Few theories on the causes of depressions actually ascribe or work with the general theory of economics. To accept any of these theories is to suggest that proven basic economic concepts must be false. This would be the same as saying 12 is a prime number. To accept this notion as truth one would have to admit that the fundamental theorem of arithmetic is wrong. Knowing this we must throw out all theories that are not integrated with general economic theory. This does not mean that an answer for the cause of depressions does not exist. On the contrary, there is one theory that does incorporate this general theory and provides a valid explanation, not just for our recent recession, but also for the Great Depression and many other economic busts. This theory is known as the Business Cycle Theory[1] founded by the Austrian economist Ludwig von Mises.
To truly debunk the other theories, one only needs to think logically about what a depression is. A recession or depression is a phase that an economy undergoes to reallocate an immense amount of malinvestment. In other words, a majority of entrepreneurs made incorrect assessments of the desires of consumers and committed large amounts of money into these predictions. Keep in mind that this is how entrepreneurs make their entire livelihood, appeasing the desires of buyers. It is not out of the question for some of these predictions to be wrong. However, what makes a depression unique is the fact that an overwhelming majority of these businessmen have all made bad choices and have incurred large amounts of malinvestment. The question is what could have possibly misled over half of an economy’s brightest supply and demand minds? It would be a mistake to think that each was individually wrong for a magnitude of reasons. Logically there must have been some common item that deceived them all. The universal link between them all is the information that they use to determine the desires of their customers. The main tool at their disposal is the interest rate.
To many people, interest rates are simply an additional amount of money, determined by a set or adjusting percentage, which an individual pays on top of a loan or a mortgage that they have assumed. However, to businessmen, interest rates are a way to determine the desires of consumers, also known as consumer time preference.[2] In order to understand how this works, one must understand how loanable funds are collected by banks, the lending institutions, and how these establishments determine the interest rate that they charge. In a free market economy, banks receive money from their depositors, which are placed in checking and savings accounts. Once in their possession, the banks in turn take the money you give them and invest it to make a profit. This benefits multiple parties such as the bankers, corporations looking for funding, and individuals seeking money in the form of a home loan or for a multitude of other reasons. Banks can choose to invest your money into the bond market or stock market, providing capital to business. Another method, which is more commonly used, is for the banks to loan the money out and make more return of investment 0 in the form of interest. The banks determine the percentage of their interest rates in accordance with how much money the bank has to lend out. Just like any business the banks need to earn a certain amount of money off of each loan they offer in order to meet operational costs and still make a profit. So the more money the banks receive in deposits will in turn lower the rate at which they lend and vice versa the less they obtain the higher the rate will be for the customer. Another way to look at this is if interest rates are low, then Americans are saving their money and waiting to buy future goods. If rates are high then consumers/depositors are choosing to buy goods currently on the market, preferring immediate satisfaction. This is what consumer time preference essentially is.
In a free market economy, the interest rate is used to decide whether or not businesses should invest to meet current consumer demands or to undertake larger projects to meet the future demands that consumers are saving for. However, in America today, most people acknowledge the fact that consumer consumption has been at a high, yet at the same time, the interest rate has been at an all time historical low. This is not possible in a true free market economy. So, if this situation is naturally impossible, then what is its cause and what are its effects? One factor not discussed yet in this equation is the supply of money itself, which is regulated by the Federal Reserve. If the amount of money a bank has to lend determines the interest rate, then an issue of great importance is the total amount of money in an economy. Logically, the more money in circulation, the more likely it is that banks will have more to lend. This logic is part of an economic trend of thought known as Keynesianism[3], founded by the English economist John Maynard Keynes. The downside to this theory is the inflationary effects of a large money supply, which will lead to higher prices.
What does this all mean in application? The Federal Reserve, in an attempt to stimulate the economy, prints new money, which increases the money supply, which then in turn increases inflation and puts this new counterfeited money into circulation through banks by loaning it to them at a lower federal reserve rate. This provides banks with a much larger amount of money to lend out then the otherwise free market would have allowed. The big drawback to this, besides higher prices in the form of inflation, is how it distorts what the true consumer time preference really is. As discussed above, the interest rate divulges this information by showing whether or not people are spending money currently or waiting to spend it later. Conversely, if the government is printing new money and then gives it to the banks, which in effect lowers the rate of interest that they charge for loans, then the true consumer time preference cannot be known. This is what causes the extreme amount of malinvestment that result in the corrective depression phase. Businessmen are led to believe that consumers are saving money for later desires and purchases so that they invest money in long term projects. A great example of this is housing construction projects. More homes were constructed in the past decade then true consumer demand required because many believed there was a high demand for them due to the low interest rates. This is what led to the ultimate downfall in the housing market. The same can be said of the derivatives market and its effect on our current depression.
Depressions are not mythical anomalies that occur for unknown reasons, nor are they the cause of greedy capitalists. In fact, they are the result of government intrusion into the free market financial system in the form of the Federal Reserve System. An important historical fact to consider is the time line of American history after the Federal Reserve System was adopted in 1913. The immediate effect was a small depression before the boom of the roaring 20’s. Then in 1929, the nation found itself in the worst depression it had ever seen then and now. It is not a coincidence that this just happened only two decades after the system’s inception. By giving the Federal Reserve control over the financial system of the country it allowed government inflation to increase six times the amount it had previously been. This was caused by the Federal Reserve lowering the reserve requirements of national banks, which is the amount of money banks must keep on hand to cover their depositors, and by giving the banks the power to print money at their discretion. Again in the 1970’s, two decades after the end of the Great Depression the country was once again suffering from depression in the era of Stagflation. The country faced inflation rates of 11-13%, while also suffering from high interest rates as the Federal Reserve withdrew money from the system in an effort to combat the high inflation they had created in the 50’s and 60’s.[4] At the same time, the country suffered from a 9% unemployment rate for two years, which were sandwiched by several years of 7-8%.[5] Yet again in 2000, twenty years after the end of stagflation during the 1980’s, America suffered from another recession known as the Dot Com bust. The solution for this recession was more of what had caused it, an increase in the money supply that only delayed and worsened the unavoidable crash for another seven years. Of course, this is the current recession we now face.
There is only one way to avoid depressions of such great enormity; that is to prevent the malinvestment from ever happening and to allow free market principles to operate at their natural pace. There is no quick way to prosperity as Keynes tried to claim. Increasing credit through the form of money creation, only leads to higher prices for consumers and producers, malinvestment by corporations, and the destruction of the middle class and businesses as they are encouraged and forced into further debt. The true problem is the very nature of the fractional reserve banking system and their relationship with the Federal Reserve. For example, before the Federal Reserve was created in 1913, banks kept an average of 20% of deposits on hand to cover their clients. By 1917, that number had decreased to 10% and today banks with transaction below $55.2 million or less only have to hold no less the 3%.[6] That means that a bank that holds $55.2 million dollars in deposits only needs to have $1.65 million on hand to cover all their clients. This is not logical by any stretch of the imagination; and, furthermore is not sustainable in an unsound economy. This is a downward spiral that is not viable. These policies will only result in complete economic collapse if seen all the way through. The scary part about our current situation today is that the Federal government seems to be putting all their eggs in Keynes’ basket, but apparently they forgot that it is hard for a dead man to keep the basket from falling.
[1]Ludwig von Mises, Theory of Money and Credit, p.134
[2]Murray N. Rothbard, America’s Great Depression, p.
[3]John Maynard Keynes, The General Theory of Employment, Interest, and Money, p.165
[4] Bureau of Labor Statistics, ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.tx
[5] Bureau of Labor Statistics, http://www.bls.gov/web/empsit/cpseea1.pd
[6] Federal Reserve, http://www.federalreserve.gov/monetarypolicy/reservereq.htm
