One of the greatest mysteries in the history of economic theory, and still the most unresolved controversy in the economic profession, is the nature and source of the business cycle. Why do recessions occur and why do booms occur? Why do they tend to follow each other with some degree of regularity?

Adam Smith and the classical economists, in seeking to answer the question of how economies grow, concluded that free exchange and capital accumulation are the sources. But the mystery of the business cycle deals with a far more complex question of why growth seems to occur intermittently.

First, it is important to realize that even in a vibrant market economy, businesses fail. Entrepreneurial forecasting ability is not perfect, innovation disrupts plans, and consumer demand is always changing. The only economies where businesses do not fail are stagnant, socialist ones. Implicit in the free enterprise process is the possibility of failure. Thus, to the question of why businesses start and fail, we already have the answer: The market rewards only those who serve the consuming public, and not all businesses do so all the time.

Marxist Encroachment

In Karl Marx’s view, the business cycle is an inherent part of the capitalist economic system’s fundamental instability. Marx foresaw cycles worsening, with each recession more devastating than the last, ultimately leading to the breakdown of capitalism itself. For decades socialists echoed his forecast and attempted to reinterpret every cycle as a sign that the capitalist system was at last collapsing.

The Great Depression seemed to confirm Marx’s view of business cycles and gave a boost to the socialist cause. Beginning in the early 1930s, a huge debate ensued between market advocates like Henry Hazlitt and socialist intellectuals writing in the pages of leftist weeklies like The Nation. The socialists pointed to what they said was the declining share of the return on capital enjoyed by the workers and the rising profits of the exploiter class. They argued that the Great Depression came about when workers no longer had the means to purchase products of their own making. Their solution was to redistribute property from the capitalists to the workers and insure that society, as embodied by the state, would control the means of production.

In 1936, John Maynard Keynes came out with his General Theory, in which he wrote that the business cycle is an inherent part of the market economy. He argued, however, that it was not necessary to overthrow capitalism and the market economy in order to control them. The government (working closely with Keynesian economists, of course) could supposedly pursue policies that would keep business cycles at bay. The problem, said Keynes, was fundamentally twofold.

First, he said, prices and wages often do not adjust in ways that coordinate the economy. But by manipulating prices, mainly through inflation, the system could be fixed. Second, he argued, the investment sector is fundamentally irrational. "Animal spirits" periodically sweep through markets, causing businesses to under-invest in things that are needed and over-invest in things that are not.

There are two ways out of this problem, according to Keynes. We can live with the resulting business cycles or we can manipulate the demand side of the economy to force it into coordination with the supply side. As a result of this Keynesian-style analysis, the government now had an intellectual justification for the huge New Deal machinery that had been established to manage the economy.

Government Intrusion

Economists deluded themselves into thinking that they could smooth out business cycles by managing fiscal and monetary policies better than the market itself. The idea was that in an economic downturn, the government could boost the money supply and run a deficit to lift the economy back into normalcy. Once the economy recovered, the economists would drive up interest rates again and run a budget surplus.

But after World War II, business cycles became progressively worse, and every attempt to manage them seemed to create new problems — among them inflation, hyperinflation, enormous government debts, and rising deficits. We should also include, as a cost of Keynesian policy, the loss of freedom that Americans had previously enjoyed. No longer did we have a government that stayed out of economic policy. Rather, we had a government that regarded itself as all-knowing, and the market economy as essentially irrational.

It is often said that Keynes and FDR’s New Deal saved capitalism from itself. In fact, Keynes’ ideas radically distorted true capitalism. The U.S. government is perhaps the most intrusive government in human history. To this day, it is involved in every area of American economic life. It has veto power over the hiring and firing decisions of virtually every business in the country. It tells people how old they must be to work, how much they must be paid, what benefits they must be provided, and how much tax they should pay from their income. The government regulates, in minute detail, the architecture of every commercial building in the country. With its antitrust laws and taxing power, government can make or break huge corporations.

Yet despite all this, the U.S. is widely seen today as the paragon of capitalism. To an observer from the past century, the contemporary U.S. would seem to be the embodiment of wild-eyed socialist experimentation. But a century dominated by the leviathan state has changed everyone’s standards of what constitutes freedom.

Is the business cycle truly a natural part of the free market? Ludwig von Mises tackled this question in his 1912 book, A Theory of Money and Credit. His theory is called the Austrian theory of the business cycle. To generate an economic boom, the central bank artificially lowers interest rates, creating the illusion of increased savings. Faced with new credit availability, the business sectors borrow to expand production and begin long-term investment projects. The boom continues as long as interest rates remain artificially held down. Businesses continue to invest in projects for which there is no underlying economic demand or rationale. This type of investment Mises called malinvestment.

Note that during this period, the increase in money and credit doesn’t necessarily result in higher prices. The monetary inflation is bringing about a fundamental structural change in the economy, but it is not creating any visible ill effects. Production is expanding, unemployment and interest rates are low, the stock market is booming, and everyone appears to be getting richer.

But this boom is not self-sustaining. When businesses bring products to market at the end of the production process, they are met with consumers who have neither the savings nor the income to purchase them. Once prices begin to creep up, the discoordination between the investment and spending sectors is revealed. The central bank raises rates to prevent conspicuous declines in the purchasing power of money, and the boom begins to reverse itself.

This is essentially what brought about the Great Depression. Throughout the 1920s, the Federal Reserve (Fed) engaged in an expansionist monetary policy, giving stocks, real estate, and heavily capitalized businesses an artificial shot in the arm. When the stock market finally crashed, the exaggerated investment was exposed as a fraud. Thus, we can see that it is not the market that is the source of business cycles. Rather, the business cycle is the working out of a market attempting to correct for the failures of central bankers and the government officials who cheer them on.

Interest Rate Conspiracy

The Fed has long felt the pressures of politics to keep interest rates unnaturally low. The President is concerned about keeping rates low before elections. Quite often, Presidents are willing to tolerate a recession after election to their first term. But they will not tolerate one leading up to the election itself. The Fed chairman, who frequently proclaims his independence on politics, is in fact dependent on the White House. In order for the Fed to maintain its much ballyhooed independence, it must do what the President wants.

The Fed also faces pressures from member banks, who profit from lower rates. Congress also has an impact. If we see the Fed chairman threatened with congressional investigations it is nearly always during times when interest rates are high. Special interest groups — from large manufacturers to farmers — lobby their congressmen to intervene.

The media plays a role in the interest rate conspiracy as well. The press is always ready to tell the public about the sad plight of borrowers who are being squeezed by high interest rates. Telling the story of a structure of production that has fallen into misalignment because of artificially low rates just doesn’t make good copy. The media fans the flames during recessions especially, when every business failure is considered a national tragedy instead of part of the natural cleansing process of the market economy.

The common misperception that economic booms should go on forever is what gives impetus for governments to intervene after the downturn occurs. But any intervention designed to soften the blow of a recession can only end in prolonging the agony, just as it did during the Great Depression — and as such efforts are doing today in Asia.

Do-Nothing Government

So what should government do during a recession? The short answer is nothing. It should take care to ensure that there are no obstacles to the downward adjustment of wages and that the market is free to generate entrepreneurial opportunities. But otherwise it should stay out of the way.

Compare the actions of Presidents Warren Harding and Herbert Hoover. In 1921, the U.S. experienced a major economic downturn, which was a direct result of the inflationized economy of wartime. Unemployment reached 11.7 percent and output crashed. This was after unemployment had fallen to 1.4 percent in 1919.

There was no shortage of advice given to the Harding Administration. Henry Ford and Thomas Edison wanted to create fiat money on a huge scale. Secretary of Commerce Herbert Hoover wanted a massive public works program. Labor leaders demanded make-work programs.

President Harding resisted, however, and the economy began to rebound. By 1922, unemployment was back down to reasonable levels, output was expanding, and the economy was rebounding across the board. The depression was over in one year.

Compare this with the actions of the Hoover Administration a few years later. Despite his reputation as a do-nothing President, Hoover did far too much. He attempted to keep wages propped up and to stop business failures. He embarked on a massive public works spending program and erected high tariff barriers. The U.S. did not enter recovery as it should have and could have and, instead, in the next presidential election it got a national socialist President for more than 12 years.

Where are we today? The line one reads again and again in the pages of the Wall Street Journal is that the business cycle has been abolished and that we have entered into a new paradigm of permanent prosperity. This is precisely what we heard about Asia for the last several years prior to the crash. And it is what was said in the U.S. during the late 1920s.

But as long as we live on this earth there are certain fixed cause-and-effect relationships that cannot be repealed. Among them is that an economy pumped up by artificial credit will eventually enter recession. When it happens and what the effects will be are open to question. But that it will happen cannot be in dispute.

We can get an inkling of where we now are by looking at the data — particularly Federal Reserve money supply figures, saving rates, and basic stock indicators. Price inflation is low and business investment doesn’t appear to be particularly overblown. But look at the stock market. We have experienced astounding increases, with stock prices quadrupling since 1990. Price-to-earnings ratios are now at a historic high of 28, from a post-war average of 14. At the same time, the personal savings rate has fallen dramatically. In 1992, personal savings was 6.2 percent of disposable income. By 1997, it had fallen to 3.8 percent. This is the lowest rate since 1946, when Americans were making up for the forced saving of the war years.

A New Bretton Woods

Fed chairman Alan Greenspan has been fortunate to preside over an era in monetary affairs in which the dollar has been catapulted from a regional currency to the world reserve currency. The dollar’s hegemonic reign has allowed him to conduct a reckless policy of socializing investment risk. From the end of 1990 to the end of 1996, the Fed used its open market operations to increase the monetary base (currency plus bank reserves) by 55 percent. Currency itself increased 60 percent.

As Jeffrey Herbener of Grove City College has pointed out, the dollar-reserve system of the "global economy" of the 1990s is the resurrection of the Bretton Woods system without gold. Under the gold-reserve system of Bretton Woods, each country’s currency had a fixed exchange rate against the dollar, and foreign governments could redeem the dollar at the U.S. Treasury for gold at the fixed rate of $35 an ounce.

The linchpin of the Bretton Woods agreement was the fixed rate of redemption between the dollar and gold. The Fed broke this link by accelerating monetary inflation in the 1960s to help finance expenditures for LBJ’s Great Society and the Vietnam War. From the beginning of 1960 to the end of 1964, the Fed increased the money base three percent per year. But from the beginning of 1965 to the end of 1970, the Fed more than doubled the rate of increase to 6.3 percent. The average annual rate of price inflation went from 1.3 percent in the earlier period to 4.2 percent in the latter one.

After increasing the monetary base 8.7 percent per year from 1971-74, the Fed accelerated the rate to 10.4 percent from 1975-81. But after the debacle of the first half of the 1970s, it was difficult to convince foreigners to hold more dollars as reserves. Accelerating monetary and credit inflation by the Fed led to severe domestic price inflation, soaring interest rates, collapsing capital values, and higher unemployment (peaking at 9.7 percent in 1982, a rate not seen since 1941).

This entire scenario is precisely the reverse of the American economy in the 1990s. From 1982 through 1990, the dollar began to regain its status as the world’s reserve currency. The Fed expanded the monetary base at 11 percent per year in the 1980s, but the demand to hold dollars overseas helped soak up the monetary inflation and the American economy experienced economic growth with low levels of monetary depreciation. But the improved performance of the economy in the 1980s was only a foretaste of the renaissance of dollar dominance in the world.

U.S. global supremacy in the wake of the "collapse" of communism allowed the Fed to fully exploit the international dollar reserve system. The new system opened up vast new vistas for overseas dollar holdings. From Russia and Eastern Europe to China and East Asia, the governments of "former" communist countries began to soak up dollars to hold as official reserves. From the beginning of 1991 to the end of 1996, the Fed increased the monetary base 9.1 percent per year, while price inflation ran only 3.6 percent annually.

Mountain of Dollars and Debt

Like Bretton Woods, the new regime depends on the willingness of foreigners to hold dollars and use them as the basis for their own domestic monetary inflation and credit expansion. Only with harmonized monetary policies can the system survive.

But therein lies the great danger of the system to the American economy. A rogue nation will be tempted to defend its currency, and stave off devaluation, by spending its dollar reserves. Any significant disgorging of dollars would threaten to ignite price inflation in America if the dollars were repatriated. Significant domestic price inflation would bring a repeat of the 1970s.

This danger explains the U.S. interest in promoting IMF austerity policies and bailouts. The bailouts are intended to soften the blow of devaluation and price inflation. In exchange for taxpayers subsidizing banks and large corporations, and other key beneficiaries of the system, the IMF can use the bailout money as leverage to impose conditions favorable for the future of the dollar-reserve system.

In the last three years, the system has faced the $50 billion bailout of Mexico, the $57 billion bailout of South Korea, $43 billion for Indonesia, and $18 billion for Thailand to fend off its own destruction. But by delaying the day of reckoning with bailouts, the international mountain of dollars and debt grows, making the inevitable collapse all the more devastating.

The system will not be able to prevent the disgorging of dollar reserves to fend off Asian-style financial debacles in China, South America, Russia, and a repeat performance in Mexico. If the euro becomes the common currency of the European Union, its members will replace their dollar reserves with euros. And if Japan recovers, the yen will become the reserve currency across Asia. Global dollar hegemony will be at an end.

The Fed has overseen the best of times for the American economy in the 1990s, a period of rapid monetary inflation and credit expansion with current benefits of low interest rates, high earnings, soaring capital values, low unemployment, and steady economic growth.

When the Fed tightens money, which it will, the joy we are all now enjoying will turn to gloom, and the reality that we are living in what the Economist calls a bubble economy will be impossible to ignore.

Llewellyn H. Rockwell, Jr. is president of the Ludwig Von Mises Institute in Auburn, Alabama.

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