The Central Bank, not Capitalism, the cause of booms and busts
(An Austrian Economic Analysis)
 
Featured Article: Mon, 29 December 2008 by Adam Murdock 


In order to understand how the central bank or Federal Reserve influences the economy we must first understand the business cycle. In order to understand the business cycle one must first distinguish between business cycles and ordinary fluctuations in business. In the natural cycle of business entrepreneurs forecast changes in market conditions of supply and demand. The more successful ones are more accurate with their predictions of future business conditions for their industry. Let us take the example of my father, Terry Murdock. He started a seat cover manufacturer in the 1970s. Fortunately, he correctly anticipated and capitalized on evolving demand for seat covers in the early 1970s and 1980s and therefore produced a product that fit that demand. Because of his accurate prediction he was able to build a successful business. Unfortunately, the demand for the type of seat cover that my father produces is dwindling as seats have increased in quality and therefore the need for protective seat covers is diminishing. Therefore, if I decided at this time to start a similar business, I would be be making an inaccurate prediction of the likely demand and would probably fail miserably. It is these kind of decisions that cause businesses to succeed and fail on a daily basis. It is easy to see that societal preferences continually change and therefore the best entrepreneurs see and adjust to these changes. However, some are better than others and some fail to adjust. An example of this is the failure of GM, Ford, and Chrysler to forecast a future decline in demand for SUVs. Naturally, it was easy for the pundits to deride the "Big Three" for this error but is important to remember that errors such as these are made all the time in business. If a company makes such a error it can still salvage the situation if it is nimble enough to quickly change its business model to fit the change in consumer demand. Unfortunately, the "Big Three" compounded the problem by not only not forecasting the decline of the SUV but also failing to adjust when demand for SUVs dropped. Instead, they went to the government to secure bailouts. From the above examples it is easy to see that changes, like the change in preference for SUVs or seat covers, are in constant flux in society. This is a natural part of the economy and helps determine the proportions of investment and consumption throughout the economy.

To use the example of my father's business again, does it follow that a decrease in the demand for seat covers and subsequent decline in the profitability of my father's seat cover business will lead to a global business depression? The answer is no. The reason is that a decline in seat covers sales is matched by a corresponding rise in the production of more durable seats that don't need seat covers. These two influences act to balance out the economy. In the example of the "Big Three," a change in demand for SUVs was met by an increase in demand for other types of vehicles. (ie. hybrids, compact cars) Therefore, there is nothing in the above examples to account for a general business decline.

Now what about general booms and busts? Many like to blame the current crisis on a housing bust. However, from the previous analogy the decline in demand for housing would be met by a increase in demand for other goods. Therefore, the current crisis cannot be explained by failure in this sector alone. A depression requires the simultaneous error of many parts of the economy.

As the economist Murray Rothbard puts it:

The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors? Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting.

According to Austrian theorists, in a pure free market the prospect of booms and busts is very remote. This is because the likelihood of millions of entrepreneurs making the same errors in forecasting at the same time is very small. Then what causes their errors in forecasting to coincide simultaneously? The answer is simple. The source of the problem is central planning. The business cycle is caused by the very institutions that are in place to supposedly stabilize the market, namely, the federal government and the federal reserve.

In order to understand how this works it is necessary to understand the natural loan interest rate. In the natural condition as the tendency for savings and investment increases the loan interest rate declines as the demand for loans decreases. As people desire to spend and consume and there is no or little savings the interest rate climbs to accommodate increased demand for borrowing. This is similar to the supply and demand of any good. For example, as the demand for "beanie-babies" goes down the manufacturer tries to lure customers with lower prices or in the case of interest rate a lower interest rate. The reverse is also true. A balance between the two forces determines the natural rate or price.

Let us examine what happens when the central bank or Federal Reserve decides to inject "liquidity" or print money out of thin air and put them in the banks. As the banks are flooded with cash this tends to lower the loan interest rate just like if there was a vast excess of "beanie-babies" that exceeded demand. The manufacturer would lower the price or the bank, the interest rate, in order to offload the beanie-babies or extra cash in the case of the bank.

What is the effect on business of all this low-interest cash from the banks?

I see the effects as two-fold. First, because the money was so easy to obtain it is more likely for businesses to be enticed into risky ventures because the risk is apparently lower. With a high interest on loans businesses are forced to act more securely because of the pressure of the payment and because collateral demands are typically higher. I like to compare this situation to the parent (ie. the central bank) leaving the kids at home with a bunch of candy (ie. easy money) and then coming home "surprised" that the house is in shambles (ie. risky failed ventures). Who is to blame, the parents or the children? In other words, with all this easy money entrepreneurs make a lot of risky and unsuccessful business decisions. This happens because consumer preferences don't change just because of the availability of low-interest rate loans to businesses. Therefore, because of the ease of getting business credit a lot of errors in forecasting are made simultaneously just like the children destroying the house with the easy availability of candy. Many ventures are started but are not met with corresponding consumer demand. The whole structure comes to an end when the money that filters down through wages, rents etc. is spent on the old consumption-investment proportions. Many of these businesses will therefore find that there judgments have been made in error and the market will adjust back to the previous balance. The end result of this is the liquidation of the misinvestment.

In summary, the "boom" is marked by malinvestment because of interference of the central bank. The "bust" comes when consumers re-establish the previous paradigm and liquidate the errors of the inflationary economy. Most importantly, the "depression" is a necessary recovery process which means the process is coming back to reality. This is actually a good thing for the economy. Further delay of the depression only makes the bust worse as we are seeing now with the current crisis. It only means that the level of error is increased and therefore level of readjustment is greater later on.

One may ask why does the readjustment take so long? Why doesn't it happen immediately? The reason is that when  banks fear the loss of the loan they are often prone to injecting more and more bad loans to bad businesses in the hope of recovering their original investment. This action prolongs the correction until the situation becomes so bad the banks are no longer able to continue the cycle. When this happens over a long period of time it leads to major depressions. It is important to remember that it was the credit expansion that produced the problem in the first place.

As Murray Rothbard puts it:

Thus, bank credit expansion sets into motion the business cycle in all its phases: the inflationary boom, marked by expansion of the money supply and by malinvestment; the crisis, which arrives when credit expansion ceases and malinvestments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires.

What does the correction look like and what are its necessary features? As we have discussed, wasteful projects must be liquidated sooner rather than later. In addition, interest rates must be allowed to increase or in other words the easy money that led to the massive errors and inflation must stop. Obviously, this involves a massive shift in production with bankruptcies and unemployment. However, the quicker the adjustment is allowed to happen the shorter this period. If continued inflation happens or if wages are propped up high rates of unemployment will continue over a much longer period.

Finally, it may be argued that the depression began only when banks stopped loaning money. Why can't the banks just continue loaning out money at low interest rates in order to keep the economy going and avoid the depression? Firstly, as I have shown above the longer the "boom" is encouraged by easy money, the bigger will the correction have to be. Second, there are many historic examples of governments that have tried indefinite credit expansion. One prominent example is that of the Weimar Republic. A policy of credit expansion by the Weimar Republic during the inter-war years led to hyperinflation. This happens because as permanent credit expansion is employed by the government, the public seeks safety in assets rather than money in order to hedge against inflation. The result is hyperinflation. Hyperinflation destroys the value of the currency and therefore destroys the savings of retirees and ruins the lives of "fixed-income" groups.

In conclusion, I must stress that to properly understand why we are in our current predicament we must first understand the problem from a proper economic perspective. I hope that the above analysis has helped. For a more in depth discussion or to read more about Austrian economics please visit the literature section above and in particular the works of Ludwig Von Mises and Murray Rothbard.