November 19, 2013

The Real Cause of Our Economic Depressions

By In Articles, Economics

When the Federal Reserve (created in 1913) prints lots of money, most people understand that higher prices result.  This is generally a known reality and it causes people to be frustrated because they know that their dollars are being made worth less.  And they should be frustrated.  This is effectually stealing from the wealth of the people.  It is a hidden tax.

However, what most people do not realize is that, not only does the expansion of cheap or fake money lead to higher prices, but it also leads to the most treacherous circumstance of all: the boom and bust cycle.  The Austrian (for a quick summary of who the “Austrians” are, see here) theory of the boom and bust cycle is known as the Austrian Business Cycle Theory (ABCT) and is the most unique and powerful explanation of all depressions, recessions, and economic downturns in the history of the economic thought.  The Austrian Business Cycle Theory is in many ways the largest contribution to economics that the Austrians have produced and it is by this cycle that the Great Depression, the “dot-com” bubble and bust (1990’s), as well as the housing bubble and bust (2003-2008) were predicted and explained.  It is also the theory by which some are predicting the crash of the dollar.

The ABCT is the major argument against the existence and action of any central bank in general, and the Federal Reserve System specifically.  The cycle theory was created by Ludwig von Mises in his book The Theory of Money and Credit and built upon by F.A. Hayek in his book Prices and Production.  For a more contemporary explanation, see Thomas E. Woods’ Meltdown. A rough summary of the Austrian Business Cycle goes as follows:

1. Interest rates in a free market are determined by the “time-preference” of investors and creditors, that is, the holders, owners, and savers of capital.  In other words, when these investors want to keep their money and consume it themselves at the present time, the rate of interest goes up.  If the investors want to invest and set aside their money for future gain, the rate of interest is naturally lowered.  It is a supply and demand issue.  The rate of interest indicates how much the society or market is willing and able to loan to borrowers.

2. However, if the central bank artificially lowers the interest rate lower than the rate at which the market is ready to loan, businesses misread the signals and start long term projects that the market cannot handle because it does not have the savings prepared for all of the production.  It is important to note that the growth occurs mainly in the capital goods industries rather than consumer goods industries.  The reason for this is because the capital goods production is the farthest removed in time from becoming the finished consumer goods and they therefore require years of production and low(er) interest rates. During the time of growth, the economy seems great, wages are increased, jobs are created, and production expands.  But since the economy cannot handle the new growth, the required resources were not saved, and time-preferences were not really lowered, two things happen.

3. First, all of the wages that are paid out are not spent on the newly created capital because the time-preference of the individuals is not focused on saving and capital but rather on consumption.  The workers who have received these wages direct their consumption to the “consumer goods industries and don’t save and invest enough to buy the newly-produced machines, capital equipment, industrial raw material, etc.” Therefore, much of the capital that was invested in was a waste, or, in other terms, a mal-investment.  The second thing that happens is, because the low interest rates make the economic actors act as if there were more savings, the demand throughout the economy is higher than the supply.  Projects run out of money, buildings are left unfinished, and so on and so forth.  This is called the bust, and it is what happens when the bubble bursts.  As can be seen, in Austrian theory it is the expansion of credit and the lowering of interest rates which are the actions of the central bank (such as the United States Federal Reserve) that causes the depressions and recessions in an economy.

It is the very activity of a central bank and its monetary policies are what cause mass fluctuations in employment, consumption based spending, and high inflation.  Since its creation in 1913, the Federal Reserve has made it its policy to attempt to control the “optimal” money supply by either expanding or contracting it.  According to the Austrian Business Cycle Theory, every expansion of credit leads to a boom and bust.  The bigger the expansion, the bigger the boom; the bigger the boom, the bigger the bust.  This bust is where the businesses in the capital goods industry experience the tough times of liquidation and a realization that the major investments during the boom were poor decisions.  Massive layoffs follow and the economy needs to recover.  Thus, in order for the American economy to ever recover, we must go through the bust.  And we must go through it completely.

It is political insanity, however, to advocate for the allowance of a bust.  Can you imagine a candidate running for office, or perhaps a congressman already in office, say something like: “well here is my proposal: we need all the malinvestments to be liquidated and we need to go through several years of depression as we rebuild our capital.”  He would probably be smeared.  He would be called all sorts of names.  There is no way any message of the honest and truthful sort could last ten minutes in the United States.  But regardless, the fact remains that what we really need right now is a good hearty bust.  We need all the malinvestments and bubbles of the past to be reconciled.  If we don’t face our problems today, they will be bigger tomorrow.  Unfortunately, in a modern democracy, this is unacceptable.  The political propaganda is far too pervasive.

The real causes of our economic depressions have nothing to do with the political narrative –the narrative that is taught as scripture in schools.  The political narrative finds fault in laissez faire, capitalism, private property, the rich, and individual liberty.  We hear about how the minimum wage laws are too low, the affirmative action legislation is not strict enough, and the unions don’t have enough power.  We hear about how the Fed is not printing enough money, about how deflation is a constant threat, and how prices are the equivalent to slavery (everything should be free!!).  We hear stories of how the poor are victims to Wal Mart, how those who make money only profit because someone else suffers a loss.  We need more laws, we are told, because to oppose increased legislation is to be selfish and conspiratorial.  The problems in our system can be fixed, not by rolling back the State, but by increasing the size and scope of the State.  The Fed needs to “do more,” the agencies need to tax more, the economy needs an injection of demand, the public school teachers should be paid more, the food stamp allowance ought to be doubled, the regulations need to be tightened, profits need to be socialized, institutions should be bailed out, those who ask the government for money should be subsidized.

This is the political narrative.  This is the story from the GOP and Democratic Party.  We must seek a better way.

The Scriptures tell us that the truth will set us free.  Given the reputation that truth has with the American people, freedom may not come in our generation.  That is, political freedom.  Fortunately, we are saved through faith in Jesus Christ.  Eternal freedom is ours.

Written by C.Jay Engel

Editor and creator of The Reformed Libertarian. Living in Northern California with his wife, he writes on everything from politics to theology and from culture to economic theory. You can send an email to