Central banks make huge mistake - financial crash like 1929 now inevitable

Investing.com - A recession is a real bogeyman. No one likes to lose their job, watch their 300 hp leased car get towed away and spend the next holiday season on the balcony with a glass of tap water in their hand.

But only very few people are even aware that the economic downturn following a boom phase is completely normal and even urgently necessary. Without this cooling off, there is neither sustainable growth nor further prosperity. Yet this is precisely what people love about the market economy.

If, on the other hand, central banks and governments intervene to prevent the downturn, then a much bigger problem presents itself.

The economist Joseph Schumpeter coined the term creative destruction in connection with recessions. What he means by this is that it is only during economic downturns that the market shakeout that is important for future growth occurs. During this phase, inefficient companies disappear and innovative businesses can flourish, as financial journalist Graham Young wrote in his recent article.

Young explains that during this elementary struggle for survival, everything is geared towards using resources efficiently, which increases productivity and leads to sustainable growth and prosperity.

If recessions are avoided, then efficiency and innovation, which are important for growth, hardly matter. The established, complacent corporations merely expand their market dominance and competitors with breakthrough approaches hardly stand a chance.

In his article, Young refers to various recessions that have occurred since the Great Depression. They all have one thing in common, they resulted from the economy running hot and the subsequent reduction of the resulting overcapacity.

The Great Depression itself, however, was triggered by something quite different.

It was preceded by the golden 1920s, when prices on Wall Street knew only one direction - steeply upwards. The reason for this was the loose monetary policy of the central bank. This gave the stock market a boom that seemed never to end.

The economy signalled again and again with company bankruptcies that demand was collapsing, which was ignored on the stock market until the inevitable happened and the stock gains vanished into thin air.

This event gripped the whole world and the accompanying economic deterioration also contributed to the NSDAP coming to power in Germany. It promised people jobs and had motorways built to the east, which was the beginning of the Second World War.

According to Young, governments and central banks made similar mistakes in the wake of the 2008 financial crisis and subsequent years as they did during the 1920s.

Printing fresh money propped up the economy and financial markets marched upwards, preventing the market clearing that is essential for real growth.

There is no difference between today and 100 years ago. The market follows the same laws as it did then. But today's central bankers have forgotten the lessons of the Great Depression, as Young writes.

Instead, they focus more on the inflation shocks of the 1970s. Their focus is that banks must not fail and that inflation is better than deflation in any case.

But both are a mistake. Young explains that when banks do not have to fear for their continued existence, they automatically move to taking unacceptable risks, risks that threaten financial stability.

Inflation should also be seen as problematic because it reduces real returns and also encourages unjustified speculation.

When central banks and governments intervene to prevent systemic recessions, GDP lags behind average growth and productivity declines.

Since the financial crisis, attempts have been made worldwide to prevent the recession necessary for a healthy market by printing new money. These efforts have led to high inflation, which people are now trying to control with high interest rates. But this automatically runs the risk of triggering the recession that was never allowed to happen.

Young concludes that cheap money from central banks is no solution to anything - quite the opposite. Trying to avoid an economic downturn makes things much worse. Because the dreaded short-lived recession quickly turns into a full-blown depression, as history has already proven.

(Translated from German using DeepL)

Get The App

Join the millions of people who stay on top of global financial markets with Investing.com.

Download Now