Money, Bank Credit, and Economic Cycles - The Ludwig von Mises ...

Bank Credit Expansion and Its Effects on the Economic System 3715. The increase in the loan rate of interest. Rates even exceed precredit-expansionlevels.The last temporary effect consists of an escalation in interestrates in the credit market. This rise occurs sooner or later,when the pace of credit expansion unbacked by real savingstops accelerating. When this happens the interest rate will tendto return to the relatively higher levels which prevailed prior tothe beginning of credit expansion. In fact if, for instance, theinterest rate is around 10 percent before credit expansion beginsand the new loans the banking system creates ex nihilo areplaced in the productive sectors via a reduction in the interestrate (for example, to 4 percent) and an easing of the rest of the“peripheral” requirements for the granting of loans (contractualguarantees, etc.), it is clear that when credit expansion comes toa halt, if, as we are supposing, no increase in voluntary savingtakes place, interest rates will climb to their previous level (in ourexample, they will rise from 4 to 10 percent). They will evenexceed their pre-credit-expansion level (i.e., they will rise abovethe originary rate of 10 percent) as a result of the combinedeffect of the following two phenomena:(a) Other things being equal, credit expansion and theincrease in the money supply which it involves willtend to drive up the price of consumer goods, i.e., toreduce the purchasing power of the monetary unit.Consequently if lenders wish to charge the same[W]ith further progress of the expansionist movement the risein the prices of consumers’ goods will outstrip the rise in theprices of producers’ goods. The rise in wages and salaries andthe additional gains of the capitalists, entrepreneurs, andfarmers, although a great part of them is merely apparent,intensify the demand for consumers’ goods. . . . At any rate, itis certain that the intensified demand for consumers’ goodsaffects the market at a time when the additional investmentsare not yet in a position to turn out their products. The gulfbetween the prices of present goods and those of future goodswidens again. A tendency toward a rise in the rate of originaryinterest is substituted for the tendency toward the oppositewhich may have come into operation at the earlier stagesof the expansion. (Mises, Human Action, p. 558)