I love the line from Obama’s address to Congress quoted in the NY Times article:

“We will rebuild, we will recover, and the United States of America will emerge stronger than before.”

The problem that some economist are pointing to is that we overbuilt and over-invested in our economy, and as a result the bubble busted. Now most would ask, how is it possible to over invest in an economy. Is not investment good? Of course its good, but it does need to match savings. The below is an articulation of the savings identity which states that the amount saved in an economy will equal the amount invested. This is an identity so it is true by definition. The affect of this identity on the health and sustainability of an economy is more closely analyzed and debated amongst economist than the identity itself. (Savings Identity via wiki)

Let’s think of a small household who is trying to manage its household budget. The household has a certain amount of monthly income, it uses this income for two purposes (1) to consume today and (2) to save to consume for tomorrow. This household’s and millions like it save a certain amount of their money. They deposit this money in banks who then turn around and make loans to businesses who are investing money to fulfill future consumption. The amount of savings in the economy tells the businesses how much consumption will occur in the future, how much people are saving for future consumption. This is conveyed to business borrowers by the price of investment, the interest rate.

The government through the Federal Reserve system manipulates the rate of interest. The rate does not match the rate that would exist without the government intervention, the natural rate which reflects the true savings of households. Economist from the Austrian perspective view this as a problem. The business owners who are investing in fulfilling future consumption are being misled by the artificial interest rate. If it is artificially low than they invest more than they should in fulfilling future consumption. When that future consumption does not materialize the investments fail, the half finished condos never get finished, car factories reduce output, small businesses go out of business.

More on the Austrian School of Economics
More on the Austrian Theory of the Business Cycle

Technorati Tags: savings identity, Federal Reserve, Austrian