We may be heading for double dip, but don’t blame the government

Ours wont be as sweet

Reading the responses to Tuesday’s news that the British economy shrunk by 0.5% in the fourth quarter of 2010 will have left many confused.

On the one hand the Keynesians made the preposterous claim that government spending cuts which haven’t happened yet are ‘taking money out of the economy’. ‘Free market’ economists rapidly responded to the contrary, blaming the weather and dodgy stats. There is, they assured us, no danger of double dip.

As well as demonstrating the truth in Harry Truman’s old joke about the one armed economist, the confusion of mainstream economics in the face of the recession demonstrates their failure to address the fundamental question: what, actually, is a recession?

Austrian theory holds that the recession is the inevitable contraction in credit which follows its previous unsustainable expansion. Interest rates are cut by central banks, perhaps as response to something like the dot com boom in 2000 in the US or simply because, as in the UK, the government has diddled the inflation figures. Whatever the reason, as interest rates fell ever more marginal investment projects began to look viable and entrepreneurs borrowed to finance them. Individuals too can get involved, as they did over the last cycle with property.

But eventually, even in a world with dodgy inflation figures and, thanks to the vast productive capacity of countries such as China, prices which should be falling, the inflation caused by this credit expansion starts to show even in the central bank’s figures. Interest rates are raised, and those marginal investments that looked viable a short while ago are now underwater.

This is the recession. Over the previous boom period, capital has been allocated to investments, more properly called malinvestments, which have no hope of ever producing a return above their borrowing costs unless interest rates are kept low and credit is kept flowing. The recession is the liquidation of these unviable credit positions and it will not be over until this process is complete.

The response of policymakers to the current downturn has generally, however, been to try and inflate an air mattress of new credit under the nose-diving economy. If borrowing costs can be kept cheap, they reason, the malinvestments of the boom can be sustained, sparing the undoubted human cost that would accompany their liquidation. But, as we’ve seen, continued credit expansion leads to the inflation we are also seeing now. Continued attempts by central bankers to prevent a short, sharp, corrective recession will simply lead to a prolonged depression as demonstrated in Japan most recently.

The alternative is to let the recession run its course. Metaphors about hangovers often obscure just how painful this would be for many people but the historic record of these ‘free market’ recessions, most notably in the United States after both world wars, shows that they can purge the economy of malinvestments and set the stage for sustainable growth quite quickly.

The full corrective gale has yet to blow through the British economy and the frenzied efforts of the Bank of England’s printing presses to avoid it have only delayed it. But with inflation starting to roar they appear unable to postpone this second dip for much longer. The British economy may well be heading for double dip, but don’t blame the government.

This article originally appeared at The Cobden Centre

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