As you read what I am about to write remember the following --- First, I am an academic economist and not an investment guru. If I really knew what the future would be I wouldn't be an academic worried about college tuition for my children. Second, in general I am an optimist about the ultimate resource being the human imagination and also the robust nature of markets. Third, my position is one of warning rather than determinism.
I find the different elements in the Austrian theory of the trade cycle to be compelling, and I find when these elements are stitched together the story of a credit induced boom-bust is also compelling. In fact, I think there has been a major intellectual underinvestment in the Austrian theory of the trade cycle among modern Austrian economists and that those of us who are persuaded of its analytical power should do a much better job of encouraging young scholars to work on the theory and applications to the contemporary world. But the theory cannot just be applied without close attention to the details. There are many empirical assumptions which have to be checked for their validity in any given situation and there are off-setting factors which mean that the magnitude of the effect of a credit induced boom-bust is variable. The most important off-setting factors are Smithian (new trading opportunities) and Schumpeterian (new innovations). These two factors ensure that while government policies may induce a boom-bust that tomorrow's trough will still be higher than today's peak ---- in short, bet on the future as being better than today.
The natural propensity for government is to borrow and then inflate --- both of which are "bad" for the economic performance of an economy --- but as long as individuals are free to pursue mutually beneficial exchanges, and able to "bet on ideas" and find the financing to bring those bets "to life" the market system will be a vehicle through which any rough patch we can successfully drive.
When markets break-down due to excess government regulation and legal rules that cut against freedom of contract and protection of property, then the ability to survive economically stupid policies becomes less. Regime uncertainty sets in --- a term from Robert Higgs --- and the exchange environment becomes less encouraging.
Where are we at today?
The Bush Administration in the wake of 9/11 has engaged in a level of fiscal irresponsibility that is shocking. It can be argued that Bush is willing to tackle tough political issues such as Social Security and Medicare, but the reality is that the cost of the war against terrorism are driving spending. Tax cut stimulated growth is not the answer to this problem. The public debt currently stands at $8,002,597,291,310.32. The costs of the rebuilding efforts after Katrina and Rita only exacerbate the situation.
Deficits become public debt and governments seek to pay off debt with cheaper money by monetizing the debt and thus inflation starts to creep into to the system. This inflation has distortionary impact. Money is the link between all exchanges in a modern economy and it is also non-neutral. Nominal variables can have real effects. Of course, predictable inflations do not cause serious problems as actors will simply adjust prices to reflect the new reality of money supply and real output. But money is not delivered via a helicopter and instead is injected into a system at particular points and this distorts the purchasing power of the first recipients advantageously and the last recipients disadvantageously. This leads to tugs and pulls on the pattern of resource allocation that otherwise would not be tugged or pulled in this or that direction.
STILL, if this is all we had to worry about markets would adjust quickly once the distorting signals were detected and maladjustments in the capital structure would be reshuffled so that investment decisions reflected more accurately the trade offs individuals were willing to make between present and future consumption and the pattern of resource allocations would tend toward one where the most willing demanders and the most willing supplies would realize their opportunities for mutually beneficial exchange. In short, markets would continue to progress and development would be such that tomorrow would be better than today, though less prosperous than what would have been the case had we not had to cope with the errors in allocating scarce resources caused by government irresponsible fiscal and monetary policy.
Things get really dicey when the exchange environment is threatened not just distorted. Distortions are short-term, and markets are self-adjusting if left to operate. So why am I getting more and more pessimistic?
We have severe distortions in our economy caused by years of irresponsible fiscal policy and monetary policy that in attempting to keep the economy afloat has been extremely inflationary (not measured in CPI, but in terms of money supply growth). But there is also growing pressure to curtail businesses in seeking to realize gains from trade in the international market (remember the flap over outsourcing), and also a decline in the respect for private property (remember the decision to expand the takings clause for real estate development). The war against terror has been a convenient excuse to violate private property and introduce everyday challenges to our liberty in the name of security.
If we combine irresponsible fiscal and monetary policy with constraints on the Smithian and Schumpeterian forces which enable us to withstand the storm of stupid government policy, then our sails collapse and we are caught in the storm rather than escaping it.
Mises and Hayek found themselves in such a situation in the late 1920s when they were running the Austrian Institute for Business Cycle Research. They both predicted that the credit induced boom of the 1920s would be followed by the bust as businessmen liquidate malinvestments and reshuffle capital in more economically productive directions. It is important again, in my opinion, to stress that the length and severity of the depression of the 1930s is not a consequence of the credit expansion of the 1920s. Markets adjust quickly. But the 1930s became severe because of government policies in the 1930s which prevented markets from adjusted and which curtailed the Smithian (think Smoot Hawley Tariff) and Schumpeterian (think tax hikes and government control of business) forces. As Higgs points out in his work, the regime uncertainty introduced during the Great Depression by government policies explain the length and severity. As Mises one time remarked, government policies curtailing markets in the Great Depression were like trying to cure a patient with bronchitis by shooting him in the chest.
My "fear" is that government doctors are waiting with their guns to shoot as economic agents start to cough. They gave economic actors the bad case of economic bronchitis with irresponsible fiscal and monetary policy, but as these actors start to recover they insist on helping with that bullet to the chest. If that is indeed what the future holds in store, then it is best now to either hide for cover, or invest in a really good bullet proof vest.
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