Credit Crisis: Precursor of Great Inflation
Daily Article by Thorsten Polleit | Posted on 2/7/2008
The Role of the Crisis
The so-called "credit crisis" is gaining momentum. Investors
increasingly question the solidity of the banking system, as evidenced
by banks' tumbling stock prices and rising funding costs. With bank
credit supply expected to tighten, the profit outlook for the
corporate sector, which has benefited greatly from "easy credit"
conditions, deteriorates, pushing firms' market valuations lower. In
fact, peoples' optimism has given way to fears of job losses and
recession on a global scale.
Free market advocates, however, should not get carried away by the
price action in the market place. In a free market, there is nothing
wrong with individuals reassessing hitherto held expectations,
entailing changes in relative prices. A free market is a discovery
process, based on trial and error. Usually the effects of errors made
by some are compensated for by the gains of successful decisions taken
by others, and the economy expands.
Sometimes, however, the effects of errors dominate, and the economy
experiences what people call a crisis: income growth is (feared to be)
lower than what people think it should, and could, be. In that sense a
crisis is a correction of bad decisions. It is an indispensable part
of the free market. It pushes those producers out of business who do
not satisfy the needs of their clients, and it rewards those who serve
their customers well.
A crisis must be feared, however, if it has been caused by government
action, and if the obvious signs of the crisis provoke ever greater
doses of government intervention. In this case, the market would be
prevented from doing its job properly. Bad decisions would be
perpetuated, and the ultimate crisis may become nasty.
Diagnosing the Causes of the Crisis
It is against this background that one may wish to review the US
central bank's series of rate cuts, the latest being a big
75-basis-points rate slash on January 22, 2008, which brought the
official Fed Funds Target Rate to 3.5%.[1] While the Fed's moves were
mostly hailed in public as appropriate measures to help the economy
avoid recession, Austrian economists hold a completely different view.
According to the Austrian Monetary Theory of the Trade Cycle it is the
government-run money-supply monopoly that has not only caused the
crisis; the theory also diagnoses that rate cuts will not solve the
crisis, but will make it even worse.
Central banks, the government agents holding the power over the
printing press, pursue a monetary policy of "interest rate steering"
or, in other words, pushing the interest rate down as much as possible
by relentlessly increasing credit and money supply. It is this
inflationary monetary policy that causes trouble.
Ludwig von Mises pointed out that
today credit expansion is exclusively a government practice. As
far as private banks and bankers are instrumental in issuing fiduciary
media, their role is merely ancillary and concerns only
technicalities. The governments alone direct the course of affairs.
They have attained full supremacy in all matters concerning the size
of circulation credit. While the size of the credit expansion that
private banks and bankers are able to engineer on an unhampered market
is strictly limited, the governments aim at the greatest possible
amount of credit expansion.[2]
Initially, the artificial lowering of the interest rate creates an
illusion of richness and affluence. The increase in the money stock
via bank credit expansion erroneously suggests that the supply of
savings increases. Investment picks up, and the economy expands. The
illusion of plentiful resources leads to malinvestment, and sooner or
later the boom turns into a bust. While the money-fueled expansion is
a manifestation of the crisis, it is actually the slump — the
correction of malinvestment — that people complain about.
The alleged fight against the crisis
Once a crisis unfolds, central banks are called upon to lower interest
rates — in ignorance of the fact that a monetary policy of pushing
down the interest rate has caused the misery in the first place.
Cheaper borrowing costs, it is believed, would revive the economy by
stimulating investment and consumption, thereby adding to output and
employment. Lower interest rates would raise the prices of stocks,
bonds, and housing, translating into "wealth effects" which in turn
strengthen demand.
The obsession with a policy of lowering the interest rate is rooted in
a deep-seated ideological aversion against the interest rate. It is a
destructive ideology, in particular if the government is in charge of
the money supply. Because then the government central bank will lower
the interest rate to whatever is deemed appropriate from the viewpoint
of the government, pressure groups, and vested interest.
However, the interest rate is a reflection of peoples' "time
preference": because of scarcity, people value goods and services
available today ("present goods") more highly than goods and services
available at a later point in time ("future goods").[3] This is why
present goods trade at a premium over future goods. That premium is
the interest rate, or the "time preference rate." The interest rate is
a free-market phenomenon.
A policy of suppressing the market interest rate through a
government-sponsore
against the free market:
Credit expansion is the governments' foremost tool in their
struggle against the market economy. In their hands it is the magic
wand designed to conjure away the scarcity of capital goods, to lower
the rate of interest or to abolish it altogether, to finance lavish
government spending, to expropriate the capitalists, to contrive
everlasting booms, and to make everybody prosperous.[
Causing Inflation
A monetary policy of lowering the interest rate via expanding credit
and money corresponds to the widely held view that "some inflation" is
a requisite for economic expansion. In fact, the "inflation bias" has
become so widespread that nowadays inflation (the rise in the money
supply) is much less feared than deflation (the decline in the money
supply).
Mises was aware of what happens once the inevitable crisis caused by a
manipulation of the interest rate unfolds: "In the opinion of the
public, more inflation and more credit expansion are the only remedy
against the evils inflation and credit expansion have brought about."[5]
The current credit crisis is a sad case in point: with monetary policy
having caused inflation and malinvestment, it is now called upon to
pursue a policy that leads to even more inflation and malinvestment.
Could monetary policy become "ineffective,
create inflation? For instance, the Bank of Japan's rate cuts around
the beginning of the 1990s — as a reaction to falling asset prices and
a growing volume of bad loans in banks' portfolio — did not succeed in
bringing credit and money growth rates back to precrisis levels. Even
with official rates at virtually zero, the economy remained in
stagnation and the Japanese stock market continued to decline.
Against the backdrop of the Japanese experience it should be noted
that there is no limit to central-bank money printing. Central banks
can, at any one time, buy any assets from banks and nonbanks such as
bonds, real estate, foreign currencies, etc. If a central bank buys,
say, debt from the corporate sector, it increases the money stock in
the hands of nonbanks directly; the commercial banking sector is not
needed for increasing the money supply.
Central banks' unlimited power over the money supply has been made
pretty clear by the chairman of the US Federal Reserve, Ben S.
Bernanke, in November 2002:
[T]he U.S. government has a technology, called a printing press
(or, today, its electronic equivalent), that allows it to produce as
many U.S. dollars as it wishes at essentially no cost. By increasing
the number of U.S. dollars in circulation, or even by credibly
threatening to do so, the U.S. government can also reduce the value of
a dollar in terms of goods and services, which is equivalent to
raising the prices in dollars of those goods and services. We conclude
that, under a paper-money system, a determined government can always
generate higher spending and hence positive inflation.[6]
So if the government is determined to create inflation, there should
be hardly any doubt that there will be inflation. The Fed's series of
rate cuts suggests that the bank tries to create additional credit and
money via lowering the interest rate on base money. But if such action
fails to yield inflation, it does not take much to expect that the
central bank may take recourse to less "regular" operations, if and
when such an inflation policy is deemed necessary to solve the credit
crisis.
So far, at least, US bank credit and money supply growth has remained
at a very high level. In December 2007, banks' commercial and
industrial loans grew at 10.9% y/y, and total bank loans and leases
were up 10.8% y/y. Real estate loans — most likely as a consequence of
the defaults in the subprime markets — slowed down somewhat, but were
still running at 6.3% y/y. Against this background the Fed rate cuts
should actually accelerate the erosion of the exchange value of money
further.
Threatening Freedom
Inflation is a societal evil. It redistributes real wealth from
creditors to debtors. It impairs the role of money as a means of
exchange. The efficiency of the market's price mechanism is greatly
reduced, encouraging bad decisions, which in turn harm peoples'
economic well-being. At the end of the day, inflation is a serious
threat to freedom. The majority of the people, suffering badly from
inflation, would most likely blame the free market for their plight,
rather than blame the central bank for the debasing of the currency.
Print $17
Audio $25
Mises noted:
Nothing harmed the cause of liberalism more than the almost
regular return of feverish booms and of the dramatic breakdown of bull
markets followed by lingering slumps. Public opinion has become
convinced that such happenings are inevitable in the unhampered market
economy. People did not conceive that what they lamented was the
necessary outcome of policies directed toward a lowering of the rate
of interest by means of credit expansion. They stubbornly kept to
these policies and tried in vain to fight their undesired consequences
by more and more government interference.
From the Austrian viewpoint, the current credit crisis appears to be a
precursor of great inflation. If a deliberate policy of great
inflation is chosen in the United States, a monetary policy of
debasing the currency would most likely also take hold in other
currency areas of the world. The credit crisis has become a threat to
the free societal order: as people become dispirited with the free
market order, the door would be pushed open for anti–free market policies.
Thorsten Polleit is Honorary Professor at the Frankfurt School of
Finance & Management. Send him mail. See his archive. Comment on the blog.
Notes
[1] The FOMC rate cut was made "in view of a weakening of the economic
outlook and increasing downside risks to growth. While strains in
short-term funding markets have eased somewhat, broader financial
market conditions have continued to deteriorate and credit has
tightened further for some businesses and households." US Federal
Reserve, Press Release, 22 January 2008.
[2] Mises, L. v. (1996), Human Action, p. 794.
[3] For the explanation of the Austrian theory of the interest rate,
see Rothbard, M.N. (1993), Man, Economy, and State: A Treatise on
Economic Principles, pp. 313.
[4] Mises, L. v. (1996), p. 794.
[5] Ibid, pp. 576.
[6] Remarks by Governor Ben S. Bernanke Before the National Economists
Club, Washington, D.C. November 21, 2002, "Deflation: Making Sure 'It'
Doesn't Happen Here."
[7] Mises, L. v. (1996), p. 444.
http://mises.
Wednesday, 17 September 2008
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