The Business Cycle Revisited

posted by Nima

May 29, 2009 · Posted in General Economics 

I have described the basic workings behind the business cycle more or less accurately. However, I have noticed that some things in my description and conclusions remain inconsistent. The lines between too much production spending and too much consumption spending are blurry and confusing.

It is necessary to distinguish between two different types of business cycles to clear this up: The production business cycle and the consumption business cycle. Both can occur separately or at the same time.

Rothbard and Mises hold that a credit expansion that aims at expanding consumer credit will not cause a business cycle:

Mises did not deal with the relatively new post-World War II phenomenon of large-scale bank loans to consumers, but these too cannot be said to generate a business cycle. Inflationary bank loans to consumers will artificially deflect social resources to consumption rather than investment, as compared to the unhampered desires and preferences of the consumers.

But they will not generate a boom-bust cycle, because they will not result in “over” investment, which must be liquidated in a recession. Not enough investments will be made, but at least there will be no flood of investments which will later have to be liquidated. Hence, the effects of diverting consumption investment proportions away from consumer time preferences will be asymmetrical, with the overinvestment-business cycle effects only resulting from inflationary bank loans to business.

Indeed, the reason why bank financing of government deficits may be called simple rather than cyclical inflation is because government demands are “consumption” uses as decided by the preferences of the ruling government officials.

I am of a different opinion. We have recently been able to witness the bust of one of the most severe consumer credit expansions, with significant effects on the alignment of productive factors. But even when we approach it with Rothbard’s explanation: if over-investment causes distortions then why would under-investment cause any less severe distortions? If anything, it will be even harder to ramp up new productive factors whose production has been neglected vs. having to abandon the use of excess capacity and move resources back into consumer based businesses.

Both cycles start with the same precondition. A market unhampered by significant government and central bank intervention. As described in the History of Money, gold and silver have emerged and are used as medium of exchange, money.

Individuals, in their function as consumers demand consumer goods, entrepreneurs employ individuals as workers, combine factors of production and produce consumer goods, seeking an entrepreneurial profit. Individuals also decide to save a portion of their pay and make it available as capitalists in credit transactions against interest. Thus it becomes feasible for some entrepreneurs to borrow this money and employ some individuals in projects that don’t turn out consumer goods but more factors of production. Those factors won’t turn out consumer goods immediately, but will turn out more and/or better consumer goods per unit of worker time in the future which enables the repayment of the loan with interest.

Whenever changes occur in any individual’s behavior, or in the behavior of groups of individuals as a whole, market data will adjust accordingly. We shall observe the effects of some fundamental changes in behavior.

If a significant number of consumers, for whatever reason, decide to consume more goods immediately and hence save less, several things may happen as a response:

- Entrepreneurs may abandon some projects that turn out factors of production and produce more consumer goods instead. No change in interest rates or prices occurs. Balance is restored by sacrificing more productive capacity in the future in exchange for more immediate consumption.

- Prices for demanded consumer goods may go up, thus crowding out previous consumers who will save more instead and make it available as credit to entrepreneurs. Balance is restored by sacrificing one group’s consumption for another one’s. No change in the supply of consumer goods or factors of production occurs.

- Due to less available savings, interest rates for credit may go up. Some entrepreneurs will borrow less money for the production of new factors of production and rather produce more consumer goods. Balance is restored by sacrificing future consumption for immediate consumption.

- A combination of all of the above may occur, only that none of the events would go all the way but rather all of them go a fraction of the way. Also, a sequential progression of the events may occur, e.g. Prices go up as an intermediary step, but entrepreneurs immediately respond with more production of consumer goods vs. factors of production.

Similar adjustments would occur if, say, some consumers decide to consume less in the present and save more for the future. Entrepreneurs may produce fewer consumer goods and more productive factors; or prices for consumer goods may fall, attracting previously abstaining consumers; or interest rates may fall, making previously abstaining entrepreneurs borrow more money in order to produce more factors of production in lieu of consumer goods.

The main point in all of this is that any of these events ensures that market data is restored and aligned to the individuals’ demands and expectations. None of the adjustment procedures come without temporary pains, such as layoffs by one entrepreneur in order to adjust for the changed demands, and the necessity for the laid off workers to find new work or learn new things. Also, overall production will initially decline, as current operations are abandoned and new ones need to be ramped up. A temporary recession might be necessary. But the quicker the adjustment, the more bearable and temporary will the pain be.

It is now necessary to observe the events caused by credit expansion and their effect on the behavior of market participants. The government turns the paper tickets issued in return for gold into fiat money. It outlaws the use of gold money. It grants to the central bank and fractional reserve banks the exclusive right and protection to issue fiat money.

The Consumption Business Cycle

The central bank and fractional reserve banks create new fiat money and make it available in credit transactions to individuals who intend to use the money for the purposes of consumption. Examples would be car loans and home loans which made the US economy align its productive factors accordingly over the past decades. It is likely, but not necessary that interest rates for such credit instruments will drop initially.

Some individuals may now enter into these new credit transactions and use the new money to consume goods that they wouldn’t have consumed before. But they didn’t do so by reducing their savings, nor did anybody else sacrifice consumption to make this money available. It was created out of nothing. No additional consumer goods have been produced.

The prices for the goods demanded will begin to increase. Entrepreneurs will respond by abandoning the production of some additional factors of production and turn out more consumer goods instead. So long as more credit is channeled into the system, prices will continue to increase while entrepreneurs try to catch up. Fractional reserve banks will begin to earn more interest revenue and expand their operations and resource usage.

Businesses that produce consumer goods will report higher profits, while profits for businesses producing factors of production and basic materials will lag behind. A myriad of consumer goods based businesses will spring up over time. The alignment for immediate consumption vs. more/better future consumption continues so long as individuals continue to be able to pay interest on the credit transactions performed and expect to be able to do so in future.

But as explained above, making interest payments and paying off debt is only possible in the long run if the workforce, as a whole over time, becomes more productive per unit of labor. But the opposite occurs. Productivity per labor unit will be lower than the additional consumer loans appeared to indicate, since in an unhampered system credit can only come out of savings (which means someone somewhere forgoes immediate consumption, making room for more factors of production). After a certain period, the amount of debt and interest payments will become higher than consumers can afford. In addition, due to lower interest rates, a lot of rather risky loans were made to individuals that would not have occurred in the unhampered state. Individuals will begin to default on their interest payments.

They start realizing that they need to consume less and save more in order to not have this happen again. Their demand for additional credit drops sharply. Their demand for money to pay off the debt and/or generate savings rises.

The fractional reserve banks will begin to slow down the creation of additional credit. They begin reporting losses on existing consumer debt.

As excess consumption comes to a halt consumer prices begin to fall, businesses aligned for the production of consumer goods will see declining profits, some will start reporting losses. They realize that they will have to abandon some projects since the demand for consumer goods starts to fall back to sustainable levels that match everyone’s time preference and expectations. The desire to consolidate one’s finances takes priority over everything else.

The further the excessive consumption went, the more severe this necessary correction will be. Adjusting the existing productive factors and workers to turn out more factors of production instead of consumer goods will take some ramp up time during which overall less will be produced and consumed. A recession occurs which aligns resources back toward the initial state. The longer individuals take to adjust their consumption behavior, the longer the recession will take. This applies particularly in the case where the government tries to step in and slow down the overall decline in demand.

The Production Business Cycle

The central bank and fractional reserve banks create new fiat money and make it available in credit transactions to individuals who intend to use the money for the purposes of purchasing factors of production. Examples would be business loans. It is likely, but not necessary that interest rates for such credit instruments will drop initially.

Some entrepreneurs may now enter into these new credit transactions and use the new money to purchase factors of production that they wouldn’t have purchased before. But they didn’t do so by reducing their consumption, nor did anybody else sacrifice such purchases to make this money available. It was created out of nothing. No additional factors of production have been produced. Also, a lot of risky projects will be embarked upon that no one was willing to make money available for, based on the entrepreneurial interest component offered.

The prices for the factors of production demanded will begin to increase. Entrepreneurs will respond by abandoning the production of some consumer goods and turn out more factors of production instead. So long as more credit is channeled into the system, prices will continue to increase while entrepreneurs try to catch up.

Businesses that produce factors of production will report higher profits, while profits for businesses producing consumer goods will lag behind. A myriad of businesses that create productive factors will spring up over time. The alignment for more/better future consumption vs. immediate consumption continues so long as businesses accept more debt and continue to be able to pay interest on the credit transactions performed.

But the consumers’ demands have not changed. They still desire the same amount of consumer goods as before. The prices for immediate consumer goods will rise sharply while the workforce is aligned in projects that will only turn out more goods in the distant future. This will continue until prices for immediate consumption goods move so high that businesses will be impelled to adjust their operations and service the immediate demands again.

They will abandon the usage of a part of the obtained productive factors and halt additional purchases thereof. They will also slow down on efforts such as research and development that only yield an outcome in the farther future. In addition to that, some of the riskier projects will naturally begin to fail. They start realizing that they need to purchase fewer factors of production and produce more consumer goods in order to not have this happen again. Their demand for additional credit drops sharply.

The fractional reserve banks will begin to slow down the creation of additional credit. They begin reporting losses on existing business debt.

Employed resources will have to be released and channeled into more consumer goods based businesses. A recession occurs, aligning resources back toward uses that match individuals’ time preferences.

The longer entrepreneurs take to adjust their purchasing behavior, the longer the recession will take. This applies particularly in the case where the government tries to step in and slow down the overall decline in demand for factors of production.

Summary

Both described cycles stem from the same root: The re-alignment of resources, induced by fractional reserve banks, and in last resort, the government. The Production Business Cycle starts by changing the behavior of entrepreneurs, the Consumption Business Cycle starts by changing consumer behavior. Both cycles may appear with overlaps, or even simultaneously. While they may or may not cancel each other out as far as the impact on time preference behavior is concerned, their impact on encouraging overly risky behavior remains, even multiplies, and thus causes severe risk-based distortions that will require recessionary adjustments. This is due to the fact that lower interest rates for business and consumer loans encourage the funding of higher risk individuals in both cases, due to a lower perceived entrepreneurial interest component.

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One Response to “The Business Cycle Revisited”

  1. [...] Great lecture by Austrian economist Robert Murphy (who by the way has invited Paul Krugman to debate him about the business cycle theory): [...]

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