Monetary Policy Is the Key to Understanding the Business Cycle

No matter which way stock markets are moving, there are always people trying to understand why they go up or down, or which way they’ll move in the future. It can be tough to weed out the important commentary from the downright false, as many pundits have a vested interest in seeing markets move one way or another. But there’s really only one way to understand why markets crash, and that’s the Austrian theory of the business cycle.

Austrian business cycle theory (ABCT) came about in an attempt to explain why business cycles occurred. The business cycle is the boom and bust process that everyone observes the effects of, but few know the cause of. Businessmen aren’t stupid, and they’re able to keep their businesses operational for years or decades. But at certain times a bust occurs, in which many businessmen all seem to make the same mistakes at the same time. Why is that?

The reason is monetary policy. Government intervention in monetary affairs, which nowadays occurs through central banks, has always had as its aim an expansion of money and credit that will allow the government to expand its operations and spending without resorting to taxation or other forms of outright theft. By expanding money and credit, the government can stimulate purchases of its debt, enabling it to spend more money.

But that expansion of money and credit has real effects throughout the economy. In particular, it causes malinvestments throughout the economy. All the newly-created money drives down interest rates, making long-term capital-intensive projects cheaper to undertake. That’s when you start seeing the boom phase of the business cycle, with construction cranes taking over city skylines, new infrastructure projects being built, and factories being expanded to accommodate greater production.

The bust phase comes once those projects are completed. Since the boom phase was caused by money created out of thin air rather than money being saved by consumers, there’s no one to rent the new apartment buildings, no businesses to occupy the glitzy office buildings, and no market for the goods created by those new factories. This is where we see the bust phase of the business cycle starting, as companies begin to scale back their operations, default on the debt they took out to pay for their expansion, and lay off workers.

This is where we also see overpriced assets such as stocks, commodities, and houses start to drop in value as no buyers can be found. It’s not a fun situation to be in, but it’s the necessary and entirely foreseeable result of loose monetary policy. It happens time and again, yet every time it happens the advocates of easy money continue to deny that they are at fault. They seek to avoid responsibility for devastating the lives and savings of million of innocent people.

Fortunately there is a way for investors to protect their savings from the devastating effects of a bursting bubble. It means forsaking the comfort and familiarity of stocks and bonds for at least a time, but that’s what it takes to properly defend investments against the volatility of financial markets. Gold has been protecting investors for centuries, and will continue to do so for centuries to come. It helped many investors weather the worst effects of the last financial crisis, and will help even more investors to weather the next crisis.

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