Business Cycle Theory

I am currently reading America's Great Depression by Murray Rothbard, and I understand that an inflationary boom will create a depression/bust, but I do not understand how that happens. Can someone explain how and when malinvestment due to inflation creates a depression? Thank you.

Well, the initial effects of inflation appear positive. Firms see that there is an increased demand for their products so they hire more workers. Unemployment falls. Production booms. This is the boom phase.

However, the boom isn't caused by an increase in productivity it's caused by an excess amount of paper money. Once businesses realise they've been fooled it is too late -- they have to lay off staff. Mass unemployment results. This is the bust.

The ABCT can be explained using the Robinson Crusoe analogy.

Do economists have some fetish for Crusoe? I've had analogies about him like every day in my Economics class and just figured it was my teacher being "cute".

banned:

Do economists have some fetish for Crusoe? I've had analogies about him like every day in my Economics class and just figured it was my teacher being "cute".

As I understand it, it was used a lot by the classics. What better way to simply illustrate some economic concept than in an island with just a few people... Robinson Crusoe was a great novel from the time. In computer science, "foo-bar" is a common placeholder; it stuck ever since it's use in eletronics for signals.

A depression is a very deep recession, and one could argue that a recession cannot become a depression without

1. Propping up of the bubble over and over
2. Interference in the post-bust recovery phase

If you're reading AGD, then you will see the case that Rothbard makes for government interference worsening what was already a bad recession, with policies so inane and counter-productive, that the recession became a depression, getting substantially worse after the bust.

In order to understand business cycles, you need to understand the Compound Interest Paradox.

During the boom phase of the economic cycle, interest rates are artificially low.  This encourages overinvestment.  Low interest rates send the wrong price signal that capital investment is profitable.

The malinvestment occurs.  During the bust, the money supply shrinks.  There isn't enough money in circulation to purchase all the new goods.  There isn't enough money in circulation for everyone to repay their loans.

Large corporations have a large asset base and can withstand the cycle.  Small businesses are bankrupted during the bust.  In this way, economic cycles encourage consolidation of industries.

Thanks to everyone for their answers. I understand it now. On a sidenote, I notice that the Austrian School is the only school to say there was inflation in the 20s, rather than deflation.

You will read in Rothbard's AGD the specific counter to the common fallacy of thinking that busts are caused by changes in the rate of monetary inflation.  Ben Bernanke and Milton Friedman, monetarists, both attribute the depression to the FED's reversal of inflationary policy.  Rothbard goes into great detail to show that 1929 still had a similar pace of monetary inflation throughout the year, while the general economy showed signs of recessing, and the stock market crashed.  Only after these events did the money supply contract and demand for cash balances increase (which Keynesians claim caused the liquidity trap).  Thus, Rothbard counters both the monetarists and the Keynesians on the biggest economic failure in American history.

Also, look at Japan in the 90's.  I haven't looked at that case in a bit, but I'm fairly sure their recession occurred without a slow-down of artificial credit; and when the monetarist solution was applied in further lowering interest rates (all the way to 0%), business still didn't recover.

Also, artificial credit does more than change interest rates.  It devalues savings.  In the Crusoe example, you may wonder how increasing the rocks will delay the bust.  In that example it cannot.  In an example where there are two people, artificial credit supplied to one person allows him to use it to fund his consumption (he will buy the fish from the other fisher).  But this causes price inflation, which means that the other fisher's savings' purchasing power has decreased.  Thus, artificial credit has forced the 2nd fisher to reduce consumption.  The difference between his production and his consumption is forced charitable investment in Crusoe's project.  The 2nd fisher is not entitled to the gains of Crusoe's investment although it was only possible because of his production of real wealth.

Thus, artificial credit can delay a bust until everyone becomes a debtor to artificial credit, relying upon it to produce more real worth than everyone actually produces.  And if artificial credit allows further false booming, investors can eventually complete their investments.  While they may struggle to pay off the debt, if their completed investments increase productivity, then the economy does gain overall, in real terms.

fsk:

In order to understand business cycles, you need to understand the Compound Interest Paradox.

Erm, if the compound interest paradox is real (and we've discussed this elsewhere - but I don't think we ever managed to agree) then no, you don't need to understand this to understand business cycles. Business cycles are caused by inflationary distortions - so mainly you need to understand the effects of inflation. You could have business cycles in economies where lending (and interest) were not even present - providing there was someone, somewhere, pumping out extra cash to subsidize activities which would not otherwise occur because they weren't profitable.

fsk:

During the boom phase of the economic cycle, interest rates are artificially low.

That's one way of creating new money in most modern economies. However it's not the only way. You can change reserve requirements (something the Chinese are prone to do) or you can come up with interesting ways to get around your reserve requirements (e.g. sweeps) as they tend to do in the US (where officially they have 10% reserve requirements but, where in reality, they only keep the same reserves as in the UK - which is to say around 3%). You could do it Mafia style (i.e. forgery), or you could print phone cards... voila, cash stored on a card (able to be spent) while the original cash used to buy that card keeps travelling around in the economy... People have all sorts of creative ways of creating money - and any number of them could potentially cause a boom subsidized by the inflation that money creation brings about..

fsk:

During the bust, the money supply shrinks.  There isn't enough money in circulation to purchase all the new goods.  There isn't enough money in circulation for everyone to repay their loans.

Large corporations have a large asset base and can withstand the cycle.  Small businesses are bankrupted during the bust.  In this way, economic cycles encourage consolidation of industries.

I think you're looking at aggregates too much. The ABCT is based on precisely the opposite - the fact that inflation is a boon to some sectors of the economy but not to others. In a bust, those sectors of the economy that existed on the back of inflationary subsidies will suffer. However those other sectors of the economy that were having resources steered away from them to the unproductive sectors of the economy, and which were seeing less real investment than they would have without inflation, will no doubt pick up.

ABCT has nothing to do with any notion of a compound interest paradox or any idea that there isn't enough money in the economy. ABCT views the bust as a correction - unprofitable activities get cleaned out and leave resources once again free to be assigned to activities that were profitable all along.

Have you read Mises or Hayek on ABCT? Does either of them ever make any mention of a compound interest paradox?

liberty student:

A depression is a very deep recession, and one could argue that a recession cannot become a depression without

1. Propping up of the bubble over and over
2. Interference in the post-bust recovery phase

If you're reading AGD, then you will see the case that Rothbard makes for government interference worsening what was already a bad recession, with policies so inane and counter-productive, that the recession became a depression, getting substantially worse after the bust.

Rothbard specifically deals with Hoover and how the Great Depression was created. He does not, however, appear to dive that deep into why it lasted through the thirties and into the mid fourties.

I would suggest that it had to do with sticky wages and prices, so sticky that the economy was not allowed to adjust properly in the labour market - the main issue that people deal with when looking at the GD.

jimmy:

fsk:

During the bust, the money supply shrinks.  There isn't enough money in circulation to purchase all the new goods.  There isn't enough money in circulation for everyone to repay their loans.

Large corporations have a large asset base and can withstand the cycle.  Small businesses are bankrupted during the bust.  In this way, economic cycles encourage consolidation of industries.

I think you're looking at aggregates too much. The ABCT is based on precisely the opposite - the fact that inflation is a boon to some sectors of the economy but not to others. In a bust, those sectors of the economy that existed on the back of inflationary subsidies will suffer. However those other sectors of the economy that were having resources steered away from them to the unproductive sectors of the economy, and which were seeing less real investment than they would have without inflation, will no doubt pick up.

ABCT has nothing to do with any notion of a compound interest paradox or any idea that there isn't enough money in the economy. ABCT views the bust as a correction - unprofitable activities get cleaned out and leave resources once again free to be assigned to activities that were profitable all along.

Have you read Mises or Hayek on ABCT? Does either of them ever make any mention of a compound interest paradox?

This is correct.  There is always enough money in circulation to purchase new goods - if the money supply shrinks, so do prices.  That's simply following supply and demand.  This may show that some products cannot be sold for profit, but in the face of such wild swings of money supply, there is no real understanding of the value of money, thus there is no concrete means to compute profit.  Yes, this is a problem, which is why it should be corrected ASAP.  The quickest means of correction is allowing contraction of credit, putting money back to base standards, such as gold.

Not having enough money to pay back loans is different.  This happens, and it is a large part of the collapse of the financial sector during a bust.  However, the options once you are at this point are (a) prop up bad debt or (b) allow debts to default and banks to fail.  You will notice that banks who tend to expand the least during a boom are safest during a bust.  Thus, choice (b) seems the most sound - the most punished entities are those that were responsible for the expansion of artificial credit.

The important thing to realize is that the bust occurs before the money supply tightens - the bust is the result of the unsustainable inflationary boom; credit contraction is the result of the bust, causing the problems of "unprofitable" demand and unpayable debts.  In the bust, demand for cash balances increases, further contributing to less circulating money supply and escalating those problems.  The quicker all the bad debt disappears, the sooner things will turn around.

The business cycle can be simplified as such.

1 - For whatever reason, the government allows banks to loan money that doesn't exist. Interest rates go down from their natural equilibrium.

2 - The production of capital goods, which depends on time, increases to match the lower interest rates. The capital goods industries expand.

3 - The policy to allow banks to loan money that doesn't exist creates inflation. The government decides to reverse the policy. Interest rates go back to their natural equilibrium.

4 - The production of capital goods shrinks to match the higher interest rates. The capital goods industries go bankrupt.

That's it.

Stranger, I reject your explanation of the business cycle.  This is the monetarist trap - that artificial credit won't cause any harm unless the government puts the brakes on monetary expansion.  This simply isn't true.  I will give my own simple example of how I understand the business cycle:

1) 2 Men, A and B, fish on a desert island with their bare hands.  They both catch around 5 fish a day and place them in a pond until they are finished working.  Every time they put a fish in the pond, they take a stone from the side.  At the end of the day, when they want to consume fish, they count their stones and take the appropriate number of fish. (I know this is simplistic and easily violated - let's say the honor system works perfect for now.)

2) A ghost pops up and tells man A he can catch twice as many fish if he takes 5 days off of fishing to build a fishing pole.  Man A asks how he will eat, and the ghost in turn gives him 25 rocks, which he can trade for fish.  Man A begins investment.  If the ghost had caught 25 fish and put them in the pond, this would cause no problems, and even make the future more productive, once the investment is completed.  Instead, the ghost simply gives man A credit to savings that don't exist - artificial credit.

3a) On night 1 of the fishing pole project, both men go to eat.  Man A and man B both attempt to spend 5 stones each on fish.  There are only 5 fish, however.  They decide to make each stone worth only 1/2 fish, and they each eat 2 1/2 fish.  Man B is displeased with this arrangement, so he demands to take 2 stones for every fish he catches.

3b) Night 2 comes.  Again, the same dilemma.  Man B can now afford 5 fish, having 10 stones, while man A also attempts to spend 10 stones to secure 5 fish.  At 1/2 fish per stone, this means they should be able to purchase 10 fish total.  But there's only 5 fish.  Again, man B gets hosed, man A consumes less than he planned, and the price of fish are again inflated.

3c) (*This is not applicable for this example - we'd need lots more people to see exactly how this works.) In the midst of this inflation, which appears to be exponentially increasing, "index speculators" notice quickly rising prices and make non-productive investments (buy low, sell high, with no production occurring between these points).  This makes the process escalate even quicker.  This process is not illegitimate - it secures plans for investment, which is needed in any economy where demand can shift from one good to another.

4) If man B chooses to leave the money system at any point, simply consuming what he produces, man A must immediately abandon his investment to sustain ANY consumption.  The malinvestment must be stopped and liquidated.  If man B continues inside the system, the inflation is never ending - each day man A must spend more and more of his artificial savings to sustain a consumption rate.  This means he will probably spend all of his borrowed credit before he can finish his investment.  Now he must go back to production while reducing consumption to repay the debt.

5) Yet he was relying on the investment's increased production to repay the debt.  He will likely default to the ghost.  If the ghost thus becomes insolvent, all of the ghost's rocks will become meaningless.  Thus, a credit contraction occurs.  The ghost's real money will remain - he will likely use it to settle some debts.  However, all of the credit based upon claims to that money will disappear from trade.

6) Reduced money supply means deflation.  Now, A and B only use rare stones to indicate their production and consumption.  Each rare stone is worth 5 fish a piece.  If B had a debt to someone else, which was measured in stones, independent of whether they were rare stones or simply the ghost's stones, he may find this impossible to now pay off.  He would have to catch 10 fish a day simply to consume 5 and pay only a single stone on the debt per day, whereas before the endevour he could catch 6 fish, consume 5, and pay down one stone.

Artificial credit in this manner does several things.  If consumption is not reduced in total, it means that everyone's savings are being reduced in real terms.  If there are no real savings, consumption must be reduced - those who are forced to reduce consumption are effectively subsidizing investments made with artificial credit.  Because the inflation is never-ending (as prices go up, so must the demand derived from the artificial credit secured by investors, causing a price bubble), investments become incredibly hard to sustain.  During this inflation, speculators seek to gain by buying low and selling high, while not contributing to production.  This escalates the speed of the process.  Investors cannot maintain their workforce, who can find better pay in industries closer to the final stages of production - ie, closer to consumption (workers must shift from investments to production to maintain real pay).  Consumers, to deal with inflation, stop saving altogether, even becoming debtors.  This creates even more inflationary pressure, and prevents using general real savings to sustain specific investments.  Eventually, investments are abandoned and debts go unpaid.  This causes a huge credit contraction.  The money supply is deflated - then you have the problems of calculating profit in real terms and impossible debts.

I think I can explain this relatively simply, but you need to understand how a normal economy grows beforehand.

A normal economy grows via capital accumulation. That is, as people acquire land, buildings, machinery, etc., real wages rise, people can purchase more goods for less, and living standards rise. The key to letting capital accumulation happen is saving. This is because you need to save and/or invest before you purchase capital, since capital costs more than basic consumer goods. For example, a society that doesn't save at all will never acquire capital because they'll spend all their time gathering berries and eating those berries. However, a society that saves most of what they make will grow quicker as eventually the people that eat berries build/purchase capital goods that allow them to fish, build homes, raise animals, etc.

What credit expansion does is that it gives the illusion of saving and investing. Credit expansion would be good if it could happen indefinitely, but it can't. Credit expansion happens through lower central bank interest rates. As banks take this money and lend it out at lower-than-market rates, people who want to build capital goods will take it. Say, for example, a car manufacturer might take that money and buy machinery to build more cars. Since this happens across all industries, the capital goods market booms. More jobs are created there, entrepreneurs borrow money to expand their capital goods-producing business, etc. However, as inflation accelerates, three things happen.

First, banks start failing, creating a contractionary atmosphere. This is because inflation washes away their gains from the interest on loans: they essentially gave away purchasing power without knowing it and the weaker banks go under because of that. Second, interest rates rise because people and banks want to hedge themselves against the high inflation that's happening. Third, high inflation makes hiring labor more profitable than buying capital goods. Since there is more money in the market, the businesses that produce consumer goods get it the earliest via consumers. Since they recieve this money first they retain more of its purchasing power and wages lag behind this, making labor more profitable for businessmen to hire.

All of these factors lead to a consequent bust in the capital goods market. As this happens, many people lose their jobs, a general monetary contraction should occur as more people are paying back loans than getting them (but many times central banks don't allow it to happen), businesses go under, etc. Since all of these people working in the capital goods industry lose their jobs, you see aggregate demand and aggregate saving falling drastically and all of a sudden the businesses that produce consumer goods start failing and turning in less profit also. Thus, you have a bust/recession/depression/whatever else you want to call it.

A similar procedure can happen if you have very high monetary expansion outside the banking system, as it would drive real interest rates up as people and banks hedge themselves for inflation, which creates a slightly contractionary environment. This is why you often see long-term busts and/or economic slow-downs occurring during times of war.

The key is to have a stable currency that cannot be easily debased and therefore cannot make economic calculation too difficult. This is why Austrians favor a free market currency like a gold or silver standard.