May 20, 2013

Booms and Busts


            The modern theory of the business cycle, as taught by conventional educators throughout the world, tells a story of ups and downs that naturally occur in the world of business. For this to be true, it would mean that a great number of firms and individuals nationwide have been making the wrong investments and allocation resources and labor in the wrong manner all at the same time. It would also mean that around the same time, a majority of these people wake up and realize the mistakes they’ve made. Even for this very unlikely event to be true in a dynamic, changing, and emergent economy; such an event would have to be tied to the money, or to some sort of nationwide laws, practices, or regulations that effect markets on a national scale.

            How might it be possible that so many people at the very same time make the same investment mistakes and suffer horrible losses during economic busts? The answer is hidden within the economic signals that entrepreneurs rely on to direct their capital. Besides having ridiculously harmful, cost-increasing regulations in nearly every single industry; government regulation and policies play only a small role in this signal disruption. The real fault of the government lies in the way it conducts monetary policy.  

The actions that our central bank has been taking in the last 100 years or so, that turn out to be so harmful in regards to recessions are the lowering of interest rates below what would otherwise be considered the “market price” for money. Low interest rates mean cheap access to money. In a market economy, they also mean that there has been an increase in amount of money people are saving in banks. This increase in savings signals entrepreneurs that there will be an increase in consumption in the future. Entrepreneurs, then, take out loans at the lower interest rate and invest the capital into various areas of the economy that they believe will be in high demand by consumers in the future. When government provides a false signal via low interest rates, the entrepreneurs are led to believe something that isn’t true: that people have increased their savings in hopes to consumer more in the future. The investments made tent to be focused on a specific area in the economy; i.e. real estate. Eventually, however, it becomes apparent that the increase in consumption is not going to occur and the investments made will not be as or at all profitable. This is when the crash begins. People start to liquidate their assets in an attempt to get out before they lose more money. As this happens, the price of the goods fall sharply and we are left with a recessed economy. The recession however, is not a process to be feared, but one to be trusted. The period of downed prices of certain good only means that the economy is adjusting to the previous period of mal-investment.

Unfortunately, recessions are harmful more ways than just unemployment increases.  Because investment and capital allocation takes time (especially real estate) many people spend a large amount of that time allocating resources into areas they believe will pay off in the long term. When the truth is realized and the investment turns out to be bad, people not only lose out on the investment, but on the time it took to make the investment. This is time that could’ve been spent doing other productive activities that may have paid off. The consumers suffer the same injury. False signals caused people to invest into things that consumers were not going to demand in the future. When all is said and done, we are left with entrepreneurs who have wasted time and money performing economic activities that are not needed to consumers. In the meantime, consumers are not being provided the goods and services they most urgently needed. The signals sent on behalf of the consumers were clouded by the false signals caused by the Federal Reserve and its monetary policies.

The lesson here is not to fear the crash of the market, but rather, the boom. The boom is always the cause of the recession, while the bust and the events that come along with it, are only symptoms of the boom. To stop the boom, we must constrain the expansion of money and the artificial expansion of credit. In order for this to be achieved, we must take on a system of free banking and sound money… something that cannot be achieved as long as the Federal Reserve System is in place.  

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