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).

Say’s Law, Part 1: Exposition

J.B. Say was a 19^th 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.

Time Preference A Day After Thanksgiving

I can’t connect Thanksgiving and economics quite as easily as Gary North can without copying others’ ideas so I’m going to stretch this one 🙂

Time itself is a scarce good that must be economized — that is, an individual must choose to act with his highest values respective of the amount of time it takes to act. All other things equal, any good will be preferred sooner rather than later. This is the universal fact of time preference.

Immediate counter-examples may be brought up: some people prefer ice cream during the summer over ice cream in the winter. Since it is November right now, doesn’t that invalidate time preference? After all, I would prefer the good, in this case, ice cream, later (during summer) rather than sooner (during winter).

This type of argument confuses the concept of a “good” with its physical properties. The good, ice cream during summer, is actually a different good than the good, ice cream during winter. In this case, ice cream over summer has so much more value over ice cream over winter that a person will choose to wait till summer rather than having it sooner or immediately.We can think about this differently by replacing the word “good” with the word “satisfaction”. A person will prefer to have any given satisfaction sooner rather than later. In this case, the satisfactions are different; hence, they are not the same good.

Another example that may be brought up is preferring to wait until next year’s Thanksgiving rather than celebrating it today, the day after Thanksgiving (this example works much better with birthdays but bare with me). If I had to choose, I wouldn’t pick to celebrate Thanksgiving two days in a row and then be “forced”(obviously we could celebrate two days in a row and still celebrate next year’s Thanksgiving but we are assuming one or the other must be picked) to skip the next year’s Thanksgiving. I would rather celebrate Thanksgiving on the actual day rather than having it sooner.

This argument also confuses the concept of a good, but it also confuses the concept of timing with the concept of time preference (we can apply this to the previous argument as well). The timing of Thanksgiving plays a role in how much it is valued: a person generally will value any holiday on its actual date (its timing) rather than celebrating it sometime earlier on a different date. Time preference still holds in that, if a person could truly have the good Thanksgiving (with its timing on Thanksgiving) sooner rather than later, he would, but it is impossible.

As we can see, time preference is not a concept that can be denied (much like the “fact” of heterogeneous subjective values during exchange). However, instead we may compare different levels of time preference: low time preference versus high time preference. Just like subjective values, we cannot put a number on time preference: for example, we cannot say that Mary has 7 time preference and Bill has 5.4 time preference. However, we can say Bill has a low time preference and Mary has a high time preference and we can compare their time preferences by saying Bill’s time preference is lower. So if Bill was willing to wait a day to receive satisfaction from eating an apple, whereas Mary was only willing to wait 10 minutes to receive the same satisfaction from eating an apple, we could say Bill has a lower time preference than Mary.

Note: There is an inherent problem in comparing time preferences because we do not know if Bill and Mary have equal satisfactions or if their satisfactions received from eating the apples are different so it would be truly difficult to compare their time preferences. We have ignored this problem for simplification purposes.

Also if anyone is interested in learning praxeology, you can check out praxgirl on YouTube.

It may be tough to follow and completely comprehend each lesson in one watching, so if you have to watch it multiple times to understand some of the concepts, don’t be frustrated. For more serious learners of economics, I would recommend buying a copy of Man, Economy, and State with Power and Market by Murray N. Rothbard. (there are free pdf and audio links in that link as well).

Why Herman Cain’s 9-9-9 Plan is Actually 9-9-9-9-9

Ask Herman Cain a question about economics and you’re bound to get an answer containing the phrase “9-9-9”.

Or various forms of “I don’t know” but I think that’s mainly for foreign policy and sexual harassment allegations.

Unfortunately for Herman Cain, 9-9-9 is actually a complete lie. Nevermind the fact Cain likes to deny that relatively poor people will have to pay much more in taxes than before if his tax code is actually revenue neutral, but there are actually two more 9’s in his plan that he conveniently forgets to mention. The first is unique to Herman Cain, and the second is a tax all politicians like to overlook.

Peter Schiff exposes the 4th 9 by pointing out Cain’s “plan eliminates the deductibility of wages and salaries from corporate income.” The effect this produces is a brand new 9% payroll tax. To explain this more clearly, Cain’s plan eliminates the entire tax code and replaces it with a 9% personal income tax, 9% sales tax, and 9% corporate tax. However, by eliminating the deductability of wages and salaries from corporate income, an additional 9% payroll tax is created, because corporations will essentially pass on this tax to the wages of wage earners.

For example, take our current payroll taxes for Social Security and Medicare. A common belief is that the employee pays half of these payroll taxes and the employer pays the other half. But the actual truth is that 100% comes out of the employee’s income. The half that the employer pays also simply comes out of the employee’s wage because the employer will now pay the employee a lower wage to make up for the fact that he/she now needs to pay a payroll tax. The same effect is produced by eliminating the deductability of wages/salaries from the corporate income tax (corporations will lower wages by whatever amount they have to pay in additional taxes because of the elimination of wage deductability).

As for the 5th 9:

Notice Ron Paul and Rick Santorum (probably because of Paul’s reaction) snickering when Cain gives his answer. I think it would be safe to say we would have an additional 9% inflation tax if Cain was in office. Greenspan blew up two of the biggest bubbles in our history, the dotcom bubble and the housing bubble. Actually, 9% is probably an understatement, I think it’d be more responsible to call it something like 9-9-9-9-20 (perhaps still understating).

More on the Minimum Wage and Obama’s attempted Christmas tree tax

I should think if I make a post on the minimum wage, I should acknowledge the most common argument for it. It’s not that the minimum wage can’t raise wages, but rather that it generally can’t do so without causing unemployment.

In a free and open market, wages tend toward the workers’ respective MRPs (what they contribute). If a worker’s wage is less than their MRP, that means their employer is receiving a profit; these profits invite more firms in until the profits are non-existent. Therefore profits tend toward zero while wages tend toward MRP.

Obviously though, there is a possibility that a worker’s wage will be lower than their MRP. If the government institutes a minimum wage of 7 dollars, for example, there are people whose wages can be raised, perhaps if they’re earning $6.50 while being able to produce $7.50. Meanwhile though, all workers unable to produce $7.00 will be unemployed.

The problem with the minimum wage is that, in addition to unemploying these specific workers, is that it will reduce the previously mentioned tendency of wages tending toward MRP. This is because the minimum wage is a harmful regulation. Businesses will be unable to hire specific people that would help contribute to a successful business. By mandating that employers must pay all employees a certain amount, certain employees will be not be hire-able. New businesses will have tougher start-ups, and therefore the tendency for wages to equal MRP will be diminished. I call this the interventionist paradox. An imposition of the minimum wage is created (supposedly) to raise wages, but ends up causing unemployment and lower wages.

Anyway, found this hilarious post over at the EPJ about the Agricultural Department trying to institute a 15-cent charge on Christmas trees. Apparently the reason for the tax is to run a ““program of promotion, research, evaluation, and information designed to strengthen the Christmas tree industry’s position in the marketplace; maintain and expend existing markets for Christmas trees; and to carry out programs, plans, and projects designed to provide maximum benefits to the Christmas tree industry” (7 CFR 1214.46(n)).  And the program of “information” is to include efforts to “enhance the image of Christmas trees and the Christmas tree industry in the United States””. It’s apparently now being delayed, but it’s hilarious nevertheless.

The Minimum Wage

Funny how I go super in-depth about subjective valuation when I’m mainly going to focus on the monetary aspects of it (as people generally do when they think about wealth) in this post, but there was a point to be made. I’ll repeat the basic argument over again and tie it with the minimum wage  now.

Suppose there are two people, David with an apple and Helen with an orange. If the two decide to exchange their respective fruits, both will benefit. David will decide to exchange only if he subjectively values the orange over the apple; likewise, Helen will decide to exchange only if she subjectively values the apple over the orange. Through heterogeneous subjective valuation and peaceful cooperation, an exchange is mutually beneficial: Helen and David are both wealthier as a result.

Therefore, any law created by government that stops this exchange from occurring necessarily makes the two poorer: they will be less wealthy than they would have been had the exchange took place. Likewise, a worker deciding to work for a wage for an entrepreneur is also making a mutually beneficial exchange. A worker will choose to work only if he values the utility of the wage over the disutility of the work. The entrepreneur will choose to hire only if he values the utility of the worker’s work over the disutility of paying the wage.

As said before, any law that stops a mutually beneficial exchange from taking place necessarily makes the two actors less wealthy. This is why the minimum wage should be viewed not as a floor holding wages up but rather as a bar needed to be jumped over. Suppose the minimum wage is $7.00. If Mark is a worker who only produces $6.00, he cannot find a job. Any entrepreneur that hires must either incur losses of $1.00 per hour or choose not to hire Mark. In essence, an entrepreneur must be willing to donate to charity. Because an exchange has not taken place, both Mark and the entrepreneur are less wealthy. In addition, the consumer is less wealthy because he cannot benefit from Mark’s work.

To say that the minimum wage is a floor pushing up wages and then asking for a lower minimum wage for teens and the mentally challenged is completely hypocritical. This acknowledges that the minimum wage is a bar to be jumped over. This logic implies that the teen generally cannot produce as much as the original minimum wage. If he was to be hired for less than he produced, the hirer would undeniably be giving to charity and incurring losses.

As an extra example of the common sense regarding the minimum wage and the associated unemployment would be an extreme minimum wage. For example, consider a minimum wage of $100.00. Under such conditions, there would be an extremely large section of the population unemployed because of their inability to contribute $100.00 an hour. A smaller minimum wage would simply unemploy to a smaller extent.

Ethical/practical counter-arguments:

1) Some critics would respond to this by saying that no person should have to work for less than 7 dollars an hour (similar to the argument made about the situation of the desperate man paying 400 dollars for a glass of water). “It is simply impossible to live with such wages.” However, those people should note that in the situation I am describing, either the person who can only “produce” $6.00 works for a wage of 6.00 or less or does not work at all. Essentially, if there is no minimum wage, then this person can earn $6.00/hr, but if there is a minimum wage he will be unemployed and earn $0.00/hr. So I would ask those who made such an argument: Is it harder to live off of $6.00/hr or $0.00/hr? The minimum wage basically does not allow humans to make choices they normally would make. The plain fact that if you eliminated the minimum wage, and an unemployed person chose to work for $6.00/hr rather than being unemployed proves that they value their situation under the $6.00/hr over the situation they previously had. So why not let them make such a choice?

2) Another line of argument would follow: well, we can just put those individuals unemployed under the minimum wage on welfare. Although I am not a proponent of welfare, I won’t argue against it here because it is irrelevant for this discussion. Even if we think welfare is good, it is not an argument for the minimum wage. This is because we could eliminate the minimum wage and still give out welfare. Instead of saying (for example), that everyone unemployed because of a $x minimum wage receives a certain amount of welfare, we could say that people earning under $x dollars receives that same amount of welfare (or perhaps less than that if we want to simply make it so that their total income (wages + welfare) equals the $x of the earlier minimum wage).

3) Others might argue: wouldn’t the extra employment of individuals caused by the elimination of the minimum wage cause a decrease in wages for everybody? I would half-agree and half-disagree (this answer would only be able to found empirically but wouldn’t be completely provable just because of all the other variables that could be taken account for). Additional competition of workers would obviously decrease wages, but by eliminating the minimum wage, it would decrease a regulation that hinders small businesses, and would increase competition of new businesses as well. In a completely free market, wages tend towards marginal revenue product (MRP; that amount which the workers contribute) because firms that pay less than the MRP are earning profits, and this profit incentivizes new businesses. Regulations such as the minimum wage hinder business competition by making it tougher to start a new business, and therefore hinder this process as well. In addition, it should be noted that new opportunities to hire people with the elimination of an $x minimum wage does not necessarily mean that the already employed have to receive lower wages. The fact that both the business owner and the new employee have to benefit from such exchanges proves that, because the business owner would only hire someone for, let’s say, $3.00/hr if that person actually contributed at least $3.00/hr. This exchange has no effect on other exchanges with workers that the employer is already making.

Sorry if it was long! I’ll probably make shorter posts from now on.

tl;dr : Minimum wage of $x dollars causes unemployment because those contributing less than $x dollars cannot be employed unless the hirer is giving to charity.

Praxeology and Subjective Valuation

Praxeology is the study of human action. Ludwig von Mises, in his magnum opus, Human Action, delved into praxeology with the claim that “all humans act,” and that all human action is purposeful behavior, by using means to obtain ends (sharply differentiating it from reflex or observed movements of inorganic matter). Mises later expanded praxeology into the study of economics by logically elaborating from these principles.

For example, Mises proved that when two actors, let’s say, Mark and Kevin, decide to exchange goods with each other, they both benefit. For example, if Mark has an apple, and Kevin has an orange, Mark will only exchange his apple for Kevin’s orange if he subjectively values the orange over the apple; likewise, Kevin will only exchange his orange for Mark’s apple if he subjectively values the apple over the orange. Through peaceful cooperation and exchange, both benefit from the trade; both are wealthier than they were before the trade.

This is scientifically unverifiable yet logically indisputable. How would a scientist prove that Mark subjectively values the orange over the apple? No full-proof method can possibly exist. As for logic, some may attempt to come up with examples that disprove the logic. I will mention a few of these arguments below.

1) A person may not actually value one good over the other in an exchange. Perhaps Charles is a billionaire with an extra house and decides to give it to a homeless man for a dollar. Obviously, Charles doesn’t value the dollar over the house; he is simply attempting to help another human being while being altruistic (not completely altruistic apparently because he still wants a dollar).

This argument does not defy the logic of subjective valuation. Monetarily, Charles may not value the dollar over the house, but he does value the dollar over the house for the utility it gives him in making another person happy. Charles would not make the exchange unless he valued what he was receiving over what he was giving. In this case, he is receiving more than just a dollar, he is receiving satisfaction emotionally.

2) A person may be desperate and pay 400 dollars for a glass of water.

This argument obviously also does not defy subjective valuation. In his situation, the person does value the water over the 400 dollars; otherwise, he would not exchange it. Some might argue that no man should have to pay 400 dollars for a glass of water, but this is not an argument against the praxeology, but rather an ethical argument.

3) Perhaps in the first situation described (with Mark’s apple and Kevin’s orange), Mark may have heard of praxeology and subjective valuation. He believes he does not value the orange over the apple; nevertheless, he makes the exchange simply to disprove the logic of subjective valuation.

Here, again, this would not defy subjective valuation. The reasoning behind this is that Mark still subjectively values the orange over the apple; otherwise, he would not have made the exchange. His reasons for subjectively valuing the orange over the apple may not be normal reasons, for example, that he liked the taste of the orange better than the taste of the apple, but rather that he subjectively values the orange over the apple because of the utility the orange gives him in disproving the praxeology. Nevertheless, this brings us to a new point. Mark has made a mistake. He valued the orange over the apple for the utility it gave him in disproving the logic, but he has not disproved the logic. He has simply made an error of judgment instead, and the law holds.

Mark may realize at some later point that he was incorrect in his judgment of the situation. Perhaps, Kevin explains it to him 5 minutes later. Now, if Kevin consents, Mark may trade the orange for the apple back, and this would prove that he now values the apple over the orange, for subjective valuations may change over time.

I have delved into what some may think is common sense reasoning in order to apply this to economic situations. One of these situations is the minimum wage, which I will go into next week.