Normally we see some businesses succeeding and others failing. Some growing, some shrinking, and some staying about the same. We see laborers leave one firm and move to another. We see whole industries rise while others decline. This is what a free market economy looks like as resources find their way to the most productive use. It is unusual for layoffs and business failures to occur in clusters and when it does happen we look for an explanation of this “business slowdown” or “business cycle”. Theories of the business cycle are legion and they come into fashion and go out of fashion as facts defeat the theory. But one explanation has stood the test of time. It was first advanced in Ludwig von Mises’s masterwork, The Theory of Money and Credit. Elaborations on Mises work has culminated in the Austrian theory of the trade cycle.
The idea is that there is a profound effect caused by interest rates on investment decisions. In a laissez-faire free market, interest rates are determined by the supply of credit (a mirror of the savings rate) and the willingness to takes risks in the market (a mirror of the return on capital). The central bank will throw this market regulating mechanism out of whack by manipulation of the interest rates and the increase in the money supply.
When the Fed creates money and feeds artificial credit into the economy by lowering interest rates it does spur investments but often these investments are those that would not have been attractive under normal market conditions. They are unwise and only look good due to central bank manipulations. Sooner or later the central bank will be forced to apply the brakes to the flood of new money and credit and the boom created will crash into a panic (also called recession or depression).
The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. An increase in saving by individuals and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocational effects on the economy’s capital structure are similar. But the ultimate consequences of the two processes stand in stark contrast: Saving gets us genuine growth; credit expansion gets us boom and bust. ~ Roger W. Garrison
This theory is strongly supported by data from example after example. Consider the dot.com bubble:
The dot come runup coincided with a money supply runup, beginning in 1995. The money supply (the Fed’s MZM) slightly flattened in 1996 and the begin zooming again in 1997, peaking at a 15% increase in January of 1999. The rate of increase began to fall precipitously thereafter, triggering a much needed sell-off. The money supply as measured by MZM began at $3.2 trillion in 1997 and sits at $4.7 trillion today. Clearly, the judgments of investors and entrepreneurs were being distorted by massive injections of money and credit. (Lew Rockwell)
With our present economic woes in 2012, conventional wisdom says that the US Fed should continue to flood the economy with money and credit even though it was precisely this path that created the problems to begin with. The Fed has been unable to correct the economic woes of the country by its dramatic interventions as there is no lasting good effect on the markets of the Fed’s “pumping”. There are ways to help make recessions easier to endure like cutting taxes or getting rid of regulations that hinder investment. The purpose of these efforts is to unshackle entrepreneurship and permit the market to function freely. But the bad investments of the boom years will have to be liquidated and that is painful. Painful but necessary.
This theory of the business cycle that von Mises, Friedrich Hayek and the Austrian School of Economics has given to the world shows us that the government is the biggest impediment to a thriving economy and should never be looked to for economic help. The government is the enemy of prosperity as well as the enemy of liberty. Government interventions into the market keep the masses from being prosperous and well off. The Fed, regulations, incentives, corporate welfare and other government interference is the root of our problems with the economy. We must find a way to get the government out of things they can not handle. (which is everything of course)