According to Keynesians, the business cycle is a natural product of the free market which occurs because human psychology causes participants to make irrational decisions, which leads to a misallocation of resources in an economy and the creation of asset bubbles. So when the economy experiences a downturn, governments must step in to provide liquidity to the market in order to 'stimulate' the economy out of recession.
Yet Keynesians fail to realise that goods and services (which are the only source of economic growth) do not automatically come into existence when the money supply increases. Money has no inherent value; it is simply a means of determining the allocation of resources within an economy. During downturns in the business cycle, a period of deleveraging must take place in the market place. Asset prices must fall and the money supply should consequently sink as assets were irrationally overpriced. However, Keynesian economists fail to understand this concept.
It's no surprise that the Federal Reserve failed to predict the Global Financial Crisis while the Austrian School of Economics did. Indeed, Fed minutes for 2006 reveal they had almost no idea about the Housing Crisis! For example, Timothy Geithner, the current US Secretary to the Treasury stated “We think the fundamentals of the expansion going forward still look good”.
But Peter Schiff, an investment manager and a follower of the Austrian School was warning about such a crisis years in advance. In 2006, when asked about his opinion on a possible recession, Schiff responded “I think it’s going to be pretty bad…and I also think it’s not going to last for quarters but for years”. Furthermore, he acknowledged that the disease was caused by “debt financed consumption”. US Republican Presidential Candidate Ron Paul, another Austrian School supporter, also predicted the crisis. In a statement to the Banking Committee on 10 September 2003, Paul warned that:
"The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out".
Austrians understood that the Global Financial Crisis was a result of policies such as the Community Reinvestment Act of 1977, the government guaranteed mortgages through Fannie Mae and Freddie Mac, and interest rates that were fixed far below the market rate. The low interest rate policy of the Fed under Alan Greenspan enabled borrowers to access cheap money with which they were able to speculate on sub-prime mortgages. Interest rates were lowered to 1% in 2003.
According to Schiff, markets are governed by two opposing forces: fear and greed. However, a combination of bad government regulations and monetary policy dramatically shrunk the amount of fear in the market, enabling speculators to make risky loans they would not have made under normal market conditions. The Troubled Asset Relief Program and loose monetary policy created a dangerous moral hazard that reduced fear of making losses. In this environment, gains are privatised while losses are socialised. In a free market economy, both gains and losses would be privatised.