How inflationary banking creates economic depressions and recessions

In response to my post of yesterday , a student of mine, Sankalp, had asked this question to which I responded thus. Sankalp raised an important point that I am sure a lot of people believe. With a little elaboration from my side, his question becomes this

What is the problem in banks being inflationary by nature if by engaging in such inflation, they will be able to lend much more and a lot more investment can happen? Would not an economy where lending is constrained by the actual amount of cash experience highly hampered growth in comparison?

Ordinary people see no problem in this state of affairs. Those with an exposure to mainstream economics would in fact jump to a fierce defence of this system and argue that growth would become highly constrained if the banking system were to allow cash to sit idle in the bank’s vaults while thousands of investment-worthy projects gather dust and go to rust.

The Austrian School of Economics in the tradition of Carl Menger, Böhm Bawerk, Ludwig von Mises, Friedrich Hayek and Murray Rothbard takes a radically different view of this situation. Austrian School economists explain that the much dreaded economic depression (including its modern semantic avatars, the economic recession, slowdown, downturn or whatever you wish to call it) is caused by the inflationary banking system.

The explanation, known by the name Austrian Business Cycle Theory, originated in the work of Ludwig von Mises in his book, The Theory of Money and Credit (1912) and was further developed by his student, Friedrich Hayek, in his books Monetary Theory and the Trade Cycle and Prices and Production. In fact, Friedrich Hayek went on to win the Nobel Prize in Economics in 1974 for his Business Cycle Theory, the only Austrian School economist to do so till date.

The brief version of Austrian Business Cycle Theory

In an earlier post, I had presented a stylised representation of a production system in which the original means of production, labour and land, are applied across various stages of production and eventually transformed into consumers’ goods. We saw in that case that the consumers’ goods output worth 100 oz was made possible and supported by a total capitalist saving of 318 oz.

What would happen if consumers were to decide to save 20 oz? Two things happen.
1. Consumption now falls to 80 oz
2. Capitalist savings go up to 338 oz
But what is the use of greater saving being available from capitalists when people have decided to consume less? The trick is to recognise that saving is a deferral of consumption, not permanent abstinence from consumption. In simpler terms, the saving is intended as future consumption. Saving is a decision to change the time of consumption.

This decision by consumers gets communicated to producers through a fall in the rate of interest. Producers take a cue and decide to rejig their production for a more distant future. In doing so, the production system becomes longer, with more stages of production. Hayek presented this in a highly stylised form using what are today known as Hayekian triangles as shown below.

Fig 1 - Hayekian Triangles representing the effect of new capitalist saving on the structure of production

Originally, a total saving of 160 oz churned out an output of 80 oz worth consumers’ goods. Now, a total saving of 180 oz churns out an output of 60 oz worth consumers’ goods. In our 6-stage production structure, a similar outcome would occur with a corresponding increase in the number of stages of production.

Many outcomes result. The immediate fall in demand for consumers’ goods leads to a fall in their prices. This is transmitted up the production structure, but the lower consumption does not put factors out of employment. The lower interest rate causes remoter stage capital goods prices to rise on account of much lower discounting (lower interest rates) of their imputed future contribution to revenue (called their discounted marginal value product). In the long run, greater availability of savings results in increased demand for factors in remoter stages of production.

The addition of stages implies greater specialisation and division of labour implying more efficient production thus leading to greater volume of consumers’ goods output in the future. This leads to a further fall in consumers’ goods prices in the future. However, when the greater output of consumers’ goods hit the market, the saved funds are now available to support their consumption. For the same 60 oz of spending, consumers get to consume the greater output of the longer and hence more efficient production system. This is the normal process by which an economy advances and standard of living improves.

Inflationary credit expansion and the production structure

When the banking system inflates money supply, it does so by injecting credit into the production system in the form of loans made to producers. This injection, however, takes place without saving by consumers. An injection of 80 oz of credit makes the production structure as long as in the earlier case with the 80 oz of consumers’ goods output being supported by a total apparent capitalist saving of 240 oz.

Fig 2 - Hayekian Triangles representing the effect of credit injection through monetary inflation on the structure of production

To achieve this credit expansion, the banking system will need to depress the interest rate. This lowered interest rate raises the prices of remoter stage capital goods as in the case of real savings, shifting factors of production there. However, the greater availability of capital without a fall in the demand for consumers’ goods results in a rise in the prices of factors of production. When the greater income is spent on consumers’ goods, their prices start going up as well, though after the prices of capital goods and their factors of production go up.

A general feeling of prosperity is created all around as capital goods prices, consumers’ goods prices, wages and rents go up and profits emerge in the economy. This is the inflationary boom like the one we experienced from 2001 to 2007.

However, inflationary pressures soon catch up and the system is forced to raise interest rates. Production processes that started in the reduced interest rate regime suddenly become impossible to continue further. To make matters worse, when the greater output of the more efficient, longer production structure hits the market, savings are not available to be spent on them. Unsold inventory piles up and businesses rack up huge losses.

The result is widespread business failure including failure of financial institutions that made loans to borrowers who end up defaulting. This is what we understand as the bust, commonly known as an economic depression or recession.

What we see

The lengthening of the production structure caused by genuine saving was stable and sustainable in the long run. Lengthening fuelled by credit expansion, however, is unstable as the manner in which it is done creates pressures that force an untimely increase in interest rates resulting in the depression stage of the business cycle. We see that once the inflationary boom is triggered by credit expansion through monetary inflation by the banking system, the bust is inevitable.

Thus, Austrian Business Cycle Theory helps us understand that it is the inflationary banking system that is the primary cause of all the misery created by the phenomenon of economic depressions. The key question now is

Are these boom-bust cycles inherent to the capitalist system of production or are they a result of intervention in the economy? Is it at all possible to eliminate the business cycle?

These important questions shall be the subject of another post on another day.

How inflationary banking creates economic depressions and recessions
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