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PrudentBear.com on Price Controls and the Business-Cycle

January 20, 2005

PrudentBear.com has an essentially Austrian analysis of the business cycle by Jeff Ferguson: Is a Secular Bear Market Inevitable?

What determines the extent of the damage caused by price controls? The answer depends in part on the size of the market in question. If, for example, a small market such as the market for hand turned fruit bowls was being controlled the damage would likely be immaterial to the economy as a whole with insignificant subsidiary effects in other markets. On the other hand if a large market, such as the market for oil, were price controlled the effects would be extensive with impacts on any market dependent on oil as a production input along with direct impacts on end consumers who employ oil products while driving cars and heating homes. In addition, the longer controls are in effect the greater the damage. Not only is a lower level of satisfaction imposed over a longer period but structural capital changes occur. Using the previous oil price control as an example we can readily sense that oil companies would cut back on current capacity along with exploration for and development of future supplies. Scarce capital which would have been profitably employed maintaining or expanding the supply will be locked into other less valuable uses in outside industries. Over time a considerable misallocation of capital can be expected and a longer recovery period will have to be endured when prices are once again allowed to reflect the preferences of consumers.

The most profound damage would be caused by perpetual distortion of a price which affects all consumption and investment decisions in all markets. Does such a price exist? Certainly…the rate of interest! Every consumption decision involves, although perhaps not explicitly, the choice between consumption now or saving now and consuming more in the future. Depression of interest rates makes current consumption less expensive relative to future consumption with saving relatively less attractive since earnings on savings are lower. Business investment decisions are also affected by interest rates. Every such decision, at least implicitly, involves a valuation of discounted cash flows. A lowering of the interest rate reduces the discount making business investments look more attractive than would otherwise be the case.

Ferguson then goes on to expound upon an essentially Austrian analysis of the business cycle, which must have been heavily or entirely influenced by the Austrian school. Now, the way in which the Fed and central banks manipulate interest rates is not what we normally think of as price-controls. Rather, it is a more indirect manipulation. However, the authors points are essentially correct.


One interesting point is that price-controls alter the structure of production to be less efficient (that is, such that the most urgent wants are unsatisfied). The greater the degree of the price-control, the greater the malinvestment. When the price-control is lifted, the greater the previous malinvestment, the more painful and lengthy will be the recovery. It takes time to alter the production structure from one which does not truly reflect preferences to one which does. The only error I see here is the authors apparent assumption that price-controls will eventually be lifted. Price-controls can essentially go on forever. Thus, the misallocation of resources caused by them can last indefinately (or as long is there is a State enforcing them).

The misallocation of resources caused by interest-rate manipulations, however, cannot go on forever. The State lowers the interest-rate below the market interest-rate which would reflect consumer preferences in several parallel manners. They debase the dollar by reducing its gold backing, directly inflate the monetary supply by printing out more money, and pump that money into the fractional reserve system, which pyramids on top of that inflation. What happens as a result of this increased credit is that the "price" of loans is lowered, due to increased supply. That is, via these methods, interest rates are lowered indirectly.

Because of this, projects that are actually unprofitable now appear to be profitable to businessmen. Thus, an economy-wide misallocation of resources occurs, as businessmen nation-wide invest in unprofitable ventures. This state of affairs cannot go on forever. What is actually happening is that both investment and consumption are increasing beyond a sustainable rate. That is, there is more investment than the rate of savings can actually support. Eventually, many ventures will run out of capital, and the businessmen will realize that their investments were actually unprofitable and liquidate them. Or, if the inflation stops, businessmen will realize that the investments they previously thought were profitable are in fact not. This results in a deflationary contraction of credit, in which the fractional reserve process reverses itself, faciliating the re-allocation of resources to efficient uses. Alternatively, continued and great debasement, inflation, and fractional-reserve banking can lead to a crack-up boom and hyperinflation.

During a deflationary credit-contration bust, resources are reallocated, the structure of production altered to better fit consumer-preferences. This is actually a good thing. The deflationary retraction of credit (via the reversal of the fractional reserve) speeds up the recovery process.

That is the best possible outcome, once a credit-bubble has been created. The worst alternative is the crack-up boom, otherwise characterized as the flight into real goods, or hyperinflation. Under this alternative, the monetary system is obliterated in mortifying fashion. Essentially, monetary exchange breaks down, and currency rapidly becomes worthless. Fortunately, most of those reading this have never experienced a crack-up boom or hyperinflation, aside from the "hiccup" of "hyperinflation" during the 70s. The classic example is Germany under the Weimar Republic. Inflation was so enormous that prices at restaurants would increase from the time one sat down to the time one received one's restaurant bill. Workers would carry their salaries home in wheelbarrows.

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