Biz Talk: Economic Dip - Causes & Cure

By Shanu Athiparambath

Bangalore, India 

The world economies are withering in financial pain. If there is anything more dangerous than the suffering we are going through, it is the belief held universally, both by economists and laymen alike, that this crisis was born out of the excesses of free-booting capitalism, or “greed”. Nothing could be farther from the truth. As some good economists have noted, to blame the crisis on greed is tantamount to blaming plane crashes on gravity. Economic depressions are caused, not by anything inherent in the free markets, but due to government intervention in the economy-specifically, government manipulation of money and credit.

There is one thing in common between the intellectuals who blame the crisis on “laissez faire” capitalism. It is a complete lack of understanding of economics and the nature of capitalism. The term capitalism has a specific meaning and is not to be used loosely. Capitalism is a politico-economic system in which all property is privately owned, and the economy is left uncontrolled and unregulated by the government. It is ridiculous to blame the present mess on capitalism, when capitalism never existed anywhere in the first place.In the United States, government extorts a large part of personal income in the form of taxes.There are fifteen federal cabinet departments and more than hundred federal agencies and commissions.There are several other rules and regulations which tamper with the functioning of the free market.

It has also become customary to point out that we got here due to the deregulation that happened in the past three decades. No such deregulation happened. Fifty-one thousand new regulations were added in the past twelve years. The federal register has seventy-three thousand pages of government regulations, of which, ten thousand pages were added in the past three decades.The financial and housing system are highly controlled by the Government. There was never a free market in finance and housing. Fannie Mae and Freddie Mac are government-sponsored, government regulated mortgage giants. Banks are chartered, defined and regulated by the Government. Government promoted increased home ownership through loose monetary policy. Artificially low interest rates wouldn’t have been possible in the absence of the Fed. The existence of the Federal Reserve is totally incompatible with Capitalism. So is the existence of the Securities and Exchange Commission.

To make sense of the present crisis, one should first have a strong causal theory. This phenomenon of boom-bust cycles is clearly explained by the Austrian theory of Business Cycles. At any point in time, a particular amount of money would be spent in investment and savings and the rest in consumption. This investment-consumption pattern would be decided by the collective time preference of the people. If time preference is low, the investment consumption proportion would be high and if time preference is high, it would be low. The boom starts when banks print money and lend it at lower interest rates to businessmen and the general public. The increased money supply lowers the rate of interest below the market level artificially. This artificial lowering of the interest rates makes several projects seem profitable to businessmen which wouldn't have appeared so otherwise. If the interest rates had fallen due to lower time preference of people, and was backed by real savings, boom-bust cycles wouldn't have taken place. But, the artificial lowering of the interest rates sends wrong signals to businessmen about the savings-consumption pattern of individuals. Businessmen are mislead to think that there are more savings, when there isn’t. This low interest rate sends a signal to the entrepreneurs that consumers are asking for more goods and services in the future. In order to fulfill those future demands at a future date entrepreneurs starts new long term capital projects in present time which will enable them to produce more in future and thus meet the future demand of consumers. This leads to mal-investments. The recession is the necessary part of liquidating these mal-investments.

It is important to realize that the recession is the markets readjustment process, and is to be embraced. Business failures and bankruptcies are to be celebrated, as the market is correcting its own errors. There is no reason for the recession to last for a long time, if the government doesn’t intervene with the markets correction process. The intervention of the Government with the markets adjustment process aggravates the very problem it is supposed to cure.Bailouts are neither necessary, nor just.Usually governments prevent or delay the liquidation process,which prolongs the depression period.They inflate and creates more malinvestment,and this keeps down the interest rate.They keep wage rates up and hence aggravates the unemployment problem.They keep prices up creating unsaleable surpluses.They subsidize unemployment and hence prolong it.They stimulate consumption and discourage savings.All the above are the courses resorted to be the governments during a depression and each one of them is a bad course to take.

It might seem disturbing for some when I say that the Government should do nothing during a depression. Yet, “laissez-faire” is the ideal policy to take during a depression.Ideally, the government should liquidate the federal reserve and institute a free banking system based on 100% reserve requirements. Prices would steadily fall, year after year, and boom-bust cycles would come to an end!