False signals and recession – are recessions a natural phenomenon in capitalism?

With two consecutive quarters of negative GDP growth recorded in the first half of this year, most agree that our economy has entered a recession. But few will agree on its cause.

Given attempts by the Biden administration and others to blame soaring price inflation on multiple factors besides its true cause, opponents of a market economy will try to blame the recession on the capitalism itself and the supposed excesses and greed it facilitates. Booms and busts are inevitable in a capitalist system, many will insist.

Not true.

Just as it is true that the machinations of the Federal Reserve – the nation’s central bank – are to blame for price inflation, they are also the cause of booms and busts. “The centralization of credit in the hands of the state, by means of a national bank”, is moreover one of the pillars of the Communist Manifesto, decidedly not a characteristic of free market capitalism.

Business cycle theory takes many forms and has been the subject of countless books and essays. But the layman can save months of reading and studying and get at least a cursory, superficial understanding of how boom leads to bust with an analogy provided by 20e the economist of the century Ludwig von Mises in his 1949 book “Human Action”.

Mises began: “The whole entrepreneurial class is, so to speak, in the position of a master builder whose task it is to erect a building from a limited supply of building materials. If this man overestimates the quantity of the supply available, he draws up a plan for the execution of which the means at his disposal are not sufficient.

Imagine a builder making plans to build a house. He makes these plans thinking he has access to a certain amount of resources – bricks, lumber, siding, labor, etc. So why would the builder “overestimate the amount of supply available,” as Mises wrote?

False signals and incentives.

Interest rates in the economy, which are largely determined by the monetary policy of the Federal Reserve, send important signals and incentives throughout the economy. Low interest rates incentivize businesses to invest by making borrowing cheap and also signal that the supply of loanable funds is plentiful. Specifically, investments in longer-lasting durable equipment or even consumer durables like housing that are most interest rate sensitive will be increased. This distinction is important to make because the boom/bust cycle is not a story of general overinvestment, but of investing in the wrong lines of production that turn out to be unsustainable – what Mises called bad investing.

Ludwig von Mises and his pupil Friedrich A. Hayek. (Public domain)

But when interest rates are dropped to artificially low rates via the Federal Reserve’s easy money policy, as they have been for about 12 of the 14 years between 2008 and 2022, the incentive for businesses to borrow is still strong despite the falsification of the underlying signal. Indeed, interest rates were at historic lows not because of an abundance of real savings available to be lent by banks, but because of the massive creation of money out of thin air by the Fed. . As Mises wrote, this misleading signal misleads entrepreneurs about the “available supply” of resources available for investment.

Returning to Mises, he continued: “He (the master builder) over-dimensions the ground work and the foundations and only discovers later in the progress of the construction that he lacks the material necessary for the completion of the structure.”

Here, Mises is referring to entrepreneurs confronting the reality that the resources available for their projects are not as plentiful as artificially low interest rates erroneously suggested.

For example, Mises continued, “They are embarking on an expansion of investment on a scale for which there is not enough capital equipment available. Their projects are impractical due to insufficient supply of capital goods.

Artificially low interest rates encouraged increased business investment, but did not create the additional capital goods required by that investment. With increased demand for a relatively static supply of capital goods, the prices of these inputs are increased. Today, we see this reflected in producer input prices rising at rates not seen in four decades.

Moreover, as the Federal Reserve raises interest rates to calm inflation, it means a contraction in the money supply and the easy credit it fuels. Thus, not only is there less capital equipment than expected, but borrowing becomes more expensive, reflecting less availability of tax capital to complete or support entrepreneurs’ investment projects.

At high production costs, entrepreneurs begin to abandon projects “which cannot be pursued and completed because it has become apparent that they will not pay”. In other words, the cost of production increases to the point where the entrepreneur can no longer make a profit because the selling price needed to recoup the cost of production will be higher than what consumers can afford.

We see this, for example, starting to happen in the overheated housing market. Soaring construction costs (as well as rising mortgage rates) have pushed house prices to an unaffordable point for many consumers and as a result we have seen new home sales fall dramatically since the start of This year.

As Texas Tech economist Robert Murphy summed it up: “During the boom, driven by the influx of unsecured money and artificially cheap credit, entrepreneurs launch various physically unsustainable projects: there simply aren’t enough “real” savings to support all the projects through to completion.

As the recession unfolds, blame on “unbridled capitalism” and “corporate greed” will quickly circulate. But economic booms and busts are not inherent in a free market system. Instead, the false signals and distortions created by the central bank’s creation of fiat money are what lead to unsustainable investment projects. Understanding the causes of business cycle fluctuations is essential if we are ever to put an end to them.

Brian Balfour is senior vice president of research for the John Locke Foundation.

About Alexander Estrada

Check Also

Alexander Salter on National Economic Policy and Freedom

Many Americans believe that government has a responsibility to fight recessions. They should not. Politicians …