The theory of business cycles advanced by Ludwig von Mises (and refined by Friedrich Hayek, who won the Nobel partially for this work) explains the typical recession as the inevitable result from a preceding, and unsustainable, boom period. The cause of the boom is artificially low interest rates, which in turn are caused by the expansion of bank credit made possible by “fractional reserve banking.” When the banks cease (or at least slow down) their credit expansion and interest rates rise, businesses realize their operations are no longer profitable and the bust ensues. (For more on Austrian business cycle theory, and specifically how it relates to the recent housing boom-bust, see my article here.)
Naturally, most respectable economists do not endorse the Misesian theory. Yet two recent episodes show that it is still quite relevant for an understanding of the modern economy:
==> In a post entitled “Austrian business cycle theory refuses to die,” Tyler Cowen (a sharp critic of the internal logic of ABCT) relates the preliminary findings of a new paper by Princeton economists:
This paper examines financial instability associated with bank credit expansion in a set of 23 developed countries over the years 1920-2012. We find that credit expansion, measured by the three-year change in bank credit to GDP ratio, predicts a significantly increased crash risk in the returns of the bank equity index and equity market index in the subsequent one to eight quarters. Despite the increased crash risk, credit expansion predicts both lower mean and median returns of these indices in the subsequent quarters, even after controlling for a host of variables known to predict the equity premium.
==> A recent Bloomberg article relates the concern among Fed officials that slowing asset purchases will cause a crash:
Federal Reserve Governor Jeremy Stein endorsed a warning by economists that raising the main interest rate may cause a financial-market convulsion similar to the “tantrum” that occurred last year after the Fed said it was considering trimming its bond purchase program.
“Whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear,” economists including Michael Feroli, the chief U.S. economist for JPMorgan Chase & Co. in New York and a former Fed economist, said in a paper released today. “Risks of instability have not been eliminated.”
Stein lined up behind Feroli’s argument in comments on the paper during a conference in New York, saying “monetary policy makers cannot wash their hands of what happens” in financial markets when they begin withdrawing stimulus.
Of course, few mainstream economists are going to say, “Maybe that Ron Paul guy was on to something?” but we are seeing the familiar playing out of unintended consequences that free-marketeers admit occur in most other areas of government “helping.” Why central planners should suddenly have an advantage in the production of money and setting of interest rates has never been adequately explained.