The Problem With Economic Stimulus as a Response to Recession

The Keynesian Theory of Recessions

While modern economists are loath to admit it, the dominant view now appears to be that economic schools of thought no longer exist! - the dominant macroeconomic paradigm is still that proposed in Keynes' "A General Theory of Employment, Money, and Interest". Keynes argued that the problem during a recession was a failure of 'aggregate demand'. A lack of consumer spending leads to falling production, which leads to a lack of consumer spending, and so on. A nasty loop. However, there is a solution. The state can leap onto the scene, a veritable deus ex machina, saving the day by pumping money into the system through deficit spending. This spending will put people back to work, and they will spend the money they earn, boosting total production, and increasing spending, until the economy roars again.

It's a neat little story, unfortunately, it is total bullshit.

Austrian Business Cycle Theory

The problem is that we start at the end of the business cycle, not the beginning. And the business cycle isn't really a cycle per se, but rather a series of credit expansion events. How the business cycle really works is that banks engage in credit expansion (lending out money to businesses which doesn't exist). This expansion of credit mimics increased savings and hence directs resources towards capital goods industries. We then see a boom in capital goods industries, as the newly created money bids scarce resources away from other projects. However, these "malinvestments" are not reflective of consumer demand, and will thus start generating losses. Businessmen will not want to sustain losses, so they will liquidate these investments, and factors of production will be realigned with consumer demand. The boom and bust.

Why Keynes Was Wrong

The problem with the Keynesian system is that it intervenes at precisely the wrong time. What you want to do is intervene at the start of the business cycle, by nipping the whole thing in the bud. Stopping the credit expansion before it gets started. They try to intervene during the bust. But the bust is the healthy phase of the business cycle when factors of production are being realigned with consumer demand. One feature of the bust is falling prices (or was, before the advent of the Federal Reserve and the ensuing perpetual inflation). Prices (including wages) fall during the bust, which is a good thing because it helps factors of production be realigned. What happened during the Great Depression was, following the narrative established in paragraph 1 of my response above, Hoover intervened to try and keep wages high. This is the last thing you want to do during a recession when wages naturally drop because it will create unemployment, which in turn will lower spending and prolong the recession.

On Monetary Expansion During the Bust

So why is monetary expansion, i.e. the creation of credit, an inappropriate fix for a recession? Because that is exactly what causes the boom-bust business cycle in the first place! So by engaging in credit expansion during a recession, what you are actually doing is setting up the next recession. In America's Great Depression p. 19, Murray Rothbard outlines the problem with engaging in monetary expansion in response to a recession.

"Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government “easy money” policy prevents the market’s return to the necessary higher interest rates."

He also outlines the proper steps for the government to take in a recession shortly after the previous passage.

"In sum, the proper governmental policy in a depression is strict laissez-faire, including stringent budget slashing, and coupled perhaps with positive encouragement for credit contraction."

Supplemental

A note on credit expansion. The reason why the Federal Reserve was founded was precisely so that banks could engage in the expansion of bank credit without triggering bank runs. What existed before the Federal Reserve during the postbellum period was mostly Free Banking. Banks at the time would issue bank notes, which were paper certificates redeemable for gold, and these bank notes functioned as private money. It was very difficult for banks to engage in fractional reserve banking (FRB) under this system because once the bank notes were spent they would be deposited in rival banks, which would call upon the original bank for redemption. The whole history of banknotes and the market surrounding them is quite fascinating.

Under the Federal Reserve system, bank notes were instead redeemable for federal reserve notes. The Federal Reserve notes were technically redeemable for gold, but because they were rarely called upon for redemption, this system enabled a de facto paper money standard to come to America.