. 6
( 10)


economic good, meaning a good traded in a market, is in
scarce supply. People will not pay for something, no matter
how pleasant or important it is to have around, if they find it
present in such abundance that economizing its use is unnec-
essary. Air is certainly a good”all people need it for their very
survival”but no one feels the need to breath less in order to
avoid wasting it, and it does not fetch any price on the mar-
A shortage of a good, in the economic sense, does not
mean merely that it is scarce, but also that at its current price,
people attempt to buy more of it than is available. Shortages

This section was co-authored with Dr. Robert Murphy of Hills-
dale College, and is based on his original article “Blame It on the
Rain,” available at http://www.mises.org/fullarticle.asp?control=

usually come about when a legally mandated price ceiling is
below what the market price would have been. In response
to shortages, governments frequently resort to rationing the
good in question. The outcome of one government interven-
tion in the market, in this case the shortage that arises from a
price ceiling, is used to justify a further intervention, here
rationing as a response to the shortage. It is the typical pattern
of the interventionist dynamic that we examined in Chapter 11.
Let™s look at a recent case of government-imposed
rationing. New York City experienced a prolonged drought,
beginning in 2000 and stretching into 2002. The possibility
arose of a severe water shortage. However, the government
had a plan, in fact, it had a three-phase Drought Management
Plan. According to the City of New York™s Department of
Environmental Protection:
As conditions dictate the declaration of the succes-
sive phases of the City™s drought response plan, cer-
tain actions are to be implemented. For a Drought
Watch, the DEP responses are primarily operational,
while activities that involve the consumer commu-
nity are primarily informative and voluntary. For a
Drought Warning, voluntary use restrictions are
heightened and other City agencies are required to
modify their operations. When a Drought Emer-
gency is declared, rules and sanctions for failure to
comply with them are imposed.

Quite often, when the government perceives a problem”
in this case, people attempting to use more water than is actu-
ally available”it simply declares various activities, to which it
has correctly or incorrectly assigned the blame for the trou-
bles, to be illegal. It employs fines and prison sentences to
prompt compliance with its decrees.

Unlike the command approach used by the state, the mar-
ket guides scarce resources toward their most important uses
through the voluntary rationing of the price system. No threats
or fines are needed to dampen the appetites of consumers.
Anyone can have as much of a good as he wants, so long as
he is willing to pay the market price. An item that is in short
supply at its current price will become more expensive once
that situation is understood, as illustrated by Hayek™s tin exam-
ple, discussed in Chapter Ten. The new, higher price of the
good motivates people to use less of it.
A common response to such observations is that the
“necessities” of life”such as electricity, natural gas, and above
all, drinking water”are far too important to leave to the
unpredictable whims of the unplanned free market. Surely
people™s welfare, their very survival, should be placed above
the desire of a greedy entrepreneur to earn profits!
But that argument simply assumes that government
employees can provide services more reliably than profit-
seeking businessmen. Don™t most of our experiences with
government services indicate that the very opposite is true?
For example, during the hot summer months, when public
utilities impose rolling blackouts and mandatory water restric-
tions, we never find Budweiser selling beer only on even-
numbered days, or Oscar Mayer banning the consumption of
more than two wieners per person at all cookouts. Consumers
take it for granted that the privately supplied products they
desire generally will be available.
The difference between private and government provision
of goods is not due to scarcity. After all, diamonds are quite
scarce, yet we never hear of a diamond shortage. During a
drought, when the government is proclaiming that there is a

“water shortage,” consumers can always find bottled water,
supplied by private firms, on store shelves.
Of course the market isn™t perfect: no human institution is.
During the Fourth of July rush, for example, some stores may
run out of paper plates. But it is highly unlikely that an entire
city will run out of them. In contrast to monopolized public
utilities, markets diffuse the responsibility for supplying a
good among many vendors. Even if some of them do a bad
job at forecasting demand, other entrepreneurs, eager to lure
away the customers those vendors have left unsatisfied, will
leap into the breach. It is ironic that it is often the most impor-
tant goods and services that are reserved for shoddy govern-
ment provision.
Those cynical about bureaucracy may attribute water short-
ages and harsh regulations to the lust for power of the would-
be tyrants and incessant busybodies who haunt most govern-
ment agencies. But public utilities face a more fundamental
problem than that. Even if all government employees were
completely selfless public servants, they would still be inca-
pable of rationally managing the water supply in the absence
of free competition and market prices.
A public utility manager might possess detailed statistics
concerning resource supplies, precise technological formulas,
and extensive surveys of the consumers desires. But he will
still be unable to select the most efficient uses for any given
resource at his disposal. His decision to produce more of one
good and less of another is merely guesswork.
Consider, for instance, the plan the New York City govern-
ment devised in response to the area™s drought. It took into
account the capacity of reservoirs, the normal usage of resi-
dents and businesses, and the latest weather forecasts. But the
actions it ordered in response to those conditions were largely

arbitrary. Under its “Drought Emergency Rules,” citizens
couldn™t wash their vehicles with a hose, but they could water
their lawns between seven and nine AM and seven and nine
PM. However, if they lived in a house with an odd street num-
ber, they could only do so when the day of the month was
odd as well. People living in even-numbered houses were
limited to watering on even-numbered days. (Imagine your
frustration if you happened to live in an odd-numbered house
and had a job that required you to work on odd-numbered
Plant nurseries could use water, but only at 95 percent of
their pre-drought levels. (Why 95 percent, rather than 85 or 98
percent?) Restaurants could only give patrons a glass of water
if they specifically requested one. All showerheads had to
have a maximum performance of three gallons per minute at
60 pounds per square inch water pressure. Finally, a “SAVE
WATER” sign, the dimensions and appearance of which were
mandated in the plan”had to be placed in all dwellings hous-
ing more than four families.
That hodge-podge of citywide regulations could not help
but ignore the vast differences among the millions of New
York residents in both their circumstances and their personal
preferences. It is highly unlikely that even a single person has
the exact same demand for water in the exact same uses as
anyone else. In a city of eight million people, the variations in
individuals™ water needs must be immense.
During a drought, bureaucratic rules regarding water use
will prompt some people, especially those who are willing to
flout the law, to consume water that is more urgently needed
by others. The market distinguishes between more and less
urgent demands based on willingness to pay. The govern-
ment, lacking the guidance of market prices, cannot perform

the same task. It is obviously economically inefficient, not to
mention tragic, if someone dies of thirst while his next door
neighbor is watering his lawn. But it might also be wasteful
for a golf course to turn brown while a nearby car wash
remains open”or vice-versa! When choosing between such
uses, government officials are condemned to operate in the
In a free market, you determine how much of a good you
will consume. You are only constrained by what you can offer
to others in exchange for their meeting your needs. You can
enjoy long showers if you are willing to pay the cost of the
water you use. The market price of a good indicates to you
the value of its marginal unit to “the community,” because that
price is what others are paying for it. If we had a free market
in water, then during a drought its price would rise, discour-
aging frivolous uses and encouraging imports from nearby
areas with wetter conditions. We would not have water short-
ages, just as today we never have beer shortages or hot dog


L economy in which the price of farm
products is declining. Farmers may begin pleading for
the government to stop the price drop. “Wealth is being
wiped out of the economy,” they will complain, “and the
value of our farms has fallen 50 percent in the last year. That
will make everyone poorer, since we can™t spend as much on

This section was also authored with Dr. Robert Murphy.

goods produced by others.” Their reasoning makes their pleas
seem to be for the good of the whole nation, instead of just a
matter of self-interest.
Surely, most economists would debunk such wrong-
headed thinking. The conclusion that wealth has disappeared
from the economy is unjustified. The same farms, the same
fields, the same tractors are here today as were here last year.
If some farms have shut down, it is only because consumers
valued some alternative uses of the resources necessary to run
the farm more than their use in farming. They chose the prod-
ucts requiring that alternative use over the products of the
farm. Therefore, they will be less wealthy, in their own eyes,
should the government intervene to keep the farm running.
We can sympathize with those farmers who have had a
hard time. But propping up their business is wasting scarce
resources. The law of comparative advantage tells us that
there is some other role for them in the economy, to which
they are better suited in the eyes of the consumers.
All that we definitively can say has occurred is that there has
been a change in relative prices. A bushel of wheat buys fewer
dollars, but the flip side of the coin is that a dollar buys more
wheat. Those holding wheat are hurt, but those holding dol-
lars (or any other good that did not decline along with wheat)
are helped. This constant adjustment of prices by market par-
ticipants, so as to bring supply and demand into balance, is the
essence of the market process. There is little further we can say
about whether “everyone” is better off with the new price con-
figuration than they were with the old one. Certainly, though,
we can point out that it will not help most people to try to
maintain the old prices by government manipulation in the
face of the new data of supply and demand.

Or consider the continuous, twenty-year decline in the price
of personal computers. Economists have (quite correctly!)
heralded it as a sign of the wondrous powers of the market.
Certainly, computer manufacturers would like to have seen a
thirty-year rise in the price of PCs. I haven™t heard any econ-
omists worrying about the wealth that was disappearing as the
value of my old NeXT Workstation headed to zero. That price
decline occurred because better opportunities appeared on
the market. In other words, we were becoming wealthier dur-
ing the price decline, not poorer.
So why do so many economists have such difficulties when
the fall in prices occurs in the stock market, instead of in the
market for agricultural commodities or personal computers?
When stock indices fall, we hear repeated worries that “wealth
is being wiped out.” On the surface, that seems too obvious
to argue. When, during the year 2000, the NASDAQ plunged
from 5,100 to 2,400, the total capitalization of the index shrank
by over $3 trillion. It looked as though that wealth had simply
vanished into thin air.
However, as we have seen above, that view is the result of
confusion between the money prices of goods and the
amount of wealth in the economy. The NASDAQ decline did
not level any buildings or render any machines inoperable.
America was just as full of farms, warehouses, railroads, and
oil wells as it had been when the NASDAQ was at its peak.
The dot-com wipeout did not suck the knowledge of Java pro-
gramming out of anyone™s head. Certainly, some companies
shut down. But those were the companies that it no longer
seemed worthwhile to operate, in light of new market data.
A stock market decline represents a shifting of wealth. Those
who were holding cash, bonds, or gold are now wealthier, as
their assets can buy a greater share of various corporations.

Those who were short shares of companies they judged to be
overpriced are wealthier. The largest group made better off by
the decline is the non-asset-holding consumer. Before the
stock market decline, the stock-rich had been bidding up the
price of various goods”homes, carpenters, plumbers, mas-
sage therapists, domestic help, private schools, and so on.
After the decline, they are no longer able to bid as much,
making such items more affordable for others.
Cries for the government to stop a stock market decline are
no less special-interest-group pleading than are attempts by
farmers to boost wheat prices. Those holding stocks have
come to expect that they have the right to see the prices of
their assets continually rising, and call for the government to
intervene when that expectation is disappointed.
Usually, the request for intervention takes the form of the
cry, “Lower interest rates!” But such a change in a key market
price does not add a single new good to the economy. It sim-
ply shifts wealth from those who are intending to lend money
to those who are intending to borrow money.
The price of securities must ultimately rest on their
prospective future yield. While American productivity has
been increasing, and we would therefore expect higher future
yields on stocks, this explains only a small portion of the 85-
percent rise in the NASDAQ in 1999 and the further 20-per-
cent increase at the beginning of 2000.
A good deal of the NASDAQ run-up was due to the Fed
flooding the market with liquidity in preparation for Y2K. That
liquidity entered the capital market first, creating a classic
market bubble. The bubble was concentrated, as bubbles tend
to be, in the fad of the era: hi-tech stocks, in the ˜90s.
In addition, as Professor Roger Garrison of Auburn Univer-
sity has pointed out, the Fed has attempted to create a “firewall”

to protect the “real” economy from the securities markets. But
firewalls work both ways. We might reasonably suspect that
holders of securities have begun to feel that they would be
protected from changes in the rest of the economy. The gov-
ernment would step in to bail them out, as during the Mexi-
can and Long-Term Capital Management crises.
Freely established market prices are not arbitrary: they
serve an important social function. At any particular time, the
market price of a share of stock reflects the best estimates of
experts”where “experts” are those who have demonstrated
the greatest foresight in the past”of the future price of the
share (adjusted for interest). The critic of a price movement is
implicitly asserting that he knows better than those actually
risking their own money in the market.
In any discussion of share prices, we must also keep in
mind the social function of the stock market itself. The price
of a stock is closely connected with the present value of the
expected future revenues of the company. Thus, unlike stamp
collectors, those buying stocks are not merely guessing what
everyone else thinks the future price of the good purchased
will be. (In this respect, Keynes™s analogy of a beauty contest
in which each judge tries to guess which contestant the other
judges will rate highly”rather than which contestant is actu-
ally most beautiful”is dangerously misleading.) A surprisingly
poor performance will invariably reduce a company™s share
price. That is vitally necessary, in order for the market to accu-
rately price the company itself.
If a company™s market price is less than the sum of its
assets, to some market actor, the company becomes vulnera-
ble to the much-maligned “corporate raider.” The corporate
raider”epitomized by Danny DeVito™s character in the movie
Other People™s Money”may then execute a leveraged buyout,

liberating the underutilized assets (including labor) and trans-
ferring them to the highest bidders (i.e., those expecting to
use the assets in a manner that better fits consumer prefer-
ences). While small alterations in the structure of capital can
often be made within a firm, large alterations usually take
place by capital moving between firms. It is the stock market
that enables those adjustments to occur.
Before condemning a fall in a stock index, we must first ask,
“Why has the stock market plummeted?” The answer to that
question demonstrates why any interference with the process
is harmful. Many people seem to think the market drop in 2000
and 2001 was simply a case of an “irrational,” self-fulfilling
prophecy. But to the extent that was true, the real wealth of
the economy (as argued above) had not changed.
But what if the stock market plunge was due to something
more fundamental than prophecies? In that case, the euphe-
mism “correction” would be accurate. If people realized with
dismay that they had been overly optimistic about future cor-
porate earnings, that must necessarily reduce share prices.
However, the decline in prices is merely a symptom of the
previous errors, not their cause. If Americans change their
minds about the justice of the Union cause in the Civil War,
the value placed on the Lincoln Monument will fall consider-
ably. That loss of a patriotic symbol would not be offset by
anyone™s gain, but it certainly would not justify any attempts
to interfere with the adjustment. We need prices to reflect
what we value today, not to be an image of what we valued
yesterday. People might regret their previous value judgments,
but there is no use crying over spilled milk.
Of course, none of the above should be taken to mean that
the government should deliberately try to lower security
prices, either! Rather, the market should be allowed to price

securities in accordance with supply and demand. As Mises
said in Human Action:
It is easy to understand why those whose short-run
interests are hurt by a change in prices resent such
changes, emphasize that the previous prices were
not only fairer but also more normal, and maintain
that price stability is in conformity with the laws of
nature and of morality. But every change in prices
furthers the short-run interests of other people.
Those favored will certainly not be prompted by the
urge to stress the fairness and normalcy of price

Times Are Hard

I of most modern industrial nations, a
central bank manages the nation™s money supply and
attempts to control the level of interest rates, at least to
some extent. (In America, that central bank is called the Fed-
eral Reserve. Since it is the most powerful and famous central
bank in the world, we will focus our discussion on “the Fed.”)
Various rationales have been put forward for central bank
interference in the market: to supply sufficient currency and
credit to “meet the needs of commerce,” to ensure a “stable
value” for the currency, to “fight inflation,” to smooth out fluc-
tuations in the economy, and so on.
In light of our discussion of money and credit so far, those
reasons are suspicious. We have seen that prices can adjust to
whatever amount of currency is in the economy. Certainly, the
adjustment process takes time and has associated costs. There-
fore, we™d prefer gradual to rapid change, giving us more time
to adjust. The need to dig up gold from the ground in order
to create money acted as a regulator on the growth of the
money supply during the period of the gold standard. That
regulator led to a century-long period of remarkably low


volatility in prices. Being able to create new money almost at
will, as central banks can, obviously makes it easier to create
rapid changes in the money supply. The various hyperinfla-
tions that have occurred in the last century, under fiat money
regimes, attest to that fact.
Similarly, we have every reason to believe that the best
mechanism for matching the businesses™ perceived credit
needs with the available savings is the interest rate market.
What really matters to a business is that it can acquire the
goods, the knowledge, and the services it needs to complete
its plans during their progress toward producing consumer
goods. The cash a business borrows is important only as a
means to help acquire those factors of production. If the real
factors are not available, because people have not saved a suf-
ficient amount out of current and past production to bring
them into existence, then neither increasing the amount of
dollars in circulation nor artificially lowering the interest rate
will magically bring them forth from the void.
And we have already covered the reason that the search for
a stable currency is hopeless: valuation is an aspect of human
action, and there are no constant numerical values in human
action. Every freely chosen value implies the possibility of a
change in valuation. And, far from fighting inflation, the Fed
is the main cause of it.
In this chapter, we will examine the final reason listed
above, “smoothing out fluctuations in the economy,” in some
depth. Over the course of the chapter we will see that the cen-
tral bank tends to be the creator, and not the dissipater, of
economic fluctuations. When it is putting on the brakes and
deflating a bubble, it was usually the one that inflated the
bubble in the first place.


I are a bus driver, at the edge of a desert,
about to take a busload of passengers across it. You have
left all gas stations behind. Your destination is a town on
the other side of the wasteland before you. You are faced with
a trade-off: the faster you try to reach the town, the less the
passengers can use the air-conditioning to alleviate the desert
heat. Both higher speeds and higher air-conditioning settings
will use up the gas more quickly. And since, in our luxurious
bus, each passenger has his own temperature control for his
seat, you, the driver, cannot control the total amount of air
conditioning used on the trip.
In order to make your decision, you look at your fuel
gauge and determine how much gas you have. You tell the
passengers that they must now make a trade-off between
comfort on the way and speed traveled, as the more air-con-
ditioning they choose to use, the faster the bus will consume
fuel. Then you collect statements from the passengers on what
temperature they will keep their seat. You perform some cal-
culations on mileage, speed, and fuel consumption, and pick
the fastest speed at which you can travel, given the amount of
gas you have and the passengers™ statements about their use
of the air-conditioning.
The passengers had to decide whether to cross the desert
in greater comfort but arrive later at their final destination, or
in less comfort but with an earlier arrival. The science of eco-
nomics has little to say about the combination that they
picked, other than that it seemed preferable to them at that
moment of choice.
However, also imagine that, before you began your calcu-
lations, someone had sneaked up to the bus and replaced the

passengers™ real choices with a fake set that chose a higher
temperature, in other words, one that makes it seem they will
use less fuel than they really will. You will make your choice
on travel speed as if the passengers will tolerate an average
temperature of, say, 80 degrees, whereas in reality they will
demand to have the bus cooled to an average of 70 degrees.
Obviously, your calculations will prove to be incorrect, and
the trip will not come out as you had planned. The trip will
begin with you driving as if you have more resources avail-
able than you really do. It will end with you phoning for help,
when the sputtering of your engine reveals the deception.
I offer the above as a metaphor for the Austrian business
cycle theory (ABCT), which explains why most modern
economies tend to swing through boom times and recessions.
You, the driver, represent the entrepreneurs. The gas is the
sum of the resources available in the economy. The trip across
the desert is some period of production. The passengers rep-
resent the consumers. Their choice on how much to use the
air conditioning is analogous to how much consumers want to
consume now at the expense of saving for the future (i.e.,
their time preference). The speed of the bus is the amount of
investment spending the entrepreneurs will undertake. The
ultimate destination is the satisfaction of as many of the con-
sumers™ wishes as possible. And it is the central bank”for
instance, the Federal Reserve”that has sneaked up and tam-
pered with the consumers™ choices.
What the central bank tampers with is the market™s reading
of the consumers™ average time preference, which is the rate
of originary interest. Consumers™ time preferences tell us how
much capital will become available through consumer saving,
or, in our metaphor, through cutting back on the air-condi-
tioning. When the central bank artificially lowers the rate of
interest”we hear on the news that the Fed has cut rates to

“stimulate the economy””entrepreneurs make their plans as
if consumers were willing to delay consumption and save
more than they really are. As the bus driver, you act as if the
passengers are willing to endure the heat enough for you to
drive 70 miles per hour. In reality, they will force the bus to
consume gas so rapidly that you should have planned to drive
only 55. Your attempt to cross the desert will fail, leaving you
out of gas.
Of course, the real economy does not simply come to a
halt. At some point in the trip, it becomes apparent that the
bus is using fuel too rapidly. The Fed, expressing a concern
about “overheating,” will raise rates. The entrepreneurs will
slow way down so that the bus does not simply die”they lay
off employees, cancel investment projects, and reduce spend-
ing in other ways. The economy, after the boom at the start
of the trip, has fallen into a recession.1
Our metaphor also allows us to differentiate between a
“soft landing,” a “hard landing,” and a full crash. The further
the bus has gone before the discrepancy between the market
interest rate and consumers™ real time preference is accounted
for, the “harder” a landing the economy will undergo. If the
entrepreneurs discover the error early (or the central bank cuts
short the expansion quickly), the bus may only have to slow
to 50 miles per hour to complete the trip. If the credit expan-
sion is continued for a long time the bus may wind up having

For those familiar with mainstream macroeconomics, Roger
Garrison™s way of putting this may be helpful. In his book on Aus-
trian macroeconomics, Time and Money, he says that the economy
had been pushed beyond its production possibilities frontier, or PPF,
during the boom, and falls back inside the PPF during the bust.

to coast down hills with the engine off”and we have a full-
scale depression, or crash.
As we saw in earlier chapters, interest rates reflect con-
sumers™ time preference because it is what borrowers must
pay lenders, in order to persuade the lenders to delay their
own consumption. If I have $100, I could spend it today on a
nice dinner with my wife. Or, I could lend it out for a year, at
the end of which I could spend it on a somewhat nicer din-
ner. Exactly how much nicer a dinner I must expect to receive
before I will lend the money is an expression of my prefer-
ence for current consumption over future consumption. If I
demand a rate of interest of at least 5 percent, that means that
a $105 dinner next year is marginally more valuable to me
than a $100 dinner this year. On the other hand, if my friend
Rob demands 10-percent interest, he is demanding a $110
dinner. He values current consumption compared to future
consumption more highly than I do.
The net result of all lenders and borrowers expressing their
time preference by offering and bidding on loans is the mar-
ket rate of interest. In any real interest-rate market, that rate
will include, besides originary interest, added interest to
account for inflation (or subtracted interest to account for
deflation), as well as a risk premium to account for the chance
that the venture or person that the money has been lent to will
go belly-up.
The rate of interest tells entrepreneurs whether a particular
investment is worth making or not. In an unhampered market,
without inflation or deflation, that rate would be approxi-
mately equivalent to what is termed, in finance, the risk-free
rate of interest. Since entrepreneurs can earn that return on
their money simply by buying high-grade bonds, they will not
undertake capital projects if they estimate that their return will

be lower than the risk-free rate of interest. In terms of our
analogy, it makes no sense to plan to travel 70 miles per hour
on our trip if the consumers are only willing to turn off the
AC (put off current consumption) enough for us to travel 55
miles per hour. For any project that returns less than the risk-
free rate of interest, the consumers are indicating that they
would, in fact, prefer that the resources necessary be used for
current consumption rather than being invested in that proj-


L at the recent Internet boom-and-bust as
an example of using the Austrian theory to explain an
episode in economic history.
It™s been said that the Fed™s job is to take away the punch
bowl once the party gets going. The aphorism doesn™t men-
tion that it was usually the Fed that had filled it in the first
place. ABCT has sometimes derisively been referred to as a
“hangover theory.” In fact, the metaphor is fairly apt. The Fed
gets the party ginned up on cheap credit, then has to cut
everyone off before disaster strikes.
MZM (money of zero maturity, one of a number of money
supply measures) increased at a rate of less than 2.5 percent
between 1993 and 1995. But over the next three years it shot

Parts of the “The Fed Starts a Party” were co-written with Roger
Garrison, and first appeared in our article, “A Classic Hayekian
Hangover,” in the January 2002 edition of Ideas on Liberty.

up at an annualized rate of over 10 percent, rising during the
last half of 1998 at a binge rate of almost 15 percent.
Sean Corrigan, a principal in Capital Insight, a UK-based
financial consultancy, details in “Norman, Strong, and
Greenspan,” the consequences of the expansion that came in
autumn 1998, when the world economy, still racked
by the problems of the Asian credit bust over the
preceding year, then had to cope with the Russian
default and the implosion of the mighty Long-Term
Capital Management.

Corrigan continues:
Over the next eighteen months, the Fed added $55
billion to its portfolio of Treasuries and swelled
repos held from $6.5 billion to $22 billion. . . . [T]his
translated into a combined money market mutual
fund and commercial bank asset increase of $870
billion to the market peak, of $1.2 trillion to the
industrial production peak, and of $1.8 trillion to
date [August 2001]”twice the level of real GDP
added in the same interval.

The party was in full swing. The Fed had kept the good
times rolling by cutting the federal funds rate a whole per-
centage point between June 1998 and January 1999. The rate
on 30-year Treasuries dropped from a high of over 7 percent
to a low of 5 percent.
Stock markets soared. The NASDAQ composite went from
just over 1000 to over 5000 between 1996 and 2000, rising
over 80 percent in 1999 alone. With abundant credit being
freely served to Internet start-ups, hordes of corporate man-
agers, who had seemed married to their stodgy blue-chip
companies, suddenly were romancing some sexy dot-coms
that had just joined the party.

Meanwhile consumer spending stayed strong”with very
low (sometimes negative) savings rates. Growth was not being
fueled by real investment, which would require the putting
aside of current consumption to save for the future, but by the
monetary printing press.
Buoyed by the stellar stock market returns, consumers built
massive additions to their houses and took trips they other-
wise would not have taken. Real estate, especially in the “dot-
com areas” such as Silicon Valley, soared in price.
As so often happens at bacchanalia, when the party
entered the wee hours, it became apparent that too many
guys had planned on taking the same girl home. There were
too few resources available for all of their plans to succeed.
The most crucial”and most general”unavailable factor was
a continuing flow of investment funds. (Of course, a contin-
ual supply of such funds by the Fed would only extend the
boom and worsen the ensuing crash.) There also turned out
to be shortages of programmers, network engineers, technical
managers, and other factors of production. Internet startups,
which had planned to operate at a loss for years by raising
capital, found that not only was there less investment money
available than they had hoped, but the cost of staying in busi-
ness had gone up as well!
The business plans for many of the start-ups involved neg-
ative cash flows for the first ten or fifteen years, while they
“built market share.” To keep the atmosphere festive, they
needed the host to keep filling the punch bowl.
However, the Fed knows that such a boom cannot be sus-
tained indefinitely without eventual price inflation. Ultimately,
if credit expansion continues, it will lead to the crack-up
boom, where the economy enters into a period of runaway
inflation. Fears of inflation led to Federal Reserve tightening in

late 1999, which helped bring MZM growth back into the sin-
gle digits (8.5 percent for the 1999“2000 period). As the punch
bowl emptied, the hangover”and the dot-com bloodbath”
began. According to research from Webmergers.com, at least
582 Internet companies closed their doors between May 2000
and July of 2001. The plunge in share price of many of those
that remained alive was gut wrenching. For example, shares
of Beyond.com, split adjusted, went from $619 to $0.79. The
NASDAQ retraced two years of gains in a little over a year.
Unemployment shot upward, and the economy slipped into a
In the fall of 2001, Enron exploded in the largest corporate
bankruptcy in U.S. history. It appears, at the time of writing,
that some at Enron were at least morally and perhaps crimi-
nally culpable in the meltdown. But Enron™s rise took place
during a period of free-flowing credit, and it crashed once the
last call was made. Ponzi schemes, too, thrive when credit is
Another prominent explanation for booms and busts, one
that has been applied to the Internet craze, might be called
“mania theory.” Investors become entranced by some particu-
lar investment”tulip bulbs, French colonial trading ventures,
Florida real estate, the “nifty fifty” stocks, or Internet compa-
nies”and begin a self-perpetuating process of bidding more
for the asset, seeing its price rise, bidding even more, and so
on. Like a manic-depressive who can only maintain his manic
phase so long before crashing, eventually people begin to
have doubts about the mania, and it all blows up.
Commenting on the psychology of the theory is beyond the
scope of this book. Nevertheless, we can say that there is
nothing in the mania theory that contradicts the Austrian
account. They look at the same phenomenon from the vantage

point of two different sciences: social psychology and eco-
nomics. They may, in fact, prove to be complementary. The
Austrian theory offers a coherent explanation of the onset of
the mania”a credit expansion”and the onset of the depres-
sion”the cessation of the expansion. After all, the mere fact
that people are excited about the Internet cannot create a
speculative bubble by itself. The funds to speculate with must
come from somewhere, and the Austrian theory identifies just
where. On the other hand, the mania theory might help
explain the reason that booms often do seem to be channeled
into certain faddish investments.


T AUSTRIAN THEORY is concerned primarily with malin-
vestment, not with overinvestment. Entrepreneurs have
spent time and resources on projects that they cannot
actually complete and that they would not have undertaken if
there had been an accurate reading available of consumers™
time preference. As Mises put it in Human Action,
A further expansion of production is possible only
if the amount of capital goods is increased by addi-
tional saving, i.e., by surpluses produced and not
consumed. The characteristic mark of the credit-
expansion boom is that such additional capital
goods have not been made available.

Differentiating overinvestment from malinvestment is only
possible because of the key Austrian insight that capital has
structure, which we examined in Chapter 8. Many entrepre-
neurial plans count on complementary capital goods being

available sometime in the future. For example, as I launch my
e-commerce business, my plan may have a step such as: “Six
months after start-up: hire 100 web programmers at $100,000
each annually.” But in the intervening months the boom is
proceeding. Other companies are flush with cash from the
credit expansion as well. As we all begin to hire our pro-
gramming staffs, it turns out that web programmers are not
available in the quantity and at the price we thought they
would be. Any company that can™t afford to put its plan on
hold must bid more for those services.
The new credit tends to flow first into the higher-order cap-
ital goods”things like business plans, new buildings, new
plants, and so on. It is later, when those goods require com-
plementary goods to continue production on their road
toward consumer goods, that the transitory nature of the
boom becomes apparent. If real saving had occurred, there
would have been a much better chance of the complementary
goods being available. Take our example of my e-commerce
business: If enough people had been setting aside enough
time to learn web programming (a form of saving), then per-
haps there would have been enough web programmers avail-
able for both my plans and those of my competitors to suc-
Yet another metaphor for the process by which the Fed
“manages” the economy would be that of a hyperactive pedi-
atrician, who never feels that the children under his care are
growing at the “right” rate.
The body grows by a process we do not consciously con-
trol, based, in ways we only partly comprehend, on genetic
makeup, nutrition, rest, exercise, and so on. Each cell responds
to its own local conditions, and the net result of all of these
responses is the body™s overall rate of growth. Similarly, each

individual in the economy makes local decisions based on his
unique circumstances, the net of which is the overall state of
the economy. By using this analogy I do not mean to contend
that the economy is “really” some sort of organism, only that
the process of economic growth is in some ways similar to
that of organic growth.
The Fed, the pediatrician of our analogy, feels it can
improve on its patient™s natural state. It doesn™t alter any of the
real inputs to the process, such as the number or nature of
capital goods available, or the willingness to save. Instead, it
fidgets with the economy™s “hormonal levels” by adjusting the
interest rate. When it makes credit easy, the economy™s appar-
ent growth speeds up. In fact, what has occurred is that cer-
tain visible manifestations of growth have accelerated, while
other, equally necessary but less visible growth processes
have suffered as a result. Without the necessary “nutrients”
being present, the “growth” is not built on a solid foundation.
The “bones” weaken and cannot support the body. The cen-
tral bank, fearing a collapse, then tries to reduce the rate of
growth through tightening credit. That in no way undoes the
damage done during the period of credit expansion, but,
rather, adds a new set of distortions to those already present.
Of course, once the central bank has engaged in credit expan-
sion, it is foolish to blame it for reining in the boom. The only
alternative is eventual economic collapse in the crack-up
boom: hyperinflation and the breakdown of the indirect
exchange economy.
The proponents of Austrian business cycle theory do not
hold that credit expansion unsupported by savings is the only
way an economy can come upon hard times, or that, even
when ABCT does apply, that it accounts for all of the hard-
ships experienced in a downturn. For instance, although

many Austrian theorists contend that the path to the Great
Depression was paved by expansionist central bank policy in
the 1920s, they generally acknowledge that ABCT does not
fully account for the depths of the crash.
For instance, in the U.S., both the Hoover and Roosevelt
administrations disastrously attempted to hold post-crash
prices, especially wages, at pre-crash levels. That halted the
adjustment process of the bust in its tracks and created the
mass unemployment that made the Great Depression so noto-
rious. (W.H. Hutt did extensive work on this aspect of busts.)
Milton Friedman feels that Fed blunders led to a collapse of
the money supply. Austrians acknowledge that further Fed
errors would exacerbate the downturn. And at the same time
the stock market crashed, the system of international division
of labor, made possible by the free trade policies of the late
nineteenth century, was collapsing in an international trade
war among the increasingly interventionist states of the 1930s.
(The infamous Smoot-Hawley tariff was the main American
salvo in that war.)
Nor is the Austrian business cycle theory deterministic, in
that it does not claim to reveal beforehand precisely where the
distortions resulting from an artificially low interest rate will
appear. The story we have given here is a typical one, but not
the only one possible. When the government sets the price of
eggs too low, we cannot say exactly where distortions will
appear, but we can say it is likely they will. Piero Sraffa
objected to ABCT as stated by Hayek: Why, he asked, could-
n™t relative wealth changes from the rate cut drive marginal
time preferences down to exactly where the central bank had
set the rate? Well, we suppose, they could. So could the
wealth changes from price-fixing in the egg market just hap-
pen to set supply and demand equal. But it would be pure
chance and would happen very rarely.


A RICHARD E. Wagner of George Mason Univer-
sity says, in a paper published in the Review of Austrian
Economics, “Austrian Cycle Theory: Saving the Wheat
while Discarding the Chaff,”: “the primary criticism that has
been advanced against Austrian cycle theory . . . is that the
Austrian theory assumes that entrepreneurs are foolish in that
they do not act rationally in forming expectations.”
Wagner goes on to point out that “a variety of occupations
and businesses have arisen that specialize in forecasting the
timing and extent of all kinds of governmental actions, includ-
ing those of the central bank.” Presumably, entrepreneurs
now have better information with which to form their expec-
The idea of rational expectations entered into economic
theory chiefly through the work of Robert Lucas. Justin Fox,
in a Fortune magazine article entitled “What in the World Hap-
pened to Economics?” explains Lucas™s theory as follows:
He argued that if people are rational . . . they can
form rational expectations of predictable future
events. So if the government gets in the habit of
boosting spending or increasing the money supply
every time the economy appears headed for a
downturn, everybody will eventually learn that and
adjust their behavior accordingly. . . . But the deduc-
tive logic of Lucas and other “new classical” econo-
mists led them to the stark conclusion that govern-
ment monetary and fiscal policy should have no
effect on the real economy.

As Austrian theory posits central banking as the primary
cause of the cycle of booms and busts that have characterized

modern market economies, it is easy to see why a wholesale
acceptance of rational expectations theory entails a rejection
of Austrian business cycle theory. For instance, Gordon Tul-
lock, in his article “Why the Austrians Are Wrong about
Depressions,” says:
The second nit has to do with [Austrian™s] apparent
belief that business people never learn. One would
think that business people might be misled in the
first couple of runs of the [Austrian] cycle and not
anticipate that the low interest rate will later be
raised. That they would continue unable to figure
this out, however, seems unlikely.

What can Austrian theory say to this objection? If business
people, aided by legions of “Fed watchers” and econometri-
cians, could tell just what the Fed (or any other central bank)
is up to, would we see a disappearance of the cycle?
To begin an examination of that question, I would like to
recall the metaphor of the hyperactive pediatrician. Unsatis-
fied with how his patients were growing, the doctor kept
administering doses of hormones that alternately sped up and
slowed down that process. Let us imagine that we visit one of
these patients after ten years of “treatment.”
What do we know about this child™s height compared to
what it would have been without the treatment? Very little, I
contend. The child might be taller than he would have been
at his natural rate of growth, shorter, or even, by chance,
exactly the same height. We might know that, at present, the
doctor is applying growth-promoting hormones. But are they
merely boosting growth up to where it would have been with-
out the previous round of growth-retarding hormones, or are
they boosting it above that?

Entrepreneurs are in a similar situation vis-à-vis the central
bank and the rate of interest as it might have been on an
unhampered market. When, exactly, could we point to a time
when we saw that rate on the market? The Fed is always inter-
vening, attempting to establish some rate. We might assume
that, at least some of the time, the Fed-influenced rate has
been close to the market rate, but how do we know at which
times? Even if we somehow did know that on, for instance,
July 12, 1995, the interest rate was at its natural level, how
could we relate that fact to what the rate should be now? Fed
watchers might be able to tell entrepreneurs that the Fed is
easing. But is it easing toward the market rate of interest from
some level above it, or further past the market rate from some
level already below it? The idea that entrepreneurs are com-
mitting significant errors by not somehow divining where the
rate ought to be is to criticize them for lacking superhuman
Entrepreneurs do know, however, whether the Fed is cur-
rently easing or tightening. But here the knowledge that is
most important to them is how long that policy will be pur-
sued. The Fed has a motivation to act contrary to whatever
expectations the business community forms. If businessmen
feel the Fed will raise rates, and therefore they refrain from
hiring, undertaking new projects, making new capital good
orders, and so on, then the Fed, watching the statistics col-
lected on new hires, capital good spending, etc., will be less
likely to raise rates. The Fed will explain that the economic
growth seems “under control.” Of course, the reverse is true
as well: If the Fed thinks businesses, busily hiring, undertak-
ing new projects, and so on, are not anticipating a rate
increase, it will be more likely to raise rates”the economy is

Wagner™s point, mentioned above, that businesses have
become better at watching the Fed must be complemented by
the observation that the Fed has become better at watching
businesses. Entrepreneurs and the Fed have entered into a
sort of poker game, and it is hard to see how entrepreneurs
can be faulted for not always guessing correctly which card
the Fed is about to play.
We must also look at the issue of which entrepreneurs will
have the strongest motive to first take advantage of easier
credit, and in what position that will place the remaining
Let us, for simplicity, divide entrepreneurs into classes A
and B. (Such a sharp division is not crucial to our analysis, as
you™ll see; it is merely a device to simplify our picture.) Class
A entrepreneurs are those who are currently profitable, i.e.,
those most able to interpret the current market conditions and
predict their future. Class Bs are struggling, money-losing, or,
indeed, unfunded “want-to-be” entrepreneurs, less capable at
anticipating the future conditions of the market.
Now, let us go to the start of the boom. It is 1996, and the
Fed begins to expand credit. To where does this new supply
flow? The As are not necessarily in need of much credit. If
they wish to expand, they have available their cash flow. In
the state of the market prior to the expansion, they were the
ones most able to secure loans. They quite possibly have been
through several booms, and, adept at interpreting the state of
the market, suspect that they are witnessing the start of
another one. They are cautious about expansion under such
The situation for the Bs is quite different, however. Their
businesses are marginal, or perhaps nonexistent. They have
previously been turned down for funding. Even if they could

tell that they are witnessing an artificial boom, it might make
sense for them to “take a flier” anyway. As it is, they are either
not capitalized, or on the verge of failing. If they ride the
boom, they will have a couple of years of the high life. And who
knows, their business just might make it through! Or, perhaps,
they will build a sufficient customer base to be purchased,
maybe even enough to retire on. In that case, it might not
matter to them if their company ultimately fails.
They use the easy credit to expand or start their business.
We should notice that the As are much less susceptible to such
a motivation”they expect to be “living the high life” anyway,
since their businesses are already doing well.
As the Bs create and expand businesses, the boom begins
to take shape. However, we can see that the actual situation
of the As has changed:
Of course, in order to continue production on the
enlarged scale brought about by the expansion of
credit, all entrepreneurs, those who did expand
their activities no less than those who produce only
within the limits in which they produced previously,
need additional funds as the costs of production are
now higher. (Mises, Human Action)

Although the most skilled entrepreneurs suspect that the
expansion is artificial, most can™t afford to shut down their
business for the duration of the boom. But if they can™t, they
must increasingly compete with Bs for access to the factors of
production. Take, for instance, the A company Sensible Soft-
ware, Inc., and the B company, Dotty Dotcom.
Dotty Dotcom, flush with venture capital and an “insanely
great business plan,” is luring top Java engineers with salaries
matching Sensible™s while throwing in stock options that could
be worth millions after the IPO. (That is an investment in

higher-order capital goods, as top engineers are needed
chiefly for more complex projects, which typically can take
several years to complete.) Sensible simply cannot afford to
lose all of its best programmers to Dotty. It must bid compet-
itively for them.
However, in order to do so, Sensible must take advantage
of the same easy credit that Dotty is using to back its bids. At
the market rate of interest existing at the start of the boom,
Sensible was already bidding as much as it deemed margin-
ally profitable for producer goods. So the A entrepreneurs,
willy-nilly, are forced to participate in the boom as well. Their
hope is that, in the downturn, the basic soundness of their
business and the fact that they have expanded less enthusias-
tically than the Bs will see them through, perhaps with only a
few layoffs.
Or, take the case of a class A mutual fund manager who
suspects that stock prices are artificially high. If he simply puts
his funds in cash and attempts to sit on the sidelines, he™s
sunk. All of his customers will leave, and he™ll never survive
to see the bust that proves he was right. In order to stay in
business, he will continue to invest in stocks, perhaps keep a
bit more money in cash than usual, and watch carefully for
signs of the turn.
Our analysis of the banks proceeds in the same fashion. It
is precisely the marginal lenders, those with the least ability to
evaluate credit risks, that have the least to lose and the most
to gain from an enthusiastic participation in the boom. They
will tend to have the strongest motivation to expand credit.
The more prudent lenders are eventually sucked in, in order
to compete. The problem is compounded by the tendency of
the International Monetary Fund, central banks, and other
government bodies to jump in and bail out large investors

when they get in trouble. The Mexican bailout of 1994 and
1995, and the bailout put together, at the Fed™s urging, after
the collapse of Long Term Capital Management a few years
later, are two prominent, recent examples of the creation of
moral hazard. If you are promised all of the upside of making
a risky loan, should the borrower being funded succeed, but
are protected on the downside by the likelihood of a bailout,
you are much more likely to make the loan!
Our A/B division of entrepreneurs adds to the explanation
of the radical difference between an artificial boom and a sav-
ings-led expansion. In the latter, the A entrepreneurs are able
to sense that the consumers really do desire a lengthening of
the production process and an increased investment in capi-
tal goods, as demonstrated by increased saving. Therefore,
they are eager to take advantage of new credit. There is no
reason to turn to the B entrepreneurs to find takers for the
new funds.
Of course, there is no sharp A/B division in entrepreneur-
ial ability. That was introduced only to simplify the discussion
above, but the fundamentals remain unchanged under a more
realistic assumption.
Another source of investment maladjustment from the
boom, in addition to the intertemporal one, is the interper-
sonal one”the Bs are those entrepreneurs that the consumers
least want to have capitalized! One of the corrective forces
operating to bring on the downturn is the fact that capital
must be wrested back from the Bs and into the hands of the
As, who can better satisfy the desires of the consumers.
The Austrian explanation fits well with the experience of
real booms and busts. For example, an architect I worked with
several years ago was quite aware that we were in a boom
phase. He told me stories of witnessing a previous wipeout in

Connecticut real estate in the late eighties. He expected
another downturn, yet he had expanded his business anyway.
There were simply jobs that he couldn™t afford to turn down
coming his way.
Meanwhile, with the established builders so busy, new
builders popped up everywhere. When the downturn came in
2001, one local contractor told me, “Some guys are going
broke”but they™re the ones who should not have been in the
business in the first place.” As Auburn University economist
Roger Garrison said, in commenting on this chapter:
In lectures more so than in print, I have often
referred to the “marginal loan applicant” in explain-
ing it all (your Class B entrepreneur). At the opera-
tional level, the relevant margin is the creditworthi-
ness of the borrower and not an eighth of a percent
difference one way or another in the rate of interest.


A WAGNER POINTS out, the idea that the Austrian cycle
depends on systematic, foreseeable errors on the part of
entrepreneurs arises from confusion between individual
outcomes and aggregate outcomes. Certainly, an omniscient
socialist planner in perfect control of the economy, who had
by some miracle solved the problem of economic calculation
in the absence of a market for capital, would not choose to
misalign the time structure of production. But in a market
economy, as Wagner says, the “standard variables of macro-
economics, rates of growth, levels of employment, and rates
of inflation, are not objects of choice for anyone, but rather
are emergent outcomes of complex economic processes.”

I™d like to introduce one last metaphor to clarify Wagner™s
point. Picture a small town centered on a village green. It is
an ordinary town, except that the town council has acquired
an odd ability and has chosen to use it in a most curious way.
Somehow, the council has devised a way to abscond with 50
percent of each resident™s store of goods, including money,
every evening at midnight. No effort to hide wealth from the
council is of any avail. In a redistributionist fantasy, the coun-
cil has decided that it will deposit this pile of stuff in the mid-
dle of the green every morning at six o™clock, available to any-
one who wants to grab some.
It is obvious that this activity cannot make the town as a
whole better off. In fact, as everyone will now be spending
time trying to grab back as much wealth as they can, the town
will be worse off. (They obviously had better things to do
before this program started, as they weren™t all hanging out on
the green at six.) Some less-well-off residents may occasion-
ally do OK, but as time goes on, the net effect of the lost pro-
ductivity will tend to punish them as well. Our process also
will alter the distribution of wealth, with wealth moving from
those who are best at meeting the needs of the consumers to
those who are best at grabbing things from the green.
Still, it is not an economic error on the part of residents to
plop down on the green at 5:55 every morning. They are sub-
ject to a phenomenon that they cannot control. Each of their
micro-level decisions leads them to participate despite the fact
that, at the macro-level, the activity is wasteful. There is only
one error necessary to generate this wasteful activity, and that
is the error of the town council™s foolish policy.
During a credit expansion, the entrepreneurs are in a sim-
ilar position. On the one hand, they may suspect the frantic
activity around the green is in the long run unproductive. On

the other hand, they cannot produce without resources, with-
out being able to secure access to the factors of production.
To the extent that those factors are being placed out on the
green every day, the entrepreneurs must go and participate in
the competition to employ them. There are many long-term
plans already under way that count on access to those factors.
In many cases it is not financially feasible to halt those plans
until the central bank™s expansion has ended.
Anthony M. Carilli and Gregory M. Dempster, in a paper in
the Review of Austrian Economics, look at ABCT from a game
theory perspective. As I mentioned earlier, Austrians tend to
view game theory as having limited applicability to market
exchange. But the relationship between investors and the Fed
is like a game in many ways.
Carilli and Dempster employ a simple game theory model
to help explain expectations and ABCT. The Fed acts as “the
house.” The players are the investors. The best net result for
all of them is when no one takes advantage of artificially low
rates. But for any individual player, the worst result is when
he fails to take advantage of the low rate while all of his com-
petitors do take advantage of it. And the best result for each
individual player is when he does take advantage of the credit
expansion while his competitors don™t. Since no entrepreneur
can count on all of his competitors to abstain from the easy
credit, his best move is to get “his bus” heading across the
desert first.
Earlier, we had a single bus driver, representing the entre-
preneurs, driving a single bus, representing the economy. The
passengers (the consumers) had voted on a level of air-con-
ditioning for the trip, but the Fed had replaced their vote with
its own.

To incorporate the game theory perspective, we need to
have many buses crossing the desert, each with its own driver.
Meanwhile, scattered across the desert are several gas stations,
with limited supplies of gas, where the drivers can refuel. The
drivers are competing for passengers, who will, to a great
extent, board a particular bus based on the combination of
comfort and speed that the driver offers them. The drivers,
while knowing that they do not have the passengers™ real
preferences on air-conditioning, do not know what those
preferences are, or how the temperature they have been
handed actually relates to those preferences.
In particular, the drivers (entrepreneurs) who first take
advantage of a low apparent time preference from the pas-
sengers have the best shot at making the crossing. They will
arrive at the intermediate gas stations first, and have the first
shot at the scarce gas available to complete the crossing.
Meanwhile, the drivers who hesitate to use the low apparent
time preference may not attract any passengers.
In addition, as the supposed air-conditioning preference
(the interest rate) is lowered, it lures more drivers into the
business, many of whom are not really qualified, but may
have no better shot at “making it” than to attempt the desert
crossing. Perhaps, after all, they will get across!
It is clear that the situation is far from optimal. Whenever
the Fed sets a supposed demand for air-conditioning (current
consumption) that is too far below the real one, many buses
will fail to make the crossing. Recovering from the problem
(liquidating the failed investments, or, we might say, sending
out the tow trucks) adds unnecessary costs to production, cre-
ating the losses of the downturn. But it is hard to see why the
bus drivers are to blame.

One of the most famous theories in economics is Say™s Law,
first formulated by Jean-Baptiste Say: the supply of a good on
the market always represents the demand for other goods. If
I am selling apples, this is because I intend to use the pro-
ceeds to purchase bananas. Of course, there may be too much
or too little of some particular good on the market at a partic-
ular time, given its current price. But we have seen that on the
unhampered market such situations soon correct themselves:
If the price for some good is too high, some sellers will be dis-
appointed in their attempt to sell their goods, and will be


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