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ANYTHINGPEACEFUL

Behin d Busin ess CyclesOCTOBER15, 2013 by STEVEPATTERSON

We ve all heard the story: An unregulated free market leads to wild boomsand busts. If cowboy capit alists are left without careful

oversight, the economy is doomed to fluctuate like a roller-coaster. Thats why it is the government s job to tame the business cycle.

Given that financial markets are where a lot of t his unregulated mischief takes place, the central bank has a very special role.

This is the conventional wisdom t hese days. It s the story taught unchallenged in schools, repeated in the news, and generally

accepted as trut h.

Libertarians know better. We argue that, in fact, central bankscause the business cycle; they don t correct it. The United States has

not seen even a mildly unregulated financial market in the last century, so if w e wish to identify what causesour booms and busts, it

cannot be laissez-faire capit alism.

The basic Austrian school explanation is compelling: The central bank artificially lowers interest rates by creating moneyexnihilo,

which causes malinvestment and an unsustainable boom. The market eventually corrects itself when resources, labor, and capit al get

reallocated back into their appropriate sectors. This reallocation process is painful it includes bankruptcy and unemployment but

it isnecessary, like the drug addict who has to go through withdrawal before he is healthy again.

I believe thisnarrative to be true, but it is abstract. And if we want t o understand the concepts more concretely, we need to dig

deeper into specific aspects of t he theory.

For example, just howdoes money creation lead to booms?If banks merely lend out more paper bills, why does that result in

disaster?And does the boom really have to be unsustainable? If so, why?

We can answer these questionsby first understanding how banking works in a free market.As this art icle explains, bankscoordinate

the plans of savers and consumers.

To briefly summarize, when someone saves their money in a bank, it becomes available for an entrepreneur to borrow. But even

though an individual might deposit cash at a bank, this coordination is not about paper changing hands. It s about something deeper.


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When individuals save, they are choosing not to consume goods or services. And, at any given time, there is only a certain amount of

goods and services in the economy. The act of saving allows certain people to consume resources in other people s place.

Banks play the role of a middleman, coordinating who gets access to the finite pool of savings. Accurate coordination is paramount to

a healthy economy, and it is why central banksare the root cause of the business cycle.

The amount of savings providesa natural constraint on the number of projects entrepreneurs can undertake at any given time. If

there were an infinite amount of goodsand services at our disposal, anyone could undertake the grandest, most resource-intensive

project imaginable wit hout caring about the consequences. But we live in a world of scarce resources; some projects can go forward

and othersmust wait, or else the savingsw ould run out before all t he projects could be finished.

For example, imagine that a group of bricklayers thinks they have 10 timest he amount of brickst hey actually have in inventory. What

happens after all t heir projects start? They run out of bricks and probably go bankrupt in the process.

This is what happens when central banksstimulate t he economy by creating new money. Banksare encouraged to make loans not

backed by real savings. In contrast to the free-market system, in which individuals have to refrain from consuming goods in order t o

save them, these new loans are made without any party forgoing their consumption. The pool of savings gets depleted faster than it

is replenished.

This increased economic activity usually gets mistaken for real growth, as the economy transitions into the boom phase of the

business cycle. Unfortunately, the boom carries the seedsof an inevitable bust, for a number of reasons.

Many of the new projects entrepreneurs undertake don t have enough realsavingst o finance them. Thisis especially true of longer-

term projects that would not be profitable at higher interest rates. Those projects are only undertaken because the central bank is

pumping out cheap money.

Tangible wealth also gets destroyed during these artificial booms. For example, the resources and labor poured into the U.S. housing

market prior t o 2008 could have been utilized in other sectors of t he economy. Instead, wealth was diverted into housing projects

that proved worthless but the resourcesw ere now unavailable for anything else. Ludwig von Mises called this phenomenon

malinvestment, or literally, bad investment.

When the housing bubble popped, a huge, painful correction had to take place; capital and labor do not seamlessly tr ansition from

one sector of the economy to another. You can t t urn an empty subdivision into, say, an iPhone factory overnight. Temporary

unemployment and bankruptcy are the inevitable results of malinvestment.

The story of business cyclesw ould be bad enough if it ended there. However, when central banks are involved, it rarely does. Central

banks often view an economic bust as reason for further intervention. Whats their solution?Create more money and lower interest

rates even further.

If this spiral of intervention is not halted, central banks run a much higher risk than causing recessions; they risk destroying a currency

Asmore and more money gets pumped into the system, the value of each monetary unit decreases. And, given the reluctance of

central bankst o quit meddling in the economy, so much money can be created t hat it causeshyperinflation an extremely painful

economic scenario when a currency rapidly loses its purchasing power.

This is not mere speculation check out the long list of countries that have destroyed their currencies through hyperinflation in the

last century.

In fact, the United States central bank is currently pursuing a policy of extreme credit expansion, known as quantitative easing. The

first two rounds of quantitative easing have predictably failed, so the third has started, despite lip service of slowing down. If our

economy is not allowed t o correct itself and liquidate all t he malinvestment currently pervading it, the dollar may soon be added t o

the list of currencies destroyed by hyperinflation.

When central banks destroy the relationship betw een savers and consumers, between the amount of currency and t he amount of rea

savings in an economy, we should expect business cycles as a result. And history seems consistently to back up thistheory. Economic

disaster could be avoided if one principle wasclearly understood: Governments and central banks cannot create wealth by printing

money. Real savings do not come fresh off a printing press.

SHARETHIS


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ABOUT

STEVEPATTERSON

Steve Patt erson is a freelance motion graphics producer and writer. He is the creator ofThe Truth About... educational animation

series.

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