Arguments surrounding the causes of the global financial crisis have been heated since the recession began in December 2007. Economists, Politicians, activist groups and the media have all given a variety of different reasons for the economic meltdown. X said X Y said Y and Z said Z. This essay however, will focus on what the Austrian Economists deem to be the root cause of the crisis. Starting with an outline of Austrian Economic monetary theory as well as business cycle theory, this essay will apply these theories to the financial crisis. To strengthen the Austrian case, past depressions and recessions will be looked at to examine both how they occurred and how market intervention influenced recovery. The essay will then concentrate, still through an Austrian Lens, on how global inequality contributes to the present difficulties of the global economy.
“End the Fed” and “Restore sound money” are slogans often repeated at Ron Paul rallies around the US. Texan Senator Ron Paul is one of the head founders of the Campaign for Liberty movement, which seeks to end the Federal Reserve’s stranglehold of the monetary system. According to its campaigners, the cause and the prolonging of the current crisis – and all previous depressions and recessions – is monetary policy as well as government intervention in the market. To understand how they came to this conclusion it is necessary to lay out the Austrian economic principles that they adhere to.
Austrian economics is built on the foundation of sound money. This means that money must be fixed to a pure gold standard. ****linking sentence*** The fractional reserve system and its network of banks, backed by a central bank – the Federal Reserve – is now the dominant money system of the world. At the same time, the fraction of gold backing the debt money has steadily shrunk to nothing. Money’s basic nature has changed. On the gold standard, a paper dollar was a receipt that could be redeemed for a fixed weight of gold. In today’s banking system, a paper or digital dollar can only be redeemed for another paper or digital dollar. Privately created bank credit used to exist only in the form of private banknotes. Now however, privately created bank credit is legally convertible to government issued fiat currency. Fiat currency is money created by government decree. On the gold standard, the total amount of money in existence was limited to the actual physical quantities of gold. In order for new gold money to be created, more gold had to be found and mined out of the ground. With the present system, money is literally created as debt. New money is created whenever anyone takes a loan from a bank. As a result, the total amount of money that can be created has only one real limit – the total level of debt. Governments place an additional statutory limit on the creation of new money, by enforcing rules known as fractional reserve requirements. On the old gold standard, it was common to require banks to have at least one dollar’s worth of real gold in the vault to back 10 dollars worth of debt money created. Today, reserve requirement ratios no longer apply to the ratio of new money to gold on deposit, but merely to the ratio of new money to existing money. Today, a bank’s reserves consist of the amount of government-issued cash or equivalent that it has deposited with the central bank, and the amount of already existing debt money the bank has on deposit.
To explain why this is the basis of economic boom and bust cycles, the Austrian business cycle theory will now be introduced. The Austrian theory of the business cycle emerges from a simple comparison of a savings-induced boom, which is sustainable, with a credit-induced boom, which is not. An increase in saving by households and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocation effects on the economy’s capital structure are similar but whose ultimate consequences are sharply different. (*****Garrison)
According to the theory, the boom-bust cycle of malinvestment is generated by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks. This credit creation makes it appear as if the supply of “saved funds” ready for investment has increased. Borrowers are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. When the pool of “saved funds” increases, entrepreneurs invest in “longer process of production”. (******) Borrowers take their newly acquired funds and inflate the prices of capital and other producers’ goods, stimulating a shift of investment from consumer goods to capital goods industries. Lower interest rates increase the relative value of cash flows that come in the future. Because the debasement of the means of exchange is universal i.e. the Federal Reserve’s credit expansion influences the entire economy, many entrepreneurs can malinvest at the same time. As they are all competing for the same pool of capital and market share, some entrepreneurs begin to borrow simply to avoid being “overrun” by other entrepreneurs who may take advantage of the lower interest rates to invest in more up-to-date capital infrastructure. (*****) A tendency towards over-investment and speculative borrowing in this “artificial” low interest rate environment is therefore almost inevitable. This new money then spirals downward from the business borrowers to the factors of production: to the landowners and capital owners who sold assets to the newly indebted entrepreneurs, and then to the other factors of production in wages, rent, and interest. (*****) The ultimate recipients of the new money will tend to spend it on consumption items – not capital items – and the initial borrowers will find that their projections about demand for their capital goods will be mistaken. As losses mount, credit conditions will deteriorate as bank balance sheets are affected. Capital goods industries will find that they have over expanded and their malinvestment must be liquidated. In other words, the particular types of investments made during the monetary boom were inappropriate and “wrong” from the perspective of the long-term financial sustainability of the market because the price signals stimulating the investment were distorted by fractional reserve banking’s recursive lending which creates a bubble in the pricing structure in various capital markets (*****).
These theories will now be put into context of the present day crisis, starting with the housing crash that exposed the system as a debt-built Pyramid scheme. Back in 2002 the US economy was in need of recovery from the dot com crash. In May of that year, President George Bush announced that Freddie Mac was introducing 25 initiatives to eliminate home ownership barriers. Under these initiatives consumers with poor credit would be able to get a mortgage with an interest rate that automatically goes down after a period of consistent payments. Austrian scholars and supporters immediately saw a housing bubble in the making due to these measures. Many mainstream analysts at the time saw this as part of the recovery process from the dot com recession. Market analyst Peter Schiff however, a follower of the Austrian school, said just a week before the President’s announcement that the recession had not begun yet. “Recessions do not occur when consumers go deeper into debt, with home and auto sales at record highs. This is still the boom period and it’s being fed by foreign demand for US financial assets, which is allowing US interest rates to be low and access to cheap credit to be available.” (Schiff, 2002)
****The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit (de soto****)
****the theorem of the economic impossibility of socialism is fully applicable to central banks in general. According to this theorem, it is impossible to organize society, in terms of economics, based on coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. Indeed, nothing is more dangerous than to indulge in the notion that anyone can be wise and powerful enough to be able to keep the most suitable monetary policy fine-tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve has been the main architect and the culprit in their worsening. (de soto)
Ron paul/Austrian school intro/current crisis/peter Schiff predicting crisis and being laughed at 700
What money is/Monetary theory/business cycle 800
Past depressions/recessions 700
Inequality consumerism 700