Most heads of state reacted to the financial crisis of 2008 by proclaiming the need for government stimulus and regulation. Economists like John Taylor and Thomas Woods point to evidence that government stimulus and regulatory policies caused the boom that led to the recent crisis. While there is frequently a wide gap between the opinions of politicians and professional economists, at least one politician has broken with the political consensus on the recent crisis. In a recent Financial Times interview German Chancellor Angela Merkel blamed last year’s meltdown on a policy driven boom during the Bush years.

"We must look at the causes of this crisis. It happened because we were living beyond our means... governments encouraged risk-taking in order to boost growth.”

"We were spending too much to create growth that was not sustainable. It isn't just that the banks took over too many risks. Governments allowed them to do so by neglecting to set the necessary (financial market) rules and, for instance in the US, by increasing the money supply too much."

Merkel’s explanation of the boom and bust of the past decade is consistent with the boom-bust theory that earned economist F.A. Hayek his Nobel Prize in economics. Hayek’s theory indicates that rapid increases in the money supply cause unsustainable investment booms¹. Increased money supply lowers interest rates, and lower interest rates cause businesses to invest more, especially in longer term projects. Low interest rates also cause households to put less money into savings, while focusing more on immediate consumption. It is obvious that the recent boom was driven largely by both a boom in household consumption and investment in new construction. The problem with all this consumer and business spending is that it is financed by increased money supply, rather than by real increases in economic productivity, and such monetary booms must lead to inflation. Efforts by central banks to sustain money driven booms lead to uncontrolled increases in inflation. Of course, it takes years for inflation to become apparent, but once inflation begins to build the only way to prevent it from rising to a ruinous rate is for central banks to raise interest rates. Increased interest rates have a depressing effect on economic activity, and in this case higher interest rates led to a major financial crisis.

The basic story and evidence behind a policy driven boom-bust cycle is not terribly complicated, so why have so many heads of state ignored this explanation? It is probably not a coincidence that the German Chancellor agrees with the Hayekian explanation of the recent boom and bust. Germany endured a severe inflationary boom and bust cycle during the 1920’s. Instability in the German economy following WW1 contributed to Hitler’s rise to power. Consequently, Germans tend to be fearful of inflation. Hayek was the director of The Austrian Center for Business Cycle Research in Vienna during the 1920’s. He developed his theory of boom-bust cycles by analyzing data on Interwar European inflation, including the German example. It is not clear that Merkel is familiar with the particulars of Hayek’s theory. But there does seem to be common intellectual ground between Merkel and Hayek.

Unfortunately Chancellor Merkel has been harshly criticized for her sensible views of policy concerning the recent crisis². Economist Paul Krugman believes that Merkel has misjudged the severity of the recent crisis. Krugman has also accused Merkel of intellectual rigidity. These are specious claims. The idea that any head of state is unaware of the severity of this crisis is implausible. What is at issue is the cause of this crisis. On this point one could easily accuse professor Krugman of intellectual rigidity, particularly in his insistence that increased money supply and more government deficits are the solutions to this crisis. Krugman advocates a theory of boom-bust cycles developed by several economists during the Great Depression, including John Maynard Keynes³. According to Keynes private spending collapses every so often, so the government must offset shortfalls in private spending with increased money supply and deficit spending. Economists like Krugman have been beating the drum of fiscal and monetary stimulus since the Second World War, and without any discernable success.

The old saying that those who do not learn from history are doomed to repeat it has never been more relevant. Germans learned the dangers of inflation through a depression that caused 33% unemployment and additional political and military consequences. Hayek rightly understood the dangers behind manipulation of the money supply by central banks. The current drive for increased government spending and inflation will simply cause yet another boom-bust cycle. Of course, the extreme consequences of the German boom-bust cycle of the 1920’s will not be fully replicated now. But this recent crisis is itself serious enough to show the dangers of government management of economic activity. Yet heads of state seem nearly unanimous in their support of policies that cased the recent global financial crisis. Consequently, Chancellor Merkel appears to be the lone political voice of reason during the current recession.

D.W. MacKenzie teaches economics at the U.S. Coast Guard Academy. The views expressed in this paper do not represent the official views of the Coast Guard Academy.