by Alasdair Macleod, GoldMoney:
It was Karl Marx who was among the first believers that cyclical behaviour was endemic to free markets.
He lived through a time when there was a regular cycle of boom and bust, with phases of economic expansion followed by contraction. Workers were employed and then unemployed, and the only way this could be stopped, in Marxian economics, was for the workers to acquire the means of production, or more correctly, the state to do so on their behalf.
Other economists, such as Jevons and Wicksell, recognised the possibility of long-term fluctuations in commodity prices, but they did not formalise them into cyclical behaviour. Since Marx’s vision, several cycles have been identified, some of which go in and out of fashion. Groundwork on long-term cycles was conducted by the Russian-Marxist Nikolai Kondratiev, who identified a long wave cycle of 45 – 60 years, and by Joseph Schumpeter, an economist of the Austrian school, who identified several overlapping cycles, drawing on the work of others, such as Juglar (7-11 years fixed investment) and Kitchen (3-7 years fixed inventory)i. The American economist and father of gross domestic product, Simon Kuznets, reckoned there was a 15-20 year cycle of infrastructure investment.
Additionally, and more recently, cycles in human behaviour have been attributed to sunspots and other phenomena. Since the 1980s, computer aggregation of data has allowed technical analysts to devise proprietary systems for forecasting cycle-driven price events. Cycles are big business today, fuelling an unprecedented public participation in securities markets, today’s destination for savings, and the media for wealth management.
Accurate price data are not generally available from the time before commodity markets were properly established in the nineteenth century. Reliable data on commodities only really dates from about 1865, some time after global commodity trading had become established and people began to record historic prices. Modern data collection, the basis of GDP and consumer price indices, dates from the 1930s with the commencement of national accounting. Therefore, extrapolation back in time, particularly for evidence of long-wave cycles, requires a leap of faith to replace hard evidence. Therefore, the only way to identify their origin and validity is to consider the subject on a sound aprioristic basis. The intent of this article is to explain the phenomena that give rise to business and economic cycles, demonstrating they can only be the result of unsound money.
The sound money hypothesis
Sound money is defined as physical gold, or fully-backed substitutes redeemable in total for physical bullion. It is a condition that has never occurred with fractional reserve banking, which formally dates from Peel’s Bank Charter Act of 1844, because that legislation permitted banks to create credit money not backed by bullion. Furthermore, a note issue monopoly was granted to the Bank of England, partially backed by government debt, though subsequent note issues had to be gold-backed. Therefore, money and credit in issue were far from sound.
Before 1844, sound money was also compromised, with gold convertibility of banknotes suspended by the Bank of England in February 1797, and only resumed in 1821. Between 1821 – 1844, country banks issued their own bank notes, and there were periodic failures, the result of over-issuance of these liabilities relative to bullion and genuine claims on bullion in the banks’ possession.
This is an important point, because it is wrongly assumed that money was sound before the First World War. It was only sound enough for price relationships to be maintained measured in gold. Our sound money hypothesis is therefore a theoretical construction.
Even with sound money, newly-mined gold is an additional source of supply, and was a contributed to price inflation following Spanish importation from the New World after Columbus, major discoveries in California in 1849, and in South Africa in the 1880s. However, with these notable exceptions, above-ground stocks have generally grown at a similar rate to the global population, so the inflation of above-ground gold stocks had limited inflation effects.
With that in mind, when money is only gold, and its substitutes are fully backed by vaulted coin and bullion, excepting domestic mine supply, increases in the quantity of money in circulation in a country only arise as counterpart to an arbitrage, which corrects price differentials between communities. If the prices of goods in one community differ from those in another commercially-connected community, merchants will exploit the differential. Counterpart to these transactions is gold, so gold will flow to the state where prices are low from the state where prices are high, correcting discrepancies.
There are two broad conditions that can lead to price disparities, which attract arbitrage: different supply factors for individual goods or types of goods, and a differential in an overall preference for holding money, as opposed to acquiring goods. In the normal course of business, cross-border flows of gold are concerned with individual goods.
We must also consider the effects of technical innovation. An entrepreneur seeking to exploit a technological discovery will bid up for savings to finance his investment. So, we see at times of technological innovation a shift from current spending, or consumption, towards deferred spending. It is financed from savings, to accommodate the investment. Most of the time, the net price effect of these shifts is too small to be noticeable in the total economy, being part and parcel of continual product improvement, and is offset by disinvestment from redundant production. But when a major technological advance is achieved, the switch from consumption into savings will tend to lower the prices of consumption goods relative to the goods of a higher order, because gold has been switched from current spending to savings to finance the investment.
The price effect reflecting periods of innovation therefore exists, but limited to the goods in question, and in a direction different from that posited by cycle theorists. Therefore, the price consequences from progress is for prices to fall over time, expressed in gold, and the greater the innovation and rate of progress, the greater the decline in prices. The prices of final products in turn set the costs of the factors of production, including raw material prices. And while there may be intertemporal dislocations between the trend for prices at both ends of the production chain, these are temporary and inherently non-cyclical.
To argue that the advent of railways drove up the price of coal was only true until demand for coal encouraged greater supply, when prices then stabilised and began to fall. The same is true of any innovation that requires new materials, and where extra supplies are not easily forthcoming, substitutes are deployed. While a pedant might justly describe it as a production cycle, it is certainly no more than that, and generally a one-off effect and not the basis for the repetitive cycles of economic activity alleged by the likes of Kondratiev.
In any event, with sound money, price differentials are corrected by arbitrage across community boundaries as described above. A shortage of coal tends to attract imports. The effect is very powerful. In a more recent example, When the Belgian Congo disintegrated into civil war in 1960 and foreigners were fleeing the country, traders from East Africa’s Asian community were attracted by the high prices for basic goods in the Congo, making fortunes despite the dangers.
So, when there’s a threat of war, famine, plague or even state intervention in markets, there can be a more general alteration of preferences for holding gold relative to goods, which only persists for the duration of the crisis. For example, people might stock up on vital goods, driving their prices up, and the purchasing power of gold, measured in these goods, would fall. Alternatively, uncertainty over government actions might drive preferences in favour of gold, leading to falling prices. But always with sound money, the price differences between one state and another are finally resolved by the flow of gold one way, and goods the other.
The opportunity for price, trade or business cycles to develop however defined are therefore very restricted. We have seen that with sound money, technical innovations demand extra savings, lowering the prices of consumption goods. But this was not what Schumpeter appeared to think. He believed that entrepreneurial innovation caused long price cycles, identifying 1786-1842 as Britain’s first industrial revolution, 1842-1897 the spread of railways, steamships and textiles to other countries, and from 1897 onwards came the internal combustion engine, electricity, speciality chemicals and steel. These were all periods of rising prices.
What Schumpeter appears to have missed is the price effects, which coincided with innovation in those periods, had their origin in the expansion of unbacked credit. The first period especially saw significant price inflation, not because of canals, their connecting of remote communities and the transport of goods, but it was at a time of the Napoleonic Wars and the suspension of the gold standard. The second period saw the formalisation of fractional reserve banking, leading to several banking crises, and an accelerated production of gold from California. The third period saw yet further expansion of bank credit following the establishment of the Bank of England as the lender of last resort, accompanied by the expansion of gold mining in South Africa.
In all these instances, unsound money was present in growing quantities. Coincidence, or what?
In conclusion, trade imbalances cannot persist without the oxygen of unbacked credit or other monetary expansion. Supposed business cycles, which is the wrong term for changes that do not repeat periodically, with sound money must be limited to shifts between classes of goods, reflecting the interaction between technological progress and changes in preferences between different goods. A shift from horses as the power behind transport in favour of the internal combustion engine was never going to go back to horses again. It was progress, and is essentially non-cyclical. Thank goodness for progress, otherwise we would be periodically repeating the Great Horse Manure Crisis of 1894. And that is the point: in free markets using sound money, progress is accommodated and embraced, leading to falling prices over time and prices that are not subject to cycles.