 The truth about central banking and business cycles. Pretty much every country on the planet has a central bank, and they are causing more harm than good. For some reason, the topic of banking is shrouded in confusion and mystery. It doesn't need to be. Banks provide an essential service in market economies, and when governments create a central bank, it throws a wrench into everything. To understand the problems with central banking, we first need to understand what banks are supposed to do in a free market. Simply put, banks coordinate people's plans, the plans of savers and consumers. As we already know, when somebody saves their money in a bank, it becomes available for an entrepreneur to borrow. But banking isn't just about paper changing hands, we've got to dig a little deeper. Bank money represents something, the ability to consume goods and services. When you have a dollar, you have the ability to purchase a candy bar, and you don't, you don't. Here's what that means. When somebody saves money at a bank, they're choosing to forgo their consumption and allow somebody else to consume in their place. Why is this coordination important? Because at any given time, there are only a certain amount of goods and services in the economy, and if our plans aren't coordinated, there's no way to know what projects we're able to undertake. Turns out, which projects entrepreneurs start is strongly influenced by the interest rate, how expensive it is to borrow money. In a free market, interest rates are determined by the balance between savers and consumers. The more people save, the more funds become available to lend, and the lower the interest rate. The less people save, the less funds available to lend, and the higher the interest rate. When credit's expensive, only the safest projects get funded. When credit's cheap, entrepreneurs can start longer term or riskier projects. But remember, banking isn't just about paper changing hands. When a developer needs money to construct a building, it's not the paper that he needs, it's what the paper represents, goods and services to consume in the short term. After all, it takes many different goods to construct a building, not just concrete and steel. It also takes food, shelter, cars, clothing, health services, and many other goods and services for the employees. Construction workers obviously don't get paid in foolier clothing, they get money. But that money represents all the goods and services which can be purchased with it. So here's the key. When someone saves their money, which means they don't consume a good or service, they are making it possible for other people to consume with their money, while undertaking projects, like the construction worker who demands goods and services while he works. Now, this works fine and dandy within a free market, but we don't have a free market. Instead, this precise system gets turned on its head when governments intervene. Remember that interest rate? Well, when central banks meddle with it, it no longer represents the true relationship between savers and consumers. In fact, central banks often intentionally lower the interest rate to help stimulate the economy. How do they do this? By creating new money to inject into the economy. And sure enough, when the interest rate is artificially low, the economy tends to boom. Banks lend more as businesses undertake new and longer term projects as they expand. Unfortunately, many of these loans turn out to be bad investments. And this boom is destined to bust for the start. Here's why. Instead of what happens in a free market, where one person's savings is another's consumption, loans not backed by savings result in both parties trying to consume at the same time. Legendary economist Ludwig von Mises called this overconsumption, and it leads to all kinds of problems. For example, if a bricklayer thinks he has 10,000 bricks and starts a new construction project, but he really only has 1,000 bricks, he is destined to fail, and there will be an inevitable bust as he runs out of bricks. This is what happens when central banks artificially lower interest rates. Too many loans are given relative to the amount of real savings in the economy, and those extra projects are doomed to fail from the beginning. Most economies go into a slump after these artificial booms. There's only one cure, a bust. All those doomed projects have to go belly up, and the bad loans have to be liquidated. Unfortunately, central banks don't like to let this happen. Instead, they usually try to create more money and lower interest rates even further. This just adds fuel to the fire, and makes the crash that much worse. Think about it, if all we needed to be wealthy was paper with numbers on it, we could solve everyone's economic problems just by turning on a printing press. But governments have been trying that throughout history. It doesn't work. Most countries now have central banks, but the economic principles remain the same. We'd all be better off if the delicate dance between savers and consumers remained free from the meddling of central banks. To learn more about sound economics, visit fee.org.