10. How to Avoid Business Cycles: Prevention of and Recovery from the Economic Crisis

At this point we can easily deduce that once banks have initiated a policy of credit expansion, or the money supply has increased in the form of new loans granted without the support of new voluntary saving, processes which eventually provoke a crisis and recession are spontaneously triggered. Thus economic crises and depressions cannot be avoided when credit expansion has taken place. The only possible measure is to prevent the process from beginning, by precluding the adoption of policies of credit expansion or of growth in the money supply in the shape of new bank loans. The final chapter of this book contains an explanation of the institutional modifications necessary to immunize modern economies against the successive stages of boom and recession they regularly undergo. These institutional reforms essentially involve restoring banking to the traditional legal principles which regulate the contract of irregular deposit of fungible goods and which require the continuous maintenance of the tantundem; in other words, a 100-percent reserve requirement. This is the only way to guarantee that the system will not independently initiate any credit expansion unbacked by real saving, and that the loans granted will always originate from a prior increase in society's voluntary saving. Thus entrepreneurs will only undertake the lengthening of the productive structure when, barring unusual circumstances, they are able to complete and maintain it in the absence of systematic discoordination between the entrepreneurial decisions of investors and those of the other economic agents with respect to the amount and proportion of their income they wish to consume and save.

Assuming credit expansion has taken place in the past, we know the economic crisis will inevitably hit, regardless of any attempts to postpone its arrival through the injection of new doses of credit expansion at a progressively increasing rate. In any case the eruption of the crisis and recession ultimately constitutes the beginning of the recovery. In other words the economic recession is the start of the recovery stage, since it is the phase in which the errors committed are revealed, the investment projects launched in error are liquidated, and labor and the rest of the productive resources begin to be transferred toward those sectors and stages where consumers value them most. Just as a hangover is a sign of the body's healthy reaction to the assault of alcohol, an economic recession marks the beginning of the recovery period, which is as healthy and necessary as it is painful. This period results in a productive structure more in tune with the true wishes of consumers.³¹

The recession hits when credit expansion slows or stops and as a result, the investment projects launched in error are liquidated, the productive structure narrows and its number of stages declines, and workers and other original means of production employed in the stages furthest from consumption, where they are no longer profitable, are laid off or no longer demanded. Recovery is consolidated when economic agents, in general, and consumers, in particular, decide to reduce their consumption in relative terms and to increase their saving in order to repay their loans and face the new stage of economic uncertainty and recession. The boom and the beginning of the readjustment are naturally followed by a drop in the interest rate. This drop arises from the reduction and even the disappearance of the premium based on the expectation of a decrease in the purchasing power of money, and also from the increased relative saving the recession provokes. The slowing of the frantic pace at which goods and services from the final stage are consumed, together with the rise in saving and the reorganization of the productive structure at all levels, furthers the recovery. Its effects initially appear in stock markets, which are generally the first to undergo a certain improvement. Moreover the real growth in wages which takes place during the stage of recovery sets the “Ricardo Effect” in motion, thus reviving investment in the stages furthest from consumption, where labor and productive resources are again employed. In this spontaneous manner the recovery concludes. It can be strengthened and maintained indefinitely in the absence of a new stage of credit expansion unbacked by real saving, an event which is usually repeated, giving rise to new recurring crises.³²

Nevertheless now that we have established that economic crises cannot be avoided once the seeds of them are sown, and that the only alternative is to prevent them, what would be the most appropriate policy to apply once an inevitable crisis and recession have hit? The answer is simple if we remember the origin of the crisis and what the crisis implies: the need to readjust the productive structure and adapt it to consumers’ true desire with regard to saving, to liquidate the investment projects undertaken in error and to massively transfer factors of production toward the stages and companies closest to consumption, where consumers demand they be employed. Therefore the only possible and advisable policy in the case of a crisis consists of making the economy as flexible as possible, particularly the different factor markets, and especially the labor market, so the adjustment can take place as quickly and with as little pain as possible. Hence the more rigid and controlled an economy is, the more prolonged and socially painful its readjustment will be. The errors and recession could even persist indefinitely, if it is institutionally impossible for economic agents to liquidate their projects and regroup their capital goods and factors of production more advantageously. Thus rigidity is the chief enemy of recovery and any policy aimed at mitigating the crisis and initiating and consolidating recovery as soon as possible must center on the microeconomic goal of deregulating all factor markets, particularly the labor market, as much as possible, and on making them as flexible as possible.³³

This is the only measure advisable during the stage of economic crisis and recession, and it is particularly important to avoid any policies which, to a greater or lesser extent, actively hinder or prevent the necessary spontaneous process of readjustment.³⁴ Also to be especially avoided are certain measures which always acquire great popularity and political support during crises, in view of the socially painful nature of such phenomena. The following are among the main steps which are normally proposed and should be averted:

1. The granting of new loans to companies from the more capital-intensive stages to keep them from going through a crisis, suspending payments and having to reorganize. The granting of new loans simply postpones the eruption of the crisis, while making the necessary subsequent readjustment much more severe and difficult. Furthermore, the systematic concession of new loans to repay the old ones delays the painful investment liquidations, postponing, even indefinitely, the arrival of the recovery. Therefore any policy of further credit expansion should be avoided.

2. Also very harmful are the inappropriately-named policies of “full employment,” which are intended to guarantee jobs to all workers. As Hayek very clearly states,

   [A]ll attempts to create full employment with the existing distribution of labour between industries will come up against the difficulty that with full employment people will want a larger share of the total output in the form of consumers’ goods than is being produced in that form.³⁵

   Thus it is impossible for a government policy of spending and credit expansion to successfully protect all current jobs if workers spend their income, originating from credit expansion and artificial demand from the public sector, in a way that requires a different productive structure, i.e., one incapable of keeping them in their current jobs. Any policy of artificially preserving jobs which is financed with inflation or credit expansion is self-destructive, insofar as consumers spend the new money created, once it reaches their pockets, in a way that makes it impossible for those very jobs to be profitable. Hence the only labor policy possible is to facilitate the dismissal and rehiring of workers by making labor markets highly flexible.

3. Likewise, any policy aimed at restoring the status quo with respect to macroeconomic aggregates should also be avoided. Crises and recessions are by nature microeconomic, not macroeconomic, and thus such a policy is condemned to failure, to the extent it makes it difficult or impossible for entrepreneurs to review their plans, regroup their capital goods, liquidate their investment projects and rehabilitate their companies. As Ludwig M. Lachmann articulately puts it,

   [A]ny policy designed merely to restore the status quo in terms of “macroeconomic” aggregate magnitudes, such as incomes and employment, is bound to fail. The state prior to the downturn was based on plans which have failed; hence a policy calculated to discourage entrepreneurs from revising their plans, but to make them “go ahead” with the same capital combinations as before, cannot succeed. Even if business men listen to such counsel they would simply repeat their former experience. What is needed is a policy which promotes the necessary readjustments.³⁶

   Therefore monetary policies intended to maintain at all costs the economic boom in the face of the early symptoms of an impending crisis (generally, a downturn in the stock market and real estate market), will not prevent the recession, even when they are sufficient to postpone its arrival.

4. In addition the price of present goods in terms of future goods, which is reflected by the social rate of time preference, or the interest rate, should not be manipulated. Indeed in the recovery phase the interest rate in the credit market will spontaneously tend to decline, given the drop in the price of consumer goods and the increase in saving brought about by the reorganization the recession entails. Nevertheless any manipulation of the market rate of interest is counterproductive and exerts a negative effect on the liquidation process or generates new entrepreneurial errors. In fact we can conclude with Hayek that any policy which tends to maintain interest rates at a fixed level will be highly detrimental to the stability of the economy, since interest rates must evolve spontaneously according to the real preferences of economic agents with respect to saving and consumption:

   [T]he tendency to keep the rates of interest stable, and especially to keep them low as long as possible, must appear as the arch-enemy of stability, causing in the end much greater fluctuations, probably even of the rate of interest, than are really necessary. Perhaps it should be repeated that this applies especially to the doctrine, now so widely accepted, that interest rates should be kept low till “full employment” in general is reached.³⁷

5. Finally any policy involving the creation of artificial jobs through public works or other investment projects financed by the government should be avoided. It is evident that if such projects are financed by taxes or via the issuance of public debt, they will simply draw resources away from those areas of the economy where consumers desire them and toward the public works financed by the government, thus creating a new layer of widespread malinvestment. Moreover if these works or “investments” are financed through the mere creation of new money, generalized malinvestment also takes place, in the sense that, if workers employed through this procedure dedicate most of their income to consumption, the price of consumer goods tends to rise in relative terms, causing the delicate situation of companies from the stages furthest from consumption to deteriorate even further. In any case, in their contracyclical policies of public spending, it is nearly impossible for governments to resist the influence of all kinds of political pressures which tend to render these policies even more inefficient and harmful, as indicated by the conclusions of public-choice theory. Furthermore there is no guarantee that by the time governments diagnose the situation and decide to take the supposedly remedial measures, they will not err with respect to the timing or sequence of the different phenomena and tend with their measures to worsen rather than solve the mal-adjustments.³⁸