Mises and Hayek had developed a theory blaming depressions on excessive money creation and overly low interest rates in the preceding boom that led to massive misallocation of capital- or, as Robins put it, “inappropriate investments fostered by wrong expectations.” Hayek thought the theory explained the Great Depression, which he argued was “due to monetary mismanagement and State intervention operating in a milieu in which the essential strength of capitalism had already been sapped by war and poverty.
If it was true the overinvestment during the boom- not underinvestment in the recession, as Keynes contended- was to blame for the slump, then what was needed was simply “time to effect a permanent cure by the slow process of adapting the structure of production”- in other words, waiting until excess capacity was absorbed or written down and new investment was once again called for. “The creation of artificial demand,” Hayek argued, would do nothing to undo the misallocation of capital and therefore would only lead to another burst of inflation and another downturn, as it had in 1921, when Austria suffered a hyperinflation.
From Grand Pursuit- The Story of Economic Genius by Sylvia Nasar
We often consider the main damage from inflation as the destruction of individual purchasing power, but Hayek suggests that the great evil may be the misallocation of capital. This certainly seemed to be the case with the housing and real estate boom and its recent collapse.
While the central bank may easily create money and credit, it may be less deliberate on where the new money ends up. It may fund a rise in high tech stocks in one decade or real estate in the next. If the boom created the misallocation of capital that caused the bust, then stimulating with deficits and more money creation may do little to resolve the crisis.
The recovery must do more that create smoke and mirrors that make us feel good for a short time. It must rectify the misallocation of capital, and that can be a slow and painful process.