Creative Destruction – A New Economic Order

When the Capital Research Institute (CRI) states that a reform of the international monetary system is needed and that the underlying economic theories are outdated, we specifically mean that the theories of John Maynard Keynes need to be reformed to synthesize with other economic schools such as Austrian economics. The Austrian belief gained popularity with a small group of Austrian Economists that included Ludwig von Mises and Nobel laureate Friedrich Hayek. The Austrians are often associated with libertarian beliefs, even though that is not always the case. Their economic beliefs are rooted in a distrust of government intervention, especially intervention in the monetary system. Followers of the Austrian belief make a clear distinction between sustainable economic expansion from private savings, and unsustainable economic expansion from easy money due to government intervention.

Keynesianism is rooted in the belief that governments should intervene during economic crises in order to have lose monetary policies to flood the system with easy credit and government spending to keep aggregate demand stable. That belief system if implemented in a sustainable way can help economies mitigate collateral damage, but can also bring the whole system down due to hyperinflation and very high unsustainable public debt levels as we have seen in the last decades. Joseph Schumpeter, a follower of the Austrian belief coined the term “Creative Destruction”, which describes the times of economic depression that follow periods of economic prosperity. Based on Schumpeter’s theory of Entrepreneurship, in his view these periods of depression should not be avoided and that corrections are needed to regulate the economy from which the winners will create a new economic order. It is a belief in survival of the fittest, rather than creation of zombie banks and zombie households such as the “Lost Decades” of Japan. When the Japanese asset bubbles collapsed in the 1990’s and 2000’s, the Japanese government created insolvent zombie banks, which used accounting fraud and other trickery to stay afloat even though they were insolvent.

The Austrians belief that weak overleveraged banks, corporations, and households should fail due to excessive risk taking rather than being rewarded with bailouts, which sends the wrong message and creates moral hazard. The chance for a repeat is high, since the excessive risk taking and irrational exuberance has been rewarded, meaning that those who took the risks in the first place will do so again – nobody learned their lesson and business continues as usual for most investment banks and hedge funds. Instead of rewarding bad behaviour, we should punish it and make sure that it does not continue to threaten the entire world’s financial system. Let the weak fail and the strong survive, sadly we continue to reward excessive risk taking and leverage. These too-big-to-fail organizations now unload their bad behaviour to the public by government having to take on extra debt to make up for those driven by greed. It is hardly fair to unload the problems to the public while the perpetrators keep billions in profits.

The economic theories we have in place are flawed for that exact reason, we reward those that should be in prison and the public pays the price. The Austrians may be extreme in their way of thinking, especially in the short term, since letting those who live by irrational exuberance fail could mean short term chaos and a potential collapse of the entire financial system. On the other hand the creation of massive credit and asset bubbles over and over again threatens the financial system in a similar way. What should happen is to synthesize both theories and take the best of both worlds. Austrians argue that excessive easy money and quantitative easing will just prolong the recession and that price to pay will just increase in the long run. We should take the hit right away such as the default of Greece. The extremely high public debt of the United States is another good example, the short term crises may have been overcome, but due monetizing of public debt and huge fiscal deficits the real crisis is still to come. The US government does not have the ability to raise interest rates to fight inflation as Paul Volker did in the 1980’s, since it would curtail any “economic growth” from the easy money to date.

The USA appears to be on the same path as Japan was during the “Lost Decades”, rewarding insolvent zombie banks, corporations and households means very slow economic growth and high unemployment. The zero interest rate policies (ZIRP) will have to continue as in Japan, which until today never recovered from the mistakes made by the Central Bank, by trying to keep the economy from falling into a recession. Austrians would further argue that inventions like deposit insurance and lender of last resort give banks the right to take excessive risk in their lending practices, since banks do not have to worry about bank runs. If the public would have full transparency of banks balance sheets, people could make informed decisions in which bank to deposit their money based on the amount of risk each bank takes. Instead the governments guarantee bank deposits, therefore banks take larger risks to make higher profits and they tend to make bad loans. If things go wrong the government would ensure that depositors would get their money back and that banks are given sufficient cash to operate. This is the reason that banks will lend out between 90-95% of people’s deposits and show deposits on their balance sheets that do NOT even exist anymore since the cash money of the depositors was lend out in loans. Without deposit insurance and lenders of last resort a bank would collapse as soon 5-10% of depositors would demand their money back, hardly a stable banking system without government guarantees and intervention.

As Austrians appear too extreme in the short term and Keynesians too extreme in the long run due to excessive easy money and credit, the Capital Research Institute is of the firm belief that both schools should synthesize and start to work together. These days neither of the two sides communicates with each other, even though both would benefit. Economics is not a perfect science, yet many try to belief that, it is based on individual and collective actions that cannot always be explained with mathematical models. The study of Behavioural Economics is an additional theory that should be integrated into reformed financial theories, since bubbles are created by sheepish behaviour of jumping on the band wagon. When for example stock prices go up, even more people will buy into it and prices will further rise, and when prices crash they tend to create negative bubbles by pushing the price of the asset below its intrinsic and fair market value from excessive fire sales due to being over-leveraged.

It is time to reform the international monetary system and its underlying theories. This is not an easy task, but a necessary one to stabilize the world’s financial system. By keep applying the same rules and hope for a different result is the definition of insanity. The whole system has been poisoned by utter greed due to compensation structures at investment banks that can only cause another crisis in the near future, since traders are being rewarded to take excessive risk. If it goes well they will see a huge bonus and if it does not, oh well someone else will pay the price down the road. Especially in the United States, sanity should return and actual tangible products should be manufactured, rather than complex financial products that do nothing for the core economy.

Please help us educate the public, we appreciate your comments and for regularly checking back with the Capital Research Institute (CRI) as we unravel the Web of International Finance.