We accept as a fact of economic life that plush times inevitably give way to lean times. Just as the moon waxes and wanes, the economy goes through booms and busts.
Median homes price increased by 150 percent from August 1998 to August 2006. Over the next two years, home prices fell by 23 percent. Foreclosures skyrocketed.
The stock market has followed a similar course. When the New York Stock Exchange closed on Oct. 9, 2007, the Dow was 14,164.53, the highest close ever. Thirteen months later, it closed at 7,552.29, a drop of 46.7 percent. Retirement portfolios have been eviscerated. Unemployment has increased. When the figures are compiled the way governments calculated them in the 1970s, the unemployment rate in November 2008 was 16.7 percent.
These personal dimensions of busts are used to justify government intervention, whether creating a safety net or drawing up regulations aimed at smoothing out the cycle supposedly inherent in the free market. But is this inevitable? Is the market economy really prone to sudden, inexplicable episodes of massive business error—or could something outside the market be causing it?
If politicians are honest in seeking a culprit, they will find that it’s not capitalism. It’s not greed. It’s not deregulation. It’s an institute created by government itself. No one is surprised when a business has to close. Entrepreneurs may have miscalculated costs of production, failed to anticipate patterns of consumer tastes, or underestimated resources necessary to comply with ever-changing government regulation. But when many businesses have to close at once, that should surprise us. The market gradually weeds out those who do a poor job as stewards of capital and forecasters of demand. So why should businessmen, even those who have passed the market test year after year, suddenly all make the same kind of error?
Economist Lionel Robbins argued that this “cluster of errors” demanded an explanation: “Why should the leaders of business in the various industries producing producers’ goods make errors of judgment at the same time and in the same direction?” We call this pattern of apparent prosperity followed by general depression the business cycle, the trade cycle, or the boom-and-bust cycle. Does it have a cause, or is it, as Marx argued, an inherent feature of the market economy?
F.A. Hayek won the Nobel Prize in economics for a theory of the business cycle that holds great explanatory power—especially in light of the current financial crisis, which so many economists have been at a loss to explain. Hayek’s work, which builds on a theory developed by Ludwig von Mises, finds the root of the boom-bust cycle in the central bank—in our case the Federal Reserve System, the very institution that postures as the protector of the economy and the source of relief from business cycles.
Looking at the money supply makes sense when searching for the root of an economy wide problem, for money is the one thing present in all corners of the market, as Robbins pointed out in his 1934 book, The Great Depression. “Is it not probable,” he asked, “that disturbances affecting many lines of industry at once will be found to have monetary causes?”
In particular, the culprit turns out to be the central bank’s interference with interest rates. Interest rates are like a price. Lending capital is a good, and you pay a price to borrow it. When you put money in a savings account or buy a bond, you are the lender, and the interest rate you earn is the price you are paid for your money.
As with all goods, the supply and demand for lending capital determines the price. If more families are saving or more banks are lending, borrowers don’t have to pay as much to borrow, and interest rates go down. If there’s a rush to borrow or a dearth of lending capital, interest rates go up.
There are some results of this dynamic that contribute to a healthy economy. Start with the case where people are saving more, thus increasing the supply of lending capital and lowering interest rates. Business respond by engaging in projects aimed at increasing their productive capacity in the future—expanding facilities or acquiring new capital equipment.
Also consider the saver’s perspective. Saving indicates a lower desire to consume in the present. This is another incentive for businesses to invest in the future rather than produce and sell things now. On the other hand, if people possess an intense desire to consume right now, they will save less, making it less affordable for businesses to carry out long-term projects. But the big supply of consumer dollars makes it a good time to produce and sell.
Thus, the interest rate coordinates production across time. It ensures a compatible mix of market forces: if people want to consume now, businesses respond accordingly; if people want to consume in the future, businesses allocate recourses to satisfy that desire. The interest rate can perform this coordinating function only if it is allowed to move freely in response to changes in supply and demand. If the Fed manipulates the interest rate, we should not be surprised by discoordination on a massive scale.
But suppose the Fed lowers rates so that they no longer reflect the true state of consume demand and economic conditions. Artificially low interest rates mislead investors into thinking that now is a good time to invest in long-term projects. But the public has indicated no intention to postpone consumption and free up resources that firms can devote to these developments. On the contrary, the lower interest rates encourage them to save less and consume more. So even if some of these projects can be finished, with the public’s saving relatively low, the necessary purchasing power won’t be around later, when businesses hope to cash in on their investments.
And, as a company works toward completing its projects under these conditions, it will find that the resources it needs—labor, materials, replacement parts—are not available in sufficient quantities. The prices will therefore be higher, and firms will need to borrow to finance these unanticipated increases in input prices. This increased demand for borrowing will raise the interest rate. Reality now begins to set in: some of these projects cannot be completed.
Moreover, the kind of projects that are started differ from those that would have been started on the free market. Mises draws and analogy between an economy under the influence of artificially low interest rates and a homebuilder who believes he has more resources—more bricks, say—than he really does. He will build a house much different than the one he would have chosen if he had known his true supply of bricks. But he will not be able to complete this larger house, so the sooner he discovers his true brick supply the better, for then he can adjust his production plans before too many of his resources are squandered. If he only finds out in the final stages, he will have to destroy everything but the foundation, and will be poorer for his malinvestment.
In the short run, the result of the central bank’s lowering of interest rates is the apparent prosperity of the boom period, Stocks and real estate shoot up. New construction is everywhere, businesses are expanding, people are enjoying a high standard of living. But the economy is on a sugar high, and reality inevitably sets in. Some of these investments will prove unsustainable.
That is one of the reasons the Fed cannot simply pump more credit into the economy and keep the boom going. Yet the economist John Maynard Keynes—back in fashion even though his system collapsed in the early 1970s when it couldn’t account for stagflation—proposed exactly this: “The remedy for the boom is not a higher rate of interest, but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and keeping us permanently in a quasi-boom.”
Keynes was dealing in fantasy. The more the Fed inflates, the worse the reckoning will be. Every new wave of artificial credit deforms the capital structure further, making the inevitable bust more severe because so much more capital will have been squandered and so many more resources misallocated.
As it becomes clear that so much of the boom is unsustainable, pressure builds for liquidation of malinvestments. The misdirected capital, if salvageable, needs to be freed up. Should the Fed ignore this and simply carry on inflating the money supply, Mises warned, it runs the risk of hyperinflation, a severe, galloping inflation that destroys the currency unit.
Writing during the Great Depression, Hayek scolded those who thought they could inflate their way out of the disaster:
Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. …
To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection—a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end. … It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.
Although painful, the recession or depression phase of the cycle is not where the damage is done. The bust is the period in which the economy sloughs off the capital misallocation, re-establishes the structure of production along sustainable lines, and restores itself to health. The damage is done during the boom phase, the period of false prosperity. It is then that the artificial lowering of interest rates cause the misdirection of capital and the initiation of unsustainable investments. It is then that resources that would genuinely have satisfied customer demand are diverted into projects that make sense only in light of artificial conditions. For the mistaken bricklayer, the damage wasn’t done when he tore down the large house he couldn’t complete; the damage was done when he laid the bricks too broadly.
Investment adviser Peter Schiff draws an analogy between an artificial boom and a circus that comes to town for a few weeks. When the circus arrives, its performers and the crowds it attracts patronize local businesses. Now suppose a restaurant owner mistakenly concludes that this boom will endure and responds by building an addition. As soon as the circus leaves town, he finds he has tragically miscalculated.
Does it make sense to inflate this poor businessman’s way out of his predicament? Creating new money doesn’t create any new stuff, so lending him newly created money merely allows him to draw more of the economy’s resource pool to himself, at the expense of genuine businesses that cater to real consumer wishes. This restaurant is a bubble activity that can survive only under the phony conditions of the circus boom. It needs to come to an end so that the resources it employs can be reallocated to more sensible lines of production.
One more point is important to remember: all firms are affected by the artificial boom, not just those that embarked on new projects or came into existence thanks to artificially cheap credit. Mises observed, “in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher.”
Notice that the precipitating factor has nothing to do with the market economy. It is the government’s policy of pushing interest rates below the level at which the free market would have set them. The central bank is a government institution, established by government legislation, whose personnel are appointed by government, and which enjoys government-granted monopoly privileges. It bears repeating: the central bank’s interventions into the economy give rise to the business cycle, and the central bank is not a free-market institution.
But why can’t businessmen simply learn to distinguish between low interest rates that reflect an increase in genuine savings and low interest rates that reflect nothing more than Fed manipulation? Why do they not avoid expanding when the Fed ignites an artificial boom?
It is not so easy. Even businessmen who know the Fed is keeping interest rates artificially low may still find it in their interest to borrow and launch new products, hoping they can get out before the bust hits. If they do not react to the lower rates, their competitors surely will and might be able to gain market share at their expense. Someone will take the bait.
This does not, and is not intended to, account for the length of a depression. It is a theory of the artificial boom, which culminates in the bust. The bust period is longer the more government prevents the economy from reallocating labor and capital into a sustainable pattern of production. Government interference, in he form of wage or price controls, emergency lending, additional liquidity, or further monetary inflation—all aimed at diminishing short-term pain—exacerbate long-term agony. Malinvestments need to be discontinued and liquidated, not encouraged and subsidized, if the economy’s capital structure is to return to a sustainable condition.
There will always be those who, not understanding the situation, will call for more and greater monetary injections to try to keep the boom going, and their number has skyrocketed since the fall of 2008. In mid-December, the Fed set its federal-funds target at 0 to 0.5 percent, the Keynesian dream. Blinded by the same folly, Bank of England governor Mervyn King said he was ready to reduce rates to “whatever level is necessary,” including as low as zero—a move sure to perpetuate the misallocations of the boom and set the stage for a far worse crisis.
Keynesian “pump priming,” whereby governments fund public-works projects, often financed by deficits, are another destructive if inexplicably fashionable course of action, based on the modern superstition that the very act of spending is the path to economic health. Take from the economy as a whole and pour resources into particular sectors: that should make us rich! Economic historian Robert Higgs compared plans like these to taking water from the deep end of a pool, pouring it into the shallow end, and expecting the water level to rise.
Additional public-works spending not only deprives the private sector of resources by taxing people to support these projects, it diverts resources toward firms that may need to be liquidated and drives up interest rates if the projects are funded by government borrowing, thereby making bank credit tighter for private firms. These projects are the very opposite of what the fragile bust economy calls for. It needs to shift resources swiftly into the production of goods in line with consumer demand, with as little resource waste as possible. Government, on the other hand, has no way of knowing how much of something to produce, using what materials and what production methods. Private firms use a profit-and-loss test to gauge how well they are meeting consumer needs. If they make profits, the market has ratified their production decisions. If they post losses, they have squandered resources that could have been more effectively employed on behalf of consumer welfare elsewhere in the economy. Government has no such feedback mechanism since it acquires its resources not though voluntary means, but through seizure from the citizens, and no one can choose not to buy what it produces. These projects squander wealth at a time of falling living standards and a need for the greatest possible efficiency with existing resources.
Neither can the state seem to resist the temptation to extend emergency credit to failing businesses. If their positions were sound, credit would be forthcoming from the private sector. If not, then they should go out of business, freeing up resources to be used by more capable stewards. Diverting resources from those who have successfully met customer demands to those who have not serves only to weaken the economy and make recovery that much more difficult.
One argument has it that economic bubbles, sectors of the economy in which prices are artificially high, are caused by psychological factors that lead people to become irrationally committed to the production of particular kinds of goods. Such explanations may play a role in determining exactly which path the business cycle will take and which assets will be overvalued, but they cannot by themselves explain the bubble economy. Manias may steer overinvestment in one direction or another, but it’s the Federal Reserve pressing the accelerator.
Mises reminds us that a sudden drive for a particular kind of investment will raise the prices of complementary factors of production, as well as the interest rate itself. For a mania-driven boom to persist, there has to be an increasing supply of credit to fund it, since investments in that sector would grow steadily more costly over time. This could not occur in the absence of credit expansion.
The best way to avoid bursting economic bubbles and to clean up the wreckage caused by artificial booms is to not initiate artificial booms in the first place. This would mean abandoning our superstitions about the expertise of Fed officials and their ability to manage the monetary system. But it’s about time we listened to people who have a coherent theory to explain why these crises occur, saw this crisis coming, and have something to suggest other than juvenile fantasies about spending and inflating our way to prosperity. The choice is stark: we can follow the suggestions that prolonged the Great Depression or we can try a different approach that actually accounts for what is happening.
That would be change we can believe in.
Thomas E. Woods, Jr. is a senior fellow at the Ludwig von Mises Institute and the author of the New York Times bestseller The Politically Incorrect Guide to American History. This essay is adapted from his latest bestseller, Meltdown. Used with permission from Regnery Books.