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An economy built on an illusion is hardly a sound structure


George Melloan’s “The Fed’s Asset-Inflation Machine” in today’s Wall Street Journal, while not mentioning Austrian economics, provides some very Austrian sounding analysis of the impact of Fed policy, both current and past on the economy.

Some highlights:

The nearly 2,000-point rise in the Dow Jones Industrial Average since last June no doubt at least partly reflects asset inflation, since there has been very little in the economic or political outlook to justify it.

Echoing Salerno’s recent excellent analysis of the overconsumption aspect of ABCT:

Asset inflation often produces something called “wealth illusion,” the belief that pricier asset holdings necessarily make one permanently richer. Illusions are dangerous. Eventually, painful reality intervenes.

Fed error feeds the boom and housing bubble leading to the current bust:

Mr. Greenspan would fail to heed his own warning. Urged on by his soon-to-be successor, Ben Bernanke, Mr. Greenspan would hold interest rates down too long, setting off a mid-2000s credit binge that sent assets soaring, home prices in particular.

The inevitable bust:

As Mr. Greenspan had feared, a crash in asset values did profound damage to the real economy. We are still living with it.

I would argue, following Frank Shostak (“Fed’s policies expose mainstream fallacies”), it was the credit expansion and the resulting malinvestments that did considerable harm to the real economy. A return to asset prices to more realistic values is part of the correction, not the cause of the ‘profound damage’.

Melloan concludes:

But an economy built on an illusion is hardly a sound structure. We may be doomed to learn that lesson once again before long.

Credit creation which causes both malinvestments and over-consumption due to ‘wealth illusion’ of asset inflation. Asset inflation is a direct result of created credit. Melloan thus informs the reader indirectly through a quote from German banker/economist German banker and economist Kurt Richebächer (April 2005 newsletter) ”there is always one and the same cause of [asset inflation], and that is credit creation in excess of current saving leading to demand growth in excess of output.”

For a detailed discussion of ABCT which spells out how these forces played out and are continuing to play out in the current economy see Joe Salerno’s excellent (maybe the best new paper on ABCT in the last 10 year?) paper, A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis.

Melloan concludes:

But an economy built on an illusion is hardly a sound structure. We may be doomed to learn that lesson once again before long.

Too bad Chairman Bernanke’s vast scholarship on the Great Depression does not appear to have included the best study of the 1929-1933 period, Rothbard’s America’s Great Depression.

Peter G. Klein is Carl Menger Research Fellow of the Mises Institute and W. W. Caruth Chair and Professor of Entrepreneurship at Baylor University's Hankamer School of Business.

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