The Economy Pulls an All-Nighter
When economic times are good, people pay very little attention to the work of economists. Only when an economy experiences a downturn do people come to economists asking how this latest disaster happened and how do we get out of it. Unfortunately, the economist tends to speak in a cryptic language using references to things like the NAIRU, the short and long-run Phillips curves, and detrended variables found in stochastic processes.
While the Austrian Business Cycle theory (ABCT) doesn't contain as much jargon as alternative theories of the business cycle, the ABCT is a complex theory that sometimes seems just as confusing and impenetrable to the average reader. In order to overcome this obstacle, perhaps an explanation and an analogy may help. In the course of a business cycle, the ABCT observes that the economy moves through five phases: credit expansion, a malinvestment boom, a crunch, a recession, and a recovery phase.
The Austrian theory states that the initial cause of the business cycle is an artificial injection of credit into the economy. This injection falsifies market signals which induce entrepreneurs to engage in investment projects that are not in alignment with the wishes of the consuming public. These projects are called "malinvestments." While the malinvestments are under construction, there is a boom in the economy. However, this artificial high cannot last forever and sooner or later there is a crunch. The economy either hits a credit crunch (with rising interest rates), a real resource crunch (with rising input prices), or a combination of the two. As the interest rates and prices rise, the malinvestments are liquidated. Much pain is involved in the liquidation process. Only after the malinvestments are cleared from the system will the economy have a solid foundation on which to recover.
To help explain this complex story, an analogy seems to help. Suppose that, in his 8:00 a.m. class, a student was assigned a paper which is due tomorrow. Of course, he has not yet started working on it. In order to finish the paper on time, he decides to pull an "all-nighter."
As he types along, he starts to feel sleepy. So what he does he do? He takes some No-Doze and chases it down with a Jolt Cola ("Twice the Caffeine, and All the Sugar") This artificial stimulant puts him on an artificial high. Around 2:00 a.m., the effects of the caffeine start to wear off and he has a choice: either take more caffeine or go to bed. Since he is not done with his paper, he chooses to take more caffeine, but this time he has to increase the dosage to get the same effect.
The additional credit in the economy has the same effect as the caffeine in this example. The economy is sent on an artificial boom. The effects of the new credit eventually wear off as the stimulus on real business activity is transformed into increases in prices. The monetary authorities face a choice between further expanding the money supply, or letting the economy "go to sleep." However, an economy doesn't go to sleep, instead it must clear out the effects of the stimulant through the process of liquidation. When the monetary authorities expand the money supply, they must expand it at a rate greater than before to get the same effect.
Now our procrastinating student's roommate comes back from a late night of studying and finds his friend asleep at the keyboard. Knowing that his friend's grade depends on this paper, the roommate wakes him. The student gulps down more caffeine, and gets back to work. However, his mental processes are not at 100% efficiency. He tries to be productive, but his body is reaching its limit. His roommate finds him asleep at the keyboard, yet again, and rouses him. Again the student is jarred back to consciousness. Again our hapless student is not working productively.
When the monetary authority tries to stimulate the economy before the malinvestments are fully liquidated, it is acting in the same manner as the persistent roommate. The economy attempts to get back to previous levels of growth, but because there are many malinvestments that are tied up in nonproductive activities, the economy cannot achieve its potential.
Finally, the student is done with his paper and rushes to his 8:00 a.m. class to hand it in. Now, he can "crash." However, the economy is not so lucky. It is never able to sleep, but it can crash. There comes a point where there are so many resources tied up in malinvestments that a real resource crunch occurs. There are too few resources to complete all the current projects. Despite the monetary authorities best efforts to "wake up" the economy, it refuses to get back to high levels of growth. It must go through the liquidation process (sleep) before it can again recover on a solid foundation.
Let's say the student is only permitted a few hours sleep before he is awakened again, perhaps by a phone call from his teacher. He is told that he must do revisions. He gets to work on them but, again, the student underperforms. So he is awakened again to undertake more revisions. This wake-sleep pattern continues as the student enters into a long decline. This is an interdeterminate stage of the cycle that corresponds very closely to what in economics is considered a secular stagnation of underperformance punctuated by bursts of positive signs which only lead to disappointment. The policy authorities try every method to "get the economy going" again (deficit spending, more inflation, protectionism, etc.) but the positive effect, to the extent there is one, is always short term. This seems to correspond to where the US is today.
The lessons from this tale are not only to avoid procrastination and do one's papers early, it also recommends to the monetary authority, that despite the temporary benefits of credit stimulation, the result is a recession. Furthermore, once a malinvestment boom is underway, a recession is a necessary step to return the economy back to a healthy growth rate. Let the student sleep so that he can do better work later!