"Every serious discussion of the problem of credit expansion must start from the distinction between two classes of credit: commodity credit and circulation credit. Commodity credit is the transfer of savings from the hands of the original saver into those of the entrepreneurs who plan to use these funds in production. The original saver has saved money by not consuming what he could have consumed by spending it for consumption. He transfers purchasing power to the debtor and thus enables the latter to buy these nonconsumed commodities for use in further production. Thus, the amount of commodity credit is strictly limited by the amount of saving, i.e. abstention from consumption. Additional credit can only be granted to the extent that additional savings have been accumulated. The whole process does not affect the purchasing power of the monetary unit.
"Circulation credit is granted out of funds especially created for this purpose by the banks. It increases the amount of money substitutes, of things which are taken and spent by the public in the same way in which they deal with money proper. It increases the buying power of the debtors. The debtors enter the market of factors of production with an additional demand, which would not have existed except for the creation of such banknotes and deposits. It is the main tool of policies aiming at cheap or easy money."
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"Every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic equilibrium. This disturbance, brought about by attempts to depress the interest rate artificially, is precisely the cause of the crisis. The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital [i.e. savings made available for productive investment], but by banking policy."
"The calculation of entrepreneurs is misguided by the issue of additional fiduciary media. The greater this quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable [as soon as] the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.
"It may well be asked whether the damage inflicted by misguiding entrepreneurial activity by artificially lowering the loan rate would be greater if the crisis were permitted to run its course. Certainly many saved by the intervention would be sacrificed in the panic, but if such enterprises were permitted to fail, others would prosper. Still, the total loss brought about by the "boom" (which the crisis did not produce, but only made evident) is largely due to the fact that factors of production were expended for fixed investments which, in the light of economic conditions, were not the most urgent. If banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit?
"The discrepancy between what the entrepreneurs do and what the unhampered market would have prescribed becomes evident in the crisis. The fact that each crisis, with its unpleasant consequences, is followed once more by a new "boom," which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups - political economists, politicians, statesmen, the press and the business world - not only sanctions, but also demands, the expansion of circulation credit."
Ludwig von Mises, Monetary Stabilization and Cyclical Policy (1928)
Historical note - The Great Depression began the following year.
"If the market rate of interest is reduced by credit expansion, many projects which were previously deemed unprofitable get the appearance of profitability. The entrepreneur who embarks upon their execution must, however, very soon discover that his calculations were based on erroneous assumptions. However, as the banks do not stop expanding credit and providing business with 'easy money,' the entrepreneurs see no cause to worry. Everybody feels happy and is convinced that now finally mankind has overcome the gloomy state of scarcity and reached everlasting prosperity.
"In fact, all this amazing wealth is fragile, a castle built on the sands of illusion. The artificial prosperity cannot last because the lowering of the rate of interest, purely technical as it was and not corresponding to the real state of the market data, has misled entrepreneurial calculations. Deluded by false reckoning, businessmen have expanded their activities beyond the limits drawn by the state of society's wealth. In short, they have squandered scarce capital by malinvestment.
"The sooner one stops, the less grievous are the damages inflicted and the losses suffered. Public opinion is utterly wrong in its appraisal of the [business] cycle. The artificial boom is not prosperity, but the deceptive appearance of good business. Its illusions lead people astray and cause malinvestment and the consumption of unreal apparent gains which amount to virtual consumption of capital. The depression is the necessary process of readjusting the structure of business activities to the real state of the market data, i.e., the supply of capital goods and the valuations of the public. The depression is the first step on the return to normal conditions, the beginning of recovery and the foundation of real prosperity based on the solid production of goods and not on the sands of credit expansion.
"It is vain to object that the public favors the policy of cheap money. The masses are misled by the assertions of pseudo-experts that cheap money can make them prosperous at no expense whatever. They do not realize that investment can be expanded only to the extent that more capital is accumulated by savings. What counts in reality is not fairy tales, but people's conduct. If men are not prepared to save more by cutting down their current consumption, the means for a substantial expansion of investment are lacking. These means cannot be provided by printing banknotes or by loans on the bank books.
"If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing, and by letting the market determine the height of interest rates, one chooses the German way of 1923."
Ludwig von Mises, The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money (1946).
Historical note - Von Mises recognized that inflation is not simply a monetary issue but a fiscal one. While conditions in 1946 did not reflect the credit strains that presently keep monetary velocity in check, fiscal conditions were similar, with war-related deficits peaking at just over 10% of GDP. It is often forgotten that in the U.S., the CPI, which had averaged only about 2% inflation prior to 1946, shot to an inflation rate of over 20% by 1948. The S&P 500 plunged, and despite a dividend yield exceeding 4%, it would not durably exceed its 1946 peak until 1950