According to the classical economists, like Ludwig von Mises and Friedrich A. von Hayek of the Austrian school, recessions should not be resisted but embraced. Not that recessions are any fun, but they are necessary to correct conditions caused by the real problem, which is the artificial booms that precede them.
Such booms, created by inflation, send false signals to the capital markets that there are additional savings in the economy to support higher levels of investment. These higher levels of investment, however, are not authentically funded because there has been no actual increase in savings. Ultimately, when the mistakes are revealed, the malinvestments, as Mises called them, are liquidated, creating the bust. Legitimate economic expansions, financed by actual savings, do not need busts. It is only the inflation-induced varieties that sow the seeds of their own destruction.
This flies in the face of modern economic thinking that regards the business cycle as the inevitable result of some flaw in the capitalist system and sees the government’s role as mitigating or preventing recessions. Nothing could be further from the truth. Boom/bust cycles are not inevitable and would not occur were it not for the inflationary monetary policies that always precede recessions.
Economists today view the apparent overinvestment occurring during booms as mistakes made by businesses, but they don’t examine why those mistakes were made. As Mises saw it, businesses were not recklessly overinvesting, but were simply responding to false economic signals being sent as a result of inflation. For that reason Mises called such mistakes malinvestments rather than overinvestments. One of my pet anecdotes makes the point clearly.
The Circus Comes to Town: How Inflation Causes Business Cycles
Let’s suppose a circus comes to a small town, temporarily increasing the population and bringing a surge of business to local merchants. One restaurant owner, however, mistakes the upturn in his business for a permanent increase in demand and proceeds to hire more workers and add a new wing. This is the boom.
All is well until the circus pulls up stakes and moves to another town, leaving our restaurant owner with surplus staff and capacity and exposing a malinvestment that must now be unwound. This is the bust.
So the bust had to occur to correct for the malinvestments of the false boom that preceded it. Had the increased patronage been the result of a real increase in the town’s population, the expansion would have been economically justified and the bust unnecessary. It is only because the owner misinterpreted the economic signals that there had to be a false boom and a corrective bust. Had the owner tried to prevent the recession by keeping the additional workers on and the new wing open, he would have been looking at bankruptcy. The recession was necessary to restore balance and maintain the viability of the business.
This analogy describes perfectly the false boom of the 1990s; just put the circus in place of the dot-com bubble. As a result of the inflation of the 1990s, start-ups flush with cash from their initial public offerings (IPOs) spent money without regard to profitability. This sent false economic signals to technology and telecommunications companies with respect to demand for their products. A wave of malinvestments ensued, which needed to be liquidated once the dot-com boom went bust.
Absent inflation, it is still possible for individual entrepreneurs to misread economic signals and make bad investments that need subsequently to be liquidated. But it is only with inflation that malinvestments are made on a national scale and result in economy-wide recessions. That is why inflation is such a destructive force in a market economy, even if its effects are not immediately reflected in rising consumer prices.