Not only is the central bank constantly creating money out
of thin air, but the fractional reserve system allows
financial institutions to increase credit many times over.
When money creation is sustained, a financial bubble begins
to feed on itself, higher prices allowing the owners of
inflated titles to spend and borrow more, leading to more
credit creation and to even higher prices.
As prices get distorted, malinvestments, or investments that
should not have been made under normal market conditions,
accumulate. Despite this, financial institutions have an
incentive to join this frenzy of irresponsible lending, or
else they will lose market shares to competitors. With "liquidities"
in overabundance, more and more risky decisions are made to
increase yields and leveraging reaches dangerous levels.
During that mania phase, everybody seems to believe that the
boom will go on. Only the Austrians warn that it cannot last
forever, as Friedrich Hayek and Ludwig von Mises did before
the 1929 crash, and as their followers have done for the
past several years.
Now, what should be done when that pyramidal scheme starts
crashing to the floor, because of a series of cascading
failures or concern from the central bank that inflation is
getting out of control? It's obvious that credit will shrink,
because everyone will want to get out of risky businesses,
to call back loans and to put their money in safe places.
Malinvestments have to be liquidated; prices have to come
down to realistic levels; and resources stuck in
unproductive uses have to be freed and moved to sectors that
have real demand. Only then will capital again become
available for productive investments.
Friedmanites, who have no conception of malinvestments and
never raise any issue with the boom, also cannot understand
why it inevitably leads to a crash. They only see the drying
up of credit and blame the Fed for not injecting massive
enough amounts of liquidities to prevent it.
But central banks and governments cannot transform
unprofitable investments into profitable ones. They cannot
force institutions to increase lending when they are so
exposed. This is why calls for throwing more money at the
problem are so totally misguided. Injections of liquidities
started more than a year ago and have had no effect in
preventing the situation from getting worse. Such measures
can only delay the market correction and turn what should be
a quick recession into a prolonged one.
Friedman who, contrary to popular perception, was not a
foe of monetary inflation, but simply wanted to keep it
under better control in normal circumstances was wrong
about the Fed not intervening during the Depression. It
tried repeatedly to inflate but credit still went down for
various reasons. This is a key difference in interpretation
between the Austrian and Chicago schools.
As Friedrich Hayek wrote in 1932, "Instead of furthering the
inevitable liquidation of the maladjustments brought about
by the boom during the last three years, all conceivable
means have been used to prevent that readjustment from
taking place; and one of these means, which has been
repeatedly tried though without success, from the earliest
to the most recent stages of depression, has been this
deliberate policy of credit expansion. ... To combat the
depression by a forced credit expansion is to attempt to
cure the evil by the very means which brought it about..."
The confusion of Chicago school economics on monetary issues
is so profound as to lead its adherents today to support the
largest government grab of private capital in world history.
By adding their voices to those on the left, these confused
free-marketeers are not helping to "save capitalism," but contributing to its destruction.