Wicksell's Theory of Unnatural Interest Rates with Cyclical Inflations and Deflations Should Be Regarded As the Most Decisive Progress in the Field of Economics

The over-investment theories being entirely unsatisfactory, the Swedish economist, K. Wicksell, developed a theory according to which cyclical inflations and deflations are due to, or at least made possible by, fluctuations in credit supply. For Wicksell and his followers the credit policy of the banks and Central Banks is primarily responsible for the business cycle. Their theory runs roughly as follows. If demand for credits picks up for one reason or another, the interest rates on the free markets--which appear as the natural rates to Wicksell--have a tendency to move up. If the Central Banks, and with their support also the commercial banks, fail to adjust their interest rates and keep them unnaturally low, the increased demand for credit will partly be satisfied by the banks' inflationary credit expansion. Later on, but too late, the Central Banks and consequently also the commercial banks raise their interest rates--either because they are losing gold or foreign exchange, or for other reasons. Now demand for new credits is discouraged, and at the same time the credits granted earlier appear less profitable and are repaid. Deflation ensues. In other words: delay in adjustment of the bank rate to the increased credit demand opens the death trap for money with the result that the volume of money grows; the subsequent belated adjustment forces the money back into the death trap so that the volume of money shrinks.

The Wicksellian argument is basically correct. His theory should be regarded as the most decisive progress in the field of economics. Much of what has been taught later appears retrogressive in comparison.

--L. Albert Hahn, Common Sense Economics (New York: Abelard-Schumann, 1956), 162-163.