Escaping recession: as easy as ABCT

We must either allow zombie banks to collapse or keep putting off recovery with more monetary and fiscal stimulus. One option is wrong; one is right; there is no third

Isn't it time we faced up to economic reality?
John Phelan
On 10 April 2012 16:15

In economics, as with medicine, any cure must begin with a sound diagnosis. But if economists were doctors the patient would have died on the table. Despite its pretensions to scientific exactitude, the discipline has offered a bewildering array of diagnoses; the doctors are all still arguing.

The Marxist theory of economic cycles with its declining rate of profit is clearly useless; businesses were making record profits on the eve of the bust. There was no shock to Total Factor Productivity which a Real Business Cycle explanation would require. Keynesian ‘animal spirits’ are also unsatisfactory. The flight from mortgage backed assets was a totally rational response to the Federal Reserve raising interest rates between 2004 and 2007.

But there is another theory which fits the facts quite well: Austrian Business Cycle Theory (ABCT), so called because it grows out of the Austrian School of economics founded in Vienna by Carl Menger in the nineteenth century. It describes the causes and course of the current crisis better than any other theory and offers some insights in to what lies ahead.

ABCT starts with the idea that the interest rate is a price like any other matching the supply of something to the demand for it. Funds for investment are supplied (via saving); savings are demanded (for investment). If people cut back on current consumption and save more to increase future consumption then the interest rate falls and firms are able to borrow more to invest in the means to supply that future consumption. And when people begin drawing down their savings to fund current consumption the interest rate rises and firms cut back on investing for future consumption.

The key insight is that the interest rate is a real phenomenon. It reflects the ‘time preference’ of economic agents – the value they place on consumption of something now as opposed to consumption of the same thing in the future. The interest rate reflects the reward/incentive for abstinence on the part of the saver.  

But in the real world we have central banks. In response to something like the bursting of the dot com bubble, the Federal Reserve can lower interest rates, as it did in that instance, from 6.25 percent to 1.75 percent over the course of 2001.

The interest rate is not falling because of increased saving, rather it is being forced down artificially by the expansion of credit – the creation of phony capital, in other words.

As interest rates fall firms see ever more marginal investment opportunities becoming profitable; they borrow and undertake them; a boom is underway.

But eventually the inflation caused by this credit expansion starts to show even in the central bank’s cooked figures as when inflation went above 4 percent in the US in 2006. Interest rates are raised; the Fed Funds rate went above 5 percent the same year. Those marginal investments that looked viable at 1 percent are now scuppered.

This is the bust. Over the previous boom period capital has been allocated to investments, more properly called malinvestments, which have no hope of ever producing a return above their borrowing costs unless interest rates are kept low and credit is kept flowing.

The recession is not some mysterious collapse in aggregate demand which can be stopped with a dose of government spending. It is the liquidation of these unviable credit positions and it will not be over until this process is complete.

The Austrian School economist Ludwig von Mises wrote “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”

This is the Austrian choice: recognize the liquidation and allow zombie banks to collapse and stop soaking up scarce capital so we can get the recovery going or keep putting it off with more monetary and fiscal stimulus. True, this is a grim prospect, but that matters less than whether it is correct.

Anyone who says there is a third option, a painless way out which can be found simply by ticking a different box on a ballot paper, is selling snake oil.  

John Phelan is a Contributing Editor for The Commentator and a Fellow at the CobdenCentre. He has also written for City AM and Conservative Home and he blogs at Manchester Liberal. Follow him on Twitter at @TheBoyPhelan

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