An Economy on Heroin

The global economy is on heroin. And heroin, is a dangerous drug…

When you take heroin, you feel really fantastic (or, at least, that’s what they tell me). That euphoric feeling is an artificial high though; a temporary sense of wellbeing that is inevitably followed by a precipitous decline in wellbeing.

This is what is happening to the global economy (metaphorically speaking, of course).

Business Cycle Theory

To explain this analogy, let’s first take a look at the historic work of Nobel prize winning economist, Friedrich von Hayek. Hayek won the Nobel prize in 1974 for his Business Cycle Theory. More colloquially, for explaining why the economy moves in “boom – bust” cycles, generally known as the business cycle.

Hayek’s theory begins with a question…

Why is it that, during the “bust”, or economic downturn, we see an enormous “cluster of errors” happening in the economy? In other words, why do disparate sectors of the economy experience enormous and simultaneous losses all of a sudden?

This question is especially puzzling when you consider that the free market has a natural, built-in mechanism for weeding out entrepreneurs who are bad at forecasting consumer demand. Entrepreneurs in the private sector are, essentially, in an election every day of their lives. We, as consumers, cast daily votes with our Rands, Dollars or Euros, voting for the products and services that best satisfy our demands.

So, the entrepreneurs that are creating wealth and best satisfying our needs attract more votes and are, thus, rewarded with profits. Conversely, when entrepreneurs are failing at this, the market punishes them with losses. So, capital in an economy naturally flows to those entrepreneurs who are creating societal wealth and away from those who destroy it.

This then poses quite the conundrum. Why should people that are selected by the market to be good forecasters of consumer demand, all suddenly make poor forecasts that are all completely wrong and at exactly the same time?

In answering this question, Hayek showed that there’s something else at work here, something other than private market actors interacting on a voluntary basis. There is another actor on the scene that is introducing discoordination throughout the system – the central bank.

Interest Rates

Hayek’s theory goes as follows…

Interest rates are not just arbitrary numbers. The interest rate is effectively the price of money, and, like all prices, perform an essential coordinating function in the economy; namely, coordinating production across time.

Interest rates mean that consumers are deferring consumption for the time being. Although consumers continue to consume, they are not consuming everything that they have worked for and save resources for the future instead.

For example, if you and I work and earn R10,000, that R10,000 entitles us to go back into the economy and claim R10,000 worth of goods and services. But if we save, and put R4,000 in the bank and only consume R6,000 worth of goods and services, we defer R4,000 worth of goods and services for future consumption.

Interest rates can decline by two very different mechanisms; the healthy, and the unhealthy.

Let’s take a look at the healthy way first. When you and I save more of our hard earned Rands, banks have more to lend with and, hence, the price of lending goes down – simple supply and demand.

So, what happens when we save and interest rates decline? Well, two very important consequences..

The first is, when interests rate are low, businesses engage in long-term production. This is due to the fact that projects become cheaper. The longer the term of the project, the more interest rate sensitive it is.

So here we see the coordinating function of interest rates. At the very time that consumers are deferring a portion of their income to the future, that’s also the time that businesses prepare for this future demand by engaging in long-term production.

Secondly, remember when we saved the R4,000 of our income in the bank we were deferring consumption of goods and services for the future, we were essentially releasing R4,000 worth of resources into the economy that we’re not going to consume right now. The saved resources in our economy that are not immediately consumed provide the material wherewithal to see all these new investment projects through to completion.

The Boom

Now, let’s consider the second way that interest rates can decline.

Interest rates can decline when the central bank, established by the government, forces them down artificially.

In the short run, you have the same consequences. Businesses embark on long term projects amid the apparent abundance of resources. But while interest rates that decline due to voluntary saving lead to genuine economic growth, interest rates that are forced down artificially create boom and bust cycles.

Let’s again consider our two consequences of a decline in interest rates under this forced situation (and, this time, notice how both of our coordinating functions of interest rates are distorted).

In the first case, it was the coordinating function of consumers to defer consumption for the future that allowed businesses to prepare for that. Now, just because the central bank force down interest rates, it does not mean that consumers are, in fact, deferring consumption for the future. So what you get when this happens is that businesses engage in long-term production processes, but at the same time, people are preferring to consume right now. It’s clear that this creates a time mismatch, which is obviously unsustainable.

Secondly, just because interest rates were forced down, it does not mean that people genuinely abstained from consumption and thereby released saved resources for use by investors. In the meantime, investors are being encouraged to engage in long-term projects for which the necessary resources do not exist. So investors all start bidding for a pool of unchanged resources and find costs to be much higher than initially anticipated.

So, now we can conclude that when the central bank artificially reduces interest rates, investors begin on investment trajectories that cannot all be sustained with the existing resources available in society – result is the inevitable bust that follows.

The Bust

Now, finally back to our heroin analogy.

The economic boom is an artificial high – just like the heroin addict’s. When the heroin addict wants to get healthy, he has to go to rehab and go cold turkey. The withdrawal symptoms are very unpleasant but it’s necessary to remove the toxins from his system and get healthy.

It’s the same with the economy in the midst of the business cycles. The boom is the problem and the bust is the solution. The malinvestments created by the inflationary monetary policies of the central banks need to be purged and resources have to move out of the unprofitable sectors of the economy and redirected to the sustainable, profitable sectors. Interest rates need to naturally rise and people allowed to naturally defer consumption and save.

This is painful but it’s necessary for recovery.

Intervention in this natural cleansing process (by central banks further increasing the money supply or reducing interest rates, discouraging saving) would be akin to injecting the addict with more heroin and risking overdose

The economic equivalent of an overdose would be a sovereign debt crisis and hyperinflation.

And that’s how our economic woes stand to end – in a global currency crisis.

Got gold, anyone?

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