Updated: 4/13/20
He fed you in the wilderness with manna that your ancestors had never known, so that he might humble you and test you, to do you good in the end, but you may say in your heart, ‘My power and the might of my hand acquired all this wealth.’ But you will call to mind the Lord your God, for it is he who gives you the power to get wealth; that he may establish his covenant that he swore to your fathers, as it is today (Deuteronomy 8:16–18).
I analyzed this passage in Chapter 22 of my commentary on Deuteronomy. This is the central passage in the Bible that establishes biblical social theory. It establishes a system of positive sanctions. This system is supposed to be self-reinforcing. There is supposed to be positive feedback with respect to economic growth. This positive feedback is supposed to confirm the nation in its commitment to the God of the Bible.
There is a threat inherent in economic growth. This threat is the lure of autonomy. People may conclude that their own wisdom is the source of their wealth. Under these circumstances, positive sanctions are not a blessing. They are a prelude to a curse. It is the curse associated with unbelief. Unbelief will lead to negative sanctions. “It will happen that, if you will forget the Lord your God and walk after other gods, worship them, and reverence them, I testify against you today that you will surely perish. Like the nations that the Lord is making to perish before you, so will you perish, because you would not listen to the voice of the Lord your God” (vv. 19–20).
Leviticus 26 and Deuteronomy 28 are both devoted to the system of sanctions. They are not limited to economic sanctions, but they include economic sanctions. The goal of the negative sanctions is to bring the nation, meaning the rulers and the ruled, back to faith in God. The ultimate sanction for Israel was national captivity (Deuteronomy 29:28). This would not be permanent. God would return them to the land (Deuteronomy 30:3–5). [North, Deuteronomy, ch. 72] This took place in Israel’s history. It culminated in the fall of Jerusalem. The church then replaced Israel as the favored nation, as Jesus said it would. “Jesus said to them, ‘Did you never read in the scriptures, “The stone which the builders rejected has been made the cornerstone. This was from the Lord, and it is marvelous in our eyes”? Therefore I say to you, the kingdom of God will be taken away from you and will be given to a nation that produces its fruits’” (Matthew 21:42–43).
The biblical doctrine of progress is an extension of the biblical concept of linear history: creation, fall, redemption, and final judgment. Progress is not an inherent doctrine of linear history. Linear history in the ancient world was held only by two groups: Jews and Christians. All other systems of historical interpretation were cyclical. Outside of the nation of Israel, there was no document supporting the idea of progress until Christianity emerged.
1. Questioning Social Progress
Linear history had profound effects in the development of Western civilization. It meant that there could be permanent progress within the Christian church. But this view of linear history was always ambivalent about the doctrine of social progress. There can be no permanent reversal of the extension of the kingdom of God in history. There are ups and downs, but there can be no permanent reversal. This is not the same as saying that civilization as a whole will also experience progress. To argue that way would involve arguing that the kingdom of God will eventually extend its influence over the face of the earth, thereby replacing the kingdoms of men. This was not held by anybody until the early 1600s. The question arose: “Is this progress irreversible culturally?” The general attitude of the Christian church until the seventeenth century was this: there will never be permanent progress. The kingdom of God will extend in history, but the various kingdoms of man will rise and fall. This outlook goes back to Augustine in the early fourth century.
It is a debate over eschatology. Premillennialists have believed that Christ will return bodily to set up a thousand-year kingdom. There will be progress on a permanent basis after this. However, we should not expect anything like this kind of progress prior to the return of Christ to set up his kingdom. In contrast to this is the position of amillennialism, which was Augustine’s position. Jesus will not return until the final judgment. Until then, the kingdoms of man will rise and fall.
In the seventeenth century, a new view began to be promulgated in Calvinist circles: postmillennialism. This began in the Dutch Republic during the time of the revolt against Spain in the first half of the century. It spread to Scotland. Some of the Puritans adopted it. It was a prominent outlook during the first generation of New England Puritanism from 1630 until the restoration of Charles II in 1660. Its defenders argued that there will be an expansion of the kingdom of God in history due to evangelism. Postmillennialism was not universally held, but it became prominent as the century developed. There was a growing confidence that the kingdom of God will have greater prominence, eventually replacing the kingdoms of man. There will then be increasing correspondence between covenant-keeping and growing wealth. This outlook offered optimism regarding the possibility of social and economic transformation in history. The setbacks of life will not be permanent. These setbacks will lead to repentance, and repentance will lead to a restoration of the positive economic feedback that is described in Deuteronomy 8:15–18.
2. A New Optimism
Accompanying postmillennialism was an increasing optimism about economic progress. The Dutch Republic began to experience economic growth through international trade in the late 1500s, despite the costs of the eighty-year war against Spain (1568–1648). This growth continued until the 1670s.
This optimistic outlook began to spread into non-Christian thinking in Western Europe. By the end of the seventeenth century, the new optimism was associated with Newtonian science. Newton was a secret Unitarian. If he had admitted this publicly, he would have been fired from his professorship at Cambridge. His disciples began to spread the gospel of mathematical science as the proper tool of understanding in all human affairs. A new confidence in the scientific transformation of the world began to take hold in intellectual circles. This continued through the eighteenth century. The Enlightenment of both Scotland and the European continent secularized postmillennialism. It led to a confidence regarding the ability of man to transform his world. This was the ancient lure that Moses had warned about in Deuteronomy 8: the lure of autonomy.
If society is constantly experiencing economic development, then the ups and downs of national or international economic life are peripheral to the general progress of civilization and the accompanying economic growth. In other words, there is a long-term pattern of economic expansion, but within this framework, there can be and have been periods of economic setbacks for nations and for the world economy. These setbacks are not permanent.
Economists debate about the origin of these setbacks. There are cycles of boom and bust, but always within the pattern of constant economic development, technological improvement, and scientific innovation. This outlook has become almost universal among professional economists. They believe in long-term economic growth, but they also attempt to offer explanations for the periods of recession and even depression that accompany long-term economic growth. Economists generally are secular postmillennialists. They believe in the idea of progress, and they believe that economic growth can be sustained indefinitely. They investigate the business cycle as deviations within the general framework of compound economic growth.
The first great bank failures in the West took place in the 1340s when the banking houses of two Italian families, the Perruzi and Bardi, failed in a three-year period. The Peruzzi bank went bankrupt in 1343. The Bardi bank went bankrupt in 1346. In 1348–50, the bubonic plague wiped out something in the range of one-third of Europe’s population. This launched the beginning of the Renaissance. This was the last great biological catastrophe to strike Western Europe. The economy recovered within a generation. The Renaissance was one aspect of this recovery.
Bank failures have marked Western economic history ever since. Fractional reserve banking is inherently unstable. The expansion of the money supply creates a boom, as we shall see, and then the boom turns into a bust. Contraction follows expansion. But then expansion follows contraction. Optimism returns. Investment returns.
1. Mises’ Theory of the Cycle
What is the relationship between fractional reserve banking in the business cycle? The answer was provided in 1912 by Ludwig von Mises in his book, The Theory of Money and Credit. He argued that the expansion of the money supply that takes place as a result of the expansion of bank reserves beyond the size of bank deposits lowers rates of interest. Banks have extra money to lend, and the only way that they can persuade borrowers to borrow the newly created money at interest is to lower the rate of interest. An increase in the supply of money leads to a temporary reduction in the price of borrowing money.
The newly created money enters the economy at specific points. When he wrote his book, the development of consumer credit was a decade away in the United States. So, he argued that the newly created money is borrowed by businessmen. They can borrow at a lower rate of interest. They are tempted to borrow the money in order to expand production. They see that certain investments that did not seem profitable at the older, higher rate of interest now appear to be profitable because of lower rates of interest. Businessmen take advantage of these lower rates by borrowing the money to expand production.
Mises argued that these lower rates of interest were based on deception. If people had become more future-oriented, and if they were willing to save money in order to increase their wealth in the future because of interest payments, there would be no problem. But, he argued, people’s rate of time preference had not dropped. They were not more future-oriented than before. So, the reduced rate of interest was an illusion. The public was unwilling to lend money at lower rates of interest. Banks were willing to lend money at lower rates of interest, but only because they had created this money as part of the process of fractional reserve banking. Thus, there would be a problem later in the economic development process. People were unwilling to save money. They wanted to spend money. Interest rates would go back up. Only a new round of monetary inflation could force rates down. But this would not be permanent. The inflationary money would begin to have an effect on prices. Prices would rise. People would spend money to buy consumer goods. But, unless there were new rounds of monetary inflation, they would not be able to continue to spend at the recent rate of spending.
Entrepreneurs had made long-term plans on the assumption that interest rates would stay low. They had assumed that they would be able to complete their projects and sell the output at a profit. Then the rising money supply would begin to raise long-term interest rates: the inflation premium in loans. Businessmen would no longer be able to borrow money at low rates to complete their various entrepreneurial projects. At this point, they would begin to close down the projects. They would begin to sell off capital assets that they had thought would become productive at some point in the future. They would begin to fire employees. This is the contraction phase.
Mises asked a relevant question. Why is it that large numbers of entrepreneurs make the same kinds of investment mistakes at the same time? Normally, entrepreneurs are in competition against one another. Some are expanding their businesses; some are not. Some are profiting; some are not. There is no pattern associated with their losses. But, in a time of economic recession, large numbers of entrepreneurs find that they had made the same mistake at the same time. They had bought production goods and hired laborers in the hope that there would be greater demand for their output. Why did they make the same mistake at the same time? There had to be some common factor that led them to make the same kinds of errors at the same time. Mises identified this common factor: the banking system. Specifically, it was the low interest rates produced by the fractional reserve banking system. The rates were lower than what market rates would otherwise have been. There was a distortion in the pricing system, meaning the interest rate, that normally allocates present consumption in relation to future consumption.
Mises’ theory is a theory of misallocated capital. The false signals provided by the low interest rates lure businessmen into a mistake. They believe that future consumer demand will be higher than it turns out to be. They also believe that interest rates will stay low during the period of capital formation. But rates begin to rise as a result of price inflation. Why? Because lenders want a higher rate of return in order to compensate them for the falling purchasing power of money. Rising rates force marginal businesses to end their projects. The prices of capital goods begin to fall. Businessmen sustain losses. In an attempt to reduce the extent of these losses, they begin firing workers. Unemployment rises. Inventories of capital equipment are sold at discount prices. The prices of consumer goods fall because of the sale of inventories. The economy goes into recession.
2. Competing Explanations and Policies
There are several competing explanations for what causes business cycles. There are also competing suggestions for what national governments and central banks can do to alleviate the effects of the contraction phase. Keynesians favor large government deficits and also the purchase of government debt by central banks by means of the expansion of the monetary base. The central banks must create money out of nothing, and then use the money to buy debt issued by the national government. In contrast, Austrian School economists believe that central banks should not expand the money supply because this will introduce another round of malinvestment. Governments should cut spending and reduce budget deficits. They should allow the market process to re-price capital goods and labor.
The Austrian theory had defenders during the Great Depression. F. A. Hayek, a disciple of Mises, wrote Monetary Theory and the Trade Cycle in 1932. It was published in 1933. Lionel Robbins, also a disciple of Mises, wrote The Great Depression in 1934. He followed Mises’ theory. A trio of economists wrote a book in 1937, Banking and the Business Cycle. They also followed Mises’ theory.
In between, John Maynard Keynes wrote The General Theory of Employment, Interest, and Money. It appeared in 1936. Keynes’ ideas became dominant within a decade. Keynes defended the policies of deficit spending and central bank money creation that all Western governments had adopted by the mid-1930s. His message, when interpreted by economists who could communicate more effectively than his book did, was what national political leaders wanted to hear: run large deficits. It was also what a generation of younger economists wanted to hear. Like the politicians, they had lost faith in the market process as a means of eliminating depression and launching a new phase of economic growth. They were convinced that the government had to intervene.
Economic booms and busts have accompanied the process of compound economic growth that began around 1800. The first American depression took place in 1819. Murray Rothbard wrote his doctoral dissertation about this depression. In 1837, another depression took place in the United States. In 1857, another depression hit. These depressions did not last long. The market process led to a re-pricing of capital resources. Economic growth began again.
There was a series of depressions in the West, beginning in 1873 and recurring in the early 1890s. This culminated in the American banking panic of 1907. The Federal Reserve System began operating in 1914. Yet this era, 1879–1913, was marked by the most rapid economic growth in American history.
Every Western nation has had booms and busts, but the worst was the depression of the 1930s. It was worldwide. Economic growth ceased in this decade. It was the only decade after 1800 in which economic growth ceased. These business cycles did not end compound per capita economic growth above 2% per year.
Critics of the free market have argued that the business cycle is endemic to capitalism. There is a fundamental failure in the capitalist system, they insist. Generally, these critics have argued that the major failure of the free market economy is that there is insufficient demand on the part of the broad masses of the population to sustain long-term economic growth. Some critics argue that capitalism suffers from overproduction. Others argue that it is a problem of underconsumption. All of the critics blame the distribution of wealth. The rich have too much money.
The Pareto distribution of wealth does not change much, decade to decade. This 20-80 distribution is a familiar pattern in the West. No economic reforms fundamentally change the distribution. Most of the investment in any society is provided by the 20% in the top income bracket. The higher up this distribution we look, the greater the percentage of invested capital. The rich cannot possibly consume all of their wealth. They are the source of capital accumulation that most economists believe is the source of rising per capita wealth. If they misallocated, there ought to be an explanation for this. Mises has provided such an explanation.
1. Optimism
The periods of recovery last longer than the periods of contraction. Governments continue to run deficits. This has been true ever since 1930. They run them in boom periods. They run even greater deficits in recessions. Far larger debts are the politicians’ promises made to retirees that they will receive financial support and low-cost medical care. These unfunded liabilities dwarf the official deficits of the various nations in the West. There is a statistically looming crisis for Western governments. They cannot possibly deliver on the political promises made by two generations of national politicians. The money will not be available to governments to meet these promises. There is no agreed-on solution to this problem. Politicians will not admit publicly that there is a discrepancy between the promises made and the level of taxation necessary to fulfill these promises. We might call this the political misallocation of promises.
Voters have become confident that long-term economic growth is now inevitable. Technological progress continues to accelerate. This is especially true in the realm of digital innovation. There is a widespread belief that the power of men’s hands and minds has made the world rich. For the first time in history, it looks as though it will be possible to eliminate starvation-level poverty within a generation. This intense optimism about the economic future of mankind is becoming widespread. Men believe that there can be temporary economic setbacks in the form of recessions, but they do not believe that these setbacks are permanent. This is a kind of secular economic postmillennialism. This outlook became common within the non-Christian intelligentsia in the West in the late eighteenth century. Today, there is economic evidence to support such an outlook.
2. A Looming Collision
For those who look at the unfunded liabilities of Western governments, and who also look at rising per capita economic growth around the world, there appears to be an inevitable collision between the fiscal reality of national governments and the economic reality of the market process. The market process continues to deliver the goods and services that people want to buy, and it does so at prices they are willing and able to pay. But, in the political realm, there is a disconnect. The statistical evidence of a monumental fiscal crisis is not widely known among the general public, and at the national level, politicians simply ignore what statisticians and a handful of forecasters insist is going to happen.
The last time that there was a disconnect of this magnitude was in the Great Depression. It was during this time that Keynes and Keynesians offered an alternative to the free market economic theory that had prevailed in the West ever since Adam Smith, with the main exception of Marxism. By late 1940s, Keynesianism began to replace all rival forms of free-market economic theory. One book was dominant in the college classroom: Paul Samuelson’s Economics. It was published in 1948, and it became the largest-selling college textbook in the second half of the twentieth century. I discuss this book in Chapter 41.
If there is another economic crisis comparable to the Great Depression, and if this coincides with the fiscal insolvency of national governments, and if central banks refuse to inflate in order to bailout central governments because of the bankers’ fear of hyperinflation, there will be a rethinking of Keynesian economics and the political system that has been built on the assumption of the validity of Keynesian economics. Keynesian economists will insist on greater fiscal deficits, but politicians will be facing the insolvency of national governments. The political battle over the resolution of the problem of the unfunded liabilities will be at the heart of Western politics until such time as it becomes politically feasible to default on these unfunded liabilities.
The optimism regarding compound economic growth and also government-funded retirement programs will be shaken. Millions of people will lose faith in the market process. Other millions will lose faith in the political process. It is not clear how this allocation of optimism and pessimism will take place.
Optimism is a crucial economic resource, although it is not for sale in organized markets. This optimism has been dominant in the West for over three centuries. The economy for the last two centuries seems to have validated this optimism. It has long been argued by scholars that times of political revolution are preceded by rising optimism among the political masses and also the intellectual elite. This is sometimes called the revolution of rising expectations. Then there is a setback. When these rising expectations are thwarted, intellectual and political revolutions sometimes take place. The West has been living in a period of rising economic and political expectations ever since the late eighteenth century. There have been revolutions along the way. The American Revolution, which began in 1775 and was not settled politically until 1788, was followed by the French Revolution, which prevailed from 1789 until 1794. Then came the Russian Revolution in 1917. Each of these revolutions had been preceded by the optimism of revolutionary intellectuals. The Chinese Communist revolution in 1949 was an extension of the Russian Revolution. Communism seemed to be the wave of the future. But this wave was in retreat by 1979 in China and by 1991 in the Soviet Union. No worldview has replaced the intellectual corpse of Marxian Communism, whose bodily representation is the encased corpse of Lenin in Red Square in Moscow.
The century of the gold coin standard, which began at the end of the Napoleonic wars in 1815 and ended at the beginning of the First World War in 1914, was an era of stable money, rising productivity, and either stable or falling consumer prices. Common men had a common currency. Sometimes, they made their transactions in silver coins. The Spanish coin known as the Spanish dollar (piece of eight) was dominant in the United States from the early colonial period until 1857. It was a stable currency. It had been stable ever since its introduction in 1497.
Today, there is no physical commodity that serves as the primary monetary base for any central bank. The interest rate in the bond market is a major factor retarding the expansion of unbacked digital money. In the past, long-term bond rates have been between 3% and 5%. These rates have reappeared in the free market after recessions. The extremely low rates of government bonds and corporate bonds during the Great Depression were temporary. Most economists believe that the low rates that have prevailed since 2008 are also temporary. While they may be another period of low rates for government bonds as a result of an international recession, when investors seek safety, economists do not believe that a period low interest rates or even negative interest rates will prevail. This raises a series of questions. What degree of the re-pricing of capital will be required in order to restore economic growth? Will the market process be allowed by politicians to re-price capital? How long will it take for the market process to reassert its authority over the pricing of capital? What kinds of economic theories will be offered to justify either the political pricing of capital or the market pricing of capital? Which theories will prevail?
For as long as there is fractional reserve banking, there will be boom-bust cycles. For as long as national and regional governments regulate entry into the market for banking, there will be fractional reserve banking. Government control over the entry into the market establishes a cartel for the banking system. Central banks will continue to protect the largest banks in the system. A free banking system would place authority into the hands of solvent banks that would demand payment by suspected insolvent banks. This was the system that Mises recommended. “Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular—one is tempted to say normal—feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions” (Human Action, XVII:12).
Murray Rothbard recommended 100% reserve banking, but since he was an anarchist, he did not believe that there should be a civil government to enforce such a requirement. He never explained how 100% reserve banking could be established and enforced apart from a civil government. Thus, operationally, he also believed in free banking. The problem with civil governments in an era of fractional reserve banking is simple: politicians do not understand monetary theory, and they leave it to the banking cartel, which the government has created, to make the decisions regarding reserve requirements. A national government should not have the authority to establish 100% reserve banking. This would be the authority to establish something less than 100% reserve banking. Reserves should be established by the market process. This was Mises’ position. It is consistent with the biblical law prohibiting multiple indebtedness: the same coat serving as collateral for many loans (Exodus 22:25–26). The enforcement of this law was voluntary. The lender could require the return of the collateral every morning, but this was not required by biblical law. This is the equivalent of free banking. [North, Exodus, ch. 49:J.]
The market itself should be the dominant force in the restoration of monetary policy. No central planning agency will be successful in designing a banking reform system that will overcome the problem of the boom-bust cycle. Instead, the world needs a retreat of civil government out of banking affairs, including regulation, other than enforcing contracts. The first step would be for national politicians to sever all connection between the nation’s central bank and the national government. It should be left to compete without government support. This was done in the United States with the First Bank of the United States (1791–1811), a privately owned bank, and the Second Bank of the United States (1816–1836), a privately owned bank. The government allowed each of the banks’ 20-year charters to lapse. Without government support, both banks soon went bankrupt. The United States did without a central bank from 1836 until 1914.
There is no explicitly biblical theory of the business cycle. There is no indication that the ancient world suffered from business cycles. We must therefore look to other aspects of Christian economics, specifically the question of dishonest money, in our quest to explain the business cycle.
Mises developed a comprehensive theory of the relationship between fractional reserve banking and the business cycle. His theory of what constitutes honest money is consistent with the Bible’s revelation of what constitutes honest money. Honest money for millennia was established by precious metals. But whether precious metals can ever again be placed at the foundation of the digital monetary systems of various nations remains an open question.
The industrial West has avoided hyperinflation ever since 1924. It did not do this on the basis of the gold coin standard. That standard had been abolished by national governments a decade earlier. The end of the gold coin standard in the United States came in March 1933. The end of the international gold exchange standard came on August 15, 1971. Ever since then, fiat money, which is primarily digital money, has ruled the world unchallenged. Fractional reserve banking, which is administered by central banks, has resulted in a series of recessions around the world. But economic growth has continued for most of this period. The recovery periods have lasted much longer than the contraction periods.
Rising per capita debt, especially government debt, has accompanied both the booms and the busts. If the unfunded liabilities to retirees are counted, then this growth in civil government that must be seen as irreversible until such time as the solvency of national governments is threatened by the rising payments to retirees.
Paul wrote that we see through a glass indirectly (I Corinthians 13:12). We cannot see much of the future. We do not know which ideas will become dominant. But we know this much: central banks in the West have resisted the temptation of hyperinflation ever since 1924. But they have not resisted the temptation to intervene in the national economies during times of recession. They have always inflated. They have always preserved the largest commercial banks from failure. They have done so by the expansion of fiat money.
With respect to the business cycle, the questions now are these. First, will central banks be able to continue their policy of preventing large banks from going bankrupt? Second, will there be bankruptcies of major banks that lead to years of economic recession? If central banks fail in their attempt to restore economic growth, there will be a great intellectual battle over the question of what went wrong. This battle will be accompanied by political battles over the correct policies to restore the economic growth rate of national economies. The answers will be clearer in half a century. They are not clear today.
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