Friday, July 3, 2009

Causes of Recessions

There is a perception that the current economic crisis stemmed from appropriate regulatory oversight, compounded by the creation of opaque financial instruments. None of these issues by themselves adequately explain the dire circumstance we are presently experiencing. In fact, considering the first part of the alleged reason leaves a lot to be desired. The fault lies in Central Bank policy.

The creation of money out of thin air by Central Bankers all over the world gave financial institutions perverse incentives to undertake unprofitable business. The financial instruments created during the bubble period could not have happened if money were not so easily available. Indeed, any financial firm (just like any other business) that desires to expand needs capital, which comes from saving not by resorting to the printing press. Printing money is not capital. Ask yourself this question, why is that a large number of businesses, which its owners are risking their capital in this endeavor and receive profits by adequately forecasting future demand, suddenly and in unison fail in their function? In other words, why business owners experience a “cluster of errors”? The answer lies in that Central Bank policy (i.e. printing money) fools them.

The severity of an economic crisis is directly related to the level of interference preceding it. The U.S. Central Bank, for example, lowered interest rates to historically low levels in 2003-2004 (1%). The easy money fed through the financial system and to the housing market. When the Central Bank reversed the easy money policy in 2006, the bust phase was inevitable. The economy began to crack in mid-2007 and busted in 2008. “Austrian” Theory says that we are not out of the woods yet; but rather a bigger bust is ahead, given the unprecedented level of market interference that has occurred thus far.

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