This post may contain affiliate links. Please read our disclaimer for more info.
Shares

Welcome back you bunch of HomoEconomicus! Today we will explore the Boom and Bust Cycle (and understand its dangers).

boom and bust cycle

The inspiration for this post comes from the online course: Booms and Busts by the Foundation for Economic Education (FEE). I vividly remember how enlightening it was when I completed it a few years ago, and reviewing it for this post mirrored the same eye-opening experience. Disclaimer; when I was studying economics at high school, the focus was almost exclusively on Lord Keynes… Keynes this, Keynes that, Keynes everything! It bored me to death, and so my mission to explore the dozens of economic schools of thought began. The FEE guided (and continues to guide) my journey into the Austrian, the Neo-classical as well as the Chicago School. FEE Courses

Let’s hop into it!

INTRODUCTION

Business Cycle

“The rise and fall in production output of goods and services in an economy. Business cycles are generally measured using the rise and fall in real gross domestic product (rGDP) or GDP adjusted for inflation.” Investopedia

First, we establish our definition of the business cycle (the famous booms and busts) – agreed on by all economists. Now, what drives the cycle? Is there a way to control it? Can we soften the ups and downs? What is the best way to emerge from a rut? These questions are the ones which spark lively debate amongst economists; notably between the Keynesians and the Austrians. Today, I will be diving into the intricacies of the Austrian School in regards to this topic, due to the fact that the Keynesian view is the prevalent one across the globe. Therefore, my aim is to shine light on the Austrian interpretation of the issue, and provide the relevant Keynesian counterpoints so as to fully expand on the economic context of the question. The business cycle has four phases:

“Each business cycle has four phases. They are expansionpeakcontraction, and trough. They don’t occur at regular intervals. But they do have recognisable indicators.

An expansion is between the trough and peak. That’s when the economy is growing. The GDP, which measures economic output, is increasing. The GDP growth rate is in healthy 2 to 3 percent range. Unemployment reaches its natural rate of 4.5 to 5 percent. Inflation is near its 2 percent target. The stock market is in a bull market. A well-managed economy can remain in the expansion phase for years. That’s called a Goldilocks economy.

The expansion phase nears its end when the economy overheats. That’s when the GDP growth rate is greater than 3 percent. Inflation is greater than 2 percent and may reach the double digits. Investors are in a state of “irrational exuberance”. That’s when they create asset bubbles.

The peak is the second phase. It is the month when the expansion transitions into the contraction phase.

The third phase is a contraction. It starts at the peak and ends at the trough. Economic growth weakens. GDP growth falls below 2 percent. When it turns negative, that is what economists call a recession. Mass layoffs make headline news. The unemployment rate begins to rise. It doesn’t happen until toward the end of the contraction phase because it’s a lagging indicator. Businesses wait to hire new workers until they are sure the recession is over. Stocks enter a bear market as investors sell. 

The trough is the fourth phase. That’s the month when the economy transitions from the contraction phase to the expansion phase. It’s when the economy hits bottom.” The Balance

This “exact” definition of the four phases of the cycle would not bode too well with the Austrians. Firstly, it is too technical in its statistical descriptions of the cycle and assumes the indicators are sacred – which they most certainly are not (Diegonomics: Shadows Stats). Then, it suggests that the macroeconomy can be fine tuned through the expert manipulation of these indicators. However, there are somewhat identifiable distinctions between the phases and that is what I wanted to highlight, so as to provide full context.

Here is a brief synopsis of the Austrians Business Cycle Theory: Sustainable economic growth is driven by production, not consumption. To ensure the long-run productive capacity of an economy, individuals must engage in the act of saving  today, and in so doing provide the necessary financial base to ensure future investment. Saving, capital formation and investment precede production; these are the true return drivers of a healthy economy. Austrian Business Cycle Theory

PRODUCTION

Austrians place immense importance on the act of production, the driver of a sustainable economy. While, Keynesians expound that the consumption of wealth makes society wealthier as a whole.  Moreover, they attribute the frequency and severity of booms and busts to governmental intervention; prior to the FED the introduction of fractional reserve banking laid the groundwork for macroeconomic instability as theorised by the Austrian School. However, the state control of monetary policy has led to more and deeper recessions – since the introduction of the Federal Reserve Charter in 1913.

boom and bust us history

In its initial stage, production is the use of labour to convert natural resources into capital goods and subsequently into consumer goods. As an economy progresses, production becomes the combination of the factors of production (land, labour, capital and enterprise) to produce either capital or consumer goods. In the case of the former, the aim is to increase the efficiency/volume of present as well as future output. The latter, is the creation of material wealth for consumers to acquire. Ultimately, production is the cessation of present consumption in favour of increased consumption in the future. Therefore, one must save, invest and sacrifice consumption to sustainably expand an economy. This concept is flawlessly developed through a 10 episode desert island miniseries (Diegonomics101: FI$H). Plus, I highly suggest you pick up Adam Schiff’s How An Economy Grows and Why it Crashes.

But what guides production so that it is wealth-creating? What keeps producers from making things we don’t want? What keeps producers from wasting resources? (FEE Courses). Well, simple answer: the invisible hand. And longer answer, these factors:

  1. Production takes time.
  2. Production requires saving and specific capital formation.
  3. The factors of production have varied capabilities in producing different goods.

Therefore, individuals must take great risks and sacrifice current consumption in order to produce – the incentive is to get it right or fail miserably; die (centuries ago), or lose money (today). So, the market allocates productive resources towards their most valuable uses through the price mechanism. Can there be instances of erroneous allocation? Well, that depends on perspective… would you place higher value on the production of a school, or on the production of a crocodile-skin dog kennel? It’s a trick question! The market is the most effective and unbiased method we have to allocate scarce resources, and it certainly does not care at all about your perceived instances of “conspicuous consumption” (Diegonomics101: John Kenneth Galbraith).

Now, many economic schools of thought have ignored these aspects of production; notably the fact that it necessitates saving and a sufficient base of financial capital, so as to ensure true capital formation and sustain the productive capacity of the economy. Moreover, Austrians tend to be very dubious towards economists who believe wholeheartedly in their ability to control the economic machine – through the use of complex mathematical models and centrally planned methods.

keynesian output labour and capital graph

This model suggests that a simultaneous increase in capital (K) and labour (L) will lead to a maximal expansion of output (Y). However, it fails to account for several input factors, such as: the necessity of savings in order to produce, entrepreneurial risk which drives innovation, and time preferences. The intricacies of specialisation, division of labour and the concept of comparative advantage (Diegonomics101: Ricardian Law of Association) which some economists argue to be the bedrock of modern civilisation are entirely glossed over.  

MONEY

Let’s quickly review the functions of money, to properly understand the context of how this applies to Austrian Business Cycle Theory.

  1. Medium of exchange – A good which allows for the successful trade of goods and services, by overcoming the issues of a barter system.
  2. Unit of Account – Allows goods and services to be valued in comparable terms (in USD for example).
  3. Store of Value – An asset whose value holds throughout time, and can be spent/invested in the future (with the exception of inflation).
  4. Standard of Deferred Payments – The ability to express the value of a debt, and pay it at a future debt.

Austrians underscore the fact that in a full reserve banking system, the money in circulation must reflect the actual quantity held by banks in their vaults. Conversely, a fractional reserve system allows for the mismatch between vault reserves and actual money in circulation – leading to erratic expansions of the money supply. More money slushing around, decreases the value of existing money units; inflation101. Therefore, the organic creation of fractional reserve banking laid the framework for modern monetary instability – increasing the expansion phase of the boom as well as the severity of the bust.

Firstly, here are the conclusions from the analysis of fractional reserve banking from the enlightening video above:

  • The account was free because the bank makes money off of lending deposits to other people. However, if everybody came to withdraw their deposits at the same time, the bank would be in big trouble.
  • The bank earns interest on the newly created paper money, even though it does not have the sufficient reserves in its vault to back them up.
  • By creating a larger money supply, inflationary pressures would rise and drastically cut the purchasing power of the entire currency (prior and post fractional reserve banking).
  • The lower the fraction of reserves held, the more the bank can lend to other – aggravating the inflationary threat. 

Secondly, let’s take a look at the conclusions from the analysis of a full reserve banking system as developed in the video:

  • The demand deposit was not free, since the bank is providing a safekeeping service. Plus, the interest only affects the bank and the depositor.
  • There is no new money creation, which does not add to inflationary pressures.
  • There is no risk of insolvency or bankruptcy in the case of a bank run, due to the fact that depositors can claim all their money – backed up by the bank’s reserves.
  • The lending process is contractual between both parties, and is not outsources to other depositors like in fractional reserve banking.

There is a stark dichotomy between more Austrian-minded economists on this matter. Some argue in favour of a full reserve banking system, to curb the pernicious effects of magnified business cycles. Nevertheless, some debate that the profit-and-loss system within free markets would keep these fractional reserve banks in check, because being reckless in their lending would translate to suspicion from existing and incumbent customers as well as lower profits. On the contrary, the current solution to this dilemma is complete governmental oversight of the monetary system and a fractional reserve banking framework – which Austrians argue has augmented the negative swings of the macroeconomy.

SAVING AND INTEREST RATES

Now, let’s begin to evaluate the relationship between individual time preferences and the marginal propensity to save. A person that has a high time preference (meaning they value the present), will have a higher marginal propensity to consume and will save little. Conversely, if someone has low time preference (meaning they value the future more), they will have a much higher marginal propensity to save and consume little at present. The market brings individuals with low as well as high time preference together to engage in economic transactions, namely loans; the prices that emerge in these exchanges become the natural interest rate.

theory of interest
robinson crusoe economy

Above, I have pasted my notes on the theories of Irving Fisher as well as Eugen von Bohm-Bauwerk. They developed the idea that a natural rate of interest emerges within an economy without the mandate from a central monetary authority – the supply and demand for savings converge and establish the interest rate at a market clearing optimum. For example, Bohm-Bauwerk (Econlib Bio) pioneered the analysis of the factors which establish a particular interest rate within an integrated economy:

  • Technical progress; the perceived differences in value between present and future goods.
  • Advantages of roundaboutness; the organic time limits of the production process.
  • Time preferences; either high or low determine the degree of savings.

Moreover, Bohm-Bauwerk furthered his theory by introducing the practical case of a desert island economy with only one inhabitant – The Robinson Crusoe Economy! The individual’s natural rate of interest would be determined by his time preferences and the fact that his Production Possibility Frontier (PPF) is linear, as the degree of technical progress is severely inhabited without the possibility of trade. Additionally, due to the fact that our sole inhabitant cannot borrow from another with a lower time preference means that the development of capital is hampered; thus, preventing technical advancements. 

However, let’s introduce a second inhabitant to the island. Now, all three factors which naturally determine the interest rate are present. The PPF is no longer linear as the introduction of a loan market between both individuals allows for capital formation, saving and investment – increasing the productive advantages of roundaboutness as well as the degree of technical progress. Plus, both inhabitants will have different time preferences and thus, encourage the long-run productive capacity of the island economy. Nonetheless, the ability to trade between both parties and the benefits of comparative advantage allow for both individuals to maximise their productive output. This theory can easily be expanded to a modern economy as the three factors continue to become more efficient and enhance the mechanism through which the natural interest rate emerges. Needless to say that Bohm-Bauwerk was an Austrian and was incredibly skeptical of centralised monetary oversight particularly with the introduction of fiat currency. He argued that governmental intervention would distort the natural relationship between savers (low time preference) and consumers (high time preferences); market signals would no longer reflect market condition, and lead to malinvestments and over consumption (we’ll explore this in depth later on!).   

What is the process through which a central bank distorts the interest rate? How exactly does this impact market signals? Why does this magnify the boom and bust cycle?

First, let’s nail down why the amount of savings within an economy (without a central bank) determines the interest rate. Banks can only lend and enable more corporate investment if they have sufficient monetary reserves in their vaults (savings). The relationship between the supply of savings and the demand for investment creates the loanable funds market, which determines the natural rate of interest. Therefore, if they have a large amount of money (savings) this will drive down the interest rate and vice versa… simple supply and demand!

Image result for loanable funds market

Accordingly, when a central bank decides to increase the money supply in circulation, they inject it directly into these loan markets – through the use of intermediaries, such as banks and financial institutions. So, this new money essentially reflects a fake increase in savings. The economy begins to conduct itself under the assumption that real savings have increased, when the reality is quite the opposite… real savings have drastically dropped! Thus, borrowing [nominal], consumption [nominal], the wage rate [nominal], investment [nominal] all exponentially increase without the backing up of real savings in the banks. All these nominal factor increases, lead to the complete distortion of the economy through the manipulation of the money supply through the loan markets. An artificial expansion of credit, drives overconsumption in the short-run as well as the rise of dubious investments; a perfect cocktail for an economic downfall! And I still haven’t even mentioned the monetary inflation which follows an artificial increase of credit, which slashes the purchasing power of consumers and dissolves the value of savings.

We mentioned the difficulty in formulating mathematical models to analyse the economic machine. Austrians posit that the Keynesian Circular Flow of Income (CFI), is intrinsically flawed due to the fact that it does not take into account the complexities of the production process, the crucial relationship between time and savings as well as the variabilities of the factors of production (land, labour, capital and enterprise).

keynesian circular flow of income

I encourage you to google the different iterations of the Keynesian CFI. There are some clear things which jump out of the diagram; savings (the preceding necessity to production) is considered a withdrawal, the economy is centred around consumption, and the intricacies of the production process are nowhere to be found. Here are the links to some intriguing articles underscoring the debate between the Austrians, the Neo-classicals and the Keynesians:

BUSINESS CYCLES

Let’s introduce some Austrian concepts which further develop the idea of the magnification of the business cycle (I will mostly let the videos do the talking 🙂

boom and bust cycle

Austrian Business Cycle Theory

The idea emerges from previously discussed phenomena, such as: the fact that a lower degree of savings, leads to higher interest rates which creates an incentive to engage in short term investments as they are the safer alternative. On the other hand, an increase of the savings base translates into a lower interest rate and thus, encourages long-term/riskier investments – these improve the long-run productive capacity of the economy (sustainable growth). However, when a central bank or centralised monetary authority intervenes, the true relationship between savers (low time preference) and consumers (high time preference) is entirely distorted. Plus, the inverse correlation of savings and investment is distorted as the mutually beneficial loan agreements are now dictated by the artificial controlling of the money supply. Currently, we continue to have incredibly low rates of interest throughout the globe and have been following this trend for a few decades. The artificially low interest rates spur malinvestements as individuals and corporations are encouraged to engage in risky long-term investments without adequately evaluating the pertaining repercussions. Moreover, due to the fact that the loan market is no longer backed by a true degree of savings, both savers and consumers have the artificial incentive to over purchase goods and services at the present time. Now, if these artificially low interest rates are sustained (as has been the case for the past few decades), it can set a collision course for the economy and require the government to step in and save it from the brink of collapse (2008?). Austrian academics have argued that the Global Financial Crisis (GFC) was only the beginning, and that if central banks continue their policy of artificially suppressing interest rates, the ensuing economic catastrophe will dwarf the effects of 2008’s GFC.

boom and bust global leverage cycle

Leverage Cycle

Additionally, the degree to which asset purchase are leveraged within financial markets follows a cyclical phase of expansion and contraction. Austrian economists argue that the Leverage Cycle in unison with the artificial manipulation of currencies by a central authority, magnify the pernicious effects of the business cycle. These are the consequences:

“A very highly leveraged economy means that a few investors have borrowed a lot of cash from all the lenders in the economy. A higher leverage implies fewer investors and more lenders. Therefore, asset prices in such an economy will be set by only a small group of investors.

According to Tobin’s Q, asset prices can affect economic activity. When prices of assets are high, new productive activity can be stimulated that can lead to over production. Alternatively, when asset prices crash, production may come to a standstill. Therefore, the leverage cycle has the potential to amplify real economic activity.

When financially constrained arbitrageurs receive a bad shock, they are forced to shift to low volatility – low margin assets from high volatility – high margin assets, thereby increasing the liquidity risk of already illiquid (risky) assets. This can be categorized as a “flight to quality”.

Broadly speaking market-making arbitrageurs can hold net long positions and as a result capital constraints are more likely to be hit during market downturns. This is likely to result in a sell-off making the markets more illiquid.

Large fluctuations in asset prices in the leverage cycle lead to a huge redistribution of wealth and change in inequality. During a good shock, all optimists become extremely rich relative to lenders thanks to their highly leveraged position while during a bad shock, the optimists are wiped out and the relatively optimistic lenders become rich in the subsequent good shocks.

Highly leveraged agents can potentially become indispensable to the economy if the failure of an extremely leveraged agent increases the likelihood that other leveraged agents will have to follow suit. In other words, high levels of leverage can potentially lead to the “too big to fail” problem.” Wikipedia

Here are the videos evaluating the differences between the Austrians, the Keynesians and the Monetarists vis-à-vis the business cycle:

ECONOMIC INTERVENTION

Austrians hold that after an artificial boom phase amplified by the suppressing of real interest rates, inevitably leads to a grave bust phase. During this necessary bust, the economy adjusts to the excesses of the boom phase by allowing prices and employment to drop as capital goods find their way to more profitable uses. Plus, malinvestments are corrected as businesses who engaged in such actions go bankrupt and unlock capitalism’s “creative destruction“. However, this correction phase is hampered by government’s and central authorities as they enact two erratic policy applications:

  • Expansionary monetary policy (the preferred “remedy”); by increasing the money supply they are able to further suppress interest rates, and artificially boost the relevant economic indicators. Austrians warn against this type of policy, due to the fact that it simply postpones and magnifies the correction phase – with increased market distortions.
  • Expansionary fiscal policy (they rarely decrease taxes, they usually only increase government spending); by hiking governmental expenditure, they artificially expand Aggregate Demand (AD) so as to mask the true economic imbalances (Diegonomics101: Shadows Stats) – further indebting the nation and deepening the phases of the business cycle.  

Keynesian

Aggregate Demand (AD) = C + I + G + (X-M)

During the bust phase, they argue that an increase in government spending (G) will create a magnified expansion of consumption (C) and private investment; essentially, one dollar of public spending means GDP will rise by more than a dollar – the Keynesian Multiplier.

keynesian multiplier theory

Courtesy of yours truly!

Austrians

In contrast, Austrians as well as Monetarists argue that an increase in governmental expenditure (G) will cause private-sector investment to fall by a greater amount – CROWDING OUT! (Diegonomics101: US Debt CrisisDiegonomics101: The Myth of Scandinavian Socialism). The links above are to some articles I’ve written evaluating instances of crowding out across national economies… here is the most basic definition:

austrian crowding out theory

“The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.” Investopedia

Furthermore, the government spending needs to be financed. The state can do so directly, through increasing taxes – further hurting private consumption (2/3 of AD according to Keynesian theory) and hampering business creation/investment. Nonetheless, the influx of state spending diverts resources from their most productive uses as allocated by the ruthless profit-and-loss system of the market; the economic distortions deepen the ups and downs of the cycle. Austrian scholars emphasize the need to create economic value, whereas Keynesians often argue that through job creation the economy can recover entirely.

CONCLUSION

Overall, the issue of business cycles seems to be quintessential to the economic machine. However, the riveting argument is over how exactly to effectively manage these booms and busts. To my estimation, the Austrian School evaluates the root cause of the issue and prescribes preventative measures. For example, they analyse the fact that a central monetary authority inevitably distorts the relationship between savers and consumers; therefore, by artificially setting the rate of interest they prevent the loan market from functioning effectively. Thus, they suggest that a system under which the interest rate is more influenced by market conditions than by the intellectual recommendations of the financial technostructure. Nevertheless, Austrians understand the necessity of a bust and generally refer to it as a correction phase – where “creative destruction” enables capitalism to function as intended.

Conversely, the Keynesian School seems to prescribe reactive places to fine tune the economic machine. Firstly, they encourage the artificial lowering of interest rates to create as well as sustain the expansion phase due to the fact that it encourages private consumption – the bulk of their economic growth models. Additionally, they advocate for expansionary fiscal policy; increases in government spending during a bust so as to grow out of it. An increase in government spending leading to the Keynesian Multiplier which sparks economic recovery, due to the fact that private consumption and investment are stimulated. However, the taxation levels tend to remain the same due to the need for present financing of governmental expenditure – or they issue debt.

It is certainly a fascinating issue and I recommend you continue researching the various perspectives of the economic schools of thought regarding this issue. My objective was to evaluate a more obscure interpretation of the issue, due to the fact that nowadays nations follow mostly Keynesian policy prescriptions. It is my belief that the more perspectives one can integrate into one’s knowledge the better; this allows for a battlefield of ideas to emerge. A constant war in which the truth is the ultimate goal… and the truth emerges from this beautiful chaos.

May the ECON be with you

BIBLIOGRAPHY:

Articles

Austrian Business Cycle Theory – Mises Institute

Do Longer Expansions Lead to More Severe Recessions? – ClevelandFED

Excess Burden of Taxation – Wikipedia

A Bunch if Stuff – Diegonomics101

Courses

Booms and Busts – Foundation for Economic Education

booms and busts us economic history