When economic crises hit people eventually turn to ask two questions; 1) How did it happen? 2) How do we stop it happening again? The current crisis has been no exception.

The popular reason put forward is “greed”, usually bankers lending to people unlikely to pay it back to achieve their bonuses. Such a simple minded explanation leaves many questions unanswered such as where did the bankers get all this money to lend out in the first place?

On a more scholarly level the old Keynesian theory of recessions has been dusted off which, essentially, puts everything down to a decline in business confidence. But this begs the question of what caused the decline in business confidence. It treats the symptom, the recession, without addressing underlying illness.

At times like this the search for explanations covers ground usually left alone. Marxists have been happily claiming that Marx has, after 160 years of waiting, been proved right. But another usually obscure theory offers answers to the two questions posed at the top.

Austrian Business Cycle Theory sounds like a tedious nightmare. In fact it is a school of economic thought which proudly renounces long winded, irrelevant, and often self defeating mathematical equations, relying, instead, on logical deduction. It is probably this accessibility to the general reader that accounts for its being largely ignored by mainstream economists eager to give their art the appearance of science by dressing it up in algebra.

Austrian Theory starts with the idea that the interest rate is a price like any other, matching the supply of something to the demand for it. In this case the supply is savings and the demand is funds for investment. So, if the public decide that they want to increase the amount of money they are saving they put it in a bank. A business, on the other hand, which wants to borrow cash to invest in a new factory, must go to the bank and borrow this money.

The interest rate matches the two sides of this transaction. When people save they are, essentially, postponing spending today for spending tomorrow. The banks offer interest to savers so they can encourage them to deposit their money with them and, thus, give the banks money to loan out to businesses for investment. When people decide to save the banks don’t need to offer such a high incentive to deposit so can afford to offer lower interest rates. These lower interest rates are passed on to the businesses. They see that the cost of borrowing from a bank has fallen so they borrow to fund investment projects, such as new factories, which will not produce a return in the short run but will in the future. The signal has passed, via the interest rate, from the savers who wish to postpone their spending, to businesses who will now borrow this money to cater for the future spending.

So far so good. Savings equal investment. And when people decide they want to spend rather than save they pull their money out of the banks which forces them to offer higher interest rates to attract loanable funds. These higher rates are, as before, passed onto business which sees the signal that people are spending their money now so investment spending on future projects is stopped.

But then the monetary authority steps in. In the UK it is the Bank of England, in the US the Federal Reserve, in the EU the European Central Bank, and there are as many around the world as there are currencies to be issued. Say, for example, that the Federal Reserve decides that it wants low interest rates to spur investment and economic growth, exactly, in fact, what it is doing now. It does this through what are called ‘Open Market Operations’. The Fed offers to buy securities from banks and buys them with money created out of thin air. It’s that simple.

But this intervention destroys the interest rates ability to balance saving and investment and the two things rapidly tumble out of kilter. This is where it hits the fan.

The banks are now awash with cash and can go merrily lending out to anyone they like whether they can pay it back or not (especially if, as in the US, they are under Congressional pressure to lend to poor families). Indeed, interest rates are so low that to make a profit they may be forced to lend to just the sorts of marginal borrowers least likely to be able to pay it back.

Business, meanwhile, sees these low interest rates and begins borrowing to invest assuming that people are saving to spend in future. They may decide to build units in places like Michigan assuming that they will be bought in a few years when people have decided to start spending again.

But people are already spending. The lower interest rates mean there is no incentive for them to save as they will see no reward for it. So they go out and spend and, encouraged by the low interest rates, they borrow and run up massive credit card bills and take out mortgages at 6 times their salary.

The economy is, by now, being constantly pumped up by continuing injections of new money. But eventually the penny drops. The central bank raises interest rates. Business can no longer borrow to fund investment. People begin saving thanks to these higher interest rates and, coupled with a fall in consumer borrowing, another source of income for business dries up. We now have a recession.

That, in a nutshell, is the theory. How does it stack up in practice?

A recent book by Thomas E Woods, ‘Meltdown’, applies the theory to the US and shows how the property bubble (like the dot com bubble before it) was inflated then popped by the loose monetary policy of Alan Greenspan’s Federal Reserve.

But the theory doesn’t just hold for the US. In Britain too we’ve had a long period of historically low interest rates. Between 1993 and 2001, interest rates averaged 6%. From 2002 to 2008 they averaged 4.5%. This prompted corporate borrowing in the UK to balloon from £99 billion in 2003 to £269 billion in 2008. Consumer debt also rocketed to more than £1.4 trillion. Then interest rates rose from 4.5% in July 2006 to 5.75% in July 2007; right when the crisis began.

Much has been left out here, notably the role of the inevitable inflation which follows the credit expansion in prompting central banks to raise interest rates. In the UK the RPI index rose from 2.6% in April 2006 to 4.8% in March 2007 prompting the Bank of England’s to raise interest rates from 4.5% to 5.75% in July 2007. Similar inflationary pressures in the US saw the inflation rate rise from 2.6% in spring 2005 to 4.75% in the autumn. This prompted the Fed to edge the Fed Funds Rate up from 1% in mid 2004 to 5.25% in early 2006 where it stayed until late 2007. These central bank rate increases were a direct cause of the bursting of the property boom the same authorities had created.

We’ve also not looked at how the credit expansion especially effects the capital goods industries, such as manufacturing or building which thrive on cheap borrowing but suffer disproportionately in the credit contraction. In June this year LDV Vans went bust in the UK after failing to secure a government bailout. In the US Chrysler had no such trouble getting its hands on taxpayer cash. In the UK the housing construction market declined by 13% in 2008. In the US McGraw-Hill Construction calculated a 12% decrease in construction starts in the same year.

So we have, perhaps, an answer to our first question. We can also answer another question of why Austrian Theory is paid little attention by monetary managers; Shifting the blame from greedy bankers, mysterious declines in business confidence or inherent flaws in capitalism and placing responsibility squarely with the mangers of the national currency is a sure way to earn the opposition of those very same managers. For an answer to the second question, how stop this happening again, Ill return next week.

Heres a link to the book ‘Meltdown’


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