The Free Market 20, no. 11 (November 2002)
There are those who want to believe that a market economy is itself unstable, prone to periods of excess and in need of stabilization by some outside authority. As Jeff Madrick wrote recently for the New York Times, “government itself is a necessary bulwark against recession.”
Proponents of this view look at the recent stock market decline as evidence of market failure, since billions of dollars were diverted into what turned out to be unneeded and wasteful investments. Mr. Madrick, for example, writes that the steep stock market decline was “an enormous market failure that could have been mitigated by better regulation.”
Moreover, the recent headline grabbing episodes of corporate deceit only add to their belief that the government should have some role in dampening economic cycles. In this view, any deregulation or reduction in the government’s presence on the economic stage is precisely the wrong thing to do. The government is seen as a stabilizing force in a never-ending economic drama.
These critics miss the mark. They pay too much attention to the symptoms—the losses and the destruction of apparent wealth—and they pay no attention to the underlying causes. They blame the sneeze and the cough for the common cold, rather than as necessary consequences of viral activity. They must look to the essence of the thing, as Marcus Aurelius advised, and they will find that there is a kinship among these economic maladies. The essential characteristics of these repeated cycles are, to use an Aurelius metaphor, as familiar as roses in the spring and crops in the summer.
Business cycles don’t just happen randomly without reason; there is an underlying logic and pattern. While some critics maintain that the government must be a stabilizer, the sweet irony is that government itself is the destabilizer.
To discover why, one only needs to think about the basic mechanics of any market. With private ownership of the means of production, entrepreneurs seek to satisfy the wishes of consumers. No sovereign authority is needed to direct this process. The simple pursuit of profit is enough.
As Mises wrote, “In the capitalistic economy, it is consumer demand that determines the pattern and direction of production, precisely because entrepreneurs and capitalists must consider the profitability of their enterprises.” If ignored, this fundamental law of the market dictates that the entrepreneur will suffer losses and ultimately the loss of his capital.
It is this market process that gives meaning to economic activity: to satisfy the wants of consumers. Cyclical economic crises are precipitated by disturbances in this mechanism, which lead production astray and along wasteful paths that inevitably must be corrected.
The primary source of economic disturbance arises from interference by government.
Monetary interventions—fiat currency, fractional reserve banking, monetary manipulations by the Fed—create the primary fuel for launching the boom.
In a collection of interwar essays titled On the Manipulation of Money and Credit, Ludwig von Mises addresses the phenomena of economic fluctuations. In an address included in that book, “The Causes of Economic Crises,” Mises clearly lays the blame on the manipulation of interest rates. Since he was addressing an assembly of German industrialists in 1931, Mises’s points are particularly lucid. He describes how, in a market where monetary matters are not interfered with, only those businesses that appear profitable are able to raise funds to pursue investment opportunities. Unhampered market interest rates serve as guideposts for allocating capital to various investments.
However, in a market where monetary conditions are manipulated, suddenly those businesses that were not profitable appear to be profitable. In other words, investment opportunities arise strictly because, in an environment of easy money, they now seem profitable. These marginal activities draw resources away from other firms.
Many observers want to believe that lowering interest rates, expanding the money supply, and making it easier to obtain credit is the way to stimulate economic activity. However, as Mises describes, the early upswing in business activity is not a healthy sustainable increase. Credit expansion cannot create real wealth. Mises writes, “It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on a foundation of sand.”
Since no real resources are created by credit expansion, it should be apparent that the market cannot really support all the investments made during the expansion. Inevitably, there will be a point where interest rates will rise to reflect the reality of scarce resources.
The crucial point is that credit expansion cannot continue indefinitely, even if the Fed and banks want it to continue. Eventually, continued expansion would lead to wild price increases and intolerable declines in the value of the currency. If pushed too far, a panic emerges and people no longer desire to hold currency—and there are many classic examples in history of such hyperinflations that have ruined monetary systems and destroyed wealth (including the famous German hyperinflation of the 1920s, which Mises had predicted and witnessed).
Obviously, most credit expansion stops well before this point, but even so, the damage is already done. There is no way to get the proverbial toothpaste back in the tube. A contraction must follow, which brings about the downside of the cycle. The general Austrian view is that the sooner such a contraction is halted, the milder will be the ensuing contraction and the shorter the period of recovery.
Mises’s prescription is simple and direct. “All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis: Forgo every attempt to prevent the impact of market prices on production. Give up the pursuit of policies which seek to establish interest rates, wage rates and commodity prices different from those the market indicates.”
This is the distilled core message of the Austrian business cycle theory. In the popular press, one can find the most absurd reasons put forth for the creation of economic bubbles. For example, former Treasury Secretary Nicholas Brady wrote in a recent New York Times editorial that economic bubbles were a “byproduct of runaway human emotions . . . that arise when people congregate and talk.” Absent from such a view is any mention of the harm done by credit expansion, by fiat currency, by fractional reserve banking and by the constant tinkering done by government planners.
As Mises succinctly put it, “Hampering the functions of the market and the formation of prices does not create order. Instead it leads to chaos, to crisis.”
Regulatory Wedges
The story is often told that economic contractions are milder today because of government safety nets. Proponents of this view sometimes throw around the term “automatic stabilizers.” According to their theory, as the economy weakens, government safety nets kick in to provide a floor of stability for the economy. However, these interventions, too, only serve to hamper the market and lead to instability and waste. One analysis of the effects of these interventions was discussed in an interesting paper by professors William Barnett and J. Stuart Wood titled “Business Cycle Theory and Stagflation” (presented at the 2002 Austrian Scholar’s Conference). In this paper, the concept of “regulatory wedges” is discussed.
These wedges arise from interventions in the economy that are not directly monetary in nature—for example, “governmental purchases of goods and services, transfer payments, taxation, governmental borrowing, lending and loan guarantees, and those regulations of economic activity not included in the financial category.” In essence, these interventions are aimed at redistributing wealth to politically favored groups—recent examples would include airline bailouts, steel and lumber tariffs, etc.
As the professors point out, these interventions affect the adjustment process during the downturn. They allow these groups to escape the market process, to thwart the demands of consumers. These interventions create, to use the professors’ metaphor, a wedge between the wants of consumers and the state of the market. Economically unprofitable businesses, for example, are allowed to persist much longer than they would have without government assistance. “This condition,” the professors conclude, “manifests itself in the form of massive and persistent misallocations of resources: economic stagnation.”
Regulatory wedges then, do not provide stability. They instead lengthen the adjustment process, extending economic downturns and wasting precious resources. Rather than provide a floor, these wedges act as obstacles impeding efforts to bring the economy back in line with the demands of consumers.
In summary, using the insights provided by Austrian business cycle theory, the answer to the question of whether or not the government should stabilize the economy becomes clear. For whatever the government does, by definition, it does to circumvent the market process. Interventions seek to create a state that is not supported by consumers, which is counterproductive to economic recovery. Therefore, the only way out, as Mises recommended, is to forgo all such attempts.
Christopher Mayer is a commercial lender in Maryland (cwmayer@provbank.com).
