In this day and age, the most widely held belief on the cause of the business cycle is that it is endogenous to the capitalism system. In plain English, this means that the free-market is intrinsically unstable and fallible, though creating growth and progress, it also begets its own demise. In the turn of the 20th century, Ludwig von Mises presented his theory to the world explaining the puzzling and all-encompassing fluctuations in the economic landscape. Picking up where the Currency School of British classical economists left off in the early 19th century, his view holds that business cycles stem from disturbances generated in the market by monetary intervention. This monetary theory contends that money and credit - will be interchangeably mentioned - expansion, launched by the banking system (including all sorts of credit originators), triggers booms and busts. Because a cycle takes place in the economic realm, a valid cycle theory must be integrated with general economic theory, or as it is more commonly known, macroeconomics. Despite the followers of Keynes being the presumed superior economists owing to dominating economic thought worldwide, across academia, media and government agencies, the theory engendered by Mises is one of the only two (the other being Schumpeter's) that has been integrated into general economics. In fact, various neo-Keynesians have advanced cycle theories. However, they are integrated not with general economic theory, but with holistic Keynesian systems, which are very partial. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." To begin with, I ought to describe the theory credited to Mises, the Austrian business cycle theory (ABCT). This theory came about because Mises detected that a cluster of business errors would suddenly emerge, causing an economic contraction. Clearly, such widespread failures cannot be provoked by business fluctuations due to changes in consumers' preferences or by entrepreneurs out of the blue becoming terrible at their jobs, which is to anticipate future economic conditions. Regarding business fluctuations, these are not the same thing as business cycles. On account of shifts in consumer tastes, in time preferences, in the labour force's quantity, quality and location, in natural resources' availability and in technologies, business activity is constantly mutating. Thus, we may expect specific business fluctuations all the time. Be that as it may, a special "cycle theory" is not necessary to account for them, being instead products of changes in economic data and are fully explained by economic thinking. Despite many economists attributing general business slump to weaknesses effected by a reduction in one or a few sectors of the economy, declines in specific industries can never ignite a general contraction, either a recession or a depression - the latter being an acute and/or a long period of substandard growth, stagnation or even continuous plunge of output. In view of shifts in data that will result in surges in activity in one field and declines in another, there is nothing here that points to general economic contraction, which is a phenomenon of the actual "business cycle". In relation to the pervasive mistakes made by the entrepreneurial class, this can only occur due to some external factor from the free-market. Since we live in a society of constant and unending change, this can never be precisely charted in advance. Although people try to forecast and anticipate changes as best as they can, such forecasting can never be reduced to an exact science. Nevertheless, entrepreneurs are in the business of foreseeing variations on the market, both for conditions of demand and of supply. While the more successful ones make profits, insofar as their judgements are accurate, the unsuccessful forecasters fall by the wayside. Hence, the successful entrepreneurs will be the ones most adapt at anticipating future business conditions. Needless to say, the forecasting is always imperfect, leading entrepreneurs to continuously differ in the success of their assessments and choices. Indeed, if this were not so, no profit or losses would ever be made in business - that is, they would operate in a market of perfect competition, which never transpires in the real world. Therefore, the market provides a training ground for the reward and expansion of successful and shrewd entrepreneurs, while weeding out the failed and unperceptive ones. In order to uncover the origin of the bust part of the business cycle, one must explain why there is a sudden cluster of business errors. This is the first and foremost peculiarity any cycle theory must account for. In spite of business activity moving along nicely with most businesses turning a profit, without notice, conditions change and the bulk of companies begin experiencing losses, revealing to have made grievous mistakes in their projections. On that account, a general review of entrepreneurship is now in order. As a rule, only some businessmen suffer losses at any other time; with the large majority either breaking even or making a profit. How, then, to justify the curious phenomenon of the crisis when almost all entrepreneurs accrue losses or simply earn less than they were expecting? How did these astute businessmen come to make such miscalculations together? And why were they all promptly unveiled at this particular time? Seeing that it is the duty of entrepreneurs to forecast future conditions, some of which being abrupt, it is then not legitimate to reply that instant changes in the data are responsible. Accordingly, you have to wonder why their analyses failed so abysmally. Another common feature of the business cycle calls for an explanation as well. Interestingly, throughout the cycle, capital goods industries oscillate more widely than do the consumer goods industries. Comparing to the latter group, the former one, chiefly the industries supplying raw materials, construction and equipment to other industries, scale up much further in the boom, being ultimately hit far more drastically in the bust. Lastly, a third feature of every boom that needs explaining is the expansion in the quantity of money in the economy. On the flip side, there is generally, though not universally, a decrease in the money supply during the bust. Bearing in mind those considerations, what immediately springs up as the explanatory element for the general movements in business is the general medium of exchange, money, for it is the mechanism of exchange (a.k.a., money) that links all economic activities. If one price of a particular good goes up and another one goes down, one may conclude that demand shifted from one industry to the other (with supply remaining the same). Having said this, if all prices, by and large, move up or down together, then something must have happened in the monetary sphere. In a nutshell, general price fluctuations are driven by changes in the supply of and demand for money. On the one hand, an increase in the money supply, with demand for it remaining constant, will cause a fall in the purchasing power of each monetary unit, occasioning a general rise in prices; vice versa, a drop in the money supply, ceteris paribus, will precipitate a general decline in prices. On the other hand, an increase in the general demand for money, the supply staying the same, will cause lead to the purchasing power of the currency to climb and, consequently, prices to wane overall; while a fall in demand will cause a general surge in prices. Ergo, when people are willing to hold in their cash balances (demand for money) the exact amount of money in existence, the purchasing power of money will remain constant. If the demand for money exceeds the stock, the purchasing power of money will soar until the demand is no longer excessive, clearing the market. Conversely, a demand lower than supply will subdue the currency's purchasing power, raising prices on average. Even though it has to be the case that any cycle in the economy as a whole must be transmitted through the mechanism of exchange, this relation between money and prices alone does not give the grounds for the business cycle. In short, why should this generate a business cycle? More importantly, why should it bring about a depression? According to the ABCT, it is due to the total disregard shown the banking institutions (including all types of credit originators) towards the people's time preferences. As we learned on the last couple of posts (parts I and II), time preferences give us the pure interest rate and its mirrored consumption-to-saving/investment ratio. Succinctly, a lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production and a building-up of capital, and vice versa. Moreover, the market rates of interest consist of the pure interest rate plus entrepreneurial and inflation risks. What is crucial to understand is that the resulting rates manifest themselves as the interest rates on the loan market. In practice, the interest rates are derived from the price differentials between businesses' selling prices and costs of production, that is the profit rate. Unsurprisingly, as banks expand credit to companies, giving the impression the supply of saved funds for investment has increased, the money enters the loan market, perhaps lowering or not the loan rates of interest - whether or not that happens is totally irrelevant. However, price differentials are, as a result, reduced. This occurs on account of businessmen being misled by the bank inflation into believing that the savings are greater than they actually are. Hence, when saved funds, are perceived to have increased, entrepreneurs invest in "longer" processes of production. In other words, the capital structure is lengthened, especially in the "higher" orders, most remote from the consumer. Essentially, entrepreneurs, using their newly acquired funds, bid up the prices of capital and other producer's goods, stimulating a shift of investment from the "lower" (near the consumer) to the "higher" (furthest form the consumer) orders of production. All in all, an "artificial" shift of investment from consumer goods to capital goods industries ensues. Soon, the new money percolates downward from the business borrowers to the factors of production: in wages, rents and interest. Unless time preferences moved lower, people will spend their higher incomes in the old consumption/investment proportions. In sum, capital goods industries, to a greater extent than the consumer goods sector, will find that their investments have been in error. What they thought profitable really fails for lack of demand by their entrepreneurial customers in the lower orders. Therefore, the higher orders of production have turned out to be highly wasteful (not all of it, of course) and the malinvestment must be liquidated. Owing to the credit expansion, beyond the true level of savings, ubiquitous bad decisions are committed. Naturally, the crisis arrives when the consumers come to reassert their desired proportions. The bust is for that reason the process by which the economy adjusts to the wastes and errors of the boom, re-establishing (or at least trying to) the efficient service of consumers' wants and needs. . . . additional investment is only possible to the extent that there is an additional supply of capital goods available. . .. The boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment on a scale for which the capital goods available do not suffice. Their projects are unrealisable on account of the insufficient supply of capital goods. . .. The unavoidable end of the credit expansion makes the faults committed visible. There are plants which cannot be utilised because the plants needed for the production of the complementary factors of production are lacking; plants the products of which cannot be sold because the consumers are more intent upon purchasing other goods which, however, are not produced in sufficient quantities. . .. The observer notices only the malinvestments which are visible and fails to recognise that these establishments are malinvestments only because of the fact that other plants - those required for the production of the complementary factors of production and those required for the production of consumers' goods more urgently demanded by the public - are lacking. . .. The whole entrepreneurial class is, as it were, in the position of a master-builder [who] . . . overestimates the quantity of the available supply [of] materials . . . oversizes the groundwork . . . and only discovers later . . . that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not over-investment, but an inappropriate [investment]." In view that the inflationary boom precludes the efficient allocation of resources that a real free-market would generate by satisfying voluntarily expressed consumer desires, including the public's relative preferences for present and future consumption, the productive structure gets distorted, no longer serving consumers properly. Thus, the crisis signals the end of this inflationary distortion, and the contraction is the process by which the economy returns to the efficient service of consumers. Undeniably, far from being an evil scourge, the ensuing economic contraction is the necessary and beneficial return of the economy to normal. As a result, the boom plants the seeds for its future bust. Whether it becomes a garden-variety recession or a profound depression depends solely on the degree of government meddling, as I am going to demonstrate later on. Furthermore, the boom can last for a longer period than one would reasonably expect because banks tend to delay the day of reckoning. Seeing factors bid away from them by consumer goods industries, finding their costs surging and themselves short of funds to boot, the capital goods firms turn again to the banks. If the banks keep the credit spigots open, the borrowers are kept afloat. Once more, the new money pours into businesses and they can again bid factors away from the consumer goods industries. On the whole, as credit is relentlessly expanded, the wasteful enterprises can be shielded from consumer retribution. Clearly, the greater the credit swelling and the longer it goes on, the longer will the boom last. Without surprise, the boom will end when the inflationary credit expansion ceases at last. The longer the boom proceeds or the more intense it is in originating credit, the more imprudent errors are perpetrated, requiring more rigorous corrections and readjustments of the productive structure. On that account, some key features of the bust-recovery phase are going to emerge inevitably. For one, wasteful projects must either be abandoned or scaled down, with inefficient companies liquidated, completely or just partially, or turned over to their creditors. In addition, prices of producers' goods must dwindle, particularly in the higher orders of production, including capital goods, lands and wage rates. Just as the boom was marked by an illusory fall in the pure interest rates, although not necessarily in the market rates of interest, entailing that the price differentials between stages of production were too subdued, the bust consists of a rise in this interest-differential. This means that the prices of the capital and producers' goods must drop relative to prices in the consumer goods industries. Besides the indispensable price decreases of certain machines, whole aggregates of capital such as the stock market and real estate have to see their values contract. Finally, since factors of production must journey from the higher to the lower orders of production, some "transient" unemployment will materialise during the contraction phase, even though it does not have to be any greater than the unemployment corresponding to the shifts in production. In practice, the level of joblessness will be aggravated by the numerous bankruptcies and the vast malinvestments laid bare. Albeit it still needs to only be temporary. Simply put, the speedier the adjustment, the more fleeting will the unemployment be. Notwithstanding, if wage rates are kept artificially elevated, preventing them from falling, the unemployment will progress beyond the "transient" stage, assuredly becoming very alarming and harmful for the prospects of recovery. Due to being extensive and having still much to unravel, I will continue this discussion another day. Meanwhile, I would invite to read the other articles in this blog, if you have not already read them.
0 Comments
Leave a Reply. |
AuthorDaniel Gomes Luís Archives
March 2024
Categories |