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- It is indeed sad that most Indian economists still believe in the Keynesian analysis that recessions are caused by insufficiency of demand and that the solution is a fiscal stimulus. Indian economists — barring Brahmananda and perhaps Surjit Bhalla — are totally oblivious to the Austrian business cycle theory, best articulated by Hayek. According to Hayek, recessions are brought about by excess supply, which is brought about by overinvestment. Each boom contains the seeds of the subsequent recession and each recession, the seeds of the subsequent boom. Readers would do well to study the above-mentioned Economist special issue which succinctly explains the Hayekian analysis (pages 8-9).
- Hayek argues that if central banks hold interest rates below the equilibrium rate (that is, the rate at which the supply of savings equals the demand for investment funds), credit and investment would rise too rapidly and there would be a shortage of savings. Cheap credit and inflated profit expectations cause overinvestment and malinvestment in the wrong kind of sectors. Eventually, the mismatch between savings and investment can be resolved only by a rise in interest rates, making some investments unprofitable. Excess capacity will reduce profits and lead to investment collapses, ushering in a recession. As excess capacity is cut, profits rise and investment eventually recovers.
- According to this analysis, the only way to prevent the turn of the cycle is to inject more credit which becomes unsustainable. A recession is not only inevitable, but necessary to correct the imbalance between saving and investment. The Economist argues that recent business cycles in the US and Japan have typical Hayekian features. The right policy response is to raise interest rate well before the boom spins into a downturn. But if inflation is low, central banks are reluctant to raise interest rates and as the cost of capital is way below the expected return, there is a surge in credit and investment to unsustainable levels. It is overinvestment which causes the return on capital to decline. The Hayekian analysis would point to the repeated easing of interest rates to be wrong as it merely delays the correction of past excesses.
- Sir John Hicks,as far back as 1966, argued that developing countries typically fit into the Hayekian overinvestment mode. A recession is necessary to work off an imbalance between too much investment and too little saving. The moral is that injecting created money and lowering interest rates only delays the cleansing process. The output losses would be much less if central banks prevent the boom from reaching unsustainable levels by a timely increase in interest rates when growth rate and investment goes into an unsustainable upswing. Monetary policy is most effective when it cools the overheating; it is totally impotent during the downturn of activity. Lowering interest rates would be ineffective and only delay the adjustment.