Business Cycles for Dummies

This is my attempt to explain business cycles in the simplest way possible, so that even a three-year old could understand (possibly a precocious three-year old who can read and is interested in economics for some reason).

Interest rates are a price in a market economy. When you go to get a loan from a bank or a private individual, the interest rate is the fee charged to lend you money now that you will return at some point in the future. Let’s say I’m an individual that decides to loan out $1,000.00 right now. According to the fact of time preference, all individuals prefer a given satisfaction sooner rather than later. Because of this universal truth, if I choose to loan out $1,000.00 now, I need to expect more than $1,000.00 back in the future; otherwise there is no reason for me to make the loan. So the premium charged on top of the $1,000.00 I want back is the interest rate. In other words, the interest rate is the price of money being loaned out with respect to the time that it will take for it to be returned.
In a free market economy, interest rates are set as all other prices are: through supply and demand. In the case of the interest rate, the supply and demand relevant are the supply and demand of loanable funds, i.e., funds that can be loaned. Think of the supply of funds as savings and the demand for funds as investment. At the equilibrium interest rate (equilibrium price), savings will equal investment.

Three points of importance before we move on:

1) In a market economy, money represents real goods. When we discuss $1,000.00 being loaned out, we are talking about $1,000.00 in real goods essentially being given to a certain person (Right? Because a person will use $1,000 to purchase actual goods).

2) Consumers have two choices: to consume now or save in order to consume more in the future. Thus increased savings means consumers in general value consuming in the future more than consuming in the present (this is consistent with time preference if they believe they will receive more satisfaction in the future. Don’t worry about this too much if it confuses you). And vice versa.

3) Increased investment means companies will put more of their resources in longer production processes aimed at increasing production in the future, versus increasing production in the present. As Tom Woods explains in Meltdown, “From a business’s perspective, low interest rates provide an opportunity to engage in long-term projects that would not pay off under higher interest rates. Businesses respond to the lower rates by taking the opportunity to engage in long-term projects aimed at increasing their productive capacity in the future – e.g., expanding existing facilities, building a new physical plant or acquiring new capital equipment.”

So let’s say savings decrease. Funds that can be loaned are scarcer (always thought this was ‘more scarce,’ but it’s actually ‘scarcer’) than before. Therefore, the price of loanable funds, the interest rate, will rise. Investment will correspond; as it becomes harder to get loans, investment will decrease as well. Note how here, firm behavior and consumer behavior matches: consumers decrease savings because they want to consume more in the present, and businesses decrease investment and focus more on producing in the present.

Now let’s say savings increase. Funds that can be loaned are more abundant than before. In this case, the interest rate will fall. As it becomes easier to get loans, investment will increase as well. Again, note how firm behavior and consumer behavior matches: consumers increase savings because they want to consume more in the future and businesses increase investment and focus more on producing goods for the future.

Now to the heart of the matter. This correspondence of consumer behavior and firm behavior can only occur if the interest rate is allowed to change as savings go up and down. If the Federal Reserve were to alter the interest rate from what it would have been on the free market, as it actually does, firm behavior and consumer behavior will not match and serious distortions in the market will occur. These distortions are the business cycle.

The Federal Reserve along with the institution of fractional reserve banking have the ability to increase the money supply through credit expansion. Credit expansion is the increase of the money supply, essentially the printing of dollar bills, through the banking system. After creation, this money is loaned out to businesses.

When the money supply is increased through credit markets, the supply of loanable funds is increased as well. Because banks have more money to loan out, the interest rate is lowered. However, remember point 1 from before. Money is supposed to represent real goods in an economy. But because the apparent supply of loanable funds has increased without real savings increasing, firms believe there is more real savings than actually exist; they believe there is more real, tangible equipment than actually exist. The mismatch here is that firms decide to produce more in the future while consumers have not changed their desires at all. This leads to a misallocation of resources as firms invest in longer production processes while the real goods necessary to do so do not exist and consumers do not actually want many of these future goods.

This time period is called the boom phase, when, spurred by low interest rates, individuals borrow more than they would under free market interest rates. Businesses invest in long-term projects that would not be profitable under higher interest rates, and consumers take out loans to buy goods such as houses and cars. In fact, not only do lower interest rates encourage consumers to take out loans, but they discourage savings because consumers are paid at a lower rate for saving (because remember, the interest rate is the price of borrowing, and if this price is lowered, it decreases the incentive for someone to save and then lend out those savings).

But because consumers do not want these future goods, they do not save in order to consume these goods in the future; in other words, consumers will not have the money to spend on consumption in the future that firms believe they will, so these investment projects the firms have taken on will eventually and inevitably fail, leading to the bust phase of the business cycle.

The central bank can prolong the boom phase by continually increasing the supply of money, but it must do so at a faster and faster rate. We can conclude from this that there are really only two options: 1) hyperinflation, or 2) allowing the bust to take place.

In order for the bust phase to end, the malinvestments (incorrect investments made by firms) must be corrected. This can only occur if the interest rate is allowed to return to the free-market rate. That’s why any further inflation (mentioned in the paragraph above) will only prolong the problems inherent in an economy with a tampered interest rate. If the boom phase is present, it can be prolonged with more inflation. If the bust phase is present, it can be prolonged with more inflation, and with sufficient inflation it can even lead to a temporary upswing. But in each of these situations, the actual cause of the problem isn’t fixed and therefore a period of fixing the malinvestments is inevitable and necessary.

To be fair, I don’t think any three-year old is going to understand this, but hopefully this is presented in a much less complicated fashion than before. In fact, some of this is actually oversimplified (on purpose), as any avid reader of Austrian economics will likely notice (stating this as a disclaimer).


Posted on August 22, 2012, in Economics and tagged , , , , , , , , . Bookmark the permalink. 2 Comments.

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