The Necessary and Inevitable Recession to Come
by Patrick Barron
Perhaps the most destructive premise of modern, mainstream economics is that a central bank-induced monetary/credit expansion can cause an economy to grow without adverse consequences. Let’s be perfectly clear from the start…this policy has been tried by many central banks many times and all such attempts have led to economic disaster. The latest victims are the poor citizens of Venezuela, a once prosperous nation. Furthermore, we Austrian economists have sound economic science to explain why it must be so, despite the fervently held wishes of mainstream economists, politicians, and the public at large.
Born of Depression Era Keynesian economic theory which elevated “aggregate demand” as the driving force of an economy, central banks have constructed a fallacious model of how an economy works. Repeated failures of this model have served only to embolden them to double down and double down again and again, driving interest rates in some countries below zero in order to force the world to conform to their religiously-held theory. The simplest explanation of this theory is that counterfeiting money will cause people to spend and it is a dearth of spending that holds back prosperity. If people won’t spend enough themselves, then it is incumbent upon government to do it for them by paying people the equivalence of digging holes in the ground and filling them back up. No, I am not making this up. Keynes himself said it! (Book 3, Chapter 10, Section 6 pg.129 “The General Theory..”)
The theory of lack of aggregate demand fails to recognize two essential facets of how an economy really works. The first is that production MUST precede consumption. In other words, we cannot consume what we have not first produced, and one’s production constitutes one’s demand either through direct or indirect exchange. This is the essence of Say’s Law, which Keynes unsuccessfully attempted to refute in developing his theory of an economy driven not by production but by aggregate demand. The second is that the structure of production is determined by time preference. Sounds complicated, doesn’t it? Well, it is simplicity itself. The structure of production is merely all the intermediate steps that constitute production. There are fewer steps taking less overall time in an economy with a high time preference, meaning that people wish to spend most of their production borne income in the short term. Likewise there are more steps taking more overall time in an economy with a low time preference, meaning that people wish to save more of their current income in order to have more in the future.
A simple example is that one must plant seeds in order to grow vegetables for current consumption. (Please keep in mind that what I describe is applicable for all types and levels of production.)The steps in this process are the saving of seed from previous crops, the tilling of the soil, the planting of the seeds, the watering and perhaps fertilizing of the seeds, the spraying or covering of the young plants from the predations of birds, insects, and bacteria. You get the idea. The “structure” is the steps and the amount of production that is involved in each step. In a high time preference economy in which people wish to consume almost all of their crop production, saving more seed is a waste of resources. Likewise, producing more fertilizer than is necessary for the size of the crop is also a waste of resources. Time preference is the underlying guide. However, if people are more future oriented, they will save more from current production in order to plant more crops; they will clear and till more land with the extra seeds; they will buy more fertilizer, etc. The increase in crop yields spurs a new level of production in the preservation of excess production for future consumption. The refraining from current consumption–i.e., savings–is what funds this increase in the new level of production. The preservation process takes more time, but in the end there is more to consume in the future, especially in cases of future crop failure. Think of the children’s story of the ant and the grasshopper.
Keynes thought that an economy could bypass the savings process and substitute an increase in the medium of exchange for real savings. The obvious flaw in this argument is that counterfeit money is not a substitute for saving real, fungible production. Counterfeit money is simply a watered down medium of exchange. Think of the old adage of watering down the soup when uninvited guests show up for dinner. The cook can serve more bowls of soup, but the nutritional value per bowl is less.
But monetary/credit expansion does more than just reduce the value of each monetary unit. Because the counterfeit money appears no different than existing money, entrepreneurs are fooled into believing that something real has been set aside and that people have chosen a lower time preference. With a lower interest rate level their plans for expansion appear to be achievable. Canning and/or freeze-drying facilities, for example, are constructed over a longer period of time in anticipation of an increase in sales of vegetables that may be consumed much later. Eventually the entrepreneurs realize that no such longer-term demand really exists. They have wasted time and capital, neither of which may be recovered. The workers who left jobs in businesses that served the higher time preference economy for higher paying jobs in the vegetable preservation plants must find new work. This takes time, and the ranks of the unemployed grow until the economy has once again achieved a structure of production more in tune with the people’s higher time preference. Businesses lose money; the owners may even go bankrupt. Stock prices collapse. Banks may fail. Such a transition is called the recession. It is inevitable and unavoidable.
Yet it is highly likely–in fact it is almost a certainty–that central banks will fight the latest economic slowdown with the same old money printing and lowering of the interest rate. This was the conclusion drawn by Thorsten Polleit in his latest essay, published on Mises Wire: The Fed Has No Choice But to Return to Ultra-Low Interest Rates. The Keynesians at the Fed are baffled that the world won’t conform to their religiously held theory of aggregate demand. Their theory is a straightjacket from which they cannot escape intellectually. Unfortunately we all will pay the price.
