A Big Theory of Boom and Bust

Our times of boom to bust are the perfect illustration of the credit cycle first presented in its fullness in the 1920s. Why then? Because this was the first decade after most countries created central banks. They caused some very odd behavior that made 19th-century-style economics seem to have less explanatory power.

That was when a few economists working in Vienna put together a model for understanding how business cycles work in a modern economy. Their names were Friedrich von Hayek and Ludwig von Mises. They drew on their theoretical knowledge based on the following inputs:

Richard Cantillon (1680–1734) observed that when governments inflate the money supply, the effects are unevenly distributed among economic sectors, affecting some more than others and in different ways.

Adam Smith (1723–1790) explained that a critical element of rising wealth is embedded in the division of labor, in which individuals specialize in tasks and cooperate across firms and those firms cooperate with each other.

Carl Menger (1840–1921) saw money as an organic market creation, not an invention of the state, which implies that it should be produced like any other good or service.

Knut Wicksell (1851–1926) demonstrated that interest rates function as a price mechanism to allocate investment decisions over time, which is why the yield curve exists. Manipulation of the interest rate disturbs the natural allocation of resources.

Eugen von Boehm-Bawerk (1851–1914) explained the structure of production as consisting of far more than just consumer and capital goods. Capital itself is heterogeneous in that investment decisions include a forecast of time expectations, and the interest rate is crucial to coordinating them.

You can put all those pieces together to come up with a mental model of a well-functioning economy as described by Jean-Baptiste Say (1767–1832) who saw the alignment of supply and demand as a law of economics, which is to say that a market economy is inherently stable.

The Central Bank

One can see, then, how a central bank messes everything up. By lowering the interest rate, the central bank fuels the creation of new bank credit that otherwise would not exist. An artificially lowered interest rate acts like fake savings.

Savings are resources drawn from deferred consumption. They serve as the basis for sustainable investment. But artificially low rates signal the existence of savings that are not there.

Not only do low interest rates create fake savings, but they actually draw real savings away from short-term projects toward longer-term projects, thus distorting the production structure as described above. They create a kind of subsidy toward capital products that would not exist had the interest rate stayed at its natural market-based level.

Massive Distortion

The result then is not just inflation, as the monetarists would describe it. It is also a distortion of the production structure. Capital gets a subsidy over consumption goods, and not only that, but longer-term projects get a boost over shorter-term projects.

Bottom line: The last 14 years of zero-interest rates have created a paradigmatic case of the Austrian business cycle theory. It has massively distorted interest rates, more so than ever before. This was Ben Bernanke’s wonderful innovation. Many people thought his move in 2008 would generate inflation but he found a workaround.

Bernanke paid the banks to keep their new and faked resources locked away in the vaults of the Fed. This kept the hot money off the streets and kept prices stable. But that only solved one problem. It created another: It created huge malinvestments in a whole series of sectors in tech and media and housing yet again!

What resulted was a disgustingly overbuilt tech world replete with Zoom-class employees with college degrees earning six figures without limit. Central bank credit caused the creation of an overclass that eventually caused all sorts of mischief, economic and cultural. They invented idiotic ideas like ESG, DEI and woke philosophy in general.

None of this nonsense had anything to do with reality but in Bernanke’s world, reality didn’t matter anymore. This sector got so huge that it became a critical number to push lockdowns under the slogan “Stay home, stay safe.” These privileged elites forced the working classes to serve them food at their doorsteps and face the virus while they luxuriated in their fancy apartments pretending to work on laptops.

The Chart That Reveals All

So that we understand the radical nature of this experiment, please study the following chart carefully. This is the federal funds rate adjusted for inflation. What we see is the longest period of production distortion in American history. This chart goes from 1950s to the present.

This whole policy becomes unsustainable once the value of the dollar begins to fall due to price inflation. At some point, the central bank has to turn things around. When things become shaky or prices start to shift and the central bank starts to back off its pillaging policies, the house of cards starts to fall apart, as resources are drained from long-term speculation to shorter-term consumption and the restarting of real savings.

That’s precisely where we’re in the cycle. Long-term projects are falling apart. Consumers and investors are turning away from the long parts of the yield curve to make money in the short term. Resources in general are going through a massive shift in terms of time allocation as interest rates shift.

The Yield Curve

That the yield curve has dramatically inverted is hardly a surprise. It is a sign that the ship of production is turning very slowly, and investors are unconvinced yet that the Fed will keep this up.

But that point is that the Fed must keep this up if it intends to get inflation rates back to the target. The federal funds rate will have to enter back into positive territory in real terms. That means 6%, 8% or even 10%, pushing long yields far into the double-digit range.

To be sure, we should all in a macroeconomic sense look forward to a new age of more honest finance. The disaster of zero-interest rate policy is finally coming to an end. Former Fed chief Ben Bernanke’s Nobel Prize notwithstanding, this policy massively distorted capital allocation in the economy and around the world for the better part of 14 years. With its end, we’re going to get a taste of some economic and financial rationality.

We might even be able to save money without losing money. So in that sense, the man who bears the main responsibility for inflation, current Fed Chair Jerome Powell, is the same guy who will finally fix what Bernanke broke all those years ago. Remember those days when everything seemed too good to be true? There was a financial crisis that the Fed magically fixed with no downside.

Except that there was a huge economic, cultural and social downside. Frugality and prudence gave way to massive excess and a level of craziness in culture that we never imagined we would experience.

What made this preposterously unjust system possible was the Fed with Bernanke at the helm. Quantitative easing turns out to mean upending all normal life and paying the horrid price for this a decade and a half later.

Someday historians will look back at our times as a great turning point. We’ve been through calamity, and it worsens by the day. Will we enter into a new Dark Age? Or find the light and crawl our way toward it before it’s too late?

If we find our way, it will be because the Austrian economists of old will guide us.