A Hayekian HangoverWhat the economy is suffering from is a Hayekian hangover. Friedrich von Hayek and other members of the Austrian School of Economics developed a comprehensive theory of the business cycle early last century. It reached a pinnacle in 1930-31, when Prof. Hayek delivered his famous lectures at the London School of Economics... Accordingly, to comprehend where the economy has been and anticipate its future course, an understanding of Hayek and the Austrians is necessary.
For the Austrians, things go wrong when a central bank sets short-term interest rates too low and allows credit to artificially expand. Interest rates that are too low-lower than those that would be set in a free market-induce businesses to discount the future at artificially low rates. This pumps up the value of long-lived investments and generates an investment-led boom, one that is characterized by too much investment and investment that is biased towards projects that are too long-lived and too capital intensive.
An investment-led boom sows the seeds of its own destruction and is unsustainable, however. Indeed, on the eve of the downturn investors find that the loanable funds for investments are too expensive to justify commitments they made during the preceding monetary expansion. Some businesses engage in distress borrowing, profit margins collapse under the weight of too much costly debt, and-if that is not bad enough-many businesses are saddled with excess capacity, resulting from what turned out to be wrong-headed investment decisions. With that, the investment-driven boom turns into a bust. In short, artificially-created investment booms always end badly...
A Hayekian hangover will vary in its duration and intensity, depending on the degree of the preceding over-investment/malinvestment binge, as well as the state of confidence that accompanies the downturn or hangover phase of the cycle. During this phase, a central bank's attempts to restart the economy by pushing interest rates down will-contrary to orthodox economic doctrine-only delay the required capital restructuring process and prolong the hangover.
If this hangover phase-working off excess capacity and transforming the capital structure to shorten the length of production processes-is not bad enough, the economy is vulnerable during this phase to what Austrians termed a "secondary deflation." If a general feeling of insecurity and pessimism grips individuals and enterprises during a Hayekian hangover, risk aversion and a struggle for liquidity (cash reserves) will ensue. To build liquidity, banks will call in loans and/or not be as willing to extend credit. Not surprisingly, banks are already scrambling for liquidity.
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