The Global Economic Crisis of 2008 -

Summary / Contents

• The Root of the Crisis: Central Banking
• Central Banks Create Inflation and the Business Cycle
  
• Governments Make Depressions Worse
• The Fiat Dollar: Accelerated Inflation and Bigger Bubbles
• What Not To Do: inflate further, bailout banks/firms/industries
• What To Do: no government action, cut government, monetary reform

The Root of the Crisis: Central Banking

The current economic crisis is due to manipulation of the money supply.  All boom-bust cycles are caused by manipulation of the money supply.

The particular details about this crisis should be analyzed in this context - by reference to the general theory of business cycles ("Austrian business cycle theory").

Under a system of central banking, the volume of money in the system is controlled centrally.  The central bank uses its monopoly privilege over the supply of bank notes - legal tender laws - to control the volume of money.

The central bank creates new money out of nothing, and then the money supply is further increased via fractional-reserve banking.  This is when commercial banks are allowed to create new money in the form of demand deposits on top of the money created by the central bank.

The banks do this by merging the two distinct functions of a bank, which are 1) deposit banking, and 2) savings-and-loan banking.

Deposit banking is simple money warehousing.  The depositor retains property rights over the deposited money, and the warehouser cannot do anything with it while it is in his physical possession.  The money must always be available on demand.

Savings-and-loan banking is where money is lent out at a rate high rate to borrowers and a lower rate is paid to savers. Crucially, while the saver’s money is lent out, the saver cannot use it. Unlike with a deposit, savings deposits are not available on demand.

All commercial banks nowadays merge these two distinct functions, so that they can reap the benefits of fractional-reserve banking.  They lend out deposits which are supposed to be available on demand.  The effect is that they are literally creating money.

Central banking makes fractional-reserve banking possible on a large scale.  A credit expansion is induced by the central bank, and then banks multiply this new money, only keeping a fraction of their demand deposits in reserve to cover redemptions.  This increases the money supply, which causes malinvestments and an artificial boom, particularly in capital goods industries.

Lender-of-last-resort guarantees and government deposit insurance exist to support the central banking / fractional-reserve banking system.  This system is hugely beneficial to central bankers, to governments and to the commercial banks.

Inevitably, after a while the market demands a correction, and this takes place when banks contract credit in fear of a bank run which would reveal they do not have enough money to redeem all demand deposits.  This is the bust phase of the cycle.  It causes a recession, which is the market readjusting to satisfy consumer demand, after the market has been distorted by an artificial increase in the money supply. 

The length and severity of a recession depends on whether the market is allowed to make the necessary correction, or the government instead intervenes in the process.

For more information, see CHAPTER V: BANKING.


Central Banks Create Inflation and the Business Cycle, Governments Make Depressions Worse

From 1914-20, the Fed massively inflated the money supply.  The artificial boom of 1914-20 caused a crisis, but then inflation was halted.  Market forces were allowed to operate, and by 1921 the economy had recovered.  

In Germany in 1923, the central bank tried to prolong the boom with further liquidity injections and caused hyperinflation of the mark.

From 1921-29, the Fed again massively increased the money supply, creating a bigger boom, which caused a bigger bust.  Inflation was halted, but this time the government intervened, preventing the market from adjusting.  This action by the Hoover Administration turned a short, mild recession into the Great Depression (1929-46), which was made even more severe and lengthened by FDR’s disastrous policies and by World War Two.  The economy did not reach the prosperity of the 1920s again until after the war was over.

Gold served as a market-imposed limit on the amount of dollars that could be issued, but this was overcome gradually between 1933 and 1971.  In 1933, Americans' gold was confiscated and they were forbidden from owning gold. In 1945, the dollar became the reserve currency of the world.  Only foreign central banks could now redeem dollars for gold on demand.  The Fed was now able to hugely increase the money supply by ‘exporting the inflation’.  In the late 60’s, confidence in the dollar declined and demands for redemption in gold by foreign central banks caused a drain on gold reserves until Nixon declared national bankruptcy in 1971 and closed the ‘gold window’.

The dollar was now completely free of any restrictions. Massive inflation and huge artificial booms and busts could now be unleashed. With carefully chosen government regulations, the industries suffering the biggest bubble can be virtually chosen at will.

For more information, see CHAPTER VI: CENTRAL BANKING and CHAPTER VII: INFLATION AND BUSINESS CYCLES.


The Fiat Dollar: Accelerated Inflation and Bigger Bubbles

This global economic crisis is bigger than any previous crisis created by Central Banks.

As Austrian economists predicted, dollar inflation accelerated when it was freed from the gold standard.  A few minor recessions/corrections in the late 20th century were "papered over" as the Fed tried to create a new artificial boom to replace each recession - causing the phenomenon of "stagflation", which mainstream economics could not explain.

As a fiat money used as the world's reserve currency, the effects of manipulation of the dollar money supply would be felt worldwide. 

Inflation of a money supply creates a general boom and bust over the whole economy, though it creates particularly large bubbles in those industries who use the newly created money first.  The "Dot-Com" boom and bust of 2000-1 represents a boom where a great proportion of the new money was spent on Dot-Com companies.

The repeal of regulation like the Glass-Steagall Act, the creation and increased importance of government-sponsored enterprises like Fannie Mae and Freddie Mac, along with cartelization of the credit ratings industry through regulations, led to more and more complex debt packages being created.  For example, Structured Investment Vehicles and other types of mortgage-backed securities, where the true risk was near-impossible to determine. 

Massive inflation of the dollar after the Dot-Com bust, after the September 11, 2001 attacks, and particularly between 2001 and 2004 when the Fed Funds Rate was taken as low as 1%, caused house prices and the dollar itself to become a bubble.  Prices increased dramatically, and so did malinvestments.  Much of the money was channeled into the housing industry and securitization market, forming giant bubbles, and allowing the artificial boom to last a few extra years before the malinvestments became evident.

Unable to explain business cycles, and unable to recognize the imminent danger of a huge bust and recession, top mainstream economists, as well as politicians, right up to and into 2008, assured the public that the financial system was not in any trouble, while mocking Austrian economists who warned out about the imminent crisis.

In 2008, market forces finally became overwhelming.  The housing bubble burst, and houses prices began to plummet.  Defaults of all kinds increased.  SIV's were recognized as toxic.  The biggest artificial boom ever was spectacularly busting and about to send the world economy into a recession.

For more information, see The Crisis in 10 Points, by Robert Murphy.


What Not To Do: inflate further, bailout banks/firms/industries

At this point, the Fed has only two choices:

• Inflate further, risking hyperinflation and a dollar collapse for the sake of delaying the recession for longer,
  
• Or stop inflating, allowing the recession to take place.
  

The Fed decided to inflate further, through "quantitative easing", "liquidity injections" and increased open-market asset purchases.  Now in 2009, we are in an inflationary recession.

Government actions - including bailouts of banks and favored industries, "stimulus packages", nationalization of banks, job-creation projects, deposit insurance guarantees, unemployment insurance, etc - always and only slow down the recession/correction process, and make it more severe than it need be.

The fallout from the 2008 bust will remain for decades due to the irresponsible actions of the US government and central bank.  The recession will be a severe inflationary depression, without even the relief of falling prices seen in the 1930s.  It could result in the complete destruction of the dollar, and/or other fiat currencies like the UK pound, if the central banks continue to inflate.  There are no more bubbles that can be created - unless perhaps, the dollar itself is replaced by a new continental or global fiat currency.  Then, "papering over" this depression may be possible for a few further years, but that will surely mean it will last even longer and be even more severe when it occurs. 

The problem is made worse by low private savings in the US, an obsolete manufacturing base, high taxes, regulations, tariffs, subsidies, budget deficits, a large welfare state, and huge debts, both public and private.  The final demise of the dollar may come when Asian countries such as China, refuse to accept dollars for their manufactured goods, and instead start to produce more for their own domestic markets.


What To Do: no government action, cut government, monetary reform

The best thing a government can do now is to simply allow the market to work and the economy will recover in the quickest time possible.  No bank bailouts, no stimulus packages, and no government guarantees to banks or depositors.

Cutting down the size of government - cutting taxes, price controls and regulations - is the only positive action that government should take.

To prevent the continuation of the fiat dollar which is manipulated at will, fundamental monetary reform is required.  In particular, there must be a transition away from monopolized money and into freely competing private currencies and a free market banking industry - no central bank.

This would permanently eliminate inflation and the business cycle.

For more information, see "The Case Against The Fed" by Murray Rothbard.