The Economic Crisis Explained
by Jesus Huerta De Soto
Morgan Reynolds – October 6, 2008
What has caused the financial meltdown and economic crisis? What will happen next? The answers are surprisingly easy once you know some Austrian economics. An excellent authority to consult is Jesus Huerta De Soto, a prominent Spanish economist and author of the 876-page tome, Money, Bank Credit, and Economic Cycles (2006, Mises Institute). Lo and behold, Professor De Soto also has penned an article on Mises.org today.
Professor De Soto
In contemporary political economies, the central bank and the banking system are responsible for the artificial expansion of credit. This causes an artificial boom which leads to an inevitable bust. So in the case of the U.S., Alan Greenspan and company are culpable, but let us consult Professor De Soto directly:
Alan Greenspan, aka Mr. MaGoo
“The fact that new crises erupt every few years shows that they originate from the credit expansion process, which necessarily sets off the spontaneous readjustments we have studied. In the absence of credit expansion, economic crises would be specific isolated events which would result only from unusual phenomena of a physical sort (poor crops, earthquakes, etc.) or of a social sort (wars, revolutions, etc.). They would not arise regularly, nor would they be as geographically widespread as they are. (pp. 456-66).
Specifically it is necessary to highlight the way in which the current monetary system, based on credit expansion, has made it customary for booms and crises to disturb economic development. In other words, it appears as if ‘manic-depressive’ behavior were required of a market economy.
Indeed businessmen, journalists, politicians, union members, and economic agents in general have come to consider the artificial expansionary phase characteristic of a boom to be the normal stage of prosperity, which should be sought and maintained in any way possible. By the same token, expansion’s inevitable consequences, i.e., crisis and recession, are considered a very negative stage which should be avoided at all costs.”
At this point De Soto quotes Ludwig von Mises: “The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that an artificially induced boom is doomed.” De Soto remarks: “Thus it is a grave error to believe real wealth is destroyed by the stock market crash which announces the crisis. On the contrary, the economic destruction takes place much earlier, in the form of generalized malinvestment during the previous stage, the credit boom. The fall in the stock market merely indicates economic agents have finally taken notice of this phenomenon.”
De Soto continues: “Economic agents do not recognize the recession as the inevitable result of artificial expansion, and they fail to realize it has the virtue of revealing the errors committed and facilitating the recovery and readjustment of the productive structure…Moreover the new money created via the expansionary granting of loans is used to finance all sorts of speculative operations, takeover bids and financial and trade wars in which the culture of short-sighted speculation prevails. In other words the misconceived idea that it is possible and desirable to accumulate astronomical profits with astonishing ease and swiftness spreads…
Furthermore as any deviation from artificial expansion and the excessive optimism it produces is viewed unfavorably, immediately attacked by the media and used as a political weapon to be hurled by the opposition, unions and business organizations, no one dares to condemn the evils of the credit policy. This creates an environment of monetary irresponsibility which tends to aggravate problems and makes it highly unlikely they will be resolved through a sensible readjustment and liquidation which lay the foundations for a sustained recovery that does not depend on credit expansion.
…each expansion process is invariably followed by a painful stage of readjustment, which is the ideal breeding ground for justifications of subsequent state intervention in the economy and ‘proves’ the necessity for the state to intervene more in the economy at all levels to mitigate the consequences of the recession and prevent further crises…these interventionist policies only serve to prolong and aggravate the recession, and to hamper the necessary recovery. Sadly, the timid beginnings of the recovery are accompanied by such public pressure in favor of new credit expansion that expansion begins again and the entire process is repeated. As Mises eloquently concludes: ‘But the worst is that people are incorrigible. After a few years they embark anew upon credit expansion, and the old story repeats itself.'”
And what about the stock market? De Soto writes:
“…uninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis…it is impossible to determine in advance exactly when and under what specific circumstances the artificial nature of the expansion will become evident in the stock market, ultimately setting off a crisis. However the stock market will definitely offer the first sign that the expansion is artificial and ‘feet of clay,’ and then quite possibly, the slightest trigger will set off a stock market crash. The crash will take place as soon as economic agents begin to doubt the continuance of the expansionary process, observe a slowdown or halt in credit expansion and in short, become convinced that a crisis and recession will appear in the near future. At that point the fate of the stock market is sealed.
The first symptoms of a stock market crisis seriously frighten politicians, economic authorities and the public in general, and a widespread clamor in favor of enough further credit expansion to consolidate and maintain the high stock market indexes is usually heard. High security prices are mistakenly viewed as a sign of good economic ‘health,’ and therefore it is wrongly believed that all possible measures should be taken to prevent the stock market from collapsing…the securities of companies that operate in the stages furthest from consumption reflect a more dramatic fall in market prices than those which represent companies that produce consumer goods and services…market sluggishness will last as long as the readjustment, and last indefinitely if the readjustment never concludes [Japan!] because new loans prolong malinvestment, and labor and all other markets are highly controlled and rigid…This rise in saving will stimulate growth in the price of securities which will indicate the recovery has begun and entrepreneurs are again embarking on new processes of investment of capital goods. Nonetheless the upturn in stock market indexes will not be spectacular as long as new credit expansion is not intiated.
The most important idea is this: in general, no significant, continuous rise in the price of securities can be accounted for by an improvement in production conditions nor by an increase in voluntary in voluntary saving; such a rise can only be indefinitely maintained as a result of inflationary growth in credit expansion…Only continuous, disproportionate growth in the money supply in the form of credit expansion can feed the speculative mania (or ‘irrational exuberance’) which characterizes all stock market booms…the credit expansion process inevitably provokes a crisis and readjustment period, during which much of the book value of banks’ assets evaporates…
In conclusion (pp. 811-2), if we wish to build a truly stable financial and monetary system for the 21st century, a system which will protect our economies as far as humanly possible from crises and recessions, we will have to:
1) ensure complete freedom of choice in currency, based on a metallic standard (gold) which would replace all fiduciary media issued in the past;
2) establish a free-banking system; and most importantly,
3) insist that all agents involved in the free-banking system be subject to and comply with traditional legal rules and principles, especially the principle that no one, not even a banker, can enjoy the privilege of loaning something entrusted to him on demand deposit (i.e., a free-banking system with a 100-percent reserve requirement).”