[Editors Note: The following article is excerpted from Huerta de Soto’s Money, Bank Credit, and Economic Cycles, originally written in 2001]
The most characteristic feature of the business cycles which have followed World War II is that they have originated in deliberately inflationary policies directed and coordinated by central banks.
During the post-war decades and well into the late sixties Keynesian theory led to the belief that an “expansive” fiscal and monetary policy could avert any crisis. Grim reality sank in with the arrival of severe recession in the 1970s, when stagflation undermined and discredited Keynesian assumptions. Moreover the 1970s and the emergence of stagflation actually marked the rebirth of interest in Austrian economics, and Hayek received the 1974 Nobel Prize in Economics precisely for his studies on the theory of the business cycle.
As a matter of fact, the crisis and stagflation of the seventies were a “trial by fire” which Keynesians did not survive, and which earned great recognition for Austrian School theorists, who had been predicting it for some time. Their only error, as Hayek admits, lay in their initial misjudgment of the duration of the inflationary process, which, unrestricted by old gold-standard requirements, was prolonged by additional doses of credit expansion and spanned two decades. The result was an unprecedented phenomenon: an acute depression accompanied by high rates of inflation and unemployment.1
The crisis of the late seventies belongs to recent economic history and we will not discuss it at length. Suffice it to say that the necessary worldwide adjustment was quite costly. Perhaps after this bitter experience, with the recovery underway, western financial and economic authorities could have been required to take the precautionary measures necessary to avoid a future widespread expansion of credit and thus, a future recession.
Unfortunately this was not the case, and despite all of the effort and costs involved in the realignment of western economies following the crisis of the late seventies, the second half of the eighties saw the beginnings of another significant credit expansion which started in the United States and spread throughout Japan, England, and the rest of the world. Despite the stock market’s “warnings,” particularly the collapse of the New York Stock Exchange on October 19, 1987, “Black Monday,” (when the New York Stock Exchange Index tumbled 22.6 percent), monetary authorities reacted by nervously injecting massive new doses of credit expansion into the economy to bolster stock market indexes.
In an empirical study on the recession of the early nineties,2 W.N. Butos reveals that between 1983 and 1987 the average rate of annual growth in the reserves provided by the Federal Reserve to the American banking system increased by 14.5 percent per year (i.e., from $25 billion in 1985 to over $40 billion three years later). This led to great credit and monetary expansion, which in turn fed a considerable stock market boom and all sorts of speculative financial operations. Moreover the economy entered a phase of marked expansion which entailed a substantial lengthening of the most capital-intensive stages and a spectacular increase in the production of durable consumer goods. This stage has come to be called the “Golden Age” of the Reagan-Thatcher years, and it rested mainly on the shaky foundation of credit expansion.3 An empirical study by Arthur Middleton Hughes also confirms these facts.
Furthermore Hughes examines the impact of credit expansion and recession on different sectors belonging to various stages of the productive structure (some closer to and some further from consumption). His empirical timeseries study confirms the most important conclusions of our theory of the cycle.4 Moreover this recession was accompanied by a severe bank crisis which in the United States became apparent due to the collapse of several important banks and especially to the failure of the savings and loan sector, the analysis of which has appeared in many publications.5 This last recession has again surprised monetarists, who cannot understand how such a thing happened.6 However the expansion’s typical characteristics, the arrival of the crisis and the ensuing recession all correspond to the predictions of the Austrian theory of the cycle.
Perhaps one of the most interesting, distinguishing characteristics of the last cycle has been the key role the Japanese economy has played in it. Particularly in the four-year period between 1987 and 1991, the Japanese economy underwent enormous monetary and credit expansion which, as theory suggests, affected mainly the industries furthest from consumption. In fact although the prices of consumer goods rose only by around 0 to 3 percent each year during this period, the price of fixed assets, especially land, real estate, stocks, works of art and jewelry, escalated dramatically. Their value increased to many times its original amount and the respective markets entered a speculative boom. The crisis hit during the second quarter of 1991, and the subsequent recession has lasted more than ten years. A widespread malinvestment of productive resources has become evident, a problem unknown in Japan in the past, and has made it necessary for the Japanese economy to initiate a painful, comprehensive realignment process in which it continues to be involved at the time of this writing (2001).7
Regarding the effect this worldwide economic crisis has exerted in Spain, it is necessary to note that it violently gripped the country in 1992 and the recession lasted almost five years. All of the typical characteristics of expansion, crisis and recession have again been present in Spain’s immediate economic environment, with the possible exception that the artificial expansion was even more exaggerated as a consequence of Spain’s entrance into the European Economic Community. Moreover the recession hit within a context of an overvalued peseta, which had to be devalued on three consecutive occasions over a period of twelve months.
The stock market was seriously affected, and well-known financial and bank crises arose in an environment of speculation and get-rich-quick schemes. It has taken several years for Spain to recover entirely from these events. Even today, Spanish authorities have yet to adopt all necessary measures to increase the flexibility of the economy, specifically the labor market. Together with a prudent monetary policy and a decrease in public spending and the government deficit, such measures are essential to the speedy consolidation of a stable, sustained recovery process in Spain.8 Finally, following the great Asian economic crisis of 1997, the Federal Reserve orchestrated an expansion of credit in the United States (and throughout the world) which gave rise to an intense boom and stock-market bubble. At this time (late 2001), it appears this situation will very probably end in a stock-market crash (already evident for stocks in the so-called “New Economy” of electronic commerce, new technologies and communications) and a new, deep, worldwide economic recession.9
Excerpted from Money, Bank Credit, and Economic Cycles
- 1. In an article in which he examines data from the crises between 1961 and 1987, Milton Friedman states that he sees no correlation between the amount of expansion and the subsequent contraction and concludes that these results “would cast grave doubt on those theories that see as the source of a deep depression the excesses of the prior expansion (the Mises cycle theory is a clear example).” See Milton Friedman, “The ‘Plucking Model’ of Business Fluctuations Revisited,” Economic Inquiry 31 (April 1993): 171–77 (the above excerpt appears on p. 172). Nevertheless Friedman’s interpretation of the facts and their relationship to the Austrian theory is incorrect for the following reasons: (a) As an indicator of the cycle’s evolution, Friedman uses GDP magnitudes, which as we know conceal nearly half of the total gross national output, which includes the value of intermediate products and is the measure which most varies throughout the cycle; (b) The Austrian theory of the cycle establishes a correlation between credit expansion, microeconomic malinvestment and recession, not between economic expansion and recession, both of which are measured by an aggregate (GDP) that conceals what is really happening; (c) Friedman considers a very brief time period (1961–1987), during which any sign of recession was met with energetic expansionary policies which made subsequent recessions short, except in the two cases mentioned in the text (the crisis of the late seventies and early nineties), in which the economy entered the trap of stagflation. Thanks to Mark Skousen for supplying his interesting private correspondence with Milton Friedman on this topic. See also the demonstration of the perfect compatibility between Friedman’s aggregate data and the Austrian theory of business cycles, in Garrison, Time and Money, pp. 222–35.
- 2. William N. Butos, “The Recession and Austrian Business Cycle Theory: An Empirical Perspective,” in Critical Review 7, nos. 2–3 (Spring and Summer, 1993). Butos concludes that the Austrian theory of the business cycle provides a valid analytical explanation for the expansion of the eighties and the subsequent crisis of the early nineties. Another interesting article which applies the Austrian theory to the most recent economic cycle is Roger W. Garrison’s “The Roaring Twenties and the Bullish Eighties: The Role of Government in Boom and Bust,” Critical Review 7, nos. 2–3 (Spring and Summer, 1993): 259–76. The money supply grew dramatically during the second half of the 1980s in Spain as well, where it increased from thirty trillion pesetas to nearly sixty trillion between 1986 and 1992, when a violent crisis erupted in Spain (“Banco de España,” Boletín estadístico [August 1994]: 17).
- 3. Margaret Thatcher herself eventually admitted, in her autobiography, that all of the economic problems of her administration emerged when money and credit were expanded too quickly and the prices of consumer goods rocketed. Thatcher, The Downing Street Years.
- 4.
Hughes, “The Recession of 1990: An Austrian Explanation,” pp. 107–23. - 5. For example, Lawrence H. White, “What has been Breaking U.S. Banks?” pp. 321–34, and Catherine England, “The Savings and Loan Debacle,” in Critical Review 7, nos. 2–3 (Spring and Summer, 1993): 307–20. In Spain, the following work of Antonio Torrero Mañas stands out: La crisis del sistema bancario: lecciones de la experiencia de Estados Unidos (Madrid: Editorial Cívitas, 1993).
- 6. On this topic Robert E. Hall arrives at a most illustrative conclusion: Established models are unhelpful in understanding this recession, and probably most of its predecessors. There was no outside force that concentrated its effects over the few months in the late summer and fall of 1990, nor was there a coincidence of forces concentrated during that period. Rather, there seems to have been a cascading of negative responses during that time, perhaps set off by Iraq’s invasion of Kuwait and the resulting oil-price spike in August 1990. (Hall, “Macrotheory and the Recession of 1990–1991,” American Economic Review (May 1993): 275–79; above excerpt appears on pp. 278–79) It is discouraging to see such a prestigious author so confused about the emergence and evolution of the 1990s crisis. This situation says a lot about the pitiful current state of macroeconomic theory
- 7.
The Nikkei 225 index of the Tokyo Stock Exchange dropped from over 30,000 yen at the beginning of 1990 to less than 12,000 yen in 2001, following the failure of a number of banks and stock market firms (such as Hokkaido Takushoku, Sanyo and Yamaichi Securities and others). These bankruptcies have seriously harmed the credibility of the country’s financial system, which will take a long time to recover. Furthermore the Japanese bank and stock market crises have fully spread to the rest of the Asian markets (the failure of the Peregrine Bank of Hong Kong, of the Bangkok Bank of Commerce, and of the Bank Korea First come to mind, among others), and in 1997 they even threatened to spread to the rest of the world. On the application of the Austrian theory to the Japanese recession see the interesting article Yoshio Suzuki presented at the regional meeting of the Mont Pèlerin Society, September 25–30, 1994 in Cannes, France. See also the pertinent comments of Hiroyuki Okon in Austrian Economics Newsletter (Winter, 1997): 6–7. - 8.
We will not also go into the devastating effect of the economic and bank crisis in developing countries (for example, Venezuela), and on the economies of the former Eastern bloc (Russia, Albania, Latvia, Lithuania, the Czech Republic, Romania, etc.), which with great naivete and enthusiasm have raced down the path of unchecked credit expansion. As an example, in Lithuania at the end of 1995, following a period of euphoria, a bank crisis erupted and led to the closure of sixteen of the twenty-eight existing banks, the sudden tightening of credit, a drop in investment, and unemployment and popular malaise. The same can be said for the rest of the cases mentioned (in many of them the crisis has even been more severe). - 9. As explained in the Preface, when the English edition of this book was prepared (2002–2003), a worldwide economic recession was simultaneously affecting Japan, Germany, and (very probably) the United States.
Jesús Huerta de Soto, professor of economics at King Juan Carlos University, is Spain’s leading Austrian economist, and a Senior
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