How to react to the economic crisis?

On April 3, 2009, I was a panelist at the third Annual Student Conference on Business Research held at HEC Montreal on the topic of “The Financial Crisis: What’s Coming Tomorrow?”. This is the English translation of my presentation. It is a slightly modified version of the speech I gave in St-Georges-de-Beauce and Calgary this past January. — 22 April 2009

How to react to the economic crisis? A presentation at HEC Montreal

Economics has always been my favourite topic of interest: how to help our compatriots to realize their dreams and to better their lives and, by doing so, to make a better world for all of us. 

Today, I would like to discuss this crisis with you. I wish in particular to bring your attention to the monetary policies of central banks. Because they play a crucial role in the current crisis.

My thinking on this issue has been inspired by the great economist Friedrich Hayek, who received the Nobel Prize for economics in 1974 and passed away in 1992.

He and his colleagues – who belong to what we call the Austrian school of economics – have for many decades warned us about the adverse consequences of central banks manipulating the money supply.

Central banks are continually increasing the quantity of money that is circulating in the economy. In Canada for example, if we use the strictest definition of money supply, it has increased by 6 to 12% annually during the past dozen years. The situation is about the same everywhere.

The consequences of constantly creating new money out of thin air have been a dramatic increase in prices and a debasement of our money. The faster the quantity of money increases, the higher will the inflation level be and the larger the reduction in the purchasing power of each dollar.

An inflation rate of 2% a year may seem small. But when you add up 2% of depreciation of the monetary unit year after year, you end up with large numbers. Total inflation in Canada from 1990 to today adds up to 42%. This means that your dollar can now buy the equivalent of only 70 cents if you compare it to 19 years ago.

This inflation eats away at our revenues and our financial holdings. It is the equivalent of a hidden tax.

Besides pushing prices up, what happens when central banks maintain artificially low interest rates? That is, rates that are lower than the natural rate of interest, which should balance the supply of voluntary savings and the demand for investment funds?

Well, what happens is that people are encouraged to save less, because the returns on savings are lower. And they are led to carry more debt, because credit is easier to obtain.

This is precisely what we have been doing in Canada, in the U. S. and elsewhere in the world for the past 20 years. In 1990, the ratio of total debt to disposable income for Canadian families was 90%. Today, this ratio has gone up to 130%.

In 1990, Canadian families used to save about 10% of their disposable income. Today, their savings rate is down to 1%.

Many people thought that there was no problem there because the assets of Canadians would continue to grow to compensate for these larger debts. In particular because house prices had been going up since the late 1990s, and because funds set aside for retirement were increasing in value. But with the slowing down of the real estate market and the stock market crash, we now know that this too was a monetary illusion.

Which brings us to another consequence of monetary manipulations which has the effect of wrecking the economy: the creation of artificial booms followed by busts and recessions.

Remember: we had the dotcom bubble at the end of the 1990s. And now we’re experiencing the burst of the real estate and financial bubble that followed.

Between 2001 and 2004, in order to stimulate the economy after the dotcom crash, the Federal Reserve pushed down interest rates to as low as 1%. If you factor in the level of inflation, real interest rates were negative. This is the same as subsidizing people to encourage them to take loans. But we all know this lesson: you cannot live on a credit card for very long!

This bubble was made bigger by the policies of the U. S. government. It encouraged banks to extend risky mortgages to insolvent borrowers; and it encouraged people to take up these mortgages and buy houses that they could not really afford. All of which contributed to an unsustainable increase in house prices of 10 to 15% per year.

In 2006, 22% of all new mortgage loans in the U. S. were subprime.

You’ve heard the rest of the story. These mortgage loans were securitized and then sold on the market around the world. And the financial institutions that had bought them got into trouble when home owners started to default and home prices went down.

Another reason why this financial crisis reached global proportions is that central banks elsewhere in the world have had more of less the same expansionist monetary policies as the Fed. We got to a point where there was too much money and credit available, and these funds were invested in too risky and unprofitable places.

Economic downtowns are always preceded by an inflationist boom. The Great Depression happened at the end of the “Roaring Twenties.” By allowing the creation of gigantic quantities of money, central banks are responsible for these inflationist booms and for the following crisis.

Now, what should we do to get out of this crisis?

We hear a lot about artificially sustaining demand by injecting even more money into the economy. That’s the Keynesian solution.

But if you inject resources in the economy, where do you take them? They’re not falling from the sky. They have to come from somewhere else in the economy. In effect, you take resources from some and you give them to others. It’s like taking a bucket of water in the deep end of a swimming pool and emptying it in the shallow end.

A government cannot inject resources in the economy unless it has first extracted them from the private sector through taxes; or put us further into debt by borrowing the money; or stimulated inflation by printing it.

We are also being told by some commentators to continue to shop till we drop in order to kick-start the economy. In these uncertain times, when many could lose their jobs, this amounts to inciting people to be irresponsible.

In any case, isn’t this exactly what we’ve just been through? A time when monetary policies were encouraging us to go into debt and live above our means?

This is based on the belief that the more we consume, the richer we get, when the reverse is true: the richer we are, the more stuff we can buy! And you get rich by working, by saving and investing real resources, and by becoming more productive. There are no other ways.

Roosevelt prolonged the Great Depression for a decade with his very interventionist policies.

The Japanese also had recourse to such policies after their real estate bubble burst in the late 1980s. They voted gigantic stimulus packages and the Japanese central bank kept interest rates at 0% for several years. It did not work. The only apparent result is that Japan went from the country with the smallest debt in the G7 in 1995 to the country with the largest debt today. And its economy is still in crisis 20 years later.

The only thing more dangerous than this economic crisis may be our way of responding to it. If we intervene too much or in an appropriate manner, we run the risk of worsening and prolonging the crisis. The best thing to do is to stay focused on the fundamental principles that have been tried and tested: sound money, responsible finances and free markets. We will only find our way back to prosperity, and guarantee the future of our children, if we continue to fight for these values.

Thank you.