According to most financial commentators, the economy has a cyclical nature about it such that there are times where everything is booming and business is expanding and there are times when everything turns upside down and the economy “contracts.” As such, it is the times of boom when we ought to be enjoying ourselves and, if at all possible, the central bank needs to work extra hard to avoid the bust. Capitalism, according to this way of thinking, is better than socialism, but there still needs to be a central bank present which can react to signs of a bust and head it off before it gets too bad.
This narrative misunderstands the nature of money and banking, the effects of central bank intervention into the economy and therefore, the essence of the boom and bust. Contrary to popular belief, the “cyclical nature” of the economy actually has a cause; that is, the boom and bust cycle is not inherent in capitalism properly conceived.
Rather, the entire business cycle (the phenomenon of the holistic economy to go through various phases), is caused by the establishment of central banking, which perpetuates and encourages the legally and economically suspect banking practice known as fractional reserve banking. When the banks (encouraged by the Fed– we will get to the mechanics of this in a future article) expand fiduciary media (money substitutes not backed up by the money standard), by way of creating new loans, the interest rate is suppressed below its natural market level. This encourages business to borrow and invest in long term projects that they otherwise wouldn’t have been able to afford. Since interest rates are widespread throughout then entire economy, the entire economy experiences a boom.
This boom, while apparently a time of prosperity, is actually sowing the seeds for its own demise. For all these new projects are utilizing resources that otherwise would not have gone to the projects. There is a “discoordination” in the structure of production such that resources are misallocated en masse. This boom is literally a false prosperity that cannot last for long, the market must correct this misallocation of resources.
This correction is the bust. The bust, while painful, is actually a social good in that it is the liquidating of these unsustainable projects. The sooner the bust comes and goes, the sooner the economy can be ready to once again grow according to its natural rate. Unfortunately, historically the central banks, operating until a false monetary theory, do not let the bust take place and instead try to “stimulate” the economy. This of course causes the boom-bust-cycle to start over. Which is why the historical reality looks like a cyclical reality. In fact, the cyclical nature of the economy is cause by the Fed itself. By refusing to take a hands off approach to the healing of the economy, the Fed only makes things worse and ensures that the depressions will be long lived.
For more on letting the economy heal itself after a bust, see Jim Grant’s new book The Forgotten Depression: 1921: The Crash that Cured Itself.