Following the 2008 financial crisis that catapulted America and Europe into what is called the great recession,The Financial Crisis Inquiry Commission (FCIC), the committee which investigated the causes of the crisis, concluded that it could have been averted. Such conclusion has implications of large proportions. Mainly, our way of managing our financial and economic affairs is fundamentally flawed.
Our attempt to manage and influence the economy and the people within it is a byproduct of our economic beliefs, which when tested in reality, fail to stand up to the complexity that an economy represents.
Current policies used by the Federal Reserve, and all other central banks, rely on intervention by them or the government to stimulate growth in the event that the economy lacks growth. One example of this is the $700 billion stimulus package introduced after the crisis by the United States Department of the Treasury, in addition to many rounds of quantitative easing imposed by the Federal Reserve since 2008. Quantitative easing (QE) is a monetary policy whereby the central bank purchases assets from the market to increase the currency supply, in addition increasing asset prices along the way as there is an increase in demand for components in the market, such as real estate or stocks. The other example is the quantitative easing program employed by the European Central Bank (ECB) with monthly purchases ranging from €13 billion to €60.
At the heart of quantitative easing is the belief that when there is no economic growth that through intervention governments can stimulate growth, however this has its limitations and dangerous consequences. The school of economic thought that is closest attributed to this policy of government intervention in markets is the Keynesian School of Economics, modeled after the late John Maynard Keynes. When government intervenes in the economy and increases the currency supply (inflation), if funded through debt, this is called deficit spending as it increases the government’s budget deficit. However, one major shortcoming of this approach is that it increases imbalances within the economy by stimulating demand through the facilitation of cheap credit availability and newly issued currency – something that cannot and will not happen indefinitely. Therefore, what happens when the availability of cheap credit and newly issued currency disappears?
What Is A Business Cycle?
The Austrian School of Economics, pioneered by the work of Ludwig Von Mises, Fredrick A Hayek and Murray Rothbard proposes that instead of creating artificial demand by way of government currency creation and deficit spending, that unless economic growth is sponsored voluntarily and naturally by people’s ability to use their savings to fund consumption, that the sustainability of such artificial government action creates economic booms that are quickly followed by economic busts, thereby destroying the illusion of created wealth.
The Austrian School of Economics highlights that there is a trade-off and a decision to be made at some point in regards to how people can use their resources. People can either decide to consume today by way of funding this consumption through either savings or debt, or they can invest the capital today and hold off consumption until a time in the future. As such, of importance is not the consumerism that we have become accustomed to through the policies of government and the mentality of popular culture, but the ability of individuals to save or consume at their discretion.
The money allocated by people for investment into the economy makes up the funds available for lending (called loanable funds). Entrepreneurs or businesses in the economy usually demand to borrow those funds in order to obtain capital for purposes of investing. The lending happens at the market rate, also called the interest rate, which is the equilibrium point where the supply of funds and demand for them meet, taking into consideration the current risk level of lending and the investment itself. The greater availability of funds for investment, the lower the lending rate is, thus making the cost of capital cheaper for a business, thus making it easier to manage the debt and less costly, helping to grow the economy faster.
Austrian School of Economics
The Austrian School of Economics positions that economic growth happens as a byproduct of the accurate matching of supply and demand for products, or a healthy level of production that is consistent with consumption levels, and thus leading to healthy inventory levels. The Austrian School of Economics Business Cycle Theory maintains that production keeps pace with the consumption level. The more there is room for consumption as the economy grows, the more the production increases, and vice versa.
The rate of growth an economy experiences depends on one important factor: the higher the propensity of people to invest in the economy, the greater the economy can expand.
Hayek argued that there are many stages of production based on the consumption level. At the early stages of production, both consumption and production go up. In the late stages, production goes down with decreasing consumption, and people allocate more funds for savings. As people save more, it signifies that currently the rate of consumption is low, but will naturally correct itself as people renew investment and consumption as savings continue to expand.
According to this, labor and wages adjust with the current level of production and consumption. As wages increase (or decrease), the market rate also is affected with more or less availability of funds for lending.
Here is how the Federal Reserve explains it:
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.
All those different variables (consumption, savings, market rate, labor market and wages) interact together leading to a healthy business cycle and economic growth. However, instead of allowing the economy to function as a self correcting mechanism, throughout history governments have attempted to stimulate continued economic growth despite the unavailability of savings, through the creation of currency and the artificial simultaneous reduction in the interest rate, thereby artificially fueling demand and the illusion of a population that has a large amount of savings to fund future growth. These actions by central banks and governments create unsustainable artificial periods of economic growth, only to be followed by a very real economic contraction that has far reaching generational consequences on the population, something which happened following 2008.
Since 2008 the economy has witnessed a wave of central bank intervention world wide on a scale that has not occurred throughout human history. This experiment, often referred by economists as “The Great Experiment” unfortunately is based on a premise that artificial demand through the creation of currency (inflation) can lead to increased sustainable economic investment and can therefore replace the savings that are so critical to the continued prospering of an economy. However, nothing ever moves in a straight line up or down, forward or backward. While the theories of present economic experiments were created in textbooks, their application in real life is a very dangerous omen to what may happen when the experiment proves to be flawed.
Only by reviewing our theoretical foundation and reexamining our beliefs can we reach feasible practical solutions for achieving sustainable economic growth.