Meltdown summary

In the seventeenth century, a single tulip from Holland was worth more than ten times the annual salary of a skilled craftsman. Tulip mania gripped the world, inspiring rampant economic speculation which resulted in a massive financial crash, stripping ordinary people of their life savings.

Sound familiar? Whether tulips or mortgages, global markets have enjoyed countless booms and suffered through numerous busts. The most recent crisis in 2008 reverberated all over the world, with millions of people losing their jobs, their homes and their sense of well-being.

Although many economies have since recovered, economists warn that the prevailing question is not if there will be another crisis but when. There has to be a better way! These blinks will explain how we got into this mess and how we can free ourselves from this disastrous boom-and-bust cycle.

In these blinks, you’ll learn

• why the US government is to blame for the 2008 economic crisis;
• how an Austrian economic theory can explain busts past and present; and
• why suffering a bankruptcy isn’t all that bad.

The Nobel-prize winning economist Friedrich Hayek developed what was likely the most important economic theory of the modern world. It’s called the business cycle theory, and its explanation of the boom-and-bust phases of the market applies to both the most recent crisis and economic catastrophes of the past.

Here’s how it works. The business cycle theory is based on the effects of government-suppressed interest rates. That’s because artificially decreasing interest rates by printing money produces the illusion that current production can increase more than is sustainable. This deception makes entrepreneurs invest in long-term projects that aren’t based on the realistic savings necessary to feed current production levels.

For instance, a builder who thinks he has 30 percent more cement than he does will build a bigger house than he has the materials for. When he realizes he’s out of cement, he won’t be able to complete his build and will have wasted time and resources on something that’s of no use.

This means that by artificially lowering interest rates, the government causes people to act like they have a lot more money saved than they do. Therefore spending often spikes before a big crash.

We saw the business cycle theory in action during the dot-com boom of the late 1990s, for example. Between 1995 and 2000, the stock prices of internet start-ups jumped dramatically. Why did this happen?

All the classical signs of the business cycle were accounted for: low interest rates prompted by the Federal Reserve’s expansion of the money supply, causing record-high debt, coupled with quickly rising capital prices for things like programmers and real estate.

These factors meant that by 2000, the resources necessary to complete long-term market investments no longer existed. So the dot-com bubble burst, and the value of the Nasdaq stock exchange fell by 40 percent.

So it’s clear what caused the economic crisis we’re still mired in, but how can we best deal with it?

We can learn from past crises, such as the Great Depression. That’s because the foundations of the Great Depression were set by the inflationary government policies of the 1920s. So just as business cycle theory predicted the 2008 recession, it could also have predicted the depression of the 1930s.

For instance, basic economics says that when the production of goods goes up, the prices of those goods go down. But that’s not what happened in the 1920s. Instead, the government increased the money supply by 55 percent, to make it seem as if prices were stable. The government thought that if prices were stable, then the economy would be as well.

People gladly swallowed the government’s story and kept spending, while the stock market grew at an increasingly unsustainable pace until 1929. And while most economists at the time thought of the American economy as invincible, Austrian economists foresaw the boom’s eventual collapse. And their predictions were validated when, in October 1929, the stock market crashed.

We all know what happened next: President Franklin D. Roosevelt introduced the New Deal, a series of social programs to boost the economy and address unemployment. But this program didn’t pull the United States out of the Great Depression; instead, it just prolonged the crisis.

That’s because, instead of listening to reasonable ideas, Roosevelt kept throwing money into the economy. He refused to accept the lessons of the 1929 crash and its root causes. Neither the huge public works programs nor increased spending as a result of World War II would help save the economy.

In fact, by hiking taxes and funneling millions of dollars toward businesses that had no real demand, Roosevelt stood in the way of the economy’s natural efforts to restart itself, based on the real desires of consumers. So it wasn’t until the 1940s when New Deal policies were finally ended that the economy started to recover.

So just like prolonged government spending didn’t do a thing to solve the Great Depression, using government bailouts to inject billions of dollars into the broken US financial sector is a losing strategy.

In fact, bailouts just exacerbate the problem. Instead, we should let failed banks and other financial institutions go bankrupt.

For instance, by handing out billions of dollars to Fannie Mae and Freddie Mac, the government sent a message that failure will be rewarded. What the government really should have done is let the enterprises go bankrupt.

That’s because, in the short term, a small number of well-known institutions going bankrupt sends a signal that the government is using common sense and letting the free market do its thing.

Beyond this, it’s necessary to end the Federal Reserve’s unjust, Soviet-style central monetary planning. After all, with big time players such as investor Jim Rogers questioning the role of the Fed, it could be that we’re on the verge of a shift in opinion about the role of government in regulating the economy.

But where should this shift lead us?

First of all, to end the Fed’s obstruction of the free market, it’s necessary to reassess the institution’s relationship with the banking sector. For instance, since the Fed is the primary reason big banks can take ever-greater risks, it needs to have its position as the “lender of last resort” reevaluated.

Basically, if banks keep operating under the assumption that the Fed will bail them out when their risky practices fail, the boom-bust cycle will never end.

Second, the Fed needs to leave interest rates alone, as manipulating them only prolongs recessions. Instead, interest rates should float freely to fill their natural purpose of recalibrating the market to actual conditions, not artificial figures.

At this point it’s clear that a government’s ability to print as much money as it wants leads to economic crises and poor investments. We need an alternative. But what exactly would that be?

Money that’s connected to a commodity standard is a great way to limit government interference in the economy. That’s because, unlike paper money which can be printed endlessly, a commodity standard is tied to a supply of material like gold, which can only increase as more is discovered.

But don’t worry, this doesn’t mean you’ll have to walk around with a bag full of gold to buy your groceries! A paper substitute could be linked to the value of gold, and people could exchange paper money for gold at any time.

The government is naturally against such an initiative because, without the ability to print more paper money, it would need to use borrowing or tax changes to affect the economy. And it would be a lot easier for the public to protest such actions than remain perpetually in the dark, considering the secretive inflationary policies currently used by the government.

But that’s not the only reason such a system would be beneficial. Another reason is that while inflation is bad for the economy, deflation can be good for it. That’s because inflation is an increase in the money supply while deflation – the opposite – means lower consumer prices.

Some critics of a gold-based commodity standard say that having such a system would cause deflation, since the supply of consumer goods would consistently outpace that of gold. These critics maintain that falling prices would cause an economic crisis.

However, a 2004 study revealed that 90 percent of deflationary periods in the last 100 years (barring those that occurred during the Great Depression) did not in fact lead to economic depression. Deflation is, after all, a natural process in any growing capitalist economy.

Consider the technology market. While the quality-adjusted price of computers fell by 90 percent from 1980 to 1999, manufacturers were shipping out nearly 100 times more units by the end of that same period. This single example offers proof that deflation can also be good for both consumers and producers.