Pundits on CNBC often take for granted that our current economic crisis is part of the traditional boom and bust cycle of capitalism. It is treated as a natural blight, like an earthquake or flood, which originates somewhere within the capitalist system and must be combated. But there exists another school of thought that places the blame not on capitalism but rather on intervention into the market by the federal government. The Austrian Theory of the Business Cycle not only explains the current crisis more completely than any other theory, it can also be used to explain all other previous crises.

Every business cycle theory must explain two facts. One, why is it that entrepreneurs, who are trained in understanding the market, are suddenly making a cluster of grave errors? Two, why is it that goods used in production (capital goods such as machine tools, land, raw materials) rise in price faster during the “boom” and fall faster in the “bust” relative to consumer goods (final products that are consumed in usage, such as toys, computers, etc.)?

To think about the first question, imagine a situation where for three or four weeks, most National Football League quarterbacks throw four touchdown passes per game. Then, for the next two or three weeks, most quarterbacks suddenly throw three interceptions per game. I do not believe, and I think most people would agree, that it would be accurate to say that this cycle of many touchdowns followed by many interceptions is a “product of the NFL system” or somehow natural conditions of the game would be a sufficient explanation. It seems that the game fluctuations would be caused not by some mystical actions of the game of football, but rather by rule variations from an outside source like more or fewer players allowed on defense or outlawing of certain types of defenses. Placing the blame on the capitalist system rather than outside interference would be equally wrong.

The second fact with every business cycle theory is that capital goods (such as land, stocks, machine tools) rise in price during the boom much faster than consumer goods (bubble gum and coffee). This is because prices, whether the market is free or not, are determined by supply and demand. Whenever an institution sets a price above or below the market price, there will be surpluses or shortages. The more important effect here is not the actual shortage or surplus, but rather that resources are being diverted away from where the market wants. If a price ceiling is imposed on wheat at $1 per bushel, for example when wheat would normally be sold at $2 per bushel, a shortage would develop. Fewer people would harvest wheat or become farmers.

Prices deliver information to investors and capitalists on the wishes of society, when and where people want to spend money. When the Federal Reserve sets interest rates, it imposes a price control. When it lowers the interest rate below the market rate, it sends signals to the market that do not reflect the wishes of society. In any other sector of the economy, this would cause a shortage of funds available to invest. However, in the banking system, the Federal Reserve can create money from thin air so that the shortage is never noticed and certain industries are given more loans.

Since saved funds lead to a lower interest rate, this implies that a lower interest rate reflects society’s desire to save more for the future. This makes investments in capital goods production (machine tools, land or stocks) more profitable than they were before, and thus these projects are undertaken. But when the interest rate is lowered by the Federal Reserve and not by an increase in savings, the investments made in capital goods are very unprofitable. So when the Federal Reserve is forced to raise interest rates and contract the supply of credit, a recession begins.

If artificial credit expansion were really the path to prosperity, we could print money all day and not have to worry about working — but, sadly, it is not. The problem with lowering interest rates is that society does not want the goods being produced with this newly-created credit. And when the interest rate is raised, this becomes starkly revealed as a waste of resources and the price drops.

How does this look in the real world? Look at housing prices. The Fed lowered interest rates to one percent, causing an unsustainable boom in housing and creating unprofitable investments. Housing prices are falling not because there is some wicked force out there causing failure. They are falling because the Federal Government and Federal Reserve, through misguided policies, caused an unnatural rise in housing prices.

The business cycle is not caused by some mystical problems in the capitalist system that can only be solved by government, but rather is caused by government and can only be solved by free markets. If anyone is angry at the current system and wondering why it has failed, they should look into the nearly irrefutable policies of Austrian Economics.

Vincent Patsy can be reached at souljaboy@umich.edu.

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