Monday, March 9, 2009

Why Economic Theory Is Important

We live at the beginning of the era of the "New" New Deal. So say the propagandists for the current administration. This in itself is a chilling thought, because the "Old" New Deal mired the nation in economic depression for over a decade. Counting the Hoover administration’s contributions, which can rightly be called the "Pre" New Deal, America was saddled with incompetent economic interventions for fifteen years.

One of the hallmarks of the "Old" New Deal was its happy-go-lucky attitude toward trying anything and everything to bring the economy out of depression—everything, that is, except keeping its crummy hands off the economy and allowing it to recover on its own. Both "Old" and "New" New Dealers persist in claiming that our current crisis is unique in American history and, thusly, justifies these unprecedented interventions. Nothing could be further from the truth.
America has experienced boom-and-bust business cycles since its founding, and there is nothing mysterious about them at all. The same thing—artificial expansion of the money supply--caused every one of them. The depressions of 1819, 1837, 1857, 1873, 1890, 1907, and 1930 have been well documented but, for some not-so-mysterious reason, little understood, at least by our brilliant leaders.

Austrian School Economists have developed a sophisticated theory of the business cycle that explains every one of these financial crises, including our current one. I gave away the punch line in the previous paragraph, but a little more explanation is necessary and I will give the laymen’s version of this theory in a bit. First let me explain why a theory of anything, especially economic theory, is essential to our understanding of both past and current events. The "Old" and "New" New Dealers eschew theory or, at least, they do not feel required to present a coherent one to explain how they expect their interventions to work. This reinforces their love of power, for they feel no need to justify their harmful actions since they claim that it is action itself that is required--any action, the more vigorous the better. Action inspires confidence. Confidence is all that is lacking. But without a coherent theory, history yields no lessons. History becomes merely a recitation of random events carrying no lessons cause and effect for guiding us in the future. Since history never repeats itself, apparently there is nothing for us to learn.

But history does repeat itself, and its lessons are clear. Every period of economic boom has been preceded by an expansion of credit not funded by actual savings. The existence of a central bank is not required for such events to occur, of course, since the U.S. had several boom-bust cycles when it had no central bank. (The Second Bank of the United States closed in 1837 and the Third Bank of the United States—our current Federal Reserve Bank—was formed in 1913.) But private banks expanded credit beyond their means during these periods because they were protected by both national and state legislation allowing them to suspend specie payment; that is, they were not required to honor their depositors’ demands for payment in gold as promised. Governments of this time, just like our current one, regarded banking as somehow different from other businesses and allowed them to continue to operate even after they had demonstrated that they were bankrupt. They had fraudulently lent out their customers’ deposits when they were supposed to keep them readily available to meet these same depositors’ demands for payment.

By lending out these "demand deposits"--what we today call "checking deposits"--the banks expanded credit, which became an increase in money via the lending process. This money was created out of thin air, just as our current Fed creates money out of thin air. Initially all seems well. Projects are started. Employment booms. But, because no new capital has been created—people did not save more—not all of the projects can be completed. Prices start to rise as the market slowly learns that, contrary to our wishes that we have entered a new economy, scarcity still exists. We cannot have our cake and eat it, too; that is, we cannot consume and save the same money, which is what artificial credit expansion leads us to believe is possible. Many new start-up projects fail, because the peoples’ consumption patterns have not changed—we still desire the same old ratio of consumption goods to future goods. Our unchanged savings patterns reveal the error, but only after vast quantities of capital have been expended because the false signals of cheap credit have led us to the opposite conclusion.

Those in government who snicker that all this is only "theory" are making a serious mistake in logic. Theory is not the same as an opinion. An opinion is not something that can be proven by logic, but theory can be so proven. It is my opinion that the Phillies will repeat as baseball’s world champions in 2009. Obviously, my opinion is merely a wish. But a theory has precepts that cannot be denied; it has internal logic that a rational person must accept; and a conclusion that must be accepted unless either the precepts or the logic can be shown to be faulty. We do not have to wait years or decades to know that artificial expansion of credit will lead to economic disaster—that is the benefit of a good theory. If we accept as true that fiat money expansion drives down the interest rate (and that is the Fed’s purpose, after all) without a complementary increase in savings, then we know the logical conclusion. Not all business plans that appeared sound may be fulfilled, because not enough capital is available due to the unchanged level of savings in the economy. (That’s why the interest rate was higher in the first place.) In fact the very act of driving down the interest rate exacerbates the savings shortfall by discouraging the marginal saver. This is theory, but it is unassailably consistent internally and it explains the history of boom-bust cycles in the past.

Why must we repeat this sorry scenario when we know where it will lead? Our governmental elite must be blind, incompetent, or willfully engaged in acts of self-aggrandizement to force this situation upon the nation once again. I leave it to the gentle reader to decide which of the three explains government’s behavior. It matters not, for the result will be the same. The Austrian theory of economic history proves it.