The Austrian business cycle theory offers a sound explanation of what happens with the economy if and when central banks, in close cooperation with commercial banks, create new money balances through credit expansion. The said credit expansion causes the market interest rate to drop below a certain level enticing people to save less and consume more. Credit expansion also drives firms to increase investment spending. Then, the economy is seen to enter into a boom phase.

However, the boom is unsustainable. After the effect of the injection of new money balances has worked itself through the economy, consumers and entrepreneurs realise that the economic expansion has only been a one-off affair. It would be to no surprise that consumers and entrepreneurs then return to their previously preferred ways – saving more, consuming and investing less. This manifests itself into a rising market interest rate and the boom subsequently turns into bust.

In theory, the market interest rate plays a crucial role in the boom and bust cycle. As it is manipulated downwards by the central bank, a boom presumably sets off, and as the market interest returns to a certain level, the boom turns into bust. This explains why central banks have been increasingly trying to gain full control over the market interest rate in recent years - who controls the market interest rate controls the boom and bust cycle.

The major central banks around the world have effectively taken over the credit markets in an attempt to prevent the current boom from turning into yet another bust. On the one hand, monetary authorities fix the short-term market interest rate in the interbank funding market. By doing so, they also exert a rather strong influence on credit rates across all maturities.

Textbooks state that if and when central banks succeed in keeping market interest rates at very low levels, a boom can be kept going, while a bust is postponed. Basically, all major central banks around the world have taken on such a route, however its effectiveness continues to be very debatable, mainly in Europe where sluggish growth has continued to persist for years.

To start with, a supportive momentum can be kept going as long as market interest rates remain suppressed below the economy's certain level. However, if the market interest rate hits zero, things take a nasty turn, as people would stop saving and investing. In fact, with the market interest rate hitting zero, capital consumption sets in and the division of labour collapses.

With this said, given that major central banks have established a rather firm grip on market interest rates at the moment, the chances of such theory to be deemed effective doesn’t seems to flourish this time round. Case in point are the negative rates in Europe with namely the deposit rate at -0.5 per cent.

The structural issues being faced in Europe go way beyond monetary policies at this stage. Such policies are solely keeping markets afloat. In reality, we need more benevolent data from Europe to accept that the accommodating monetary policies are effective. Thus, theory this time round might not be aligned to its original principals. We need more than that, we need fiscal stimulus effort. 

Disclaimer: This article was issued by Maria Fenech, credit analyst at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.