Economic Cycles Before the Fed: An Austrian Perspective

The economic cycle, a phenomenon characterized by recurrent patterns of expansion and contraction, has been observed for centuries. The theory underlying these business cycles is known as the Austrian Business Cycle (ABCT) theory. While central banking is often seen as a key factor in creating these cycles, the Austrian economists emphasize that the root cause lies in the practices of fractional-reserve banking and the expansion of credit without reserve replenishment.

The Credit Cycle and Its Impact

The credit cycle, a critical component of the business cycle, is defined by the creation of credit beyond the actual reserves available. This phenomenon occurs through the practice of fractional-reserve banking, where banks lend out a portion of their deposits, effectively creating money out of thin air. This practice has existed for centuries, even in the absence of central banks. The credit cycle is characterized by a period of economic expansion followed by a recession or depression, a process that has been recognized for hundreds of years, though not fully formalized until the late 19th century.

The Case of Spain from the 1500s

A prime example of this phenomenon occurred in 16th-century Spain. Despite the absence of a central bank, fiat currency, or debasement of the currency, Spain experienced massive inflation spurred by the influx of gold and silver from the Americas and the Far East. This inflow of precious metals led to a dramatic increase in the money supply, causing economic booms followed by severe busts. The result was a series of economic crises and a prolonged period of decline, with Spain being considered a backwater for several centuries after the collapse of their empire.

Historical Context and Economic Practices

Theory of the business cycle in ABCT is based on the artificial expansion of the money supply and the manipulation of interest rates. Central banks like the Federal Reserve are seen as a modern institution that follows this practice. However, the expansion of the money supply has also occurred through other means, such as government actions and even historical monetary practices.

For instance, during the American Civil War, the U.S. government engaged in printing money in excess of the amount of specie (metal currency) available to fund the war. Similarly, the Roman Empire debased its currency by mixing gold and silver coins with metals of lesser value, thus increasing the money supply. These historical practices provide a wealth of evidence that the Austrian theory holds, even in the absence of modern central banking.

Central Banking and Its Role

While central banks play a significant role in modern times in creating and managing the money supply, the Austrian economists argue that their presence is not a prerequisite for the occurrence of credit cycles. Central banks institutionalize the practice of fractional-reserve banking by forming banking cartels and providing bailouts when banks expand credit too aggressively. However, the fundamental cause of business cycles remains the artificial expansion of credit and the resulting boom and bust cycles.

Conclusion

In conclusion, the Austrian Business Cycle Theory posits that the root cause of business cycles lies in the expansion of credit through fractional-reserve banking practices, not in the presence of central banks. Economic cycles existed long before the founding of the Federal Reserve and other modern central banking systems. Historical examples, such as 16th-century Spain, illustrate that the mechanisms of credit expansion and contraction can lead to significant economic swings even without modern central banking institutions.