Reading the responses to Tuesday’s news that the British economy shrunk by 0.5% in the fourth quarter of 2010 will have left many confused.
On the one hand the Keynesians made the preposterous claim that government spending cuts which haven’t happened yet are ‘taking money out of the economy’. ‘Free market’ economists rapidly responded to the contrary, blaming the weather and dodgy stats. There is, they assured us, no danger of double dip.
As well as demonstrating the truth in Harry Truman’s old joke about the one armed economist, the confusion of mainstream economics in the face of the recession demonstrates their failure to address the fundamental question: what, actually, is a recession?
Austrian theory holds that the recession is the inevitable contraction in credit which follows its previous unsustainable expansion. Interest rates are cut by central banks, perhaps as response to something like the dot com boom in 2000 in the US or simply because, as in the UK, the government has diddled the inflation figures. Whatever the reason, as interest rates fell ever more marginal investment projects began to look viable and entrepreneurs borrowed to finance them. Individuals too can get involved, as they did over the last cycle with property.
But eventually, even in a world with dodgy inflation figures and, thanks to the vast productive capacity of countries such as China, prices which should be falling, the inflation caused by this credit expansion starts to show even in the central bank’s figures. Interest rates are raised, and those marginal investments that looked viable a short while ago are now underwater.
This is the recession. Over the previous boom period, capital has been allocated to investments, more properly called malinvestments, which have no hope of ever producing a return above their borrowing costs unless interest rates are kept low and credit is kept flowing. The recession is the liquidation of these unviable credit positions and it will not be over until this process is complete.
The response of policymakers to the current downturn has generally, however, been to try and inflate an air mattress of new credit under the nose-diving economy. If borrowing costs can be kept cheap, they reason, the malinvestments of the boom can be sustained, sparing the undoubted human cost that would accompany their liquidation. But, as we’ve seen, continued credit expansion leads to the inflation we are also seeing now. Continued attempts by central bankers to prevent a short, sharp, corrective recession will simply lead to a prolonged depression as demonstrated in Japan most recently.
The alternative is to let the recession run its course. Metaphors about hangovers often obscure just how painful this would be for many people but the historic record of these ‘free market’ recessions, most notably in the United States after both world wars, shows that they can purge the economy of malinvestments and set the stage for sustainable growth quite quickly.
The full corrective gale has yet to blow through the British economy and the frenzied efforts of the Bank of England’s printing presses to avoid it have only delayed it. But with inflation starting to roar they appear unable to postpone this second dip for much longer. The British economy may well be heading for double dip, but don’t blame the government.
John Phelan’s article sets out the classic Austrian position, namely that artificially low interest rates lead to malinvestments, which ultimately turn out to be unviable, which leads to slumps / credit crunches, etc.
Obviously an artificially low interest rate leads to a misallocation of resources (“malinvestments” in particular). But I see no reason why a recession necessarily follows, and for the following reasons.
Fiddling with interest rates (which I don’t approve of) is just one way of regulating aggregate demand (AD). Or at least it is ALLEGEDLY a way of regulating AD – (I actually doubt it is very effective in this regard, but I won’t go into that here). So let’s assume that fiddling with interest rates is indeed an effective way of regulating AD.
Assuming a central bank is GOOD at regulating AD by fiddling with interest rates, there is no reason to expect a recession. That is, you’ll get more investment than makes sense, but the central bank will succeed in keeping employment at the maximum level that is consistent with acceptable inflation.
Likewise (and again, assuming the government / central bank machine is good at its job), if it uses some OTHER tool to regulate AD, like fiscal policy, you’d get a similar result: employment being kept at a level that is consistent with acceptable inflation (though in this case, there’d be no excessive investment).
ON THE OTHER HAND, if the government / central bank machine is NOT good at its job, then regardless of whether “interest rate fiddling” or fiscal policy is used, you’d get booms and slumps.
In short, I suggest the “boom / recession” problem is not a problem specific to fiddling with interest rates. Indeed, the boom / recession problem, as most Cobden Centre supporters agree, is partially attributable to something else as well: the instability that is inherent in fractional reserve.
@Ralph Musgrave
Absolutely. The low interest rates merely accelerate the onset of the bust and make it greater in magnitude.
There is however another element which I rarely see discussed in any detail. It is true that fractional reserve banking is inflationary since there is no way to limit the money supply (contrary to the Keynsian notion that it can be restrained by raising interest rates). But in today’s monetary system, no money can exist at all until it is borrowed (all money is fiduciary media). This is important, and independent of the usual issues discussed. We could have a gold standard and still have debt-money (from the central bank). We could abolish fractional reserve banking and still have debt-money (from the central bank).
The implications of debt-money are staggering. Since every penny in circulation is borrowed, interest is accruing on the total money supply daily. The sum of interest due at any point in time plus principal is greater than the all the money that exists. Interest payments suck money out of circulation which can only be replaced by more borrowing. The ratio of interest/principal in the money supply increases exponentially until the debt market becomes saturated.
To illustrate the point, I would compare the monetary system to a revolving credit card. Imagine you open a bank account (national economy) and decide to maintain the balance at £100 (the money supply). To do this you use your Visa card to put £100 in the account. Each month a payment is taken out of the account to pay the minimum Visa payment plus interest (principal and interest payments made back to the banking system). Immediately you use the Visa card (banking system) to top up the bank account (money supply) to £100. Each month a larger payment will be made to Visa. And each month a larger top-up will be made to the account. At some point the outstanding interest on the Visa card (aggregate interest due on the money supply) will represent a big chunk of the £100 (total money supply). When the amount of interest due on the Visa card reaches a certain point, there is no mathematical solution other than for you to default (not enough money in the £100 bank account to pay the bill).
The money supply behaves the same way. When the aggregate interest due reaches the tipping point, someone somewhere must default on their debt. It may not be you or me, but default must happen in order to bring the interest/principal ratio back to a sustainable level. We don’t know what the tipping point is. In fact I do not know of any statistic that tracks total outstanding interest as a percentage of the money supply (the way government debt maintenance costs are tracked). I’d be interested in knowing if this exists or if anyone even attempts to estimate it.
But, the tipping point always marks the beginning of a recession. When viewed this way, it becomes clear how ludicrous it is to increase the money supply with new debt thereby increasing interest/principal when this path is unsustainable and it is precisely the opposite that must take place.
Of course we could call into question the debt-money system altogether, but that is a topic for another time…