In the early 2000’s a bubble formed in the U.S. housing market in which housing prices rose dramatically, new housing projects were being constructed at increased rates, and speculative buying of homes and mortgages became the latest get-rich-quick scheme.  By 2008 the bubble burst and real estate prices dropped dramatically, affecting subsequent industries and triggering a worldwide economic depression.  Why did this happen, and furthermore, why is economic history replete with these boom and bust cycles?  Ludwig von Mises explained the cause of this trend with an analogy, which I will paraphrase:

An architect is tasked with building a house, but he has unwittingly overestimated the supply of resources available to him.  It appears to him that there exists a plethora of building materials at low prices and so he proceeds confidently in designing a large and grandiose mansion.  Three-fourths of the way through the building process he comes to find that the supply of materials has dwindled and he will be unable to complete the project as planned.  Had he known the accurate supply of resources he still would have built the house, only he would have designed it differently, in a manner that reflected the means at his disposal.  As it turns out, the partially completed house is useless and the materials and labor utilized to construct it have been totally wasted.  The builder will suffer a loss in his investment and will have no real asset in its place.  The misallocation of resources has actually destroyed wealth.

The villain in this cautionary tale is the price of the building materials.  Prices do much more than tell you how much you have to fork over to get something you want.  Prices function as signals that communicate relative supply and demand.  When the supply of resources dwindle, and assuming demand stays at least as high as it was previously, the price should rise.  This signals the relative scarcity of the resources and the builder will buy less of them, though he may only be considering the effect on his wallet, and not on the larger economy, at the time.  But how is it that the prices of the construction goods were kept artificially low?

This is the question asked by Austrian economists Ludwig von Mises and Friedrich Hayek and by their successors, such as Murray Rothbard, who were not themselves Austrians, but have been adopted into what is now known as the Austrian School.  Their answers to this question and to the question of why economic booms and busts are cyclic events is referred to as the Austrian theory of the business cycle.  Their conclusion can be found in the artificial lowering of prices, not of bricks or lumber, per se, but of the price of money itself.

What is an interest rate?

An interest rate is the price of credit, or of money lent to fund current projects to be paid back over time.  Like any other price, interest rates change according to relative supply and demand and serve as a signaling mechanism in communicating those relative changes.  Because credit constitutes a deferred payment and confers a debt on the borrower for a certain period, interest rates serve to coordinate production across time.  Here’s what this means:

When banks or other lending institutions raise interest rates they do so because their liquid reserves are low and a decreased supply of anything causes prices to rise, both because it is profitable to raise them and because it is an effective way to ration.  In doing so they thereby create the incentive to save money.  High interest rates signal the profitability of saving and investing money as well as the high cost of funding long-term projects.  Entrepreneurs and consumers will then save their money and defer consumption by adjusting their time preference, that is, the degree to which they prefer present consumption to future consumption.  In this way the money supply held in reserve will increase.  As capital is accumulated prices begin to fall back down; lower interest rates signal that it is then the optimal time to borrow to fund projects and produce goods that will pay off in the long-term.  The longer the term of a project the more sensitive it is to interest rates, and so entrepreneurs take advantage of the low rates to fund the big projects.  The money and capital goods that were saved have made the completion of these projects possible, but no one went around checking warehouses and banks to make sure all the resources were lined up.  They simply got the signal to start borrowing and building from the low interest rate and for all they knew they were just getting a good deal on the loan.

When individuals defer consumption and save, it provides the ability to carry projects through to completion.  Low interest rates signal the time to borrow and invest in capital goods, industrial raw material, durable equipment, and construction.  High interest rates signal the time to save and direct production to consumer goods.  This is the natural way that a market economy grows by coordinating the activities of various people with different values and competing goals.  The problem is that there is no truly free market economy in any country in the world and that most every country has an institution that can arbitrarily manipulate interest rates.  In the United States, that institution is the Federal Reserve Bank.

The Role of “the Fed”

The Federal Reserve System was established in 1913 to, among other things, control inflation, manage the liquidity needs of banks, and prevent banking panics and runs.  For the purposes of this article we will focus on the second point.

A bank may want to give someone a loan but then come to find out that they can’t for some reason, such as unexpected withdrawals or just not having enough monetary reserves.  The Fed will lend the money to the bank so that they can provide credit for their customers.  The belief is that liquidity, or the ease of exchanging assets to perform economic actions, is needed to keep the economy moving, otherwise the inability to finance projects would cause stagnation or panics.

If the banks don’t have the money to lend then how does the Fed have it, being itself a bank?  The answer is that the Fed controls the money supply by printing money.  Federal Reserve Notes are the paper currency printed by the Treasury and issued by the Federal Reserve Bank.  They are a form of fiat currency, which means they are not fixed in value by an objective standard such as gold, but derive their value simply from government decree.  The advantage of this system for the banks is that the Fed can print money whenever it wants.

The Fed is able to lower interest rates both by keeping the rate at which it lends to banks low, as well as by releasing more money into the economy, which, as we’ve discussed, puts downward pressure on the interest rates that the banks will lend at.

The ability to manipulate the interest rate and set it at levels that do not reflect true market conditions is the proximate cause for the boom and bust cycle.  Let us take a step-by-step look as to how this occurs and then what is needed to stop the cycle.

1.  Government interference causes interest rates to be lowered below market levels.

The Federal Reserve Bank is not technically a part of the federal government but it works closely with the Treasury department and is heavily influenced by the Washington bureaucracy.  This bureaucracy is inclined to intervene in the markets for political reasons, to give the perception that the government is both benevolent and in control.  Word gets out that there is a credit shortage in some market, such as real estate, and that the Fed must increase the money supply to make credit more available.  Understand that the Fed is managed by a relatively small cabal of bankers who are not only incapable of understanding the dispersed knowledge of a complex economy but are also corruptible and constantly pressured by politicians.  If the President says that more Americans need to buy houses then the Fed responds to that regardless of whether or not the economy can support a dramatic increase in construction or whether or not banks have money to lend.

In any case, the Fed pumps money into the economy and interest rates fall below that which would occur naturally in the market.  Remember that the money is not backed by any real asset.  No new wealth was generated; the money was created out of thin air.

2.  Consumers are incentivized to consume immediately while businesses are encouraged to invest in long-term projects.

The low interest rates give businesses the incentive to borrow money to fund projects that will not be profitable until the future while consumers take advantage of the rates to consume in the present.  The public is perhaps not actually ready to consume in the present because they haven’t generated sufficient savings, but they do anyway.  For example, construction firms are lead to believe that consumers have saved enough to purchase new homes (or at least to afford mortgage loans) and so engage in a building spree, while at the same time consumers have not saved and are not saving, but rather taking advantage of low rates to buy new appliances, and furniture sets, and cars on credit.  When the houses are finally built there are no buyers, or alternatively consumers are enticed into buying when they can’t afford it by shady lending practices.  The once coordinating effect of the interest rate is destroyed by the Fed’s manipulation.  Each group’s time preference becomes misaligned.  Businesses should not be borrowing for long-term projects because consumers have not saved and they will not have the money to buy the end result of those projects in the future. 

3.  The forced-low interest rates communicate a lie about available resources.

Interest rates are naturally lowered when capital is saved.  The Fed’s actions signal to entrepreneurs that sufficient capital has been accumulated but those additional resources don’t actually exist.  No new goods were added to the economy.  The only thing added was fiat money, which was spontaneously generated on a whim weeks or days or even minutes beforehand, and is not backed by anything of real value.  The pool of capital goods and of labor is unchanged but the number of long-term investment projects increases dramatically.  They cannot all be completed.  Just like the master builder, there are not enough bricks to finish the house.  If the interest rate is not allowed to rise to a natural level the bust will be inevitable.

4.  The mixed signals inflate the bubble

Borrowers borrow more for more ambitious and expensive projects that cannot be sustained.  Those projects should only be undertaken after the saving of real wealth but this is discouraged by the distorted price signals.   A perverse incentive is created which eventually leads to an outcome which is precisely opposite of what is intended:  i.e. cheap loans make homeownership more affordable but this subsequently increases demand and drives up housing prices.

An asset price bubble forms in which market prices are higher than they would otherwise have been were it not for the distortions created by government intervention.  As the prices increase, it becomes more and more difficult for consumers to afford the commodity and so more money is injected by the Fed to maintain the supply of cheap credit.  This continues indefinitely.

5.  The bubble bursts.

While the interest rate maintains its artificially low level, the asset price has been sufficiently raised to make the asset prohibitively expensive for the consumer.  Consumers’ time preferences will fall as they will defer current consumption to save for future consumption.  For example, if house prices are too high, people will stop buying houses in the present, even if the interest rate is good, and instead save their money to buy houses in the future.  As the higher prices were built on cheap credit in the absence of real wealth savings demand suddenly disappears as consumers adjust their spending patterns to correspond to their actual time preferences.  Producers are then stuck with a glut and the prices drop suddenly to correspond with changing demand.   Investors lose what they had believed to be wealth and the asset market crashes.

Diagnosing and Solving the Problem

The primary competing theory to the Austrian model was developed by John Maynard Keynes and is referred to as Keynesianism.  This is the most popular business cycle theory of just about everyone who has political influence over monetary policy.  As I mentioned before, this is because it allows politicians to believe in and propagandize their singular ability to “fix” the economy and make everyone happy.

Keynesians believe that economic downturns and depressions are caused by a shortfall in aggregate demand.  Aggregate demand is defined as consumption plus investment plus government spending; it can be thought of as the total amount of money being spent and directed toward producers.  This shortfall may be caused by various reasons, one of which may be the effect of human emotion and confidence in consumer spending; what Keynes referred to as “animal spirits” (the idea is not dissimilar to “bull” and “bear” markets).  To correct for this shortfall and get out of a recession, Keynesians believe that the government should adopt aggressive fiscal or monetary policies.  With a fiscal approach, government will increase its own spending by funding projects designed raise employment, thus raising aggregate demand.  A monetary approach sees the government increasing the money supply to boost liquidity in the credit market and stimulate the economy, which will raise aggregate demand by increasing investment.  These things will inspire consumer confidence and individuals will begin voluntarily increasing their own spending which will lift the economy out of its torpor.

If the Austrian theory is correct we can see just how disastrous the Keynesian remedy is to the recession as it suggests ramping up the very policies that lead to the crisis in the first place.  The affect of an aggressive fiscal policy is to create even greater malinvestment as more capital is utilized for projects that are out of sync with market demand and consumer time preference.  Aggressive monetary policy, rather than stimulating real growth, prolongs the depression of interest rates and perpetuates the false signal of accumulated capital.

And yet these are precisely the policies being effectuated.  Government spending in inflation-adjusted dollars increases every year.  Monetary stimulus has been achieved, not just at the consumer level through tax refunds, but also through a central banking inflation scheme, known by its misdirecting PR term quantitative easing, by which, in its current iteration, the Fed injects $40 billion to $85 billion a month into the credit market ad infinitum.  Evidence suggests that these practices, rather than correcting the economic crash of 2008, may be inflating yet another housing bubble.

The Austrian theory suggests a laissez-fair remedy.  The government, rather than engage in aggressive fiscal and monetary policy, should do nothing, or more precisely, stop doing what it had been doing to create the inflationary boom in the first place.  The government must first stop inflation by ceasing the printing of new fiat money.  This will, of course, bring the boom to an abrupt end and bring on the subsequent recession.  This, however, is inevitable.  It must happen to initiate the necessary readjustment of capital.  The recession marks the beginning of the recovery.  To delay it only augments the magnitude of the depression and the agony it brings with it.  Thus, it is preferable to get the economic recession over with as soon as possible.

Furthermore, the government should have no role in supporting failing businesses during the recession by bailing them out or lending them money.  To do so undermines the role of the recession as a readjustment of capital, rewards inefficiency, and ignores demand.  It will turn what would otherwise be a short, acute depression into a persistent and aching one.  This is what was done with the TARP and auto bailouts

The government should not prop up prices, including wage rates, as this will delay the readjustment and cause severe unemployment.  Minimum wage laws exacerbate unemployment by preventing wages from falling to the market rate that clears the demand for a supply of labor.  It has become very popular in Washington these days to talk about raising federal minimum wage during the current recession to $9 an hour or more.

Obviously, the government should not try to inflate again to get out of the depression as this is what caused the whole problem.  This is tempting because to do so appears to the uneducated to have solved the problem, making the advocator very popular indeed, but it merely sows the seeds for even greater future calamity.

Additionally, the government should not encourage consumption (which it did with the stimulus bill of 2009) or increase government spending (which it more-or-less always does).  These policies only increase the social consumption/investment ratio.  The economy does not need more consumption.  This will not, as the Keynesians believe, kick-start the economy by boosting aggregate demand.  What is needed is more saving in order to legitimize the funding of long-term projects and to reestablish employment in the capital goods industries.

It is not too difficult to see why the Austrian theory is not valued by most politicians.  Faced with hoards of angry voters, understandably pained by an economic depression, politicians have a psychological need to validate their existence by wielding their self-perceived immense power to transform an entire national economy.  And through some pretty simple tricks they can give the impression that they are capable of doing just so, but it is a mere illusion, a case of economic misdirection.  These politicians may not have even been responsible for the inflationary boom, but they know rightly that they will be blamed for the recession following the bust, regardless.  The recession has to happen before the real recovery can begin, there is no other way, but no matter how brief it might actually be if left alone, people don’t like being told that they have to wait it out.  They want a government of action.  Perhaps this explains why most civilizations fall, not from outside assault, but from internal economic implosion.  Will we be able to forfeit economic hubris for sound monetary policy before a catastrophic market collapse or hyperinflation destroy our standard of life?  I doubt it, but I consider sounding the alarm a noble endeavor, nonetheless.

Further Inquiry

A brief summary of the Austrian theory as told by Ludwig von Mises can be found in his article The Austrian Theory of the Trade Cycle, itself a distillation of Mises’ magnum opus Theory of Money and Credit.

In his article Economic Depressions: Their Cause and Cure, Murray Rothbard further illustrates the role of banks in creating the boom and bust cycle.

Friedrich Hayek’s lecture Can We Still Avoid Inflation? explores the relationship between the inflation created by the collusion of governments and central banks and the business cycle.  Hayek’s books on the subject include Monetary Theory and the Trade Cycle and Prices and Production.

This article by Jason Riddle, writing for the capitalist blog The Mendenhall, was one of my first introductions to the Austrian theory and is an excellent summary.

Here is a video of a brief talk by Thomas Woods in which he explains Austrian business cycle theory and here is an excerpt from an audio version of one of Rothbard’s books that illuminates some key ideas.

This video, Fear the Boom and Bust, sets up a fictional rap battle between Friedrich Hayek and John Maynard Keynes as they explain and defend their competing understandings of business cycle.  Here is part 2, Fight of the Century.

  • shrgngatlas

    As usual, the right thing causes near term election losses, while the wrong thing brings reelection, for a while. Eventually, the adjustment will be so severe that a politician promising a miracle will get elected. Happened in Germany in the early 1930’s, and it will happen again.

    • Jonathan Rea

      Oh man, I hadn’t even thought about that. Thinking about how bad hyperinflation would be (especially considering how preventable it is) I had forgotten that another nationalistic fascist could make things even worse promising to get us out of it.

  • Vilhelmo De Okcidento

    Utter nonsense.

    Bubbles are caused by bank credit creation, fraud and “the miracle of compound interest”.

    Most bank credit today is spent to buy assets already in place.

    Extending credit to purchase assets already in place bids up their price.
    Epidemics of fraud, specifically control frauds, are superb devices for hyper-inflating financial bubbles.
    The fraudulent loan origination causes an enormous expansion in bad loans that further bids up the price of assets.
    A single control fraud can cause greater losses than all other forms of property crime combined.

    An epidemic of mortgage fraud was essential to the creation of the largest bubble in history, the U.S. housing bubble.

    • Jonathan Rea

      While I admit that there are certainly alternative means of producing an asset bubble I’d hardly categorize the Austrian model as “utter nonsense”.

      Though the mid-2000s housing bubble was created by fraudulent mortgages, reckless lending requirements, and imprudent credit default swaps it is necessary to consider reasons for why all of these things happened. The proximate cause was the perverse incentive given to lenders for excessive risk-taking that was created by the federal government through deposit insurance and the Federal Reserve in its role as the lender-of-last-resort. To be sure, the banks should not be off the hook for their irresponsible and in some cases criminal actions, but to deny the moral hazard created by the Fed would be a tragic oversight.

      • Vilhelmo De Okcidento

        Jonathan Rea said:
        “The proximate cause was the perverse incentive given to lenders for excessive risk-taking that was created by the federal government through deposit insurance and the Federal Reserve in its role as the lender-of-last-resort.”

        This is simply not true.

        Nobody forced banks to make bad loans.

        They made bad loans because that is the way to maximize fraud, specifically Accounting Control Fraud. They were following a recipe for fraud.

        The recipe has four ingredients:
        1) Grow like crazy
        2) By making really crappy loans at a premium yield
        3) While employing extreme leverage, and
        4) Providing only trivial allowances for loan and lease losses

        The recipe produced three sure things:
        1) That the bank was certain to report extreme (albeit fictional) income in the near term,
        2) That this will, because of modern executive compensation, promptly make the CEO extremely wealthy,
        3) Guarantees that the firms will suffer massive losses

        This is a crime even under current law.

        But because the financial industry has grown so large & gives so much money to politicians it has become above the law, immune from prosecution.

        During the S&L crisis, also a case of massive control fraud, over 1000 executives were convicted & jailed, whereas the perps of this crisis’s control frauds (70x as large) have been free of prosecution.

        Enforce the law.

        No banker was forced to commit any fraud, let alone one that just happens to make the banker fabulously wealthy.
        Deposit insurance & the Fed had nothing to do with this.

      • Vilhelmo De Okcidento

        Jonathan Rea:

        “While I admit that there are certainly alternative means of producing an
        asset bubble I’d hardly categorize the Austrian model as “utter

        My understanding, which may be incorrect, is that Austrians attribute the cause of asset bubbles to government money creation.

        This is not true.

        Asset bubbles are invariably caused by private bank credit creation.

        Bank credit comprises ~93% of the money supply in the US, CA, UK, etc.

        Banks do NOT loan for new productive capacity but only against assets already in place. The vast majority of bank loans are mortgage loans for existing real estate.
        Extending credit to purchase assets already in place bids up their price.

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