I'm going to explain here what causes the business cycle in the economy.
Many think that the economy just goes naturally up and down by happenstance, but that's not the case. It is actually caused by a series of of changes in the money supply, as well as consumer and investor decisions that are influenced by this.
There are several different schools of economic thought. I am a follower of the "Austrian" school.
I feel that it corresponds the most with reality, based on my own readings and life experience. Below I will explain what each view believes, and why I feel that what the Austrian school espouses applies here.
A general overview:
The three major schools that I will focus on here are the Keynesian, Monetarist (or Chicago), and Austrian schools. These are the most common schools of thought. There are others as well (such as Marxism) but I won't discuss those here.
I will give a very brief explanation as to the differences in each one, in order to distinguish them. Obviously, I could go further in depth, but I don't want to bore anyone!
Keynesian school:
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| John Maynard Keynes |
Keynes believed that the economy was driven by consumer spending, and that economic downturns were the result of a "drop in aggregate demand". In other words, people stopped consuming, which in turn slowed the economy down. Since businesses stop making money, they lay off workers, which in turn takes more spending out of the economy. More businesses lay people off, and the process continues on a massive scale. This ripples throughout the economy which then enters a downward spiral.
Keynes believed that the key to getting out of the recession was to have the government be the "spender and borrower of last resort", that's why you may hear certain newscasters say: "it's good for the government to run deficits during recessions." The idea being that the government borrows and spends money to hire workers and start projects, which they in turn go out and spend on other things, and get the economy going again.
Keynes attributed to the drop in spending and investment to be caused by "animal spirits" or a lack in confidence in the current situation.
Chicago (or Monetarist) school:
This school was founded in the late 1950's by the professors that taught at the University of Chicago in the economics department. This school of thought was made popular by Milton Friedman, who won a Nobel Prize in 1976.
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| Milton Friedman |
They were originally followers of Keynes, but they diverged from him on how to handle the money supply.
Keynes believed that downturns were caused by inadequate spending, which in of itself was caused by an insufficient money supply. Thus, the government was supposed to create more money which in turn would get spending going and revive the economy.
The Monetarists believed that the amount of money should rise in correlation with the level of output, in order to achieve "price stability". Friedman believed that the amount of money should grow by a fixed amount every year, say 3%. If money supply was increased too rapidly, this would create price inflation (rise in prices), if money supply was too slow, there would be a downturn (recession).
Their belief was that economic downturns was caused by a contraction in money supply: For example Friedman attributed the Great Depression to the major runs on the banks, and the Federal Reserve failing to do emergency lending to keep the banks afloat. The money supply contracted by 1/3, as people took the money out of banks, stuffed it in their mattresses, and it was pulled out of both circulation and investment. His belief was that if the Fed had reimbursed the banks, we might have had a mild recession for about two years or so, not a ten year long downturn. The money taken out of the economy had long term repercussions in his view.
The "Austrian" economist Murray Rothbard called Friedman "Keynesian light". I would say that's a good assessment!
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| Murray Rothbard |
Austrian school:
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| Carl Menger |
The "Austrian" school was founded by Carl Menger in the late 19th century. The name of the school came from Menger's home country where he started it, and it was continued by his successors (except for Rothbard, who was American) who were Austrian as well.
Menger took many lessons from the "classical" economists of the previous century, such as David Ricardo and Adam Smith. The classical economists placed more emphasis on savings and production as the means for economic growth rather than spending. Money's value is determined by what it can buy, not an arbitrary value set by governments. As production increases, that puts downward pressure on prices (relative to wages), which in turn leads to increased living standards. Money that is leftover from those price declines can then be saved/spent/invested elsewhere. That is how the economy grows.
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| Adam Smith |
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| David Ricardo |
The Austrian mantle was picked up by Ludwig von Mises and his student Friedrich Hayek in the Twentieth century. Mises predicted that the Soviet Union would collapse at its outset (but sadly, passed away before it happened.) Hayek won a Nobel Prize in 1974 for explaining how the Austrian theory caused the "Roaring Twenties" and the Great Depression that followed.
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| Ludwig von Mises |
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| Friedrich Hayek |
Ludwig von Mises and Hayek were liberals in the classical sense (what we would call "libertarians" today). The men believed in laissez faire economy, minimal government, and a sound dollar backed by gold.
Mises wrote his first book "The Theory of Money and Credit" which explained the origins of money, and what effect increases in the supply of money and credit had on the economy.
Murray Rothbard trained under both of these men, and continued their school of thought, albeit with some differences. (Since that is a somewhat lengthy discussion, I won't get into it here, but I will elaborate if anyone asks.)
Here is the crux of the Austrian theory:
Booms and busts in the economy are caused by an expansion of the money and credit supply. An expansion causes an inflationary "boom", a period of rapid expansion, production, and job creation. This is also called a "bubble" (This term is often applied to the rapid increases in asset prices such as stocks and real estate, followed by a collapse in prices).
However, this is short lived, since it's not built on a solid foundation: Money is invested in businesses that there aren't enough resources for, and businesses that there is no sustained demand for. Using their terms, the money is misinvested or "malinvested".
Think of the boom as the economy being artificially "high" (whether it be caffeine, alcohol, sugar, cocaine, or whatever analogy you want to use!).
The "bust" or recession, is the "liquidation period" (businesses are shut down, their assets sold off, workers are laid off, the materials used are resold, etc.). The businesses which don't have resources or demand for are shut down, and the resources can be deployed to more needed/desired uses.Think of the bust as the "energy crash", "withdrawal", or the "hangover" from the boom.
Now, this may sound counter intuitive, but using this economic theory, the booms are actually the bad part, and the recessions are the cure.
Mises, Rothbard, and Hayek believed in general "business fluctuations", that is some businesses periodically opening and closing at various times. Entrepreneurs are trained to forecast trends and consumer demands, but are also prone to mistakes like anyone else. And of course, there are always problems that can't be foreseen, such as a bad harvests, bad weather, shifts in consumer preferences, etc.
The question is, why do so many businesses across various sectors of the economy get their forecasts wrong in unison? This is called a "general cluster of business errors".
This sudden upswing followed by a major downturn can be attributed to changes in the money/credit supply. This is because of the role that the rate of interest plays in the economy.
What is the importance of interest?
One thing interest has been called is "the price of money". That's a fitting definition, since it is the fee that has to be paid back for borrowed money.
The "Austrians" believe that interest should be determined based on savings:
- The more money that is saved, the lower the interest rate. This reflects the fact that there are lots of loanable funds available.
- The less money that is saved, the higher the interest rate. This reflects that there isn't much money available, so if anyone wants to borrow money, they have to pay more for it.
Since we have a Federal Reserve that creates money out of thin air, and sets the interest rate arbitrarily, this leads to lots of malinvestments, hence the large booms (like the ones during the Clinton and Reagan years), followed by the major recessions (the early 90's, the early 2000's, 2008 onward).
Interest rates have been at 0% for the last 7 years with almost no saving... That's bound to causes some malinvestments, no?
What's wrong with printing money and spending it to get the economy going?
The new money is inflationary:
The money is loaned to businesspeople at a low rate of interest, who invest in new construction, housing, and businesses.
Booms and busts see the greatest effect in the "capital goods" sectors, that is sectors that supply raw materials and equipment used in other industries such as mining, construction, steel manufacturing, lumber, etc. These industries expand the most during the boom, and contract the most during the bust.
Consumer goods and capital goods usually run in opposite directions price wise, For example: if lots of businesses start acquiring lumber for construction, this will drive up the cost of wood for building (capital good). However, once the wood is converted into planks for housing, the prices of houses (consumer good) will go down since the work is completed and the finished goods are available. If construction stops, the price of lumber to build will go down, but the existing houses will go up since the supply of consumer goods isn't being increased in spite of demand.
The problem is that all the money is mistaken for real loanable funds. This fools investors into thinking that if money is being loaned out, adequate money is being saved, and that means there is a demand for their businesses. But in reality, the only thing driving the boom is the money itself.
The savings aren't available, and the increased consumption drives up the prices of consumer goods. The Federal Reserve (or whatever central bank is in charge of the money supply) then typically raises interest rates in order to stave off massive price inflation in the consumer goods sectors.
(Increased spending on consumption+fixed supply of goods= price increases).
Since the money can't be paid back, (There isn't enough consumption to sustain the businesses because the increased spending drives up prices making it harder to consume at a sustainable rate. Or in the case of the "Housing Bubble" in the 2000's, the house prices kept going up and up as more and more were being bought, but income wasn't: Thus the money that was borrowed to get the houses couldn't get paid back.) and it becomes apparent that the resources needed for the businesses aren't available, the boom becomes a bust as the interest rates rise.
The economy then should go through a liquidation period in order to restore itself to sound footing. The bust (like a hangover or withdrawal) is painful, but necessary for long term prosperity.
The problem is that politicians want to be in charge when the boom is occurring, because it looks like their policies are working, and they can take credit for (what seems) to be a strong economy. A la, Bill Clinton and the 22.5 million jobs that were created during his presidency.
Yet, nobody wants to be in charge when the bust occurs, since they will be blamed for it. Clinton timed it right: The boom started in the early 90's and we hit recession in the early 2000's.. Since he was leaving office as it hit, he wasn't blamed for it. Some people have attributed the lousy economy in the early 2000's to 9/11, but as far as I can tell, it didn't play a major role.
How do we eliminate, or at least minimize the boom/bust cycle?
Eliminating the Federal Reserve overnight would cause serious problems, so I would suggest some compromises under the current system, at least until an alternative solution can be acheived.
For one thing, interest rates have to reflect actual savings. Since the average American isn't saving much right now, interest rates set by the Fed should be much higher. I don't have an exact number in mind, but most likely it would be in the double digits.
This would certainly cause some initial pain.. Many businesses will go under, and many people will be laid off. However, the economy needs this is in order to restructure itself to a point where it can grow at a sustained rate. Prices and wages will both have to fall in order to reflect actual supply and demand.
Under the system that I (and the Austrian economists) would like, the economy would most likely grow at a slower, but sustainable rate. There wouldn't be tens of millions of jobs created over a decade, but there also wouldn't be a dramatic downturn like in 2008 or 1929.
Some other ideas:
- The Federal Reserve should wind back its balance sheet (the money it has printed and is holding in reserve), which went from $500 billion in the early 2000's to $4 trillion today. This does nothing but inflate bubbles. For those that believe the Fed is necessary for economic growth, let me point this out:
The American economy grew the most between 1870 and 1914. The Fed was signed into law in December 1913.
- I'm not sure that we can go back to a gold backed dollar right away, but we need at very least responsible management at the Fed. Money should retain it's value.. Real wealth comes from production, not the printing press. This would also at least stabilize, and ultimately lower prices which would be great all around, especially for the poorest citizens.
- Taxes and spending should be cut across the board. Money left in the hands of the people that earn it will grow the economy better than government ever could.
- Entitlements (Social Security, Medicare, Medicaid) have to be dramatically overhauled. Wealthier citizens most likely wouldn't receive them, and moderate earners would receive lower amounts than low income people.
- I would like to see many occupational license requirements repealed. This does nothing but entrench already existing businesses, and make it harder for a person to get off their feet and become financially independent. There was a poor African woman that was threatened with legal action for braiding hair without a license. The license was too expensive for her, and without it, what could she do instead? The economy isn't that good, so it's hard to find a job. This would increase the chances of her going on welfare, or turning to crime. I don't know about anyone else, but I would rather see some bad weaves, rather than someone turn to crime or assistance. (Assistance is acceptable in my view as an absolute last resort, but it would be great if we could eliminate the need for it entirely.)
Conclusion:
That's all for now. Any comments, constructive criticsm, concerns, or feedback is appreciated.
Thank you all for reading! I will write more soon!
-STK
