What causes the boom and bust cycle?

[BrassDragon]

What causes the boom and bust cycle of business?

Here are some related/smaller questions:

-Does the Fed's role in changing interest rates, and the treasury's role in printing new money, have anything to do with it?

-Would a gold standard end the problem?

I have taken Econ 101 (Honors version, in fact). This question shows how much I learned (or, rather, how well the professor provided evidence for his claims.)

[DarkWaters]

What causes the boom and bust cycle of business?

This subject has interested me lately as well. I will do what I can to help explain. I really liked the explanation by Brian Simpson in his course on Money, Banking and the Business Cycle. Any mistake in my reasoning below is most likely from me and not from Dr. Simpson.

The best explanation I have heard is primarily the open market operations of the Federal Reserve:

Suppose the Federal Reserve decides to purchase a bunch of government bonds (i.e. treasury bills, treasury notes or treasury bonds) from investment banks. Here is how the economy will be affected:

• The total money supply in the economy will increase, as the banks will have more money.
  
  
• Banks will lower their interest rates to remain competitive in the lending market.
  
  
• The economy enters a boom -- businesses can now borrow money at a cheaper interest rate and therefore operate at higher profit.
  
  
• Businesses decide to make some longterm investments with their increased profits.
  
  
• Prices, which usually lag behind changes in the money supply, start to increase as a result in the increased willingness to spend.
  
  
• Interest rates, which are essentially just the "price" of money, start to increase. In many cases, these prices rise past higher than they were before the Federal Reserve undertook any operations.
  
  
• Businesses, many of whom already committed themselves to longterm investments, start to struggle with the price increases -- thus begins the bust cycle.
  

Would a gold standard end the problem?

Adopting a gold standard would certainly help reduce the number of business cycles but it certainly would not eliminate them. Banks can also still increase the money supply through risky fractional reserve lending practices. Simply put, if person A deposits $1,000 dollars in the bank, the bank may then use that money to issue a $800 loan to person B. So now person A is operating on the premise that he has $1,000 in the bank and person B is operating on the premise that he has $800 in his possession. If person A were try to withdraw his $1,000 before person B paid off the loan (or if person B defaulted) then the bank could be in a tight situation. If instead of money, these were gold controvertible bank notes, we would still have the same situation.

So why are banks so willing to engage in such risky lending practices? A good part of the reason is Federal Deposit Insurance Corporation, which guarantees deposits on all commercial banks.

Here is an analogy to help illustrate the point. Suppose a father is to issue his teenage son a credit card. The teenager is to pay off all of his own bills. However, the father tells his son that if he runs up the bill so high where he cannot afford to pay off the balance, then the father will pay it down for him in a fashion where the credit card company would not know the difference. Will the father's arrangement make the teenager more likely to be financially profligate?

I wonder how an increasing global economy will impact the frequency and duration of business cycles. If China decides to aggressively issue more government bonds, will this cause significant business cycles in the United States? I think there will obviously be some effects, but I am presently unsure of the full extent. This is an interesting area for research.

[BrassDragon]

Thanks so much for your good post, DarkWaters. That helps a lot.

Here are some follow-up questions, for you or for anyone else:

-Most importantly, are there other possible (or likely) explanations and causal factors of the boom and bust cycle? Or is this a complete explanation?

-Under this explanation for booms and busts, how long should a cycle last? In other words, if I'm understanding correctly, how long does it take for interest rates that have lowered to then rise as prices increase, and then finally (presumably) settle out? Is there empirical data that matches this?

Mainly these questions came about from arguing with a fellow college student who follows the Keynesian model, without thoroughly understanding it (neither do I), because that is what his professor told him. He basically ended up taking the stance that the economy can only be "figured out" through a lot of data and empirical research, and that there are variables that we may not even know about that could have a huge effect. I disagreed and said that we could figure out how the economy works through a proper understanding of ethics and markets (without looking at data and searching for variables we didn't expect), though I could not back up my point very well. (This seems almost like "a posteriori" vs. "a priori," but I know those terms are not correct - what would be correct here?)

And finally, who was more right about "figuring out" how the economy works - he or I? And why?

Thanks to anyone who attempts to answer any of these questions. I'm going on a trip for 4 days, so I may not get back to the thread until Wednesday night, but I'll be back.

Edited August 4, 2007 by BrassDragon

[Qwertz]

This may not be what you're looking for, but even in a free market, changing technological paradigms will cause cyclical variations. That is, as one technology matures, growth will slow until a new technology is developed, when growth will accelerate again. In this situation the length of the cycle is related to the frequency of paradigm shifts, which is accelerating, making cycles shorter and more dramatic.

-Q

[BrassDragon]

That is definitely helpful!

To follow up to that (at least, in a general sense) - is it true that one industry having a rough quarter will contribute to the entire economy doing badly?

Example: The price of animal feed goes up due to bad weather in the US corn belt. Then the price of livestock goes up, because the price of feed went up. Then the price of hamburger in restaurants goes up. So people end up paying more for hamburgers, and less on other things. Moreover, the livestock industry doesn't expand as much, due to a bad quarter. So, that might hurt the equipment industry.

Or, rather, is it true that capitalism has a softening effect when something goes wrong?

For example, the price of animal feed goes up due to bad weather in the US corn belt. But that price is passed on to every person and industry and business that does business with the corn farmers, all the way down the chain, so the loss is spread out over a huge number of people. I end up paying a penny more for hamburger, and it's no big deal.

Or, rather, is it more subtle/some of both/depends on the industry?

[John McVey]

[*] Interest rates, which are essentially just the "price" of money

AIIIIIEEEEEE!!! This common error is a serious bugbear of mine: interest rates are the price of CREDIT, not money! The idea that they are the price of money is what underlies the idea that the way to lower interest rates is by generating more money (this doesn't mean that artificial credit-creationism is any better, mind.)

JJM

[John McVey]

To follow up to that (at least, in a general sense) - is it true that one industry having a rough quarter will contribute to the entire economy doing badly?

Outside finance, your second scenario is far more prevalent than the first. The main visible effects are local, but they do radiate out and affect everything eventually - in a very dilute form. When transport was difficult, the local effects could be enormous and lasting, but with easy transportation any local short-falls are quickly met by outside supplies being brought in. This is even more so with globalisation. So, by the time you feel the effect it is indeed just like a hamburger costing 1 cent more, even when you're less than an a quarter hour's drive away or less from the disaster area. Heck, you wouldn't even notice that because the store would wear that cost. The only time the local effects are severe is when the transport systems themselves are included in what has been damaged, and last only as long as those systems are out.

Inside finance, in today's world, things can get hairy because of extreme leverage and the sensitivity of systems to governmental perfidy. Your agricultural disaster would affect a host of financial systems because of commodity trading, lending to farms and food-processing industries, insurance, lending to employees for housing etc, and so on. Echoing what others have written about, the causes of the instability are the rules generated by governments in a variety of economic and financial systems. The instability simply would not exist in a laissez-faire economy. For example, the entire field of currency derivatives - capable of wiping out billions of dollars in a heartbeat - would never exist without the use of fiat currency and interest rate manipulation. Moral hazard is rife in financial systems regulation. Get rid of all that and there would be a premium on financial soundness, which would take finance back to the same position of rapid dilution through radiated dispersal of effect as described above.

JJM

[Scott_Connery]

http://www.mises.org/tradcycl/austcycl.asp

Essentially, it is caused by the government increasing the money supply. This encourgaes banks (those under a fractional reserve system anyway) to loan out money to any yahoo that wants it. This causes a short term-boom. New businesses are started, new houses are built and bought etc.

However because banks made these loans to all sorts of customers who shouldn't have gotten money at all, and they charged too little interest on the rest of the loans. Somewhere down the road these risky loans fail, and a bust occurs.

The great depression is probably the most prominent example of this phenomenon. During the 20s, the newly formed fed increased the money supply by over 50%. Surprise surprise, this didn't work out too well as was seen in 1929.

[John McVey]

http://www.mises.org/tradcycl/austcycl.asp

The great depression is probably the most prominent example of this phenomenon. During the 20s, the newly formed fed increased the money supply by over 50%. Surprise surprise, this didn't work out too well as was seen in 1929.

Richard Salsman has argued otherwise. The collapse of banks destroyed 1/3 of the money supply because of the effect of fractional reserve banking, but there was no inflation in the 20's and the growth in that era was genuine. His lecture is well worth listening to if you are interested in this field.

JJM

[Scott_Connery]

If you look at Rothbard's America's Great Depression and then the table on page 135, you can see that the total money supply increases by about 61% from 1921 to 1929.

[Capitalism Forever]

What causes the boom and bust cycle of business?

A boom is the natural condition of a free economy, in which more and more wealth is being created as a result of innovation and capital accumulation. A bust is when this progress is interrupted by a new bout of statism, such as taxation, tariffs, regulation, and interest rate / money supply manipulations.

[Capitalism Forever]

If you look at Rothbard's America's Great Depression and then the table on page 135, you can see that the total money supply increases by about 61% from 1921 to 1929.

An increase in the money supply does not necessarily cause a depression. What it causes is an increase in prices: say, if the money supply doubles, then all other things being equal, prices will double too, as there are twice as many dollars in circulation for the same amount of goods being traded. However, all other things will usually not be equal; if productive output also doubles over the period during which the money supply has doubled, then there will be twice as many dollars for twice as many goods--and prices will remain unchanged. The price level will only increase if the money supply rises faster than production. A rising money supply can well coexist with declining prices: if the amount of money doubles over a period but production quadruples over the same period, prices will halve.

MV = PQ

where M is the money supply, V is the velocity of money, P the price level, and Q the sum of goods produced and traded for money.

Since there was a tremendous growth in productive output over the 1920s, a 61% increase in money supply does not sound all that horrible.

These Austrian fallacies regarding recessions being caused by money supply are based on the premise that John McVey has identified as false above, namely the confusion between money and credit. The two are very different things.

Money is the means of exchange. An increase in the money supply means that more assets are serving as means of exchange, either by circulating directly (gold coins in people's wallets) or by virtue of being the subject of circulating claims (gold in bank vaults backing paper bills and checking accounts; real estate and other loan collateral backing paper bills and checking accounts).

Credit is loans that have to be repaid at a specific date in the future--which means that this excludes paper bills and checking accounts, which are redeemable on demand. Credit is when somebody has produced more wealth than he wants to consume at the moment, and is willing to let you use it until he needs it. It does NOT serve as a means of exchange, but is rather a means of renting wealth; its availability does not increase prices, but rather provides opportunities for the borrowers to create more wealth--and thus, supposing an unchanged money supply, indirectly leads to reduced prices.

Edited August 5, 2007 by Capitalism Forever

[DarkWaters]

Credit ... ::: SNIP ::: ... does NOT serve as a means of exchange, but is rather a means of renting wealth; its availability does not increase prices, ...

Could you please elaborate on why the availability of credit does not increase prices?

In addition, what school of economic thought is the source of the ideas you have presented above? (i.e. it is not Keynesian, Austrian or Chicago School)

Thanks!

Edited August 6, 2007 by DarkWaters

[fatdogs12]

A boom is the natural condition of a free economy, in which more and more wealth is being created as a result of innovation and capital accumulation. A bust is when this progress is interrupted by a new bout of statism, such as taxation, tariffs, regulation, and interest rate / money supply manipulations.

That's really not true. A lot of things can cause a recession. An increase in the cost of producing a good for whatever reason, such as oil, can cause a drain on an economy in that people or businesses have less money to spend on goods and everyone starts to pear back their spending.

One example that comes to mind was back in the 80's a bunch of people were campaigning for people to eat less meat this way poor people would have some more to eat. The actual effect though was that it put a lot of ranchers/workers/machine builders/etc out of work. It had the opposite effect.

The same thing can happen in an economy, right now we are looking at an economy about to get beat up a bit because the housing boom is over and now all those people who were working on houses, the lumber producers, etc are having to cut back, so a lot of jobs will be lost. This really doesn't have much to do with the governments involvement it's just the fact that developers many times aren't economic experts on when a market is about saturated.

That's really a basic thing here, most people, even business people are pretty dumb in that sense in that they overproduce and don't realize when a market has reached an equilibrium. In that sense people really aren't perfect when it comes to business. Though they are a million times better than a government planned economy.

[DavidV]

Richard Salsman has argued otherwise.

I asked Salsman about his view of Austrian economics, and in my opinion, he doesn't understand it at all beyond a highly superficial level. He certainly doesn't understand the Austrian business cycle theory, which is one of its most crucial applications. I highly recommend that you study it for yourself rather than take Salsman's utterly uninformed word for it.

An increase in the money supply does not necessarily cause a depression.

This is a wildly inaccurate and simplistic characterization of ABCT. Just read it for yourself: http://www.mises.org/story/672

A boom is the natural condition of a free economy, in which more and more wealth is being created as a result of innovation and capital accumulation. A bust is when this progress is interrupted by a new bout of statism, such as taxation, tariffs, regulation, and interest rate / money supply manipulations.

While economic growth and recession can be attributed to these factors -- ceteris paribus -- only the ABCT provides an explanation for the existence of the boom/bust cycle.

[Capitalism Forever]

Could you please elaborate on why the availability of credit does not increase prices?

As I said, credit is a means of renting wealth. Does the availability of homes for rent increase the prices of new homes? No, all it does is make it easier to rent a home. For the same reason, the availability of wealth for rent (= credit) does not increase the prices of goods; all it does is make it easier to borrow.

In addition, what school of economic thought is the source of the ideas you have presented above? (i.e. it is not Keynesian, Austrian or Chicago School)

It definitely isn't any of those three, is it! It reflects rather sadly on the current state of economics that uttering some plain common-sense observations puts you at odds with all the mainstream schools of thought. Richard Salsman pretty much seems to be the only major exponent of these theories. They are based on good old-fashioned classical economics, especially on the ideas of Jean-Baptiste Say. Since their fundamental distinction is the recognition of the primacy of production, you might want to call them "the Productionist school."

[Capitalism Forever]

That's really not true. A lot of things can cause a recession. An increase in the cost of producing a good for whatever reason, such as oil, can cause a drain on an economy in that people or businesses have less money to spend on goods and everyone starts to pear back their spending.

Sure, natural disasters and similar metaphysically-given setbacks can also hamper growth, but the more advanced the economy, the less their effect will be felt. Consider Hurricane Katrina, for example: it was as great a disaster as one hopes will ever have happened to America, yet its effect on the economy has been almost negligible compared to the quintessential man-made disaster: the Great Depression. A politician or a central banker can wipe out more wealth with a stroke of his pen than a dozen hurricanes and earthquakes combined.

That's really a basic thing here, most people, even business people are pretty dumb in that sense in that they overproduce and don't realize when a market has reached an equilibrium.

Overproduction in a single specific sector can indeed lead to losses, but that only affects that one sector. A general overproduction, which would affect the whole economy, is not possible (to borrow your words, that's really a basic thing here--it's called Say's Law). So whenever you see a recession, and people trying to explain that recession as a result of "overproduction," you'll know they're wrong.

Producers don't cause recessions; destroyers (= statist politicians) do.

[Capitalism Forever]

Just read it for yourself: http://www.mises.org/story/672

Thanks for the link; I definitely will read it on my next free weekend. Always interested in knowing what the other side is saying!

[Fireball]

What causes the boom and bust cycle of business?

The artificial expansion of money and credit by a nation's central bank is the cause of boom/bust cycles. Creating money out of thin air (fiat currency) elevates economic activity until it no longer becomes sustainable. The inevitable bust consists of an economic adjustment where the economy is brought back down to reality...until the next round of money/credit expansion begins.

[fatdogs12]

Overproduction in a single specific sector can indeed lead to losses, but that only affects that one sector. A general overproduction, which would affect the whole economy, is not possible (to borrow your words, that's really a basic thing here--it's called Say's Law). So whenever you see a recession, and people trying to explain that recession as a result of "overproduction," you'll know they're wrong.

Producers don't cause recessions; destroyers (= statist politicians) do.

As I stated in my post, a overproduction in one sector can have huge negative implications for many others. Esp if that is a big sector.

[Capitalism Forever]

As I stated in my post, a overproduction in one sector can have huge negative implications for many others. Esp if that is a big sector.

Okay, let's say there's an overproduction in the oil industry. (Is that a big enough sector?) Oil companies make more oil than they can sell profitably; there is a glut of oil that they have to get off their hands at a loss. Oil becomes very cheap ($5 a barrel?), some energy companies go into liquidation, many employees of oil companies lose their jobs (tens of thousands of them?), and you can buy gasoline for a few dozen cents a gallon for years to come. If this happened, would you really be afraid that the economy would take a huge hit because energy shares have come down and many oil workers have lost their jobs? I'm pretty sure they would quickly find new jobs in the manufacturing and servicing of SUVs!

The addition of wealth never harms the general economy; more wealth does not make a country poorer--it makes it wealthier, as sure as A is A. It's only that adding the wrong kind of wealth is not as beneficial as adding the kind of wealth people want the most.

[y_feldblum]

The artificial expansion of money and credit by a nation's central bank is the cause of boom/bust cycles. Creating money out of thin air (fiat currency) elevates economic activity until it no longer becomes sustainable. The inevitable bust consists of an economic adjustment where the economy is brought back down to reality...until the next round of money/credit expansion begins.

If I recall correctly, Reisman notes that accelerating inflation can encourage unrealistic economic activity, temporarily, if the acceleration is not publicly known or knowable. He also notes that, from political pressure, inflation tends to accelerate. When inflation is stopped, or at least stopped from accelerating, an economic crash will occur, the scale of which is proportional to the scale and duration of inflation preceding it. The economy is not being "brought back down to reality"; rather, since government expropriated vast quantities of wealth from individuals and business via inflation, and since the scale of the expropriation was not known: as people realize they can no longer pay back loans or continue in business because their assets are now worthless, the shock of the expropriation hits the economy and crashes it.

A fiat expansion of credit can do the same thing. I read an article recently which mentioned that the current mortgage-backed-securities crash, for example, stems from government requiring companies to hold bonds and similar credit instruments far beyond what companies would normally hold and far beyond what the normal credit instruments could provide. It seems mortages are also heavily government-regulated and so holding mortages would be very risky. Mortage-backed-securities are, then, paper assets backed by Federal whim and cruelty.

[DavidV]

That's really a basic thing here, most people, even business people are pretty dumb in that sense in that they overproduce and don't realize when a market has reached an equilibrium. In that sense people really aren't perfect when it comes to business.

It's not possible for "overproduction" to be a global problem in a free market. Dealing with uncertainty is one of the most fundamental problems faced by entepreneurs, and markets have developed numerous means of dealing with it. Commodity markets, futures contracts, options, derivatives, swaps and various other financial instruments all serve to both inform actors about future expectations and protect producers and investors against uncertainty. These financial instruments allow "dumb" individual commodity producers to not have to care about future demand - they can focus on present prices.

This system fails to function when the government manipulates the money supply and interest rates, which is how we get business cycles and the myth of "over" and "under" production.

[Capitalism Forever]

http://www.mises.org/story/672

Okay, curiosity got the better of me and I read the article today--and I disagree with nearly all of it.

• First of all, it totally conflates the availability of credit (i.e. low interest rates) with a rise in money supply.
  
• Then, it seems to say that when the Fed lends money at low interest rates, the availability of credit is somehow not real but an illusion, and the low interest rates only misinform producers about people's time preferences.
  
• Third, it maintains the premise that producers will always let themselves be fooled this same way--not just the first time or the first couple of times, but every time the Fed does it, decade after decade, indefinitely.
  

As I already stated, money is something very different from credit--and I should add that the ways the Fed manipulates them are also different. When the Fed wants to increase the money supply, it "buys" assets like gold and (predominantly today) bonds, giving freshly issued money in exchange. When the Fed wants to lower interest rates, it makes short-term loans of such assets to banks.

Issuing new money in exchange for assets serves to monetize those assets, i.e. allows claims to them to circulate as means of exchange. This increases the amount of money in circulation, but it does not lend any wealth to anyone. Lending is when you take some existing wealth, or existing claims to wealth, and cede its use to someone else for a period of time. This does not itself increase the money supply, but it does make more wealth available for use in production--and this is what the Fed does when it lends money to banks at low interest rates.

Obviously, since the Fed does not produce any wealth, this raises the question of where it got this wealth from. The answer is that it has hoarded a lot of wealth, in the form of gold and government bonds it has "bought" on the "open market." Much of the gold was obtained by confiscation (ironically, Roosevelt's pretext for confiscating gold was precisely to prevent "hoarding" by individuals); and government bonds are claims to wealth that is going to be confiscated through taxation. If it hadn't been for the Fed, all of this wealth could have been available as credit. What the Fed does is take wealth away and withhold it from the economy, and make only a portion of it available as credit--a smaller or greater portion depending on whether it wants to "tighten" or "loosen." In other words, it does not make any credit available that wouldn't otherwise be available, but rather it makes a lot of credit UNavailable, and when it "loosens" its policy, it merely reduces the amount of credit it is making unavailable.

[softwareNerd]

I'm no expert on Austrian theory, but I trustGreedyCapitalist will tell me if I'm "wildly wrong" . With that caveat, here is my non-expert, simplified explanation of Austrian theory:

Characteristic of a recession: A recession is characterized by a sudden decline in economic activity across a wide range of industries. Any industry may see a sudden fall off in the demand for its products for a variety of unanticipated reasons. Similarly, a business (or even an industry) may forecast higher demand than actually transpires. That industry may then face a period of lowered prices of goods, cost-cutting, layoffs, falling stock prices, and so on. However, in a recession, this type of problem ranges across the economy. All sorts of industries find less demand for their products than they anticipated and end up cutting back.

Most economists agree with these characteristics, but offer varying explanations of the causes. Some Keynesians might explain this as a fall off in "aggregate demand". Some monetarists might explain it as a sudden curtailment of the money supply (or reduced growth in money supply).

The Austrians have a different explanation. To understand the Austrian explanation, requires a brief introduction to the Austrian concepts of Time-Preference and "pure" or "original" interest rate.

Time preference and the Pure Interest rate: Austrians explain the interest rate as follows: the nominal rate has various components. Importantly, there is a credit risk component that varies with the type of loan. Also, there is a monetary component, which compensates for expected inflation. Underlying these, however, is a "pure interest rate": the rate that would still exist if there was zero inflation and zero risk. The Austrians hold that this underlying rate is determined by the time-preference of people in the economy. If people want to save and invest a lot of their product for the medium to long term (as opposed to consuming it in the short term), then that causes a low pure interest rate. So, in the Austrian theory, the rate of interest that one gets after peeling away the monetary and risk components is a reflection of time-preference. When a business is planning investments, it uses some type of NPV calculation to see if the investment will pay off. In an economy with a low interest rate, businesses will use lower rates to discount their NPV calculations. The lower the "pure interest rate", the more attractive it will be to take a longer term view, and divert resources to more "indirect" means of production.

For instance, take a business that has to decide whether to spend $100 more on plant improvements that will pay back $10 in each subsequent year, for 20 years. At a 10% rate, it is not cost-effective to invest the extra $100. However, at 5% it is.

In general, a low rate of pure interest (assuming it's for real and not an artifact of government creation) is indicative of a strong economy with a focus on the long term.

Austrian explanation of a recession: The Austrians say that the problems start when the government, through the financial system, is able to change the nominal rate of interest, and does so in a way that -- after factoring out monetary and risk factors -- it gives the appearance that the underlying pure rate has changed. When this happens, business decisions begin to be made on this basis, and businesses makes investments that they otherwise would not have made. The essence -- according to the Austrian theory -- is not simply that everyone starts spending more, but rather that the investment is channeled into "wrong" areas (like the new machine in the example above).

If underlying time-preference (and the underlying pure interest rate) did not really change, then the government cannot keep the manipulation up. At some point, businesses realize that they have made bad investments in the wrong things. They pull back. Often, in reaction, things "overshoot on the way down" as well.

Summary of the Austrian theory of recession: They are not caused by over-investment as such, but rather by a specific type of over-investment: i.e., mal-investment in extending the chain of production. This mal-investment, in turn is caused by a mistaken belief that the underlying pure interest rate has changed. This mistaken belief, in turn, is caused by government manipulation of the financial system.