Most of us are educated (I would say indoctrinated) to believe that government is either a good institution or, at worst, a necessary evil. We learn that without a government, the world would be overrun by chaos and lawlessness. Examples typically brought up are those of Somalia, Sudan and other African nations where, apparently, government failures have led to chaos and lawlessness.
We are told that the market is an inherently fragile set up prone to frequent and severe economic crises that may be called depressions, recessions, slowdowns, downturns, etc. We are also told that without government and its intervention, people would become hapless victims of these market failures that would randomly impoverish millions of people for no fault of theirs.
Another justification given for government is that there are economic goods which are not best left to the free market to provide. The reasons are many and varied. Even the most die-hard free market advocate would face difficulty explaining why education and healthcare should be left to the free market. It is said that on a free market, the poorer a person is, the lesser the chance that he gets access to even basic education and healthcare. A free market, it is further added, would leave vast numbers of the population uneducated and sick/dying/dead simply because they are poor.
In the case of goods like “infrastructure” (that includes, roads, railways, ports, water supply, drainage, electricity generation and supply, etc.), the kind of investments required are said to be so huge that it would be impossible to build infrastructure and get on to a path of accelerated growth without government intervention. For goods such as law and order, justice and defence, it is said that it is impossible for the free market to provide these services without the society turning in a bed of chaos and lawlessness.
What we do not ever learn unless we take the initiative to do so and do that outside of the mainstream education system is the extent of harm that government is capable of and has been inflicting on human beings in general for many millennia. It is only in the last 3 centuries since the development of economic thought has it been possible for us to understand the depth and the breadth of the damage that governments do to the economy and thus to people’s lives and to the very fabric of civilisation.
In this series, I plan to cover many of the ways in which government has brought and still brings misery upon ordinary, honest, hard-working people. My arguments would be largely economic, though it is very difficult indeed to avoid the political arguments completely. As a start, I shall show in this piece how government is the cause of the massive human suffering caused by the much dreaded phenomenon called the economic depression.
Introduction to Economic Depressions
Nobody likes an Economic Depression. We don’t like recessions, slowdowns and downturns in the economy either (It’s a different matter that these are all just fancy names coined to denote what were originally called depressions, but I’ll leave that for another day). Economic Depressions are periods characterized by widespread business failure accompanied by liquidation of past investments that are suddenly not worthwhile anymore, scary levels of job losses and massive levels of unsold inventory all through the production system. On top of all this, a number of projects started in a period when unlimited prosperity seemed possible now inexplicably become not worth completing and are abandoned. The net result is general misery all around. A number of people even commit suicide unable to repay the debt burden caused by business failure.
Anyone who wants to relate to how an economic depression hurts people would do well to watch the movie “The pursuit of happyness” (See? Even MS Word knows that it is happiness and not happyness. I had to overrule it twice 🙂 ). Large number of people, even the educated and highly qualified, being out of jobs and standing in queues of soup kitchens and overnight shelters run by charities and products involving (apparently) cutting edge technology (bone density scanners in this case) suddenly appearing “not worth it” are normal during a recession. Will Smith is without a job and struggling to get rid of his inventory, not because he has suddenly become incompetent but because he is being tossed around in the storm waters of the 1980-82 recession in the US.
What are Economic Depressions?
Mainstream economic thought holds that Economic Depressions are unpredictable events caused by factors external to the economy. According to this notion, a market economy typically tends to oscillate between periods of extreme (irrational) optimism and extreme (once again irrational) pessimism. During periods of extreme optimism, the economy witnesses rapid growth in consumption of consumers’ goods accompanied by significant investments in building production capacity. Prices of various assets such as land, stocks, precious metals, commodities, etc., rise rapidly and significantly and everyone experiences a general feeling of prosperity.
Then, suddenly, just when the prosperity seems never ending and the world is about to turn into a land of milk and honey, the mood of optimism vanishes and is replaced by a general mood of pessimism. People suddenly consume far less than they were consuming during the period of optimism. Their irrational and deep pessimism also drives them to cut back severely on their investment spending. This further drives incomes down even further forcing people to cut back further in their consumption and investment spending. Businesses, seeing the sharp drop in volume of business, further cut back spending of various forms including through firing their employees. The result is a further deepening of the downward spiral in income and investment which also causes many debt defaults and sends demand for goods spiralling down as well. This condition of the economy is what we call the Economic Depression. It is also called by other names such as recession, downturn, slowdown, etc.
After sufficient time has elapsed (and sufficient measures have been undertaken, says mainstream theory), the mood of pessimism wanes and optimism returns, leading to a recovery in incomes and investments. The process described above repeats and the economy goes through a fresh cycle of rapid economic growth fuelled by (irrational) optimism and an economic depression caused by (irrational) pessimism. This cyclical process by which an economy goes through repeated phases of rapid growth and economic depressions while growing in the long term is called the Business Cycle.
Causes of Economic Depressions – The Mainstream View
According to the Keynesian school of Economics (the dominant school of economic thought, especially in the area of Macro-Economics) and its modern variants, the causes of economic depressions lie outside the market economy. Irrational bouts of pessimism and optimism are, according to this school, inherent weaknesses in a market economy. Greed fuelled by ‘animal spirits’, it says, drives the boom and a sudden waning of the ‘animal spirits’ causes the bust.
Recommendations for depressions – The Mainstream View
The mainstream view holds that since economic depressions are unavoidable, all that needs to be done is to mitigate the effects of the depression and pull the economy back on a path of rapid growth. It visualises government as a stabilising factor in the market economy. During the boom, the government is supposed to build surpluses through wise taxation policies and during the depression, it is supposed to step in in place of the now scared private sector and spend the surplus it has built to keep the economy at ‘full employment’ or bring it back to that state. Some representatives of the mainstream also recommend government engaging in deficit spending (i.e., spending beyond its revenues) to prop up the failing economy.
How sound is the mainstream explanation of depressions?
The main problem with the mainstream explanation is that it is not an explanation at all. A ‘theory’ that says that investments are driven by a surge of ‘animal spirits’ and that these ‘animal spirits’ vanish suddenly and inexplicably causing depressions is not economics at all. It is not a causal explanation. In fact, it is tantamount to saying that there is no explanation.
On a more substantive note, an important weakness with the mainstream explanation is that it does not address the rash of entrepreneurial failures that always happen at the start of and through a depression. This point is made all the more stark if we realise that the entrepreneur’s role in the market economy is to correctly anticipate future demand and organise the different factors of production, reaping entrepreneurial profit in the process. The market has an inherent mechanism to weed out less effective entrepreneurs and to ensure that only the more effective ones survive and continue as entrepreneurs – the profit and loss mechanism. Ineffective entrepreneurs soon chalk up enough losses that they cease to be entrepreneurs and become salaried employees. There is only so much loss of capital they can stand. Therefore, a good theory of the business cycle has to explain why all or most entrepreneurs make erroneous forecasts that get revealed during the depression.
A further important weakness with the mainstream explanation is that it does not address a very important characteristic of economic depressions – that the rash of business failures is more pronounced in the capital goods or producers’ goods sectors than in the consumers’ goods sectors of the economy. If, as the Keynesians say, under-consumption (driven by a vanishing of ‘animal spirits’) is the reason for the depression, the depression should be as pronounced or more pronounced in the consumers’ goods sectors as in the producers’ goods sector. That it is the converse says that something is seriously wrong with the mainstream explanation of depressions.
Thus, we are forced to conclude that the mainstream explanation of the causes of depressions is not worth considering very seriously. What is worth considering is the Austrian Theory of the Business Cycle, originating as it does in the theory proposed by Ricardo which was developed into a comprehensive explanation of every aspect of the business cycle by the great economists Ludwig von Mises and Friedrich von Hayek. In fact, it is interesting to note that Friedrich von Hayek won the Nobel Prize in Economics for his theory of the business cycle.
The Austrian Theory of the Business Cycle
The boom-bust cycle is caused by an artificial suppression of the interest rate below its free market level. By suppressing the interest rate thus, the banking system expands credit way beyond the available pool of savings. The credit thus expanded enters the production system directly at the higher stages of the production system, i.e., in the capital goods industries rather than in the consumers’ goods industries. This happens because of the false signal given to entrepreneurs by the artificially depressed interest rate. A low interest rate on the free market indicates that consumers prefer future consumption to present consumption and hence that entrepreneurs shall be better off producing capital goods that will ultimately be ‘transformed’ into consumer goods for future consumption than producing consumers’ goods for present consumption. The artificially depressed interest rate, however, indicates no such real preference. Consumers have not set aside a portion of their income, i.e., they have not saved in order to consume more in the future.
To make matters worse, the massive credit expansion is necessarily accompanied by an equally massive monetary inflation or an increase in money supply. This increase in money supply during the boom phase drives up prices of all goods including producers’ goods as well as of factors of production such as nature and labour giving an illusion of greater profitability. This is why there is a general feeling of prosperity during the boom phase. Everyone seems to be making more money: entrepreneurs, labour and owners of factors of production such as land and capital goods. This illusion of greater profitability further drives up investments in the capital goods sectors.
Banks engage in this massive credit expansion and monetary inflation simply because it is profitable for them to create money out of thin air and lend it out at an interest. The more money they create out of nothing and lend it out, the more profits they make in the short-term.
This fairy tale does not last forever. There soon comes a time when the increased supply of consumers’ goods made possible by all the boom-time investments in capital goods hits the store shelves. The increased supply is not accompanied by a fall in prices because of the general price inflation induced by the monetary inflation. Consumers haven’t saved any money to buy the increased production either (that’s why credit had to be expanded by suppressing interest rate in the first place). As a result, demand falls below the ambitious boom-time projections. In the meantime, input prices still rise as monetary inflation drives prices up further. The price inflation soon forces interest rates up in an effort to curb the supply of money sloshing around in the economy. This has the adverse effect of raising the cost of credit for businesses.
The triple whammy of below-projected demand, rising input prices and rising interest rates suddenly reveals many a boom-time investment as a bad decision, a malinvestment. Many businesses shut down, some of them even before they could be completed, unable to bear the rising interest and other costs. Since a large number of these boom-time malinvestments necessarily happen in the capital goods sector, the rash of failures too happens in the capital goods sector. Large number of people get laid off and business investments are liquidated leading to a further fall in consumption expenditure leading to further rounds of business failures, a process that repeats till all the errors of the boom period have been cleansed from the economy. A recovery starts around this time, once again fuelled by a credit expansion backed by interest rate suppression and monetary inflation. The next round of the boom-bust cycle begins.
The Austrian Theory of the Business Cycle thus explains every important observed characteristic of the Business Cycle and can be considered the most comprehensive explanation available till date. What I have not explained so far is the role of government in all this. After all, I said right up front that I would show why government is harmful to all people. I’ll do just that now.
Exposing the nasty hand of government in creating the business cycle
Very simply put, the combination of massive credit expansion and equally massive monetary inflation is not possible on the free market. This is simply because such a move would render the entire banking system highly unstable and prone to collapse. Banks that expand too much credit would face the threat of the bank run where customers, having lost confidence in the bank’s stability, land up at the bank’s door-steps en masse to withdraw their cash. The bank, having engaged in monetary inflation, clearly would not have the cash to meet all customers’ demands and would have to declare bankruptcy.
What saves the banks today and makes it possible for them to engage in unbridled credit expansion? Very simply, it is the intervention by government to protect the banking system, in the process creating a ‘never-ending’ source of spending money for government itself. Over the last couple of centuries, governments have engaged in massive interventions in the monetary system to the point where they have completely taken it over.
Today, governments, through the Central Banks, have a complete monopoly over the production of money in the economy. Legal tender laws force everyone to accept government printed pieces of paper as money. Such paper money is a blatant attempt to escape the free market limits on monetary inflation. Unlike gold and silver which are scarce commodities that have to be mined, processed and minted, paper money is almost costless to produce, making it ‘easy money’ for its monopoly producer, government.
Over two centuries, governments have used their monopoly over the use of force to thrust their pieces of paper onto a public that was until then willing to accept only gold and silver coins as money. At various points in time when money was essentially gold or silver coins and paper money was just a substitute that had to be redeemed for the promised gold or silver on demand from a note holder, banks that had issued paper money way beyond their available reserves of gold or silver and were facing bankruptcy were saved by government by engaging in gross misuse of its monopoly over the criminal justice system. Very simply put, government passed unilateral moratoria freeing banks from the legal, contractual obligation to redeem their own notes and deposits in gold or silver.
Central Banking is another massive intervention by governments in the monetary system. On a free market, a bank that faces a bank run would collapse. Under Central Banking, the failing bank can access a ready supply of cash needed to tide over temporary surges in demand for cash. The Central Bank stands ready to save banks from their own excesses. What makes it possible for Central Banks to do so is the monopoly privilege of money creation granted to them by the government. The Central Bank also greatly enhances the extent of credit expansion that the banking system can engage in by providing the funds necessary for banks to do so.
The business cycle is not a product of the free market but a result of sustained and massive government intervention in the economy. Austrian Business Cycle Theory explains how the business cycle is essentially a creation not of a free market but of a banking system run amok. What makes it possible for the banking system to run amok is the active connivance of government in an act that enriches the banks and government itself at the expense of the billions of common people who are impoverished by the boom-bust cycle. If this doesn’t convince you that government is bad for human well-being, I wonder what will. However, I shall not give up and shall continue to try doing that in subsequent articles in this series.