The US just lost its AAA credit rating, stocks are plummeting, the European states are drowning in debt and the economy is in the toilet...
Many people around the world find themselves wondering why the economic downturn we are enduring keeps persisting so relentlessly and are at a loss for an explanation. Thinking that you, dear reader, might be one of them, I have set before me the all but impossible task of shedding some light on this issue. It's not something you can learn in 2 minutes, but fear not, it doesn't require a lifetime either. On the contrary, everything is very logical and you don't have to be a trained economist to grasp it. In fact, it might even help you, since your mind has most probably not been clouded with all the political economy nonsense that is floating around these days.
I also want to throw in a word about economic literacy and why it is important. It is vitally important because you are inevitably going to make decisions in your life that reflect what you think about the economy. If you think that recovery is around the corner, you are invariably going to make different decisions than if you think the retardation is going to persist. If you know the weather, you might spare yourself getting caught wet and cold. If you know economics, you might be able to spare yourself being caught penniless in the coming economic hail. You will be able to translate the near incomprehensible lingo of Keynesian economists, such as »we must increase aggregate demand to stimulate economic output« into what they are really saying, which is »we must print money so that our friends in the government and banking sector might increase their income at the expense of everyone else.«
Back to the subject at hand. Our current recession is a part of what economists call a business cycle, whereby the economy goes through cyclical, recurring changes in the amount of goods and services the economy produces. It keeps switching between expansion or economic boom and contraction, also known as the bust, recession etc. This is why it is also called the boom and bust cycle, or the trade cycle. Its history starts roughly in the mid 18th century and this peculiar phenomenon has boggled the minds of countless economists ever since. There were economic depressions before that but not this cyclical and lacking an apparent cause. Numerous theories have been developed as to the root of this menace, but only one of them has been able to both predict and explain the cycle to the full extent. Ever since Ludwig von Mises and Friedrich A. von Hayek have developed the »Austrian« theory of the business cycle in the 1920s and 1930s, the cause of the cycle is no longer a mystery (when I say Austrian, it doesn't have much to do with Austria; it is called Austrian because it is based on a school of thought whose founders mainly came from Austria).
A correct and full explanation of the trade cycle must answer two vital questions. Firstly, why do many or most entrepreneurs suddenly find themselves producing losses all at the same time. Entrepreneurs tend to be great forecasters. If they are not, the market weeds them out and they go out of business fairly quickly. So why do all these entrepreneurs, trained to forecast future demand, make all these losses all at the same time? Secondly, why are capital goods industries hit much harder than consumer goods industries. Why is, for instance, construction and manufacturing hit much harder than retail. In every recession, case after case, you have these two phenomenon and the Austrian theory of the business cycle is the only one that answers both of these questions and many more.
So let me then try and put forth the Austrian theory of the business cycle in a nutshell as best I can. This theory holds that interest rates, much like any other price in the economy, actually have a meaning and that they should be determined by the market, not by a central planning institution, such as the central bank. Central planning of prices has been tried many, many times in the history of human kind and every time it is implemented, it wreaks havoc to the economy. It so happens that prices convey information about relative scarcity (how much of something there is available) and when they are artificially set, they put a blindfold on people’s eyes so that they can no longer make informed decisions. Interest rates then play the function of allocating credit to the most eligible borrowers that are most credit worthy and will use the borrowed funds most productively.
First, let us examine the process of saving and lending in a free market where a central bank does not exist. In this case interest rates in general will be determined by the supply and demand for loanable resources (saved money). While the demand for them will be set by different variables, such as technological advances and tendencies to take risk, the supply of loanable funds (credit) will always be determined by people's time preferences – how much of their income they wish to consume and how much of it they wish to save and invest for future consumption. Thus, when people's time preferences fall, the level of savings in the economy increases and this lowers the interest rate. This provides a powerful incentive for entrepreneurs and businesses to borrow. Since there are now more resources available to invest at a lower cost, businesses engage in new projects and new investments. Also, since long term projects are more interest rate sensitive (if you are borrowing for 30 years, the interest payments represent a much higher cost than if you are borrowing for 3 years), it follows that businesses will also engage in more long term investments that are higher in the stages of production, i.e. investments that are further removed from consumer products (investments into buildings and machinery as opposed to investment into computers). The increased pool of saved resources by the public will provide the supply of physical resources to see all these new projects through to completion, which is why they can be carried out profitably. Upon the completion of these projects, the invested businesses can now repay the loans to their borrowers (this being the public who initially saved) in the form of consumer products that they can now produce with a higher rate of productivity because of the new capital they have invested in (more and better equipment and machinery etc.). This is the way economies grow and have grown since the day man invented his first tools that we now call capital and there is no way around it. Only sufficient saved funds will provide the resources for investment and an unhampered free market will be needed to guide these resources to their most efficient uses. This is the process by which we have been able to come to enjoy the standards of living that we do today.
By contrast, when the central bank intervenes in the market interest rate, usually by lowering it, this gives businesses the false illusion that there are now more loanable funds available for borrowing and investing. The effects are the same, the interest rate drops, even though no one is saving more. The money supply increases but the pool of real resources (the real material stuff out there) needed to fund these investments stays the same. Just because a central banker decides to lower the interest rate, this doesn't release any new resources into the economy. As we have seen, the supply of saved funds is determined by people's time preferences (apportioning income between consumption and saving) and an artificial lowering of the interest rate does not cause people to spend less and save more. If anything, people will spend even more since saving has now been rendered less rewarding by a lowering of the interest rate. The economy is now being stretched apart in an unsustainable way and is »overheating«. Businesses have received new loans due to an increase in the money supply and now an increased number of enterprises is competing for the unchanged pool of physical resources, an unchanged pool of the factors of production, investing them in all the wrong places (eg. tech companies in the 1990s, housing in the 2000s) and most importantly, bidding up their prices. Since entrepreneurs were not calculating with these price increases, they now need new borrowed funds, new credit, to carry out their projects to completion. This causes a surge in the demand for credit, which in turn causes the interest rate to rise again. All those projects that seemed profitable and were started just because of the artificial lowering of the interest rate will now reveal their true nature and show to be unprofitable again because the public has not saved enough to fund them and the return to the market interest rate indicates precisely that. The projects will either not be completed or there will not be enough consumer demand (spending) to make them profitable. What needs to happen then is for these malinvestments, as they are called, to get liquidated. Some investments can be restructured and be put to new use, while others will have to be abandoned altogether. The investments were being made by an artificial boom in credit and were not allocated according to consumer demands.
Knowing this, what then is the best way to “treat” the recession? The shortest way out of it is for the government to step out of the way and let the market work. At a higher rate of interest, the public will automatically increase their savings to provide funding for profitable investments and a reallocation of invested resources to their proper productive use. In other words, the recession is not to be fought, but rather let to run its course and correct the mistakes of the boom since it is the only way back to prosperity. The worst thing a central bank can do is to lower the interest rate yet again, since that will only cause a new wave of malinvestments that will need to be liquidated later on in a longer and more painful period of restructuring, once the credit expansion cycle is over. If the central bank keeps lowering its rates and increasing its money supply in perpetuity, it will eventually and inevitably lead to hyperinflation. If it raises its rates, a recession will ensue but there is no third way. And the sooner the recession, the better, since there will be less malinvestments to liquidate. As Ludwig von Mises puts it in his opus magnum Human Action, »[t]he wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.« Get rid of the central bank and the problem disappears.
Read Austrian economics and learn more about this stuff, I could not encourage you more, for as Murray Rothbard and Mises put it, economics is far too important to leave it to the economists. If you are interested in this subject, here are some helpful links:
Introductory:
Intermediate:
Advanced:
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