16 Oct
Posted in: Blog
By    2 Comments

The Why of Undulating GDPs

Why is it that we periodically encounter contractions in economies?

This was a very active line of economic research in the 1920s and 1930s, and yet the topic is rarely researched today.  It’s as if in our postmodernism we’ve lost our inquisitive nature; such questions are now blasé, and so a consigned, apparently sophisticated nihilism reigns over examining the nature of the business cycle.

To be fair, the state of business cycle research in this esteemed era of global learning is not exactly ignored.  How could it be, when recession dominates news cycles and pushes two wars under the fold?  It does, however, have a certain flavor to it: positivism.  This is the same ideal that guides the scientific method.  To avoid a long discussion about epistemology and methodology, one that I am not qualified to lead, I will simply suggest that instead of looking to explain the Why’s of the business cycle, it focuses on the How’s and then cobbles together the (largely) numerical findings in what can only be described as a consensus theory with no coherence and even some logical inconsistencies.  These researchers tweak certain aspects when they are alarming and blatantly misleading or false, but still the looming and ultimate Why? for many was answered in 1936.

Most modern business publications give the answer in two words: animal spirits.  This was the phrase that Cambridge economist and British public policy adviser John Maynard Keynes used in his 1936 General Theory of Employment, Interest and Money.  According to Keynes, people inherently suffer from a harmful herd mentality that causes what now might be referred to as “irrational exuberance” (a la Greenspan), which drives prices far beyond what they “should” be.

This seems a plausible explanation, and one that appeals to our humbler and self-deprecating tendencies.  Is it so hard to believe that people acted stupidly, enchanted as they were with dreams of huge profits for little work, and bought into the idea of drastically increased prosperity?  At first pass Keynes’ theory appeals to our common sense.  From this acceptance, it is a short step to Keynes’ interventionist policies of deficit spending and monetary inflation, designed to break the bad psychological cycle allegedly driving the economy into recession.

To sum up Keynesian theory: societies are irrational and prone to periodic cycles of boom-bust, beginning with animal spirits that drive overinvestment, leading to boom.  This is followed by a crash, or bust, when the spirits experience an apparently whimsical change of heart.  This then leads to a contraction in consumer spending and increased saving, because the crash violated the economic security felt during the boom.  This contraction in consumer spending and increased thrift withhold resources, and businesses suffer from fewer sales and lower revenues.  More firms go out of business, leading to more crash, leading to more savings, leading to even less business, leading to even more saving… so the cycle is conceived.  It should be evident that this cycle has a positive feedback mechanism, and is thus self-reinforcing.  Saving is the culprit, which is why it has been described as “the paradox of saving,” or “the paradox of thrift.”  This is the central problem that Keynes looked to solve.

Following Keynes’ logic, governments exist in part to smooth out these cycles by taxing during the boom so that they may spend during the bust.  This helps plug the hole in consumer spending in the private sector – the alleged cause of the recession – and ultimately helps the economy as a whole.  These relatively new interventionist policies were first adopted during the Great Depression following the market crash of 1929.  Before this, American administrations claimed impotence (this is before Bill Clinton!), correctly in my view, and refused to step into the workings of the macroeconomy.

The subtler suggestion of Keynes’ theory was that even moral human societies are destined for periodic chaos, and that only government has the tools and foresight needed to save the shortsighted and parochial people from themselves.  This idea was fundamentally anti-American when introduced, not to mention fundamentally opposed to Adam Smith’s principle of self-interest and concept of organized liberty.  How the west, particularly America, came to adopt this alien view requires some historical context.

The years preceding 1936 were the interwar period, characterized in America by the so-called Lost Generation, and general disillusionment with the world as well as with American idealism.  This is evident in America’s isolationism and detachment from Europe.  For all their wonderful fashion and dazzling panache, 1920’s America was also cynical in a way that few of their ancestors would have understood.  Across the Atlantic in Europe and Russia, Communism and Fascism, the ying and yang of Marxian dogma with a Nietzschean (i.e., strongman) touch, were rising intellectually as a challenge to western-conceived freedom.  Following the crash of 1929 and facing recession, Americans looked overseas and saw the illusory successes of Germany and Italy restoring their national greatness through huge public works projects.  The continuing recession of the 1930s (resultant largely from Keynes’ ideas) incubated the insecurities of the Lost Generation, and all the doubts and bitterness accumulated from WW1 onwards matured into a full-fledged crisis in American confidence; a not-insignificant doubt in the ongoing feasibility of liberty as an organizing principle.  Only in this context can we understand how the nebulous idea of “animal spirits” gained academic traction.  It was an act of desperation from a desperate and increasingly unmoored people.

As is usually the case, however, the intuitive solution is not quite right, notwithstanding its kernel of truth.  To recount the story of how a truly general, yet largely ignored, theory of the business cycle developed, we must first take a brief detour back in time to Austria-Hungary, 24 years prior to Keynes’ publication.  In this era, Europe was extensively classically liberal; socialism was still viewed with skepticism and had not yet ossified into a dogma.  Understanding the rational conduct of free people was the agenda set for most pioneering economists.

In 1912, Austrian economist Ludwig von Mises published his Theory of Money and Credit.  Continuing in the tradition established by his teachers – Carl Menger and Eugen Bohm-Bawerk – Mises set out to fully apply the law of marginal utility to money.  Toward the end of his work, in a relatively brief section, Mises outlined how fractional reserve banking and the creation of credit out of thin air led inevitably to the boom-bust, or business, cycle.  This critical insight, not fully expanded upon by Mises but characteristically lucid, gave one of Mises’ students a starting point to fully investigate the implications of credit expansion on the economy.  This young student was the now famous Friedrich von Hayek, author of the still popular (although at the time, yet to be written) The Road to Serfdom.

In the 1930s, while the west wallowed in Keynes’ inspired economic stagnation and as a result began adopting super-authoritarian political regimes (the United States, notably, had its only four-term president), Hayek set out on a dual mission of explaining the business cycle from a free market perspective and at the same time exposing and deracinating Keynesian economics, which he viewed as subversive to free peoples

How did Hayek explain the business cycle?  It is understandable through the contemplation of the meaning and function of interest rates, which modulate the tradeoff between consumption and savings.  What of consumption versus savings?  Before anything can be loaned, it must first be saved.  This statement is parallel to the expression you can’t have your cake and eat it too! Consumption and savings are opposing concepts that describe the only two alternatives that man has when in possession of a good.  Either it is consumed or it is not – if it is not, we say it is saved.

The ontological reason for savings is anticipated future consumption; we stave off consumption today so we can consume more tomorrow.  As money is saved, a new opportunity arises that we call investment.  Investment can take the form of debt or equity, but for the sake of minimizing the complexity inherent in such consideration, let’s pretend for a minute that all investment takes the form of loans (debt), and not ownership (equity).  There are always two components to investment: risk and reward.  The riskier the investment, the higher the expected reward.  To maximize savings, people invest money across the risk spectrum and earn interest.  Interest is the cost associated with utilizing someone else’s accumulated savings – that is, it is the lender’s remuneration for his opportunity cost.  When interest rates are relatively high, it implies that people have a shorter time preference.  When interest rates are low, it implies a protracted time preference.  In a free market, low interest rates are almost certainly an outcome of abundant savings.

Interest rates are hence very important prices.  Information provided by interest rates helps shape the economy around the demographics and preferences of the population.  Artificially altering interest rates thus has real, tangible effects.  Consider the effects of lowering interest rates artificially in the context of savings and investment, described above.  In effect, the low rates send out the message that savings is abundant, and hence society as a whole can afford to invest in riskier business proposals.  In terms of finance, it shifts any number of projects with a negative net present values into profitable territory.  As the late Murray Rothbard (another student of Mises) pointed out, this phenomenon is seen especially in the increased production of long-term durable goods, like, say, houses.

The culprit here is not then the esoteric animal spirits, but the institution that sets target interest rates: the central bank.  Americans call their central bank the Federal Reserve, or simply the Fed.  Mechanistically, the Fed is able to target interest rates because it has sole, legal power over the currency.  To lower interest rates, it “prints money.”  (Note: the Fed does not literally print money anymore; this somewhat arcane expression refers to what used to happen before the invention of computerized banking systems.)  New money is given to banks in exchange for U.S. Treasury bonds, and because they have more liquid assets (that is, more loan fodder), they can lower rates to reach new customers – customers who are by definition less profitable and even unprofitable investments than those funded without the inflated money supply.  (A fuller explanation requires an integration of monetary theory, which is beyond the scope of my current ambition!)

It would be wrong to attribute all the blame on the Fed.  In truth, bankers have been creating money out of thin air for centuries.  We used to see the inevitable consequences of this scam in the form of bank runs, which have all but been illegalized by the FDIC (a government program created under that four-termer).  However old this practice may be, there is a fancy term used to describe what would otherwise be called fraud: fractional reserve banking.  It is just as the name implies: banks reserve a fraction of what they are given in deposits, and loan out the rest.  Reserve ratios are now written in law, but 10:1 is common practice.  Because these created dollars are then deposited into other banks, the total leverage achieved is closer to 100:1.  (For a better explanation, see here.)  Absent a central bank’s discounting window (i.e., bailout), however, bankers must consider that their competition can call their loans and finally bankrupt them.  Under the gold standard and absent nefarious banking bailouts, competition provided a natural check on excessive leverage and riskiness.

When the Fed dropped rates dramatically following September 11, 2001, it “printed” roughly $200 billion dollars.  This was illusory in the sense that it required no commensurate production.  It was akin to telling everybody in the nation that $200 billion dollars was now added to the savings pool.  (Of course, if this kind of action made a contribution to real savings, there would be no reason not to print $200 trillion.)  This $200 billion hit bank books, and was lent out at multiples.  This lending consumed real savings, fueled unprofitable ventures, and gave the illusion of tremendous prosperity.  But, as predicted, prices caught up eventually, and loans went bad.  Companies must liquidate their resources and find new channels of sustainable production.  Our economy is not adequately meeting our needs and must undergo a literal transformation.  This is a costly process that is, tragically, the result of our own monetary machinations and finally hubris.  A continued effort to frustrate this adjustment will prolong hardship, dispiriting the population and, if history is any guide, lead to the ascent of unsavory political forces.

For a few brief years, it looked like the Fed had figured out how to trump economic laws.  We now have empirical evidence that Mises and Hayek were correct, and the creation of money out of thin air, and not animal spirits, is the culprit.

I hope this provides an introduction to the alternative theory of the business cycle.  It should be obvious that many societal implications flow from this analysis, one of the most important being that a government that controls the money supply has no logical restraint on spending.  Throughout, I’ve tried to name the important social scientists and theorizers who developed the thoughtful system of analysis.  Unmentioned here, but influential to my own thinking, is Michael Novak, whose lifelong study of free societies and prodigious output are a treasure trove of insight.  As usual, I recommend mises.org for further reading on economics and classical liberalism.  (An article applying the theory to reality can be found here.)

DISCLAIMER: This post and the contents thereof are the views of only the author identified immediately above and do not necessarily represent the views of the New York Young Republican Club (the "NYYRC"), its officers or its members. The NYYRC expressly disclaims responsibility for the contents thereof and by its charter documents may not, and does not, endorse any candidate for any office, except in a general election.


  • I ran across this article by Gary North today. Thought it might add additional context and also correct me where wrong.


  • […] more.  The interplay of the subsequent processes that following expanding the money supply is complex, but it is not difficult to fathom the ultimate effects of falsifying information: massive […]