Most experts regard consumer’s psychological disposition as the driving force of an economy.
If consumers are optimistic and happy with the economy, no recession can occur — so it is believed. According to the popular way of thinking, if consumers are active, this is said to be a good sign for economic health. If consumers do not spend enough then it is seen as bad news. Indeed surveys of business activity show that during a recession, businesses emphasize a lack of consumer demand as the major factor behind their poor performances.
In the real world, consumer optimism is important, but by itself it will achieve nothing. Production must precede consumption. It is necessary to produce useful goods that can be exchanged for other goods.
When a baker produces bread, he doesn’t produce everything for his own consumption. Most of the bread he produces is exchanged for the goods and services of other producers, implying that through the production of bread, the baker exercises his demand for other goods.
Demand Is Limited by Prior Production
To put it differently, his demand is fully covered (i.e., funded by the bread that he has produced). Demand therefore, cannot stand by itself and be independent; it is limited by prior production, which serves as a means of securing various goods and services. What thwarts individuals’ demand for goods and services, is the availability of means to appropriate all the goods and services individuals want.
These means do not spring “out of thin air.” They first have to be produced. The production of goods and services is constrained by the real pool of wealth: the resource available to provide sustenance to the economic process. The pool of wealth is the quantity of goods available in an economy to support future production. If it requires one year of work for a man to build a tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built and the man will not be able to increase his productivity.1
In a market economy, money has just one role — to provide the services of a medium of exchange. Money permits the product of one specialist to be exchanged for the product of another specialist. The exchange of something for something also means that consumption doesn’t precede production, (i.e., we first have to produce a useful product before it can be exchanged for money and only then could we exchange money for goods we desire). Consumption is fully funded by preceding production.
Many economists are of the view that money injections and interest rate manipulations are the keys to navigating the economy along the growth path of stability and prosperity. But in a free and unhampered market, interest rates are the outcome of the supply and demand of savings. Interest rates mirror consumers’ time preferences, i.e., their wishes with respect to how much they want to consume at present and how much in the future. In this capacity, they guide businesses in the most profitable allocation of resources. By paying attention to interest rates, businesses are in fact abiding by consumers’ instructions.
Sending False Signals With Manipulated Interest Rates
However, once money is pumped it leads to an artificial lowering of interest rates in financial markets. Consequently, interest rates cease to reflect consumers’ preferences. This in turn means that businessmen who incorporate in their decision-making process interest rates in financial markets, are committing errors. They’re making investment decisions that go against consumers’ most urgent demands.2 To put the point differently, businessmen are diverting resources from wealth generating activities to non-wealth generating activities.
So long as monetary pumping and the consequent artificial lowering of interest rates remains in force, there is no way for businessmen to know that they are committing these errors. On the contrary, as the loose monetary policy intensifies, it generates apparent profits and a sense of prosperity. The longer the period of loose monetary policy, the more widespread will be the errors, i.e, the disobedience of entrepreneurs regarding the will of consumers.
All this leads to a situation where entrepreneurs are committing themselves to unprofitable businesses, which ultimately must be liquidated. It is this liquidation that is called an economic bust or recession. As a rule, the trigger to this liquidation is the reversal of a loose stance by the central bank.
The severity of a recession is dictated by the intensity of the previous boom brought about by monetary pumping and the associated artificial lowering of interest rates, i.e., by the percentage of “false activities” from total activities. The larger this percentage the more severe the recession will be, since more liquidations will take place.
According to Mises,
It is essential to realize that what makes the economic crisis emerge is the democratic process of the market. The consumers disapprove of the employment of the factors of production as effected by entrepreneurs.3
Most experts assess the likelihood of a recession or a depression by looking at the rate of growth of the consumer price index. If this index appears to be steady then it is interpreted as a sign of an economic health.
On this, Murray Rothbard wrote,
The fact that general prices were more or less stable during the 1920’s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.4
Prices are determined by real and monetary factors. Consequently it can occur that if the real factors are pulling things in an opposite direction to monetary factors, there may be no visible change in prices. While money growth is buoyant, prices may not increase. The crux therefore, is not rises in the CPI, or relative increases in money supply versus rises in goods, but the fact that money supply is rising. It is this increase in money that matters, for it is this increase that sets in motion an exchange of nothing for something.
Likewise, drawing conclusions from the strength of the GDP statistic might also produce erroneous results. For GDP mirrors monetary pumping the more money is pumped the greater is GDP. Hence it is not possible to ascertain through the inspection of the GDP statistic the state of the pool of real wealth.