What causes the boom and bust cycle?

[John McVey]

People may find this interesting.

JJM

[DavidV]

Please excuse my failure to follow up – I’ve been busy with work lately. I think it helps to explain the business cycle theory with a simple analogy – so here it is:

Imagine an economy with only one actor: Robinson Crusoe on an island. Crusoe really loves fish, so he spends all his time fishing and eating fish. Let's say that he must spend half of each day fishing so he can enjoy fish in the evenings. Additionally, Crusoe spends Saturdays mornings maintaining his fishing dinghy and fishing nets. In order to have fish on Saturday, he must fish for an extra hour every other day of the week.

So, Crusoe has a savings rate of one hour per (working) day, or 12.5%. His savings rate equals his investment rate, or the percentage of the present income he sets aside to maintain or increase future income.

All things being equal, Crusoe would rather have fish sooner than later, but he is willing to put aside the fish he catches in the "savings" hour for more fish later. The discount he gives to eating a fish Saturday is his time preference, or his originary interest rate. (To that, he adds the risk that the fish will spoil by Saturday to get the market or "real" interest rate.)

Crusoe doesn't have a fridge, so he saves his catch by throwing it in a small, dark pond. He can't see how many fish are in the pond, so he keeps a stack of small rocks near it. Every time he adds a fish, he adds a rock, and every time he eats one, he removes one. The rocks are his money supply.

Suppose there are some monkeys on the island, and they see Crusoe adding rocks to his pile. They decide to imitate him, so every time Crusoe ads a rock, they sneak in and add one as well. The monkeys are inflating the money supply by injecting currency into Crusoe’s investment fund.

Crusoe suddenly notices that his "savings rate" of fish is double the usual. He decides to compensate by eating some of the extra fish he catches during the "savings hour." This is the consumption-side of the boom phase of the business cycle. Crusoe also decides to take some extra time each day to start building himself a hut. This is the investment-side of the boom phase of the business cycle.

Crusoe now thinks that the cost (interest rate) of "future fish" is lower while in reality, his savings rate too low for the investments he is planning.

What happens on Saturday? When it comes time to eat his midday meal, Crusoe suddenly realizes that he's out of fish - despite having a surplus of rocks. He's exhausted his investment capital because the additional currency injected into his money supply did not represent an actual increase of his savings rate. He doesn't have the physical resources (fish) to maintain his previous consumption rate, much less increase it. He is forced to cut his investment rate (he must spend some of his Saturday fishing) just to have some fish for Saturday night. He also has to abandon his hut uncompleted because he does not have the time to finish it. The uncompleted hut is an extravagant expenditure that represents a loss of capital. This is the bust phase of the business cycle.

To recap, here's the overall impact of the monkey's trickery. Sunday-Friday, Crusoe catches (produces) the same number of fish, but consumes more, and therefore saves less. That's the boom period. Saturdays, Crusoe consumes less fish, and spends less time for maintaining his nets (capital). Some of his investment/consumption time must now be spent in production. That's the bust period. If Crusoe starts with a surplus of zero fish each week (that is, zero profit, an equilibrium rate of savings, or "the evenly rotating economy"), his nets (capital) will gradually decline, and he'll eventually go hungry.

Some other comments:

Crusoe now faces a 50% inflation rate - he must value each fish as two stones. As long as the monkeys contribute one stone for every fish, and there is only one pool (bank account) to add money to, Crusoe can account for their trickery. But if the monkeys are unpredictable, it will be impossible for Crusoe to set the proper savings rate.

In the real world, the originary interest rate reflects the average time preference of all savers. If someone starts monkeying around with the interest rates, it becomes impossible for investors (or the monkeys at the Fed) to know what the real rate of savings is even if they know how it is being manipulated. Even if the monkeys always add the same amount, they cannot contribute to everyone’s pool (bank account) equally.

That abandoned hut represents investments which exceed the ability of the actual savings rate to complete. The resources it takes to build compete with worthwhile investments (such as repairing one’s fishing nets) and raise the prices for all capital. Ridiculous dot-com business models and sky-high salaries during the dotcom boom, or sub-prime mortgages likewise compete with legitimate business models, salaries, and mortgages. When the money supply is manipulated, it is impossible to distinguish bad investments from good ones, so no one can escape the crunch.

Suppose Crusoe decides to ignore his hunger and work on his nets all Saturday. In other words, he trades current production (and therefore consumption) for higher future consumption (that is, economic growth). If he does so voluntarily, there's nothing wrong with that. But there's nothing inherently more desirable or efficient in spending some of one's time starving just to increase future production (that is, in valuing economic growth over present consumption.) Note that the longer Crusoe delays the shift back to production, the more severe the miss-allocation of resources (and his hunger) becomes. The monkey’s trickery does not actually make Crusoe to become a better saver – he is more likely to start saving less because of uncertainty over the future.

Edited August 27, 2007 by GreedyCapitalist

[softwareNerd]

I just got some comic books from the Fed. It's part of their PR campaign to teach kids about all the great things they do. GC's post made me think someone like Cox and Forkum could do a rival comic book with the monkey story!

[knast]

The boom and bust cycle is essentially created by inflation via credit expansion at the support and ecouragement of the government. For details read Human Action by Ludwig von Mises and Capitalism: A Treatise on Economics by George Reisman.

Or:

http://georgereisman.com/blog/2009/02/econ...es-capital.html

http://georgereisman.com/blog/2009/02/econ...capital_22.html