin air, just as you and I are legally prevented from doing so. Banks would simply be legally required to maintain 100 percent reserves on deposits. They could still borrow in the form of time deposits and other debt instruments and still make loans, but they could not create new money.

Importantly, 100 percent reserve requirements would not be a bureaucratic government regulation but simply an application of the law against fraud. It is generally considered fraudulent to have a contract to exchange something that does not exist, such as unicorns. With fractional reserves, banks have contracts to provide money immediately on demand that they do not have, which is impossible.

More money does not raise living standards in the way that new goods and services do. New money simply lowers the value of each unit of money and causes vast economic distortions that lead to the boom-bust business cycle.

If banks were required to maintain 100 percent reserves against demand deposits, we wouldn’t need government bureaucrats trying to centrally plan the economy like Soviet apparatchiks, and we would no longer suffer from inflation and the boom-bust business cycle.

This one simple measure would solve the biggest economic problems of our time, so why not do it?

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