Crisis of government, not capitalism

To say mainstream economic theory lacks explaining power is an understatement.

What really causes recessions

The Austrian school of social theory both explains and predicted the boom/bust cycle. It has never been refuted.

According to this theory, government manipulation of the money supply produces three major unintended consequences: inflation, which in turn causes massive system-wide mal-investment, which causes the boom-bust cycle.

Inflation, the root of all the evil

Rising prices are merely the symptom of inflation. The cause is increasing the money supply.

Governments increase the money supply by adding tin to gold coins and using “legal tender” laws to pass them off at their face value and pocket the difference (old-fashioned method). The more sophisticated versions of the same thing are by printing more banknotes (a la Zimbabwe), and by lowering interest rates.

It is important to understand that when governments cut interest rates, they are increasing the supply of money, and causing inflation.

Inflation is not caused by greedy unions, or “excessive demand”, or the economy “overheating”. It is not some mysterious force of nature that we just have to get used to. It is caused by government increasing the money supply.

But inflation has much bigger consequences than just rising prices.

Massive system-wide mal-investment

Inflation causes mal-investment on a massive scale. It causes capital to go into projects that cannot be completed, and that must fail and be wasted.

Why? Because money functions to send important information signals about who wants how much of what, where, and when. Inflation hijacks these signals.

How? Imagine that a builder’s contractor, who supplies bricks, inflates the number of bricks by 10 per cent. The builder plans the building on the basis of the inflated number. He builds the floor, but when he comes to the top of the walls, it turns out there are not enough bricks to finish the job. The house can’t be completed. Most of the capital that went into the house has to be wasted in order for it to be converted into some other form that can be used for something else.

The boom/bust cycle

That is what happens on a massive scale in whole industries in an economy affected by government’s injection of new money. The rising prices deceive businesses into thinking that their goods are in demand. Capitalists invest in factories, machines, employment, and so on. People easily speculate on the general rise in prices, and making profits is easy.