November 20, 2018 Reading Time: 5 minutes

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Do central banks help alleviate or actually contribute to causing the business cycle? Since F.A. Hayek won the Nobel Prize for his “pioneering work in the theory of money and economic fluctuations,” more people have been recognizing the possibility that monetary policy may have real and deleterious effects. When expansionary monetary policy lowers interest rates, that lowers the cost of debt finance and that encourages overinvestment in long-term projects from factories to housing. But the low interest rates do not last forever, and people eventually see that the capital is to be financed with artificially created credit.

The 2000s housing boom and subsequent contraction may be a prime example. Increases in the money supply do not help the economy, but instead encourage overinvestment in long-term projects unsupported by market demand. This theory has increased in popularity in recent years to the point that even the president refers to the “artificially low” interest rates leading to a “false stock market.” A recent Broadway play, Revolution in the Elbow, has a character inventing an ill-fated “prosperity machine,” whereby the characters print money on demand only to later find the prosperity illusory.

Hayek is the most well-known economist to talk about how monetary policy can destabilize the economy.  His work, however, was part of a larger research program. An important early contributor to the monetary overinvestment theory of the business cycle was former M.I.T. Professor E.C. Harwood, who began writing about the business cycle in a series of articles starting in 1927 and published his Cause and Control of the Business Cycle in 1932. To put those dates in context, Hayek, writing in German, published his first essay on the topic in 1929 and his book in 1931. To Harwood, “Booms are made possible by the erroneous use, that is to say, abuse, of the money-credit machinery. Panics and depressions are the inevitable results of such abuse” (1932, p. 126). Using language similar to the now-popular term “malinvestment,” Harwood referred to maladjustments associated with the expansion of credit. A search on Google Books only lists three mentions of the term “malinvestment” from 1936 and before, so Harwood is one of the first scholars, or maybe even the first, to systematically use such terminology.

Harwood’s writings were prescient. In 1928, Harwood likens the American economy to a foot that had swollen, noting that “there is a fair probability that the ‘shoe’ itself will shrink materially” (1932, p.58). Two months before the October 1929 stock market crash, Harwood stated there had been “a tremendous expansion of bank credit since 1920” but “the prosperity of the past few years” may be nothing more than “another credit-splurging spree” (1932, p.62). And what fuels this credit? To Harwood we need to look at how the “the introduction of the Federal Reserve System, then, made it easy to carry inflation to degrees far beyond the maximum limits possible prior to 1914” (1932, p.121). Harwood here refers to inflation as increases of the money supply, a more common definition of inflation in years past, not just as increases in general price levels, the more common definition of inflation today.

Harwood recognized that “the Federal Reserve Board is subject to political control” and has an “unwillingness to do anything which might be interpreted as a blow at prosperity even when that prosperity is the result of an inflationary boom” (1932, p.122). After developing his theory, Harwood outlined how his theory was consistent with the historical facts.

Harwood’s writings were mostly descriptive statements about how the economy works. But Harwood also had prescriptive statements about what the government should, or actually should not, do. To Harwood, government was not the solution envisioned by scholars like John Maynard Keynes. He writes, “The American business man and his brother in finance are wont to view with something akin to horror any intrusion of government into what they feel is their private business. The people in general are also distrustful of governmental experiments, and rightly so” (1932, p.125). Harwood concludes, “The more intelligent use of the money-credit system would not involve additional interference by governmental agencies, but less” (1932, p.125). At the end of the day, Harwood supported a banking system based on redeemable gold, which he says “make[s] possible all the elaborate mechanisms of the present economic order.”

How do Harwood’s ideas compare to other contributors to the monetary overinvestment theory of the business cycle? Harwood’s ideas were pathbreaking, and after Ludwig von Mises’s student and Austrian economist Gottfried Haberler published his famous Prosperity and Depression: A Theoretical Analysis of Cyclical Movements in 1937, Harwood highlighted the many parallels (along with “a few significant differences”) (1961, p.16). Many similar ideas also show up in the work of Benjamin Anderson, with whom Harwood corresponded and talked about the overlap of their ideas. In later editions of Cause and Control of the Business Cycle, Harwood also cites Knut Wicksell and F.A. Hayek. In 1954, Harwood reviews Human Action, praising Mises’s discussion of inflation and business cycles, especially when Mises argues against other theories of the business cycle by relying on facts.

Although Harwood believed in developing theoretical insights and logic, he was not content with theorizing alone. He writes, “Modern inquirers do develop hypotheses and carefully check the internal logic as well  as the logical implications of such hypotheses,” but adds that we must look at the facts as well: “modern inquiry involves the mutual efforts of theoretician and laboratorian” (1970, pp.41-42). Cause and Control of the Business Cycle begins by outlining the theory, but then states, “Although the foregoing discussion is logically consistent, the explanation cannot be considered satisfactory unless it can be verified by observable facts.” Harwood presents an Index of Inflation based on investment type assets and savings type liabilities of the nation’s banks to measure excess purchasing media. (The first edition often refers to purchasing power and subsequent editions often have that term changed to purchasing media.) Harwood shows this ratio changing indicating increasing inflation in the late 1920s, and to him it helps explain the subsequent collapse.

Later economists have also described the Great Depression using an overinvestment theory including  Murray Rothbard’s America’s Great Depression, published in 1963. Exactly how much Harwood’s book influenced Rothbard is an open question, but Rothbard’s library has a copy of Harwood’s Cause and Control of the Business Cycle as well as works from Benjamin Anderson. Today, although Hayek and Mises are quoted and cited more, I think financial writer William L. Comer was right to state in 1982 that  “E.C. Harwood, Prof. Friedrich A. Von Hayek, and Prof. Ludwig Von Mises are probably three of the most prominent authorities on inflation.”

Harwood’s ideas about inflation and the business cycle have relevance for our knowledge and for policy discussions today. In a recent speech, former Fed Chair Ben Bernanke differentiates between two perspectives in economics: “Economic science concerns itself primarily with theoretical and empirical generalizations about the behavior of individuals, institutions, markets, and national economies.” “Economic engineering is about the design and analysis of frameworks for achieving specific economic objectives.” Where Bernanke believes in both economic science and economic engineering, Harwood would certainly reject the latter view, warning against “the series of panaceas or cure-alls produced by numerous well-meaning individuals” (1932, p.83).

Rothbard (1974 [2000]), p. 86) describes history as a race between state power and markets, and I think we can describe the history of ideas, including Harwood’s ideas, in a similar way. In the most famous horse race in history, the 1973 Belmont Stakes, Sham took the lead with Secretariat at the back of the pack. In the wake of the Great Depression, those advocating more government control of the economy, including John Maynard Keynes, had their ideas clearly at the forefront. And as recently as a dozen years ago, many economists were claiming that the Federal Reserve had permanently figured out how to control the business cycle. But as time goes on, those who claim that government can engineer specific outcomes are having their ideas increasingly discredited. I submit that Cause and Control of the Business Cycle presents a more realistic alternative. I will let readers track down the ending of the 1973 Belmont Stakes, but I submit that the ideas of Keynes are represented by Sham and the ideas of Harwood by Secretariat. We are going around the first turn and entering the long run.

I am extremely pleased that the American Institute for Economic Research can make this classic work, still extremely relevant to the debate over monetary policy, available to a new generation of readers.


E.C. Harwood


Edward C. Harwood (October 28, 1900 – December 16, 1980) was an economist who founded the American Institute for Economic Research (AIER) in 1933. Harwood graduated from the U.S. Military Academy in 1920. He went on to attend Rensselaer Polytechnic Institute (RPI) before being appointed an Assistant Professor of Military Science and Tactics at Massachusetts Institute of Technology (MIT). While at MIT, Harwood became interested in economics, particularly money-credit problems, and began an intensive study on the topic. With the encouragement of MIT Vice President Vannevar Bush, Harwood founded AIER in 1933 to provide independent research to the public on current economic conditions. His earliest publications include Cause and Control of the Business Cycle and What Will Devaluation Mean to You?

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Edward Peter Stringham

Edward Peter Stringham

Edward Peter Stringham is the Davis Professor of Economic Organizations and Innovation at Trinity College, and Editor of the Journal of Private Enterprise. Stringham served as the President of the American Institute for Economic Research. He is editor of two books and author of more than 70 journal articles, book chapters, and policy studies. His work has been discussed in 15 of the top 20 newspapers in the United States and on more than 100 broadcast stations including MTV. Stringham is a frequent guest on BBC World, Bloomberg Television, CNBC, and Fox. Rise Global ranks Stringham as one of the top 100 most influential economists in the world.

He earned his B.A. from College of the Holy Cross in 1997, his Ph.D. from George Mason University in 2002. His book, Private Governance: Creating Order in Economic and Social Life, is published by Oxford University Press.



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