Why the Current Policy Prescriptions Cannot Possibly Work
[This address was given at a hearing in the European Parliament, Strasbourg, France, July 14, 2009.]
The Cause of the Disaster
Are governments doing enough to fight this financial and economic crisis? Is it a good thing that central banks have cut interest rates essentially to zero and have increased the base money supply dramatically to support the financial sector? Will depression be prevented if governments across the world run up huge deficits in an attempt to strengthen demand, production, and employment?
To answer these questions truthfully, we need to diagnose the causes of the debacle and then formulate the proper way out of it. The diagnosis can be stated in just one sentence: Governments have caused the financial and economic debacle by suppressing the free market. And the recipe for ending the debacle reads as follows: Only the free market, and not the government, can end it.
An Analysis of the Debacle
To see this, one has to analyze the causes of the credit market debacle using sound — that is, Austrian — economics.
The debacle is the outcome of the government-controlled fiat money system. State-owned central banks hold a monopoly over the money supply, and they increase it out of thin air by extending circulation credit. Such a monetary regime inevitably creates disequilibria.
The rise in circulation credit lowers market interest rates below their natural levels — that is, the levels that would prevail had the credit supply not been artificially increased. The downward-manipulated interest rate induces additional investment and, at the same time, provokes a rise in consumption out of current income at the expense of savings. As a result, the increase in the money supply makes the overall monetary demand outstrip the economy's resource capacity; the economy starts living beyond its means.
A rising money supply pushes up prices sooner or later, be it the prices for consumer goods or those for assets (such as, for example, stocks, bonds, houses, real estate, etc.). Indeed, rising prices are the characteristic feature of the notoriously inflationary, government-sponsored fiat money system.
What is more, the artificially suppressed interest rate shifts scarce resources increasingly into the more time-consuming production processes for capital goods — at the expense of production processes for consumer goods. While the increase in the money supply initially stimulates economic activity, the ensuing boom is, rather tragically, economically unsustainable and must be followed by bust.
If the injection of additional credit and money out of thin air was a one-off affair, it presumably wouldn't take long for the boom to unwind. Market agents would restore their desired relation between consumption, savings, and investment — which was distorted by the expansion of credit and money — and this would reveal malinvestment. Market demand would fall short of firms' expectations, and unprofitable investment would have to be liquidated. Jobs created in the illusionary economic expansion phase would have to be axed.
Unfortunately, under today's government-sponsored fiat money systems, the increase in credit and money out of thin air is not a one-off affair. As soon as free market forces herald a correction process — that is, signal an approaching recession — public opinion calls for countermeasures.
This, in turn, won't be lost on central banks. Monetary policy makers increase the credit and money supply even further, thereby bringing interest rates to even lower levels. In other words, monetary policy fights the correction of the debacle by taking recourse to the very action that has caused the debacle in the first place.
Such a strategy may work occasionally. An approaching recession (bust) can, by means of lowering interest rates, be reversed into a recovery (boom). Murray N. Rothbard explained why
the boom is kept on its way and ahead of its inevitable comeuppance by repeated and accelerating doses of the stimulant of bank credit.
However, as soon as credit expansion really stops, the inevitable adjustment will unfold, and firms liquidate unsound investments and axe uneconomic jobs. The longer the failing boom was kept going, the greater will be the malinvestments that have to be corrected, and the higher will be output and employment losses.
To be sure, the monetary policy of suppressing the interest rate is widely hailed by mainstream economists as paving the way towards economic recovery. It is this very creed that lends intellectual support to governments and their central banks for continuing the policy that caused the disaster in the first place.
Ludwig von Mises knew of the public's ideological aversion to raising the interest rate, and he put the ensuing tragic chain of events as follows:
In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.
But Mises was well aware that pushing down interest rates to ever-lower levels would not solve the problem. He wrote,
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. 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.
The Danger of Destroying the Free Market Altogether
As noted earlier, a truthful diagnosis of the causes of the malaise is indispensable for seeking solutions. If one subscribes to the — in effect, irrefutably true — diagnosis of the malaise provided by Austrian economics, two conclusions must be drawn.
First, more credit and money at lower interest rates will not, and cannot, prevent the ultimate disaster that has been caused by too much credit and money. Second — and this aspect may not attract peoples' attention right away — governments' attempts to fight the correction will destroy what little is left of the free market order.
This becomes clear when taking a look at the role of private ownership of commercial banks in the current credit market turbulence. Commercial banks are the main producers of money, as they extend loans to private households, firms, and public entities.
However, bank owners have become increasingly concerned that borrowers might fail to service their debt as promised. As a result, they tell their bank managers to refrain from rolling over loans falling due — let alone expand the bank's credit exposure. If banks insist on having borrowers repay their loans, the stock of money declines, and this sets into motion the adjustment that is so much loathed by majority opinion.
To sustain the current level of credit and money supply, the government may want (and may find) public support to nationalize large parts of the banking industry. It could then force the nationalized banks to extend credit and money to firms, households, and governments — in a way that is politically desirable.
Needless to say, this development spells trouble on the grandest possible scale. It puts the government in charge of deciding who gets credit, and on what terms, and such an economy would (sooner or later) turn into a command, or planned, economy.
The (Only) Way Out
Against this backdrop, one must conclude that government interventionism in the field of monetary affairs has actually caused gruesome damage. In fact, the latest credit market turmoil is par excellence evidence that interventionism doesn't reach the goals it sets out to achieve.
As Mises wrote, "Interventionism is not an economic system, that is, it is not a method which enables people to achieve their aims. It is merely a system of procedures which disturb and eventually destroy the market economy. It hampers production and impairs satisfaction of needs. It does not make people richer; it makes people poorer."
The only way out of the debacle is a return to sound money — that is, free-market money — by privatizing the state-run monetary system. The free-market order, where people freely decide on the universally accepted means of exchange, would presumably be anchored by gold, but possibly also by other media (for example, silver, platinum, etc.).
The need for a return to sound money is not, as some hysterical antagonists and mainstream economists might wish to maintain, ideologically motivated. On the contrary, it can be logically deduced from Mises's praxeology, or the science of the logic of human action; only free-market money is compatible with maintaining the free market order.
This global monetary debacle is a testimony to the truth of what Mises and his followers have stated on the basis of praxeology, namely, that government-controlled fiat money must fail. It signals to us that it is high time to seek a fundamental monetary reform: the return to free-market money, for protecting and maintaining peoples' freedom and economic well-being.