Business Cycles Are Credit Cycles

By John R. Skar

Reader’s caveat: tongue-in-cheek comments in this blogpost are deliberate.

According to mainstream economic analysts at the Federal Reserve, our nation’s economic fortunes naturally rise and fall with random, exogenous shocks to aggregate supply and demand curves. According to them, the “free market” just has a natural tendency to de-rail itself, for no good reason. Sometimes, manufacturing output just declines or consumer demand just swoons. This is when monetary policy gurus at the Fed come to the rescue, regenerating stagnant demand like spreading fertilizer on a flower bed. Our central planners remind us that Congress created the Fed in 1913 to provide a safer, more flexible and more stable financial system. The Fed uses monetary policies to achieve its twin goals of maximum employment (for those seeking jobs), along with a stable inflation rate of around 2%. These things are as complicated as rocket science. Thank goodness that we have all these Ivy Leaguers willing to lend us their brains and move things along so that the rest of us don’t have to worry.

Contrary to some people’s impression, these scholars also remind us that the Fed doesn’t actually “print” money. Rather, the Fed just influences how much money the banking system creates through the lending process. When the Fed buys Treasury securities and pays for them with newly created Federal Reserve notes, it only buys Treasuries that are already in existence, rather than new issues. Banks use the federal reserve notes as collateral to create new loans, which in turn creates demand deposits in checking accounts. We are also told to remember that the Government has delegated this critical monetary control role to the “independent” Federal Reserve, keeping it away from the potentially irresponsible hands of raw political forces in Congress and the Executive Branch.

A recent article by Alasdair Macleod challenges these standard understandings of our monetary gurus. Macleod makes the following general assertions:

  • Business cycles do not arise from the operation of free markets; they are the consequences of expansion and contraction of unsound money and credit.
  • Monetary inflation transfers wealth from savers and those on fixed incomes to the banker’s favored customers, and is a major cause of increasing wealth disparities.
  • The “credit cycle” is always boom followed by bust. The “bust” phase is the market’s elimination of unsustainable debt, created during the expansion boom. However, if the bust phase gets cut short, trouble simple rolls forward to the next cycle.
  • Today, economic distortions from previous cycles have compounded to the point where only a small rise in interest rates will trigger the next crisis; central banks have no room left to maneuver.
  • Current credit imbalances are now effectively global, rather than national.

The idea that injecting new money into the economy creates winners and losers is not new. Richard Cantillon, a French economist from the 18th century, is generally credited with describing this, known in textbooks as the “Cantillon effect.” Newly created (some would say “counterfeited”) money has more value when first put in circulation, but gradually causes prices to rise across the economy. The “winners” are typically the banks and their most favored borrowing customers, while the losers are the pensioners and the poor. 

Macleod provides a detailed description about how central banks anxiously steer the bus by looking out the rear view mirror, carefully pulling monetary levers that their discredited models still say are connected to something in the real market economy. The trouble is that this fiddling does have real impacts, since interest rates do influence economic actors.  What is forgotten is that if a market economy is to function, the price mechanism needs to work. The price of money is the interest rate, and an artificial interest rate creates dangerously incorrect information for the market.

Macleod thinks the problem is that economic cycles are increasingly systemic and global in nature. He concludes with the following admonition:

“The origin of changing levels of business activity is credit itself. It therefore stands to reason that the greater the level of monetary intervention, the more uncontrollable the outcome becomes. This is confirmed by both reasoned theory and empirical evidence. It is equally clear that by seeking to manage the credit cycle, central banks themselves have become the primary cause of economic instability. They exhibit institutional group-think in the implementation of credit policies. The underlying attempt to boost consumption by encouraging continual price inflation is overly simplistic and ignores the negative consequences.

“An economy that works best is one where sound money permits an increase in purchasing power of that money over time, reflecting the full benefits to consumers of improvements in production and technology. In such an economy, Schumpeter’s process of ‘creative destruction’ takes place on a random basis. Instead, consumers and businesses are corralled into acting herd-like, financed by artificial credit. The creation of the credit cycle forces us all into cyclical behavior that otherwise would not occur.”

E. C. Harwood believed that individual Americans need to educate themselves about the importance of economic freedoms, sound money and property rights. He was an unrelenting critic of the Federal Reserve and the inflationary bias of the monetary gurus. My guess is that he would have approved of Macleod’s description of the current situation.

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John R. Skar

John Skar is an actuary with more than 30 years of senior management experience in US and international life-insurance industries.