Boosting the Bust

Boosting the Bust
Profile photo of Thorsten Polleit

federal reserveThe root cause of the crisis is the credit money system

Economic data suggest that the large economies around the world – the US, Europe and Japan – are working themselves out of the latest financial and economic crisis. Output is increasing, financial market “stress” has declined to pre-crisis levels, credit spreads are falling and, perhaps most important, stock prices continue to edge up.

However, do these developments really suggest a sound economic recovery is under way? In fact, should we take about economic recovery at all? To answer this question one needs a solid economic theory. For one cannot make sense of any data without employing a theory; a theory-independent data interpretation is simply impossible.

The Austrian School of Economics, as formulated by Ludwig von Mises (1881 – 1973), provides an economically sound theory. It is based on the logic of human action, an irrefutably true axiom. Mises called his reconstruction of economics along the lines of the logic of human action praxeology. There is much to learn from it, especially in view of the current economic developments around the world.

A praxeological analysis reveals that the root cause of the latest financial and economic crisis can be found with the credit money, or fiat, money regime. In such a monetary system, commercial banks, with the help of central banks, keep expanding the money stock through credit extension which is not backed by real savings. It is exactly here where the trouble lays.

The creation of new money out of thin air through bank credit expansion artificially suppresses market interest rates. This, in turn, sets into motion an artificial boom. However, sooner or later the boom must come to an end: It is an inevitable outcome of the credit money system that the boom it creates will sooner or later result in a bust.

Loving the boom, reviling the bust

It is a matter of fact, though, that people love the boom. The boom seems to bring prosperity. It increases firms’ profits, brings new job opportunities, creates higher incomes and rising asset prices (such as rising stock and house prices). The boom makes entrepreneurs, employees and politicians feel good.

The opposite holds true with the bust. The bust makes people feel bad, as it is typically a fairly sobering experience. It brings people down to earth. It reveals firms’ malinvestment, causes corporate losses, reduces employment and incomes, and it wreaks havoc with peoples’ asset holdings. Governments get strained as regular tax revenues start dwindling.

What people typically don’t realize, however, is the truth that the boom is the very period in which problems are being created: It is during the boom that scarce resources are misdirected, resulting in malinvestment. And it is the bust which corrects malinvestment run up during the boom, and the bust makes the economy move back towards equilibrium.

Against this backdrop it may become clear what the latest so-called economic recovery stands for: At best it sets into motion yet another artificial upswing, a boom, fueled by artificially suppressed interest rates and increases in the money stock out of thin air.

The economy’s production and employment structure formed under artificially suppressed interest rates and government market interference can be upheld only if interest rates are being reduced to ever lower levels. This, in turn, brings about a calamitous dynamic.

Boom and bust as a result of credit money

The calamitous dynamic leads to the recurrence of the boom and bust. It was Mises who, as early as 1912 in his Theorie des Geldes und der Umlaufsmittel, had discovered the consequences repeated injections of money created through credit expansion would have for the economy:

“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion.”

In an effort to escape the malaise caused by credit money expansion in the first place, people would advocate even more of the same policy: They agree to, and even call for, an even cheaper credit monetary policy, meant to overcome current and pressing economic (and political) problems.

While there should be hardly any doubts about where such a policy sequence will lead to, a major uncertainty remains. And that is: One cannot say anything in advance about the timing of the boom turning into bust, though.

The outbreak of the next crisis will depend on special conditions, which cannot be predicted in advance on a scientific basis. The timing of the bust cannot be calculated by a rigid formula. Such a calculation is beyond the science of economics.

However, for businessmen and investors alike the Austrian School of Economics offers valuable knowledge other theories simply cannot offer: namely the true knowledge that as long as the credit money system remains in place, economies and financial markets will remain afflicted by recurrent booms and busts.

What is more, the Austrian theory provides the invaluable insight that the credit money system will, at some point, reach its limit, that is the policy of creating artificial booms cannot be kept going for ever. Mises put it succinctly:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

In that sense, the ongoing cyclical upswing, greatly fuelled by central banks’ record low interest rate policies, is sowing the seed of the next bust – which may well result in a malaise surpassing that seen in 2008 and 2009.

One thing is for sure, though: Central banks keep working successfully towards boosting the forthcoming bust.

Profile photo of Thorsten Polleit

Dr. Thorsten Polleit, Chief Economist of Degussa, Honorary Professor at the University of Bayreuth, and Partner of Polleit & Riechert Investment Management.

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