At a recent BIS Conference, Edmund Phelps, the 2006 winner of the Nobel Prize in Economics, delivered a speech on the topic of monetary policy. He outlined the difficulties encountered by monetary policymakers in trying to contain the economic troubles given the level of complexity (or dynamism) of advanced economies. Certainly there is no shortage of opinions trying to explain the genesis of the credit crisis engulfing the financial industry. These opinions, more or less, are based on understanding the root causes of the business cycle. While Mr. Phelps' speech was very good, i thought, it did not go far enough in explaining the root of economic imbalance. Granted, that was not the theme of his talk, but the views one holds about about how the business cycle operates will certainly influence the reception of the speech; thus the inclusion of such topic should have been a priority. I trust this post may shed a bit of light in this matter.
To begin to understand the root cause of the economic cycle one must understand the critical function that entrepreneurs play in an economy, especially under the influence of external factors. There are various schools of thought that try to explain this cycle. Yet, none but one satisfactorily explains why such high level of erroneous decision-making from people who are paid to forecast future business activity correctly is clustered around a particular period of time. Think about it: people make business projections, make investments based on those projections, and at a point in time there is a massive failure in their ability to forecast. Some number of businesses will always fail, there's no dispute on that argument; but it's peculiar that a lot of individuals who are good at forecasting suddenly loose that ability at the same time. Most popular theories miss this point entirely.
Brief Review of Business Cycle Theories
There are two broad camps where economists generally fall, although they are not all inclusive. Classical economists basically view the business cycle as a natural consequence to any production or spending dislocation. Because they are firm adherents to Adam Smith's invisible-hand, this dislocation would not be expected to be prolonged and it should fixed itself through market forces. Classicals do not explain in detail the rampant unemployment experienced in recessions, although some economists have made several propositions. Over the last 20 years, Classicals have expanded their theory to explain the why production and spending contract and point to productivity shocks (see Real Business Cycle Theory)--that is, as i like to say, anything that makes life easier. They were adamantly against government intervention. The other camp, headed by the ideas of John Keynes (aka Keynesians) claim that slack in private demand cause the business cycle: less demand, less businesses, less jobs, and well, less of everything we deem good. Since they believe that prices and wages are fixed in the short term, the only way to smooth out the cycle is through government spending. Keynesians are not concern about the sources of money of the government or how it gets to spend it. So, for example, if the U.S. government borrows from abroad to spend at home, Keynesian theory has no problem at all with that.
The Great Depression was certainly a turning point in U.S. economic history. Classicals expected the economic downturn to be short-lived, and when it did not turn out that way they lost credibility. Enter in the picture Mr. Keynes' The General Theory of Employment, Interest and Money published in 1936. A mathematician turned economist, Keynes' publication intentionally, it seems, created an idea that there was a scientific approach to social engineering by a central authority. The title of his book is a parallel to Albert Eistein's The Special and General Theory, where the latter expounded about the theory of relativity. Politicians, always looking for ways to increase their power, fell in love with Keynes' theory. Indeed, they took on Mr. Keynes proposition in full measure and beyond. It was until Milton Friedman came along to dispel the myth of Keynesianism. In short, Friedman (along with Edmund Phelps) stated that once market participants knew ahead of time what the government would do, people's expectations would automatically change, thereby leaving a particular economic situation unchanged. What mattered, therefore, was unexpected changes. The U.S. experience in the 1970's, a decade of rampant inflation and economic stagnation in light of government intervention, in my view, effectively nullified Keynesianism.
Monetarists, which is the school of thought that Milton Friedman belongs, insist that the business cycle in essence results from unstable money supply growth. Ask a monetarist the origin of any problem in the world and he/she will most likely answer you, "it's the money supply." While i agree with the free-market principles of monetarists, they have no problem accepting that the most important price of an economy--the interest rate, which is the price of money--is centrally-planned.
Another Business Cycle Perspective
The business cycle theory i am about to propose most likely you will not find it in any popular economics textbook nor will you hear about it much in mainstream academia. In fact, the more I learn about this theory, the more am convinced it is the most appropriate one to consider in the present day we live. Formally proposed by Ludwig von Mises, this "Austrian-school" economic theory is the only one that encamps an economy's capital structure as a pillar in understanding business cycles. In fact, base on his theory, Mises publicly declared, at the height of the 1920s boom, as a result of the Fed's intervention in the economy a severe economic recession would eventually ensue. Indeed, his prediction was realized. Succinctly, it states that when money creation is at full force, thus lowering interest rates below that which would exist in the absence of intervention, projects that would not have taken place become unrealistically profitable. The profitability illusion is destroyed, though not suddenly, once money creation ceases. Realizing they have been duped because of fictitious expected demand that resulted from too much printed money, entrepreneurs cut prices and production, thus causing an economic contraction. This is why financial institutions feel the first pinch, and why capital-intensive production falls more than consumer goods-related industries.
Consider the current U.S. experience. From 2001 to mid-year 2004, the Federal Reserve had a very loose monetary policy. This was the catalyst that fueled the housing, derivatives, and in part the commodities boom. From mid-2004 until early 2006, the FED changed its stance to a more tight policy. Once the FED initiated this policy, it was a matter of time before problems in the economy would surface. I realized in 2005 that our economy would suffer some serious setbacks; when that would happened, though, i had no idea. I expect production to continue to worsen and, given the weak balance sheet of the average U.S. citizen and the government, the horizon looks bleak.
As Ben Bernanke has acknowledged, the FED created the conditions of the Great Depression. Even though most economist focus on what the FED did after the stock market crashed in 1929, it is the excessive supply of money during most of the decade that goes unnoticed. This is why any economist who understands Mises theory could foresee the troubles ahead.