The Foundation for Economic Education is out with a new short video. It’s simple and easy to understand and I recommend watching it if you’ve ever wondered why business cycles occur.
This is one of the major reasons I started this blog 2 years ago: to explain business cycle theory.
I’ve made a few attempts at making this as simple as possible:
If you want a slightly more elaborated version of the video, feel free to check out Business Cycles for Dummies. The other two links don’t give as full an explanation of it, but they will help see how the process occurs more clearly. If you have any questions, feel free to ask them as well, I’d be glad to help in any way if I can.
I’m doing a marketing internship for a startup this summer and my boss sent me an article about the “lean startup”; this is an idea I heard about before but had no real interaction with until now. The lean startup is essentially a new methodology for starting businesses. It emphasizes testing hypotheses and responding to customer feedback with iteration and pivoting over the older methodology of forming a long-term business plan with “elaborative design” and “intuition,” as Steve Blank puts it in his article, “Why the Lean Start-up Changes Everything.”
I find the methodology very appealing. Attempting to make long term predictions about human choice among many different products appears absurd to me. Even with all the flaws in empirical testing to confirm hypotheses, the lean startup seems like a better method to use in the field of business (but not economics, as I explain in this article about the minimum wage).
However, I disagree with one point Blank makes in his article, a point made often elsewhere in articles about the lean startup. It is his belief that the introduction and spread of this startup methodology will have “profound economic consequences.”
A lower start-up failure rate could have profound economic consequences. Today the forces of disruption, globalization, and regulation are buffeting the economies of every country. Established industries are rapidly shedding jobs, many of which will never return. Employment growth in the 21st century will have to come from new ventures, so we all have vested interest in fostering an environment that helps them succeed, grow, and hire more workers. The creation of an innovation economy that’s driven by the rapid expansion of start-ups has never been more imperative.
Lean start-up techniques were initially designed to create fast-growing tech ventures. But I believe the concepts are equally valid for creating the Main Street small businesses that make up the bulk of the economy. If the entire universe of small business embraced them, I strongly suspect it would increase growth and efficiency, and have a direct and immediate impact on GDP and employment.
In this post, I’m going to focus on explaining my disagreement rather than trying to prove that it is correct. My view is based on Austrian economic theory, particularly Austrian business cycle theory, which I have set out in more detail elsewhere. I will explain the basics here (feel free to skip to part 5 if you already understand Austrian economics).
1) The concept of demonstrated preference:
Mises stated that individual humans act purposefully, choosing means to attain their chosen ends. The ability of humans to choose, means that humans have preferences. They prefer, and therefore choose, one end over another, and again prefer, and therefore choose, one set of means over another. When two individuals exchange with each other, each individual is showing that he prefers one good over the other. When Jim trades his house for Simon’s 300,000 dollars, Jim is demonstrating that he prefers $300,000 over his house, and Simon is demonstrating that he prefers the house over his $300,000. This is called demonstrated preference. Every time individuals act, they demonstrate a preference, just as displayed by the exchange between Jim and Simon.
2) Prices are predicated on demonstrated preferences:
As persons exchange, prices are formed. The price of the house in the previous exchange was 300,000. Likewise, we could say the price of a dollar was 1/300,000th of a house. As multiple men make exchanges among the same goods (houses and dollars), market prices are formed. Even most people who have never had an actual economics course have heard of supply and demand. But often they don’t understand the basis for supply and demand.
Supply and demand curves are just a graphical representation of a group of people’s real preferences. So maybe person A would be willing to buy 1 house at a price of 330,000, and 2 houses at a price of 300,0000. Maybe person B would be willing to buy 1 house only if the price was 300,000. And so on. These preferences added together would form the demand curve, stating how many houses (quantity on the x-axis) people together would demand at such and such prices (on the y-axis). The same thing would occur for the supply curve, being the preferences of sellers added together. In other words, it would state how many houses (quantity on the x-axis) people together would be willing to supply at such and such prices (on the y-axis).
3) The importance of the market clearing price:
Where the demand and supply curves meet and intersect is known as the market-clearing price. At this price, all buyers’ (“demanders”) and sellers’ (“suppliers”) preferences are satisfied. At any other price, there would either be more people wanting to buy than people wanting to sell, or vice versa. In other words, there would be a deficit of goods if the price was lower than the market clearing price or a surplus if the price was higher than the market clearing price. What brings it toward the market clearing price if exchanges occur at some other price? Arbitrage: the profitable reselling of goods (this isn’t that important for this post so if you don’t completely understand arbitrage, don’t worry about it).
4) Prices function as signals:
As we said before, prices change based on preferences, but there a number of other reasons that are derivative from preferences. For example, scarcity affects prices as well (through people’s preferences). If a good becomes more scarce, (people will value the remaining units more and) its price will go up. Considering this, prices are invaluable signals to individuals participating in the economy. For example, if a piece of machinery that a producer buys to make a product becomes more scarce and goes up in price, it is a signal to producers that they must use it more sparingly. Fewer can buy it now that its price is higher and marginal producers (those who barely profited from it before the price change) are driven out of the market as they now earn losses.
5) The government manipulates the interest rate, an invaluable price in a market economy:
When the government (and fractional reserve banking) prints money, it essentially increases the supply of loans (because they distribute this new money through the banking system by giving it out as loans), lowering the interest rate (for simplicity’s sake, the price of loans) below its free market level. This causes the business cycle. The interest rate like all prices is a signal. It represents the time preferences of individuals. If individuals want to consume more now and consume less in the future, they spend more and save less, and therefore lower the amount of money that they can loan out. By decreasing supply, this increases the interest rate. Likewise, if consumers want to consume less now and consume more in the future, they spend less and save more, and therefore increase the amount of money they can loan out. By increasing supply, this decreases the interest rate.
What happens when the government manipulates the interest rate? An exposition of complete Austrian business cycle theory goes beyond this post, but again, you can check that out here. Essentially though, now the manipulated interest rate functions as a bad signal. It does not represent the real preferences of individuals in the economy. If the interest rate is lower than what it would have been otherwise, it appears as if consumers are saving more (look at the last paragraph) when they really are not. Since the rate is cheaper, businesses can borrow more money to buy more capital goods (such as machinery; see the example in #4) to produce more goods for the future. But consumers don’t really want more goods in the future. They are spending on goods now and not saving enough money to buy those goods. As such, businesses invest in the wrong goods and start producing the wrong goods to sell at the wrong times.
Therefore, if the government does not allow price signals to work, it doesn’t matter what methodology businesses are using. They will not be able to improve the situation. If a signal is a bad signal, it doesn’t matter whether businesses are checking with it more often (as they do in the lean startup) or less often (as they do in the traditional startup methodology). In fact, if they are checking the bad signal more often, maybe they’ll make worse decisions and make the economy worse! (I say this somewhat jokingly, but certainly the reasoning is plausible)
What has to go are the structural impediments, the intervention in the economy by the government. That’s the only way the economy can recover. Then the lean startup methodology will be able to increase standards of living if it indeed is a better way of responding to consumer’s desires. But as long as the interest rate, the price representing the time preferences of individuals, is skewed, increasing the response rate to this incorrect signal will either have no effect, or at worst, be deleterious.
Two things I want to clarify about this post.
1) The word “fix” in the title might be the wrong word to use. The people I am responding to are not necessarily saying that this startup methodology will fix the economy, but they are saying it will have a noticeable effect on GDP and employment. The difference between that and fixing the economy is only one of degree. Regardless, I am disagreeing with that. I do not think it will have a significant impact in the current situation. If the structural impediments are removed, I do think it could have a significant impact on standards of living (and a common attempted measure of standards of living, GDP) and perhaps even employment, if producers are making less mistakes in judging what consumers desire.
2) A person might wonder why the interest rate is such an important signal. They might say, for example: Surely, if the price of potato chips is the price the government is manipulating, would it really have a huge impact on startups who are trying to sell different goods? Why is the interest rate any different? The reason the interest rate is so important is that it represents the time preferences of individuals. As such, any consumer decision made over time is relevant to producer decisions regarding the interest rate. If the interest rate is altered from what it should be, producer responses to supposed consumer preferences over time are now flawed. In addition, any signals correlated with the interest rate signal are flawed as well. So if a startup is looking at a slightly changed good that consumers want relative to the good they were producing, even if they’re not looking at the interest rate itself, this is still a flawed signal. As long as the consumer decision they are responding to is a decision with respect to time, the signal is flawed. There can be, of course, decisions made irrespective of time, such as if one product would never be desired, no matter what the period. But so many decisions depend on time or compare different goods with each other (often with a different period of production to make good 1 compared to good 2), more frequent producer responses to decisions irrespective of time would not have a very significant impact on GDP and employment.
One of the prime features of the free market is that you only have to know that the price does change, but not necessarily the reasons for it.
Money prices are the medium through which the communication of necessary information is made to coordinate effectively the actions of individual planners. As Hayek has pointed out, each particular decision maker does not need to know all the facts pertaining to the changes in resource usage. What is relevant to each is “how much more or less urgently wanted are the alternative things he produces or uses.”  The economic question is always a question of the relative importance of specific things available for the satisfaction of human wants. Each planner does not usually need to know why the relative importance of the things that he uses or produces has changed. What he does need is some indication of the extent to which its relative importance has been altered.
The coordinating function performed by the price system can be illustrated by assuming a sudden shortage of some resource. Those people who will eventually solve the problem of the shortage do not need to understand its cause. The price of a unit of the resource will be driven upward as those who employ it in the most important usages, i.e., use it for the generation of products promising the highest return, outbid those producers who plan to use it in less remunerative products. The shortage has meant that the marginal uses of the resources that could be supplied before the advent of the shortage cannot be provided for as long as the shortage persists. The higher price successfully causes the curtailment of the employment of the resource in its marginal uses. (Thomas C. Taylor, An Introduction to Austrian Economics, 35-36)
…the marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction….I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. (F.A. Hayek, “The Use of Knowledge in Society,” p. 87)
When that occurs with credit expansion (the reason) changing the interest rate (the price change), knowledge of the reason would allow an entrepreneur to make proper investments. The fact that he does not know how much of the lowering in the interest rate is due to credit expansion and how much is due to real increased savings is the reason the business cycle must take place. An invaluable market signal tampered with by government intervention loses its prime quality as a signal.
We have just seen that there are two factors that tend to hold down the rate of interest below the level sufficient to allow for the related elements emerging on the market: (1) The implementation of the price premium lags behind the changes in purchasing power stemming from the inflation; and (2) the additional supply of money thrown onto the market has a dampening effect on the interest rate. Concerning the latter point, it must be realized that entrepreneur-producers are unable to differentiate between additional funds that have been artificially created and additional funds emanating from real savings. (Taylor, 93) [my emphasis]
To blame the entrepeneur for not being able to understand the signal misses the point and misunderstands the esteem Austrians hold entrepreneurs with.
Tom Woods sums up this type of thinking very eloquently:
“If the free market is so great, why can’t it operate without the free market?”
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).
Here, we will define inflation as an increase in the supply of money rather than an increase in the price level. The latter is done generally by modern mainstream economists. However, the former is the fundamental causal factor that leads to the latter effect as well as to a number of other harmful effects. This distinction may not seem very important at first, but it is necessary to isolate causal factors to properly explain how the economy works. (This will be demonstrated further below)
When the supply of a good is increased, its price goes down. The same phenomenon occurs with money. As the supply of money is increased, its price, i.e., its purchasing power, declines. Thus, ceteris paribus, other prices increase. The ceteris paribus condition is very important. It is possible in a productive economy for prices to stay the same or even decrease as the money supply is massively increased. This is because the productivity of the economy is increasing at an equivalent or faster rate, therefore neutralizing the increase in the money supply. A good example of this was the 1920s, where the money supply was increased throughout the decade, but prices stayed stable. This is because productivity increased as well and thus the price level stayed approximately constant.
To explain what I was saying previously, an economist without knowledge of causal relationships would look at the 1920’s and see no price inflation. They then would assume that because of the relative price stability, inflation could not be a possible factor in leading to the stock market crash of 1929. The logic would be as follows: if a variable stays constant, how can it be the causal factor of a certain effect? Sounds like a silly mistake, but yes, that’s how most economists think (with exception to the Austrian school).
So the first effect of inflation we have expounded are increases in prices. Why is this a bad thing? Price inflation, ceteris paribus, means a lower standard of living.
However, prices do not all rise proportionately to an increase in the money supply. This leads us to our second point, Cantillon effects. When the money supply is increased, the individuals who get the money first have the ability to spend it first. The goods and services they spend it on rise in price because of the additional demand for these products. However, the individuals who receive the money last end up spending the money after prices have already risen. Thus the individuals who received the money first gain at the expense of the individuals who receive the money last. This leads to large amounts of inequality in the population.
So, in the United States, when the money supply is increased, who gains and who loses? Money is created by the Federal Reserve and the fractional reserve banking system. The Fed buys bonds in the creation of money. Therefore, the federal government is the first beneficiary of the newly-created money. Logically, the things it spends on tend to rise in price before others can take advantage of the money. Unsurprisingly, many of the things the federal government spends on have risen in price exponentially, such as housing (before the housing collapse of 2008), education, and health-care. Increases in the money supply are also created through the fractional reserve banking system. Since fractional reserve banks only have to keep a fraction of the money they owe, money that is given to them to hold is multiplied. For example, with 10% required reserves, if $100.00 is given to a bank, the bank can use all $100.00 as reserves and create $900.00 to loan out to others (assets will equal liabilities here, assets = $100.00 vault cash + $900.00 loan, liabilities = $100.00 in first individual’s checking account and $900.00 in new individual’s checking account). When money is created in this fashion, the newly-created money is loaned out, generally to individuals who are using the money to invest. Many of these beneficiaries happen to be on Wall Street.
The poor suffer higher prices while the already-rich gain at the poor’s expense. The left commonly makes the argument that we have to raise taxes in order to combat inequality. But a far more effective and morally superior way would be to just stop the money printing. That way, wealthy individuals who earn their fortunes voluntarily by selling products that consumers desire would not be affected; however, wealthy individuals who gain through the creation of money will no longer possess their unfair advantage.
The third effect of monetary inflation we’ll discuss is the business cycle. I will not go into the fine details here (that would add quite a bit to an already-lengthy entry), but I’ll save that for a future post and instead outline the basics.
Interest rates are a price: the price of money with respect to time. On a free market, an increase in the supply of funds that can be loaned, i.e., savings, would be associated with a decline in the interest rate. Increased savings would reflect the preference of individuals to consume in the future rather than consume in the present. So naturally, a lower interest rate would be consistent with this desire: firms would be able to borrow more with lower interest rates and invest in the higher orders of production (capital equipment)which lead to more goods in the future rather than in the present. Here the desire of firms and the desires of consumers match. Consumers want to consume more in the future and because of the lower interest rate brought on by increased savings, firms want to produce more in the future.
When money is artificially created through the banking system, there is more money that can be loaned, and the interest rate is lowered. This makes it seem as if there is a larger supply of savings, but savings have not actually increased. A mismatch has been introduced: firms want to produce more in the future while consumers do not want to consume more in the future (relative to their previous preferences). Investors are misled into believing previously unprofitable activities are now profitable because of the lower interest rate and tend to invest more heavily in the higher orders of production. This is the boom period. Everyone is happy, stock prices are rising, and consumers are spending themselves into debt because of the lower interest rates.
But the malinvestments are eventually realized. Persistent inflation can prop up the malinvestments for a period of time, but eventually interest rates will rise and activities profitable under lower interest rates will become unprofitable again. These malinvestments will have to be cleared for the economy to recover. Any more inflation will just create more malinvestments and delay the process.
Notice how this theory, called Austrian business cycle theory, is consistent with Say’s Law. The malinvestments refer to a misallocation in resources. There is no general overproduction, but rather overproduction in some areas (higher orders of production) and underproduction in other areas (lower orders of production). Students learn in Econ 101 that price controls have malevolent effects in creating shortages and surpluses, but what they don’t learn is that the interest rate is a price, a price affecting the whole economy. And a price control, through the artificial toy of monetary inflation, on a price affecting the whole economy has consequences far worse.
J.B. Say was a 19th century French economist whose work was mostly ignored by mainstream economists other than for one minor aspect of his economic theory that came to be known as “Say’s Law.”
Say’s Law states that the demand for a good is made up of the production of other goods. This can be clearly demonstrated by an imaginary barter economy. Suppose there are only two goods, fish and potatoes. If an individual wants to buy a fish, he must exchange a potato for the fish. He could not buy the fish without first producing the potato. Thus, the production of the potato is what constitutes the demand for the fish. And vice versa. The production of the fish is what constitutes the demand for the potato. Now, if the individual who wanted the fish did not produce a potato to use in exchange first, there would be no economic demand. All he would have is desire. But desire is only one part of demand, the other being the ability to actually buy the product. And this ability only comes with production.
In a large economy, the production of a larger amount of goods will make up the demand for the fish. And in a money economy, money only being a medium of exchange, producers will exchange their products for money and then exchange money for the fish. The only difference is that there is an intermediate step.
Why has an economic law so simplistic attracted so much attention? Rothbard explains:
Say’s law is simple and almost truistic and self-evident, and it is hard to escape the conviction that it has stirred up a series of storms only because of its obvious political implications and consequences. Essentially Say’s law is a stern and proper response to the various economic ignoramuses as well as self-seekers who, in every economic recession or crisis, begin to complain loudly about the terrible problem of general ‘overproduction’ or, in the common language of Say’s day, a ‘general glut’ of goods on the market. ‘Overproduction’ means production in excess of consumption: that is, production is too great in general compared to consumption, and hence products cannot be sold in the market. If production is too large in relation to consumption, then obviously this is a problem of what is now called ‘market failure’, a failure which must be compensated by the intervention of government. Intervention would have to take one or both of the following forms: reduce production, or artificially stimulate consumption.
This underconsumptionist theory is what Keynesians believe causes the business cycle. But as Rothbard explained, the underconsumptionist belief far predated John Maynard Keynes.
If Say’s Law is true, there cannot be a general overproduction (the flip side of underconsumption) of goods on the free market. However, there can be overproduction in one area and underproduction in another, a misallocation of goods. This insight will help us understand what really causes business cycles, which will be explained in a future post.