The first economists to develop a cycle theory centering on
the money and banking system were the early nineteenth-century English classical economist David Ricardo and his followers, who developed the “monetary theory” of the business cycle. The Ricardian theory went somewhat as follows:
the fractional-reserve banks, spurred and controlled by the government and its central bank, expand credit. As credit is expanded and pyramided on top of paper money and gold, the money supply (in the form of bank deposits or, in that historical period, bank notes) expands. The expansion of the money supply raises prices and sets the inflationary boom into motion. As the boom continues, fueled by the pyramiding of bank notes and deposits on top of gold, domestic prices also increase. But this means that domestic prices will be higher, and still higher, than the prices of imported goods, so that imports will increase and exports to foreign lands will decline. A deficit in the balance of payments will emerge and widen,
and it will have to be paid for by gold flowing out of the inflating country and into the hard-money countries. But as gold flows out, the expanding money and banking pyramid will become increasingly top-heavy, and the banks will find
themselves in increasing danger of going bankrupt. Finally, the government and banks will have to stop their expansion,
and, to save themselves, the banks will have to contract their bank loans and checkbook money.
The sudden shift from bank credit expansion to contraction reverses the economic picture and bust quickly follows boom. The banks must pull in their horns, and businesses and economic activity suffer as the pressure mounts for debt
repayment and contraction. The fall in the supply of money, in turn, leads to a general fall in prices (“deflation”). The recession or depression phase has arrived. However, as the money supply and prices fall, goods again become more competitive with foreign products and the balance of payments reverses itself, with a surplus replacing the deficit. Gold flows into the country, and, as bank notes and deposits contract on top of an
expanding gold base, the condition of the banks becomes much sounder, and recovery gets under way.
