The financial crisis of 2008 was as unexpected as it was staggering. So caught up in the irrational exuberance was the market, that the weak investment portfolios of most banks got unnoticed. It was only when the financial institutions collapsed, forcing national banks to bail them out; and stock prices fell sharply- reflecting the miserable market sentiment- that the world took notice. Declining wealth, persistent unemployment, sticky inflation, its no surprise that the crisis has been called the worst crisis after the Great Depression of 1930s.
It was around this time that the different schools of economic thoughts scrambled around to get a clearer view of the reasons behind this collapse. Austrian economists rose to prominence as their oft-repeated prophecy came true. Keynesian economists focused on weak loan portfolios of the banks and the financial rules that acted as a stimulus. Perhaps, a clearer understanding of the crisis can be attained only by contrasting the viewpoints of the two contradicting school of thoughts.
Keynesians, in a nutshell, believed that the crises took place because of blind investment and lack of demand. [1] Keynesians stress on the fact that a credit-based economy, left to itself, exacerbates business booms and busts. Left to itself, there comes a time when the credit has expanded so much that there are no sufficient savings to back it up. The credit expands because the unrealistically positive expectations in the market, the price of the capital stock rises without a complementary increase in its value. This, combined with falling aggregate demand led to the virtual credit expanding, too much compared to the real income in the society. It inevitably reaches a point where it can only crash. This Minsky moment, is what happened in 2008 in US real estate market [2]. And the British credit market. And most of the global credit market.
The lesson here is that the loan which was handed out was bad. It was a result of poor risk modeling and underwriting standards by banks, failure of credit rating agencies, of corporate governance. In short, the regulating structure failed to reign in the competing spirit of the bank market. The government did not do enough to ensure that the loan portfolio of banks was robust. What were the institutions whose job is to monitor the economy and the financial system doing? What were all the economists in the treasury doing as the Titanic was heading for the iceberg?…, the questions raised by Tony Thirlwall, Professor of Applied economics at University of Kent echo across the Keynesian chambers.
Some went back and pointed at the American dream zero equity mortgage proposals of Bush as the starting point of this mad dash of bad credit. Some point out at the inherently destabilizing financial instrument – the credit default swaps (CDS), which had a huge role in the destruction of AIG. Transferring the risk became the new financial motto, with the pyramid going right up to the AIG. Bubble formation was inevitable.
The Austrians, to a point, agreed with the Keynesians (a phrase you do not hear very often). They agreed it was due to bad credit.[5] They, however, contend that bad credit is characteristic of a fractional reserve banking system. It blames the government. Unlike the Keynesians, however, they believe that governance and good investment cannot exist simultaneously. For an economy to be healthy, it is imperative to abolish the artificial credit expansion due to fractional reserve banking system.
In a healthy economy without the artificial credit expansion, any decrease in current demands leads to a simultaneous decrease in current sales and an increase in future expected profits. Thus, the investment into the future capital is financed by an increase in current savings. The economy is sustainable.
When artificial credit expansion enters the picture, though, it creates virtual money that has no real counterpart, which exists as only entries in assets and liability chart in banks. Any investment in capital goods industry can be made regardless of the complementary savings in the current time period. The loans taken during a boom (or loans taken without corresponding savings in the economy) necessarily trigger a process that leads to malinvestments.[3] Even though the producer is acting rationally, the triggers induce him to take production decisions that corrode the profitability of his investment.[4]
This relentless increase in artificial unsustainable credit due to persistent increase in money supply and extremely low interest rate of borrowing. An interest rate of 1% in US, zero equity mortgage proposal by Bush, all lead to excess liquidity in the market, which led a false perception of richness.
It agrees that financial governance had been callous. But it believes, it is impossible to organize any area of the economy and especially the financial sector, via coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature.
The solution, Austrian economists believe, is simple.
Abolish any central banking authority.
[1] The global economic crisis in the perspective of Keynesian business cycle theory, by Cheng Ge, International Business Research, April 2010
[2] http://en.wikipedia.org…;: The increase in TED spread during financial crisis, pointing the increased perceived credit risk.
[3] As the demand of factors of production increases, with fixed supply, it leads to increase in price of the same. This increases the prices of consumer goods (the increase being more than the price of factors of production), leading to increasing current profits. As the consumer good prices increase, real wages of the workers fall, making labour relatively cheaper than capital. The capital goods fall, leading to decreased future profitability. The interest rate, thus, increases, more than the pre credit level, signaling the increased risk premium.
[4] Heyek memorial lecture by Jesus Huerta de Soto, 29th October, 2010. Transcript: http://www.cobdencentre.org…#
[5] http://mises.org/daily/1670/Americas-Unsustainable-Boom The Austrians prediction of the credit driven boom.