It is five years since the global financial crisis began but we still don’t have a true economic recovery. This article explains why that is.
In order to understand why it is we still don’t have an economic recovery, it is first necessary to understand how and why the “Great Recession” began, something which is best explained by the Austrian theory of the business cycle.
The Austrian theory of the business cycle
According to the Austrian School of economics, business cycles, that is, fluctuations in production or economic activity that occur over a period of months or years, can be explained by the relationship between interest rates and credit creation.
A period of sustained low interest rates, such as we saw in the run up to the current economic downturn, leads to increased borrowing from the banking system. And, thanks to our fractional reserve banking system, this expansion of credit causes an expansion in the supply of money.
This, in turn, leads to an unsustainable credit-fuelled boom which results in widespread malinvestment. The malinvestment occurs because money is cheap to borrow and is therefore abundant, and because over time more and more money chases fewer and fewer investment opportunities.
Eventually the process of exponential credit creation cannot be sustained and its end results in a sharp contraction in the money supply. Referred to as a “credit crunch”, this process typically results in an economic recession but in severe cases it causes a depression.
Eventually, as bad debts and poor investments are written off, asset prices fall back to their true value. Gradually resources are reallocated to more efficient uses and a new crop of savings is built. Once this cleansing process has been completed, and money is once again fairly priced, a new cycle of prosperity can begin.
Austrian economist Murray Rothbard, believed the Austrian theory of the business cycle explains best why there is a general increase in the money supply in the economy during every boom, and why there is typically, though not always, a fall in the supply of money during the economic contraction that follows.
Why are we still in recession?
The Austrian theory of the business cycle explains how we came to be in recession, but the question is: Why are we still in recession?
It is exactly five years since the global financial crisis began. It started when homebuyers in the US began missing their mortgage payments causing huge losses for those lenders that had made so-called “subprime” loans. The subprime crisis quickly became a credit crisis when, for the first time in history, banks stopped lending to each other.
As fear spread throughout the financial markets, the global economy quickly became paralysed. The cleansing process had begun.
The 7th of August 2007
On 7 August 2007 the scale of the crisis began to emerge. Here are just a handful of news headlines from that day.
- New bankruptcy shows US homes crisis widening
- Subprime crisis claims another German casualty
- Economists Brace for Worsening Subprime Crisis
- UK’s Subprime Crisis May Be Worse Than US’s
- Deutsche and JPMorgan hit by sub-prime crisis as lender falls
Despite the number of alarming headlines, many economists and political leaders simply didn’t understand the scale of the problem. On 7 August 2007, for example, the Federal Reserve decided to keep its target for the federal funds rate at 5.25%.
The FOMC’s statement issued that day read, “Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”
Moody’s was also remiss when it came to reporting the scale of the burgeoning crisis. A Bloomberg article from 7 August 2007 read: “The largest U.S. banks face modest risk and manageable fallout from subprime-mortgage losses, Moody’s Investors Service said. While earnings may be hurt by an inability to offload some corporate debt to investors, the banks won’t have trouble funding themselves”.
The reason we are still in recession is that the cleansing process was not allowed to run its course. On the same day, the European Central Bank, together with the US Federal Reserve, the Bank of Canada and the Bank of Japan, began to intervene in the markets to prevent a collapse.
The ECB injected €95 billion into the banking system to try to improve liquidity, and in the days that followed it injected a further €108 billion.
Within days the Federal Reserve was cutting interest rates and banks such as UBS and Citigroup began to reveal billions of dollars of losses from subprime loans that had to be written off.
In December 2007 the Federal Reserve co-ordinated unprecedented action by the European Central Bank, the Bank of England, the Bank of Canada, and the Swiss National Bank to offer billions of dollars in loans to help struggling banks.
As stock markets fell and ratings agencies finally issued downgrades, the rate slashing and market interventions continued. During the 2007-2009 crisis the Federal Reserve alone, either guaranteed, expanded, or backstopped between $8 and $9 trillion.
It was this intervention (which still continues today), that prevented the cleansing process from taking place, and it is this that explains why we haven’t had a true economic recovery.
If the Great Recession had been allowed to run its course, it would have undoubtedly been very painful, but by now we would be emerging from it with a fully functioning economy and the prospect of beginning a new cycle of prosperity. Instead, we borrowed incredible amounts of money and today we have a “zombie economy” which requires continual doses of new stimulus to keep it alive.
It is our opinion that policymakers and central bankers will become ever more desperate in their attempts to keep the zombie economy alive. These actions will be the most significant factor influencing global financial markets over the next few years and therefore investors need to pay close attention to them.
For more on our view of the future, click here.