How Stimulating is Economic Stimulus? (Part 1)

On the November 1st episode of Radio Freethinker (which can be downloaded here) I presented the case that economic stimulus, especially how most countries are doing it, is ineffective and does not go after the core problem of the economy.

In part one I will explain what causes the recession in the first place. On Radio Freethinker I explained that J.M. Keynes never had a theory as to what caused recessions. This isn't entirely true. Keynes argued that recessions were caused by demand not being sufficient. Skipping the question of whether he is right or not for a second, one can easily see why this theory explains nothing. If recessions are caused by a drop in demand, what caused that drop? Keynes argues that people start saving too much which makes demand too low for the economy. Statistics clearly don't back him up. It isn't until after the recession that people start saving more. Clearly Keynes hasn't provided a theory that explains the continual cyclical nature of the economy. It will take me forever to explain all of the bad theories and why they are wrong, so i'll simply give you this link if you want to read more about them.

So you might be wondering whether the field of economics has any good theories explaining business cycles, and certainly there remains great debate amongst economists about which theory, if any, is correct. I know of only one that offers both a convincing logical explanation and fits in with the evidence of economic history. This theory is the Austrian Theory of the Business Cycle. Before I explain the theory I want to point out that historical evidence can never validate or disprove a theory in economics. There are simply too many variables in play for history alone to provide convincing answers alone. Historical statistics can only go so far in economics.

The Austrian Theory of the Business Cycle is a theory that seeks to answer the important question of what it is in the "modern free-market" that causes the constant cyclical expansion and contraction in the market. More specifically, it explains why so many investors start making stupid decisions all at once which leads to mass malinvestment. In a free market it is expected that some investors will make bad decisions, but it is very unlikely that most will without some external cause. According to the Austrian theory, that external cause is money expansion.

Some economists, and seemingly most policy makers, either fallaciously think money is completely neutral, that is that changing the money supply has no effect on real production in an economy, or think that it has only small desirable effects. The modern financial system that exists in most capitalist countries is based around a fractional reserve banking system. In a fractional reserve system, the money supply is not constant, nor is it readily obvious at what level it is increasing or decreasing. This unpredictability is a problem for rational markets, but isn't the major problem of the fractional reserve system.

Austrian theory deals primarily with a different problem caused by monetary inflation. In a truly free money market, individuals can choose to either spend their money, invest their money (directly or indirectly through intermediaries), or hoard their money. Their choices between these options are known as their time preference, as investing and hoarding are foregoing current consumption for future consumption. The total of all these decisions sets the equilibrium interest rate at a certain point where the amount of money being lent out matches the amount being borrowed. If most of the population begins to look more into the future, and therefore is willing to lend more, the interest rate lowers as more money is being lent, which in turn sends a signal to borrowers that they can borrow and invest at cheaper rates. This process is fundamentally important in arranging the economy so that consumption goods (food, clothes, entertainment etc.) and investment goods (machinery, commodities etc.) are produced at levels that the economy wants as a whole.

The problem with monetary inflation is that it upsets this balance. In our system, money entering through the banks and the fractional reserve system, is lent out to specific parts of the economy. In our economy, this is largely business investments and to mortgages. These sectors then experience more profits and price increases than the economy as a whole because of the lower than natural interest rates. The balance of the economy is thrown off from what it should be based on the time preferences of people. The low interest rates also lead to bad investments as there is an almost free flow of money for investments. Eventually this imbalance and string of bad investments can no longer be sustained by increasing the supply of money and the economy tries to rebalance. This rebalancing is known as a recession.

For more information on the Austrian theory see the wikipedia article and for loads of free and in depth resources go to the website of the Ludwig Von Mises Institute.

Coming up in part 2 I will argue that economic stimulus is not the solution, and really only worsens the problem, and I will also suggest better solutions.