Easy Money: Prelude to Recession

Why is the American economy plagued by recessions?

The simplest way to answer this question is to focus our attention on individuals. Once we know why individual businessmen experience economic setbacks, we will have the key to understanding why the entire economy intermittently goes through periods of recession.

A businessman suffers heavy losses when he has seriously erred in estimating his future costs and/or his future revenues. And it is always true that some business ventures will fail. But during a recession large numbers of businessmen—sometimes a vast majority—find they have seriously erred in estimating future conditions. Why are so many hitherto successful businessmen suddenly simultaneously in error?

Critics of capitalism assert that recessions are caused by free enterprise. But when pressed on the matter, these critics can never find anything in the free market that would cause vast numbers of businessmen to simultaneously err. The cause of such widespread business error—and thus the cause of recessions—must be found outside the market economy.

Many business setbacks undoubtedly are caused by unexpected natural disasters and wars. But such calamities, fortunately, are too few and usually too localized to explain the recurrent, nationwide recessions plaguing America. The cause of widespread business error must lie elsewhere.

An important clue can be found by studying past recessions. Recessions have usually hit hardest in the capital goods industries—those industries selling tools and raw materials to other industries. Consumer goods industries—those selling finished products to the general public—have usually been least hit by recessions.

This, then, is the problem: Why do large numbers of hitherto successful businessmen, particularly in the capital goods industries, suddenly and simultaneously err in estimating future market conditions?

Misled by Government

The answer—first explained in 1912 by Austrian economist Ludwig von Mises—is that they are misled by government tampering with money and credit. In particular, government “easy money” policies lead businessmen into courses of production that later prove disastrous.

Let us see how this happens. Suppose the Federal Reserve System—the federal government’s central banking system—tries to stimulate business activity by increasing the quantity of money the nation’s banks have available for lending. The Federal Reserve System does this by increasing member banks’ reserves and/or by lowering legal reserve requirements. In order to lend the increased quantity of money—and thus earn interest—banks must reduce interest rates to encourage more borrowing. These artificially-reduced interest rates are commonly referred to as “easy money” or “cheap credit.”

It is the easy money that misleads businessmen. Projects that formerly appeared too expensive—not likely to yield profits—suddenly seem less expensive.

Suppose the Smith Toaster Company has been thinking about converting to a new production process. However, every time Mr. Smith tallies up his expected costs of conversion—construction costs, equipment costs, wages, interest to pay back the needed loan—he decides that the revenues he hopes to earn by selling his toasters probably won’t cover the total costs.

Suddenly, however, the Federal Reserve authorities act to inject more money into the loan market, causing interest rates to fall. Smith now looks at his expected conversion costs—taking into account the reduced cost of obtaining a loan—and decides to take advantage of the easy money. He obtains a loan and proceeds with his project.

Smith engages a construction company and orders tools and machinery. For a while, the economy seems to prosper. Smith Toaster Company and thousands of other companies are lured by cheap credit into projects they previously had thought too expensive. This sets off a boom in the capital goods industries. With orders flooding in, the capital goods industries expand—using easy money to finance the expansion.

But, the boom is not without dire consequences. As more and more companies use easy money to purchase capital goods, their competitive bidding causes the prices of capital goods to rise—much as prices rise in an auction. Smith finds that he was misled. The cost of his capital equipment is higher than he anticipated. Maybe he will abandon his conversion plans, leaving the project unfinished. Or maybe he will complete the project, knowing that the higher than anticipated conversion costs have greatly diminished his chances of earning a profit when the toasters are sold.

A Crucial Issue

The Federal Reserve authorities now face a crucial decision. They can stop the easy money policy—and probably create a recession in the over-extended capital goods industries. Or they can continue the policy of cheap credit, further mislead businessmen into attempting dubious projects (dubious from the standpoint of future profitability), and try to maintain the boom in the capital goods industries.

But to maintain the boom, the Federal Reserve authorities must pump credit into the loan market at faster and faster rates because businessmen have come to expect rising prices of capital goods. A vicious spiral is created. Credit expansion causes capital goods prices to rise, and the only way to keep ahead of the rising prices is to pump more and more credit into the loan market.

Of course, this cannot go on forever. As prices skyrocket, the monetary unit eventually becomes worthless, and the economy plunges into a depression—as happened in Germany in 1923.

Faced with the choice of stopping the easy money (and probably creating a recession) or continuously increasing the flow of cheap credit (and creating a runaway inflation), the Federal Reserve authorities have adopted a policy of compromise. They have tried to “fine tune” the flow of easy money, so that businessmen will embark on enough dubious projects to prop up the capital goods industries, without causing inflation to get out of hand. But fine tuning has failed. Rising prices have become a fact of life. Businessmen include them in their calculations. The only way to stimulate another artificial boom would be to increase the quantity of money at record rates, causing prices to rise even faster.

The Solution

What is the solution? There can be only one: Easy money must be stopped. The federal government must stop pumping new money (hot off the government presses) into the banking system—which only misleads businessmen and causes prices to rise.

In the short run, the results of an end of government credit expansion would depend on how the end were brought about, particularly on whether the country were given advance notice and whether the end of credit expansion were accompanied by a balanced Federal budget. In any case, businessmen probably would adopt a temporary “wait and see” attitude, and thus be hesitant about starting new projects. Hence, there probably would be a temporary recession in the capital goods industries.

In the long run, a permanent end to both government credit expansion and Federal deficits would stabilize the nation’s money stock (thus ending inflation) and stabilize the loan markets. This would greatly boost business confidence, and businessmen could start projects assured that costs wouldn’t suddenly escalate due to inflation and/or Federal tampering in the loan markets. This would particularly benefit the capital goods industries, which could plan their affairs knowing that their futures depended, not on the vagaries of Federal monetary policy, but, rather, only on how well they served their customers.

To summarize, economic recessions are primarily the result of government credit expansion which misleads businessmen into attempting dubious projects, creates a boom in the capital goods industry, and causes prices to rise. When rising prices scare the government into reducing the rate of credit expansion, the economy—particularly the over-extended capital goods industry—suffers a recession.

Further Reading