We've all seen what happens when economic policies are run at the whims of politicians. In my quest to bring you real information you can use, here is yet another essay on the economy. Financial Crisis and Recession - Jesus Huerta de Soto - Mises Institute Financial Crisis and Recession Daily Article by Jesus Huerta de Soto | Posted on 10/6/2008 The severe financial crisis and resulting worldwide economic recession we have been forecasting for years are finally unleashing their fury. In fact, the reckless policy of artificial credit expansion that central banks (led by the American Federal Reserve) have permitted and orchestrated over the last fifteen years could not have ended in any other way. That's right 15 years not just the last 8. Politicians have a very short memory. It usually ends at the time they were last voted out of office. The expansionary cycle that has now come to a close was set in motion when the American economy emerged from its last recession in 1992 and the Federal Reserve embarked on a major artificial expansion of credit and investment, an expansion unbacked by a parallel increase in voluntary household saving. For many years, the money supply in the form of banknotes and deposits (M3) has grown at an average rate of over ten percent per year (which means that every six or seven years the total volume of money circulating in the world has doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly created loans granted at extremely low (and even negative in real terms) interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets, and the securities that represent them and are exchanged on the stock market, where indexes soared. The very same expansionary cycle that we will be extending through the bail out which will result in more inflation and an extended bubble that will now take much longer to correct. Curiously, as in the "roaring" years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of goods and services at the final-consumer level of the production structure (approximately only one third of all goods). The decade just past, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction on a massive scale of new technologies and significant entrepreneurial innovations which, were it not for the "money and credit binge," would have given rise to a healthy and sustained reduction in the unit price of the goods and services all citizens consume. Moreover, the full incorporation of the economies of China and India into the globalized market has gradually raised the real productivity of consumer goods and services even further. The absence of a healthy "deflation" in the prices of consumer goods in a period of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process. In short, we have not seen a reduction in consumer prices even though world productivity has risen through globalization of the markets which should have naturally caused prices to fall because of the free credit attitude in the markets and encouraged by the feds who in their wisdom deemed that more money must be made available for more credit which will inevitably keep consumer prices from pursuing a natural course of deflation. Economic theory teaches us that, unfortunately, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no shortcut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase, but in some years has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and often not even that. In fact, today there is no doubt about the recessionary consequence that the monetary shock always has in the long run: newly created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real-estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. By making easy credit available to those who historically saved the least, we entered into a positive feedback loop where easy credit fueled rising prices which drove speculators to obtain more easy credit so they could drive prices up even higher. that same easy credit and artificially rising real estate prices allowed property owners to easily get credit in amounts greater than the actual value of their assets. Widespread discoordination in the economic system results: the financial bubble ("irrational exuberance") exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of the entire real productive structure, which inflation has distorted. The specific triggers of the end of the euphoric monetary "binge" and the beginning of the recessionary "hangover" are many, and they can vary from one cycle to another. In the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their debts exceeded that of their assets (mortgage loans granted). At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money, which permit those who desire it to complete their investment projects without suffering losses. ibid. Nevertheless, this "flight into the future" would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to rise faster than those of capital goods. At this point, an inevitable, painful readjustment begins, and in addition to a drop in production and an increase in unemployment, we are now seeing a very harmful rise in the prices of consumer goods (stagflation). The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events lead inexorably to the conclusion that central banks (which are in fact monetary central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear in the case of the failed attempts to plan the former Soviet economy from above. To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve and (at one time) Alan Greenspan and (currently) Ben Bernanke in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on 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. Indeed, nothing is more dangerous than to indulge in the "fatal conceit" to use Hayek's useful expression of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine-tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to a lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening. In short: Government policies will make our economic situation worse not better. Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable. For years they have shirked their fiduciary responsibility, and now they find themselves in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can procrastinate with a "hair of the dog" cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (This was precisely the error committed following the stock market crash of 1987, an error that led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990-1992.) Furthermore, the reintroduction of a cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion. It could even wind up prolonging the recession indefinitely, as occurred in the Japanese economy, which, after all possible interventions were tried, ceased to respond to any stimulus involving credit expansion or Keynesian methods. Hair of the dog cures result in addiction. More credit given to a creditholic economy will only result in a deepening credit addiction that will be harder from which to recover if we can recover at all. It is in this context of "financial schizophrenia" that we must interpret the latest "shots in the dark" fired by the monetary authorities (who have two totally contradictory responsibilities: both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse). Thus, one day the Fed rescues AIG, Bear Stearns, Fannie Mae, and Freddie Mac, and the next it allows Lehman Brothers to fail, under the amply justified pretext of "teaching a lesson" and refusing to fuel moral hazard. Finally, in light of the way events were unfolding, the US government announced a $700 billion plan to purchase illiquid (i.e., worthless) assets from the banking system. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. And both presidential candidates still have you believing that they will lower your taxes. Under these circumstances, the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily indebted economic agents who need to repay their loans as soon as possible. Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector. These factors are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustained economic recovery in a future that, for the good of all, we hope is not too distant. If government were to cut taxes and spending, easing the burden on business, we could see a lower rise in unemployment than we will under the current government plan that sets the burden of recovery squarely on the shoulders of the taxpayers and business.