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Origins of Financial Crises
The Con Of Inflation
By Charles Dreezer, Contributor
Design by: Ryan Trinidad, Art Director
(First published in the Arbitrage Magazine Issue 4)
Business Cycle, Business Shmycle
Where do financial crises come from? You know, those events that pull the world into a recession and, just maybe, pull you out of your job? Why do they happen? What turns a recession into a depression?
The Austrian School of economics, which today has little to do with Austria, can offer us some insight. A key tenet of the Austrian argument is that central banks and their misguided monetary policy are largely at fault.
The Austrian Business Cycle Theory (ABCT), which is mostly ignored by mainstream economics, holds that ineffective monetary policy tends to set interest rates too low for too long. This invariably leads to excessive credit creation, speculative bubbles, and unsustainably low savings and high consumption.
To illustrate, let us begin with a simple example. Low interest rates tend to stimulate borrowing from the banking system. Increased borrowing means an expansion of credit, which is really an expansion of the money supply. An abundance of cheap money leads to an unsustainable credit-fuelled boom in which artificially stimulated lending seeks out diminishing investment opportunities. Eventually, there are so few reasonable investments left that capital resources are misallocated into areas that would not attract investment if the money supply remained constant.
A recession then occurs when the central bankers wise up to the over-inflated asset prices and are forced to increase interest rates in order to stop the credit creation. The ensuing period is characterized by debt default, a rush to divest from projects that are not feasible at the new higher interest rates, and a corresponding contraction of the money supply (i.e. deflation).
At this point, central bankers become concerned that the economy will funnel into a downward spiral (DS) when low demand leads to downsizing and bankruptcy, which lead to job loss. Job loss further decreases consumption, which in turn leads to more downsizing and more bankruptcy. For fear of the DS, interest rates are dropped.
Rinse and repeat.
Now let’s apply this model to the current financial crisis. The dot-com bubble exploded at the beginning of the new millennium. Between 2000 and 2003, Alan Greenspan, then Chairman of the US Federal Reserve (Fed), lowered the Federal funds rate target from 6.5% to an all-time low of 1%. As expected, low interest rates decreased savings and increased consumption, fending off the risk of the DS. Easily obtained credit and money that would previously have flocked toward dot-com companies now focused on the real estate sector as a ‘safe investment alternative’.
So what happened?
As outlined, attractive investment opportunities diminished, still free-flowing credit was used to finance the bidding up of asset prices, as well as other increasingly unattractive and risky investments. Eventually, the Fed realized that this was going on and, as predicted by the ABCT, raised the interest rate from a low of 1% to 5.25% about two years later.
Loan defaults triggered a wave of destruction in the financial sector as complex derivatives and the institutions that held them took a nosedive. In true form, the Fed lowered interest rates again for fear that a DS would cause a systematic failure of the financial system.
Who wants to take bets on a repeat?
Remember that thing called the free market?
F. A. Hayek, one of the early influential Austrian economists, reminds us that a recession can be good for us. “Enterprises are gambles that sometimes fail: a future comes to pass in which certain investments should not have been made. The best that can be done in such circumstances is to shut down those production processes that turned out to have been based on assumptions about future demands that did not come to pass. The liquidation of such investments and businesses releases factors of production from unprofitable uses; they can then be redeployed in other sectors of the technologically dynamic economy. Without the initial liquidation the redeployment cannot take place. Depressions are this process of liquidation and preparation for the redeployment of resources.”
The ABCT explains the Fed’s (and most of the workd’s) monetary shenanigans as a shortsighted attempt to smooth out the business cycle. Unfortunately, among its true effects are misallocation of resources and prevention of the recession, which is the free market mechanism that would purge the economy of improperly employed resources. Why, then, does the Fed use such practices when it seems obvious that they are in fact intensifying the business cycle rather than easing it?
Let’s take a closer look at the subject of inflation to find out.
CPI Train Wreck
In introductory economics courses, students are told that inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The preferred measure is the Consumer price index (CPI) or, more recently, the Personal Consumption Expenditures price index (PCE). Both are calculated as the value-weighted price of a basket of carefully selected goods.
This is actually a misleading view on inflation. More accurately, rising prices are the symptom of inflation, not the cause.
The reality is that inflation is an increase in the money supply.
As expected from an increase in the supply of any commodity (ceterus paribus), the value of each unit will decrease. It is the value of the money that is changing, not the value of the goods and services. For this reason, it is a waste of time to try to accurately measure the value of money by measuring the prices of goods and services.
The prices of individual goods or services change constantly irrespective of their value. Sometimes the basket of goods is altered because of a price change in a particular category that is deemed to be distortive.
In fact, it is absurd that the Fed would use any other measure than the amount of money in the economy. The math involved is much less complex and certainly not as prone to error.
Peter Schiff, an American author, businessman, financial commentator, and a 2010 candidate for the U.S. Senate, used a witty analogy. Imagine a person, let’s call him Central Frank (I added the name), is standing on train tracks. Understandably, Frank does not want to be on the tracks when the train passes.
But Frank is not a very bright person.
Frank decides that seeing the caboose is the best way to tell that the train is coming. We have warned Frank that he should be looking for the front of the train, the engine, if he doesn’t want to be pulverized.
But Frank is stubborn in his view and insists that he use the caboose indicator.
Is Frank’s plan likely to work?
The Wizard of Inflation
Price stability is one of two goals that make up the Fed’s mandate. Ben Bernanke, current Chairman of the Fed, said in his July 16, 2008 testimony before the Committee on Financial Services (U.S. House of Representatives) that “upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation … ”
Interesting. Didn’t Bernanke say that rising prices lead to inflation?
Either Bernanke does not realize that rising prices are the result of inflation, or he does know and is purposely misleading the public. Both possibilities raise very real concerns.
The former would suggest that the most powerful economy in the world is run by a man who doesn’t understand basic economics. The latter entails an act of misdirection that would make even the great and powerful Wizard of Oz blush.
The Fed, disguised by fire, smoke and a giant head, says in a booming voice that the rising prices of several commodities are the cause of inflation. Who are we to dare to question the great and powerful Wizard of Oz?
The truth is, the Fed (of most any country), as the sole guardian of the money supply, is just the old man behind the curtain. His continued reign as the Wizard of Inflation is protected by the fact that the majority of people do just what he asks of them: “Pay no attention to the man behind the curtain.” How many people do you know that understand what the CPE is?
Ludwig von Mises, one of the first Austrian economists, explains: “[t]here is no longer any word available to signify the phenomenon that has been, up to now, called inflation… As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.”
Why do they do it?
Austrian economists agree that the state uses inflation as one of the three means by which it can fund its activities (the other two being taxing and borrowing).
Taxation is relatively straightforward. Military spending is often cited as the reason for resorting to inflation and borrowing. More recently we have seen all sorts of fiscal recklessness (bailouts, etc.) that provides another possible motive.
One method that central banks use to increase the money supply is to purchase government bonds on the open market. The bank can then create the money it uses to buy the securities and the government can create the securities that it sells to the bank (basically a complicated but common borrowing practice).
This type of arrangement is one way the U.S. government is able to service its more than $13 trillion in debt. Unfortunately, it also causes the money that everybody else holds to decrease in value (thus causing inflation).
Inflation is therefore a type of indirect tax (and a sneaky one at that). Given there is no foreseeable shortage of whims on which governments will be able to spend their taxpayers’ hard-earned money, it seems unlikely that this is a problem that will go away on its own.
The Critics
Mainstream economists tend to ignore the concerns of the Austrian School. The most common criticism of the School is that it lacks scientific rigour. According to D. Walker, its theories are not developed in formal mathematics, but by using mainly verbal logic and what proponents claim are self-evident axioms.
In fact, as M. Thomas notes in his critique of Boettke’s critique of mainstream economics, the Austrian School advocates a rejection of methods that involve the direct use of empirical data in the development of theories. A final criticism is that, while the School claims to highlight shortcomings of mainstream methodology, it does not offer a viable alternative.
The Austrian School, however, offers up a response to these criticisms.
According to Hayek, the lack of mathematic and econometric justification is a necessity. He believed that economic theories cannot be proven or disproven through the same methods of empirical observation that are commonly applied to the study of natural science.
Ludwig von Mises, another early Austrian economist, explains that we cannot build a theory to predict how humans will act in a “complex” situation from how they will act in “simple” situations. Furthermore, there may be limits to how much we can learn from observing even a “simple situation.”
Only the human actor knows to what ends he acts. Observers may try to understand why an actor behaved in a particular way but this reason must be inferred from a complex set of data, which can only be gathered once. Reproducible experiments are not possible because both the actor and the observer have been altered by the experiment.
Although the Austrian School does not offer a completely viable alternative, it does advocate a laissez-faire approach to the economy.
This conclusion follows from a key tenet of the Austrian School: that the free market price mechanism (i.e. the natural interaction of supply and demand) is the most efficient and effective way of organizing and allocating the economy’s resources. Despite the criticism, there must be something to it if Greenspan himself would say that “the Austrian School have reached far into the future from when most of them practiced and have had a profound and, in my judgment, probably an irreversible effect on how most mainstream economists think in this country.”
What can be done?
Many Austrian School economists support the abolition of the central banks and the fractional-reserve banking system. They would advocate a return to the use of Free Banking, a monetary arrangement in which banks are subject to no regulations beyond those applicable to most other corporations (see the next issue of Arbitrage for my article on Free banking).
Food for thought:
Why do we need inflation?
Do we need inflation or do we need to be protected from it?
What would happen if the money supply were fixed?
Is the free market mechanism the most effective way to control interest rates?
Have central banks become much too involved in trying to manage a process that they don’t really understand?
What would be the government’s response if the economy were to make a move toward the free market control of the business cycle? Would it resist the removal of its power to finance its activities through inflation? Would important government programs suffer because they may not have access to consistent funding?
Arbitrage Magazine
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