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The Role of the Crisis

The so-called "credit crisis" is gaining momentum. Investors increasingly question the solidity of the banking system, as evidenced by banks' tumbling stock prices and rising funding costs. With bank credit supply expected to tighten, the profit outlook for the corporate sector, which has benefited greatly from "easy credit" conditions, deteriorates, pushing firms' market valuations lower. In fact, peoples' optimism has given way to fears of job losses and recession on a global scale.

Free market advocates, however, should not get carried away by the price action in the market place. In a free market, there is nothing wrong with individuals reassessing hitherto held expectations, entailing changes in relative prices. A free market is a discovery process, based on trial and error. Usually the effects of errors made by some are compensated for by the gains of successful decisions taken by others, and the economy expands.

Sometimes, however, the effects of errors dominate, and the economy experiences what people call a crisis: income growth is (feared to be) lower than what people think it should, and could, be. In that sense a crisis is a correction of bad decisions. It is an indispensable part of the free market. It pushes those producers out of business who do not satisfy the needs of their clients, and it rewards those who serve their customers well.

A crisis must be feared, however, if it has been caused by government action, and if the obvious signs of the crisis provoke ever greater doses of government intervention. In this case, the market would be prevented from doing its job properly. Bad decisions would be perpetuated, and the ultimate crisis may become nasty.

Diagnosing the Causes of the Crisis

It is against this background that one may wish to review the US central bank's series of rate cuts, the latest being a big 75-basis-points rate slash on January 22, 2008, which brought the official Fed Funds Target Rate to 3.5%.[1] While the Fed's moves were mostly hailed in public as appropriate measures to help the economy avoid recession, Austrian economists hold a completely different view.

According to the Austrian Monetary Theory of the Trade Cycle it is the government-run money-supply monopoly that has not only caused the crisis; the theory also diagnoses that rate cuts will not solve the crisis, but will make it even worse.

Central banks, the government agents holding the power over the printing press, pursue a monetary policy of "interest rate steering" or, in other words, pushing the interest rate down as much as possible by relentlessly increasing credit and money supply. It is this inflationary monetary policy that causes trouble.

Ludwig von Mises pointed out that

today credit expansion is exclusively a government practice. As far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. They have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion.[2]

Initially, the artificial lowering of the interest rate creates an illusion of richness and affluence. The increase in the money stock via bank credit expansion erroneously suggests that the supply of savings increases. Investment picks up, and the economy expands. The illusion of plentiful resources leads to malinvestment, and sooner or later the boom turns into a bust. While the money-fueled expansion is a manifestation of the crisis, it is actually the slump — the correction of malinvestment — that people complain about.

The alleged fight against the crisis

Once a crisis unfolds, central banks are called upon to lower interest rates — in ignorance of the fact that a monetary policy of pushing down the interest rate has caused the misery in the first place. Cheaper borrowing costs, it is believed, would revive the economy by stimulating investment and consumption, thereby adding to output and employment. Lower interest rates would raise the prices of stocks, bonds, and housing, translating into "wealth effects" which in turn strengthen demand.

The obsession with a policy of lowering the interest rate is rooted in a deep-seated ideological aversion against the interest rate. It is a destructive ideology, in particular if the government is in charge of the money supply. Because then the government central bank will lower the interest rate to whatever is deemed appropriate from the viewpoint of the government, pressure groups, and vested interest.

However, the interest rate is a reflection of peoples' "time preference": because of scarcity, people value goods and services available today ("present goods") more highly than goods and services available at a later point in time ("future goods").[3] This is why present goods trade at a premium over future goods. That premium is the interest rate, or the "time preference rate." The interest rate is a free-market phenomenon.

A policy of suppressing the market interest rate through a government-sponsored credit expansion, Mises noted, is a policy against the free market:

Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.[4]

Causing Inflation

A monetary policy of lowering the interest rate via expanding credit and money corresponds to the widely held view that "some inflation" is a requisite for economic expansion. In fact, the "inflation bias" has become so widespread that nowadays inflation (the rise in the money supply) is much less feared than deflation (the decline in the money supply).

Mises was aware of what happens once the inevitable crisis caused by a manipulation of the interest rate unfolds: "In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils inflation and credit expansion have brought about."[5]

The current credit crisis is a sad case in point: with monetary policy having caused inflation and malinvestment, it is now called upon to pursue a policy that leads to even more inflation and malinvestment.

Could monetary policy become "ineffective," that is, could it fail to create inflation? For instance, the Bank of Japan's rate cuts around the beginning of the 1990s — as a reaction to falling asset prices and a growing volume of bad loans in banks' portfolio — did not succeed in bringing credit and money growth rates back to precrisis levels. Even with official rates at virtually zero, the economy remained in stagnation and the Japanese stock market continued to decline.

Against the backdrop of the Japanese experience it should be noted that there is no limit to central-bank money printing. Central banks can, at any one time, buy any assets from banks and nonbanks such as bonds, real estate, foreign currencies, etc. If a central bank buys, say, debt from the corporate sector, it increases the money stock in the hands of nonbanks directly; the commercial banking sector is not needed for increasing the money supply.

Central banks' unlimited power over the money supply has been made pretty clear by the chairman of the US Federal Reserve, Ben S. Bernanke, in November 2002:

[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.[6]

So if the government is determined to create inflation, there should be hardly any doubt that there will be inflation. The Fed's series of rate cuts suggests that the bank tries to create additional credit and money via lowering the interest rate on base money. But if such action fails to yield inflation, it does not take much to expect that the central bank may take recourse to less "regular" operations, if and when such an inflation policy is deemed necessary to solve the credit crisis.

So far, at least, US bank credit and money supply growth has remained at a very high level. In December 2007, banks' commercial and industrial loans grew at 10.9% y/y, and total bank loans and leases were up 10.8% y/y. Real estate loans — most likely as a consequence of the defaults in the subprime markets — slowed down somewhat, but were still running at 6.3% y/y. Against this background the Fed rate cuts should actually accelerate the erosion of the exchange value of money further.

Threatening Freedom

Inflation is a societal evil. It redistributes real wealth from creditors to debtors. It impairs the role of money as a means of exchange. The efficiency of the market's price mechanism is greatly reduced, encouraging bad decisions, which in turn harm peoples' economic well-being. At the end of the day, inflation is a serious threat to freedom. The majority of the people, suffering badly from inflation, would most likely blame the free market for their plight, rather than blame the central bank for the debasing of the currency.

Mises noted:

Nothing harmed the cause of liberalism more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy. People did not conceive that what they lamented was the necessary outcome of policies directed toward a lowering of the rate of interest by means of credit expansion. They stubbornly kept to these policies and tried in vain to fight their undesired consequences by more and more government interference.[7]

From the Austrian viewpoint, the current credit crisis appears to be a precursor of great inflation. If a deliberate policy of great inflation is chosen in the United States, a monetary policy of debasing the currency would most likely also take hold in other currency areas of the world. The credit crisis has become a threat to the free societal order: as people become dispirited with the free market order, the door would be pushed open for anti–free market policies.

Notes

[1] The FOMC rate cut was made "in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households." US Federal Reserve, Press Release, 22 January 2008.

[2] Mises, L. v. (1996), Human Action, p. 794.

[3] For the explanation of the Austrian theory of the interest rate, see Rothbard, M.N. (1993), Man, Economy, and State: A Treatise on Economic Principles, pp. 313.

[4] Mises, L. v. (1996), p. 794.

[5] Ibid, pp. 576.

[6] Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. November 21, 2002, "Deflation: Making Sure 'It' Doesn't Happen Here."

[7] Mises, L. v. (1996), p. 444.