Deflationary Collapse More Likely Now than in 2007

Janet Tavakoli makes some excellent points on how 2 years of endless money pumping, government bailouts, and stimuli and have accomplished the exact opposite of what was intended: Matters have gotten far worse, and the financial system is now in a much more explosive condition than back then.

Part 1

Part 2

Her book Dear Mr. Buffett sounds like a great read. I will definitely check it out.

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The Great Credit Contraction & Deflation

Lew Rockwell posted a piece by Bill Bonner which strongly supports the deflationist view:

“In a fundamental shift, consumers are saving rather than spending,” notes the Los Angeles Times.

This is the shift we’ve been talking about for months. The great credit expansion of 1945–2007 is over. Now cometh the great credit contraction.

During the bubble years, more and more credit produced less and less real prosperity. It was as if you were borrowing more and more, to invest in your business or merely to increase your standard of living, but your income didn’t rise fast enough to keep up with the interest payments.

In 2005, Americans saved nothing. Not even aluminum foil or string. Now, the savings rate is approaching 5% of disposable income – a big turnaround.

We know from logic and experience that saving money – not spending it – is the key to getting wealthier. Saving money gives you capital. And it’s capital accumulation – in the form of factories, roads, ships, buildings, machines…and raw savings – that gives people the ability to produce more. It may take a man with a shovel a whole day to dig a decent grave. Give him capital – in the form of a backhoe – and he can bury everyone in town. That’s why capitalism works. It rewards the fellow who saves his money.

Yet every yahoo economist in the year of our Lord 2009 takes news of rising savings rates like the death of Michael Jackson. If households don’t consume, they reason, how can a consumer economy grow?

The problem is that you can’t really grow an economy by borrowing and spending.

Recent history proves it. Despite the biggest splurge of borrowing and spending in history, the US consumer economy barely grew at all.

“In the five years to December 2007,” reports Grant’s Interest Rate Observer, “America’s credit market debt climbed by nearly 57%, to $18 trillion. However, in the same half-decade, nominal GDP was up by only $3.3 trillion.”

For every five dollars people borrowed, they only increased their incomes by $1. Imagine that the borrowing had an average effective interest rate of 10% (credit card debt can be much more expensive). At that rate half of the additional income earned between 2002 and 2007 had to be used just to pay the interest.

“Companies, households and banks all want to pay down debt and…prefer to hold cash rather than assets, partly because the outlook for those assets is poor and partly because after a decade of excess, everyone now looks a bit over-extended.

“This is exactly what happened in Japan during its lost decade, when a balance sheet recession, one characterized by the paying down of debt and liquidations of assets, was self-reinforcing and very difficult to stem.”

And now this from David Rosenberg:

“The ultimate question is where all this cash is going to be deployed, and we believe it will ultimately be diverted toward debt repayment.”

Let’s see. We can figure this out from the numbers above. American consumers must have added about $7 trillion in extra debt during the Bubble Epoque, 2002–2007. Now, instead of buying things, they use their money to pay it down. The average household has about $43,000 worth of income. Let’s keep the math simple by saying there are 100 million households in the United States…and that they save 5% of their income. And let’s say they use every penny of savings to pay down debt. Hey…it will only take about 30 years to pay it off! Get ready for a long, long slump.

Yesterday, stocks went nowhere. Oil went nowhere. And the dollar went down as gold went up.

The reason for the dollar’s decline and gold’s rise was given in the front-page headline of yesterday’s Financial Times. China launched a “new dig” at the dollar, it says. As near as we could tell, China merely stated the obvious – that the world is going to have to find a better monetary system. The US dollar won’t be king of the hill forever. And China, which is up to its neck in dollars, would like to find a solution sooner rather than later – that is, before the dollar goes the way of all paper.

The dollar will eventually give way to inflation and devaluation, but probably not soon.

“I’m absolutely worried about inflation,” says John B. Taylor.

But it is not inflation that worries us…it’s the lack of it. Making a long story short, as long as the feds see no inflation they will continue trying to create it. In the end, they will get more than they wanted.

Though, right now, instead of inflation, we have deflation. Yesterday’s New York Times tells us that deflation in Ireland has reached 5.4% – the highest since the Great Depression of the ’30s.

You know the reasons for deflation as well as we do. The world suddenly has too many people who borrowed too much money to buy too many things they really didn’t need and really couldn’t afford. This caused the world’s producers to greatly over-estimate the “real” demand. Their customers began to disappear in 2007. Their factories are still standing.

I may add: Who says that Americans will only want to pay down the recently amassed $7 trillion in debt during this downturn. As I explained in Inflation & Deflation Revisited, the total debt load in the US is at around $60 trillion, if one includes unfunded government obligations it is more like $120 trillion. That is not to say that all that debt needs to be paid off as part of this contraction, but it is reasonable to assume that a more significant portion will have to be paid. On the other hand, his estimate of an ongoing saving rate of 5% is a bit too low.I believe US households will be saving a lot more in the decades to come, more like 10% which is a historical average.

But in general this piece is consistent with what I wrote a while ago in Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving – The Long Term Outlook:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

And how much less we will have to consume to support such level of savings I explained in True Consumption as Percentage of GDP:


…the red line is the average over the past decades to which we will have to return during this contraction, maybe consumption will go even lower since corrections always undershoot regular levels.

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Sick and Tired of Debt

I have said it many times. The scourge in the US system is not a lack of credit, “tight credit“, “frozen credit”, or whatever else the Bernankes, Geithners, and Obamas would have us believe. Nor do we need to get “credit flowing again”, “consumers borrowing again” or anything remotely close to it.

We need the opposite: Savings. We got to where we are because of too much debt and credit. People over leveraged themselves into bankruptcy, they are sick and tired of debt. Borrowing has plunged and consumer credit will continue to contract precisely for that reason.

Rarely does anyone stop and ask the question: “Do people actually want to borrow any more money?” Of couse they don’t, why in the world should they?

Kelly Evans writes Worries About Economy Weigh on Loan Demand:

Maria O’Brien, a 27-year-old free-lance writer, and her husband are planning to do something later this year that they would have thought crazy in the past: buy a minivan — with cash.

“It’s worth the sacrifice right now to get out of debt,” Mrs. O’Brien said. “It means living more frugally, but also more freely.”

Banks are under fire for not lending enough and for tightening terms of credit, contributing to a drop in U.S. economic activity. But as the O’Brien family illustrates, the loan market’s shrinkage isn’t just about the supply of credit. It is also about weak demand for credit, a byproduct of households and businesses wary about the economy.

I would actually contend that the sole reason for lack of lending is the weak demand for credit. Banks have been flooded with excess reserves:

Meanwhile consumer credit continues to contract.

She goes on to write:

“Lending money is the bread and butter of banking,” said James Chessen, chief economist for the American Bankers Association. “The money is there, but banks are running smack into a wall of poor loan demand.”

The O’Briens, who live in Front Royal, Va., with their three children, are putting aside at least $500 a month toward the purchase of a used minivan in the $6,000-$8,000 range. They are also imagining a debt-free future.

“Once we get rid of it, we’re never going back,” Mrs. O’Brien said.

As consumer spending contracted last year, growth in household borrowing screeched to a halt in the fourth quarter after growing at a 10% annual clip earlier this decade, according to the Federal Reserve.

“We’re in a recession, and it’s one where households came in highly leveraged,” Fed Chairman Ben Bernanke said recently. Combined with firms “cutting back on their investment,” he expects to see weak demand for loans.

Loan demand began to fall sharply toward the end of last year and continued to weaken in the first three months of this year, according to the Fed’s periodic survey of bank senior loan officers. A pick-up in demand for mortgage loans is a notable exception.

In the latest survey, for instance, 18 banks said demand was moderately or substantially weaker than three months earlier, but only nine said it was moderately stronger. On balance, the Fed said, 60% of U.S. banks reported weaker demand for commercial and industrial loans.

The O’Briens have long dreamed of being debt-free. But they began to pay off loans more aggressively after Jeff O’Brien’s construction work dried up last year, leaving them at times without steady income to support mortgage, car, credit-card and student-loan payments. Mrs. O’Brien took on more free-lance work, while her husband transitioned into a career as an insurance adjuster.

In the meantime, they have scrimped and saved to pay down a third of their $30,000 credit-card and student-loan debt and sold Mr. O’Brien’s beloved Ford truck to eliminate that monthly payment. Aside from the mortgages on their two houses — one they live in, and one they rent out — they are planning to be debt-free by next April.

“Once we do that, we’ll tackle the mortgages,” Mrs. O’Brien said.

They aren’t alone. At Arizona Central Credit Union in Phoenix, which has 70,000 members, loan applications plunged last fall as the financial crisis intensified. The credit union saw more than 3,000 loan applications in September, totaling $13.9 million, a “fairly normal” month according to chief lending officer Patty Aker. That dropped to 2,300 applications in October, just over 1,000 applications in November and 900 in December. Loan applications rose slightly in January, then dropped again in February, to 895, totaling just over $4 million.

“We’ve got money to lend, it’s just that people were so nervous about what was going on in the economy,” Ms. Aker said. “So many people had lost jobs or were afraid they’d buy a car and then GM wouldn’t be around anymore to honor their warranties.”

More than two-thirds of Arizona Central’s $285 million loan portfolio are vehicle loans; the rest is comprised of other types of consumer loans and a small amount — about 10% — are small-business loans.

Across town, the National Bank of Arizona, primarily a business lender, is seeing a similar drop in demand. Business applications for new-equipment leases tumbled 28% in the first four months of this year, compared with the same period in 2008. Loan applications from small businesses are down 11.5%.

“Deal flow just came to a screeching halt” late last year, said Brent Cannon, executive vice president at the bank. He added that because many small businesses use their home equity as collateral, woes in the Phoenix real-estate market threaten to keep a lid on demand.

Lending can’t be forced. This is the End of Consumerism in action. Credit expansion only goes on for as long as the people play along. When they’ve had enough, they’ve had enough.

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True Money Supply – September 09th 2008

As you can see above, the intermediary money supply data for September 08 indicates a further slowdown in true money supply growth. The effects of the bailouts of Fannie May, Freddie Mac, and AIG are not yet included in the data available, as this is from 09/08/2008.

It will most likely be available with the next set of data.

Over the past three months the impact of the slowdown of the true money supply has finally reached commodities and consumer prices, in addition to the already declining home and stock prices.

The overall outlook for the next months is a further lowering of stock, real estate, commodities, stock prices.

The US is facing a major credit crunch and an unprecedented economic correction. Rather than allowing the correction to occur freely, the government has embarked upon a path that it will not be able to back down from. One financial institution after another is being bailed out with public funds.

The Federal Reserve Bank has already filled up close to 50% of its balance sheet with bad debt. Policymakers have realized this and hence suggested setting up a completely separate entity to do just that: Buy bad debt from troubled banks, backed by taxpayer money.

I assume their reasoning is that they want to avoid turning the FED, it being the supposedly trustful lender of last resort, into a junk deposit which would sooner or later have to write down delinquent mortgage loans and factually declare bankruptcy. Instead they are trying to spread the garbage evenly across different institutions: Large banks (BofA with Countrywide, JP Morgan with Bear Stearns), the FDIC (Indymac), the Federal Reserve Bank (AIG and various bad debt instruments acquired against treasury bills in the term auction facility), and presumably the soon to be established Treasury sponsored entity.

Of course all these measures are bound to fail. With every intervention the final shakedown is merely being postponed and aggravated.

The main actors involved are clueless about the essence of the problems of credit expansion, the credit boom, and the credit crunch: The President has completely extricated himself from the process; Hank Paulson, the Treasury Secretary has fully endorsed a policy of interventionism as the panacea to the crisis; Congress leadership is hopelessly lost (as Senate majority leader Harry Reid said: “no one knows what to do”) and will most likely go along with anything that the President’s Working Group on Financial Markets will suggest, no matter how much it will cost the taxpayer. The SEC is about to announce another pseudo measure tomorrow: banning short sales on financial institutions. More prestigious businesses will be in line for bailouts shortly, in particular Citigroup, General Motors, Ford Motors, and General Electric are likely candidates.

What has been keeping the dollar strong recently is the fact that the federal reserve has not yet resorted to the ultimate weapon: hyperinflation. The money supply, as shown here has been slowing down. Most likely the Federal Reserve officials are not even aware of this because they are using wrong data to monitor the money supply. The question is if this trend will hold up with the interventionist path that the government continues to move forward with. We will keep monitoring the money supply closely.

Events indicate that we are approaching the collapse of the global financial system as we know it. As Libertarians and Austrian Economists have been warning again and again, and have been ridiculed for again and again: A fiat money paper currency system, facilitated by a central bank, will ultimately lead to the destruction of the paper currency and the collapse of the financial system.

One can only hope that once all this is over and decision makers will have to get together and frame a new financial system, maybe, just maybe people will at least sit down for a second and listen to the common sense solutions that we have been asking for over the years:

– Abolish the Federal Reserve Bank
– Allow for free market competition in the money market
– Let the market return to a gold standard
– Significantly downsize the federal government
– Abolish the federal income tax
– Abolish unconstitutional (and wasteful) federal institutions, in particular the IRS, the SEC, the Department of Homeland Security, the Department of Education
– Phase out the federal social security and medicare programs and let people manage their money themselves (one can only hope that at this point people realize what the government will do to your money)
– Reduce US troop presence around the globe, strengthen the defense of the homeland against foreign enemies (which is the first and foremost task of the federal government)
– and finally: legalize the US Constitution

It is disturbing that the crisis is giving me hope that people will listen. Common sense should lead people to these conclusions. Unfortunately common sense has not been very popular over the past decades.

(This article was first posted on 09/19/2008)

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Credit Expansion Policy

Objectives of Credit Expansion

Credit expansion is the policy where the central bank produces additional money in order to purchase debt from the government or from entrepreneurs, such as banks. In a system where gold is used as money there exist strict limits for money producers when it comes to credit expansion, due to the natural scarcity of the precious metal. In a fiat money system there are no natural limits on the amount of additional money produced. As a result, the interest rate for additional credit transactions drops.

The policy of credit expansion is broadly accepted as a measure to make people prosperous.

It is its declared objective to make credit abundant. New credit is said to spur business activity, capital becomes inexpensive, entrepreneurs can borrow more money for investments, commerce flourishes and soon all of society is permeated by the magical boon that the credit boom bestows upon it. Everyone is supposed to enjoy all the consumer goods they have been longing for under the stingy policy of tight credit.

This idea is based on the substantially flawed assumption that capital can be created out of nothing. Capital can only exist when factors of production are produced. Every investment necessitates the use of factors of production that turn out more or higher valued goods after a roundabout process rather than consuming fewer or less valuable goods immediately. Factors of production can only exist if people have generated savings. Savings are generated if one forgoes immediate consumption for the prospect of future consumption. Foregoing present consumption can only be feasible if one considers the future remuneration he gets in return more valuable than the immediate consumption he forgoes. This is what is called time preference. Time preference is expressed on the market in the form of interest rates.

This causality ensures that market interest rates always provide an indication of the time preferences of the individuals in that market, and hence the willingness to forgo present consumption of consumer goods for future consumption of goods created by new factors of production. While prices give entrepreneurs an indication as to which consumption goods are desired more and which less at a specific moment in time, interest rates provide a measure as to when they are desired or needed in the future. It creates an environment where entrepreneurs have an incentive to fulfill demands based on value preferences and time preferences at any given point in time.

The Effects of Credit Expansion

It is now necessary to examine what the process of credit expansion entails. The central bank that creates money does not own any capital, it does not create factors of production. The only thing it channels into the market is fiat money.

Before examining the purchase of credit instruments it makes sense to take an intermediary step and look at the simple purchase of consumption goods. For example, if it were to purchase houses with the newly printed money, its governing board could decide to supply the homes to all its officials. They will be able to enjoy the houses before their prices rises and hence they will not be available to other would-be buyers who would have purchased them at a lower price that would have represented their value preferences. The entrepreneurs selling the homes, too, benefit because they are the first ones to receive the new fiat money and get to spend it before other prices go up and before others get to spend it. Those who receive the new money later will suffer from the prices that have already gone up. While on the market, people can only buy goods when producing demanded goods in return, and while all transactions are based on voluntary exchange and value preference, the central bank does not act under these constraints. Its fiat money can be produced cheaply and the government enforces its acceptance and outlaws competition. Goods are hence violently withdrawn from those who actually produced demanded goods in exchange and end up in the hands of those who didn’t. Now, entrepreneurs will begin producing more homes, while withdrawing factors of production from other, more urgent, uses. If this plan were to be carried out to completion, at one point the majority of entrepreneurs would employ workers and resources in the production of houses for those who printed and enforced the money while a shortage of other demanded goods for all other individuals would ensue.

The equivalent, however, occurs in the sphere of time preference if the central bank purchases debt on the market. People who demand credit on the market issue credit instruments such as merchant bills, governments issue government bonds and bills. The credit instruments purchased by the central bank will go up in price after each additional purchase, interest rates drop as a tendency. Other providers of credit on the market whose time preferences were matched by the credit instruments offered will abstain from entering into the corresponding credit transaction. Now the central bank has withdrawn future money from the market that would have gone to those who were outbid by it in the process of purchasing the debt. They were not able to enter into a transaction that would have represented their time preferences.

On top of that, the interest rates for the loan contracts purchased drop below the market rate that represents actual time preferences of those operating in the market on a voluntary basis. This has the effect that the entrepreneurs’ assessment of time preferences is skewed. They think that present goods against future goods are valued less than actual voluntary time preferences warrant. Those roundabout projects, that were not being embarked upon, because interest rates indicated time preferences in favor of less roundabout projects (whose goods would be consumable earlier) now appear to be feasible. Entrepreneurs begin embarking upon more roundabout projects that yield an output in the farther future. At the same time they set aside those less roundabout projects which the market interest rates would have induced them to begin, had the credit expansion not taken place. The result is now precisely that consumers are again not supplied with products as desired as per their time preference.

The Credit Boom

Since no additional capital has been created via real savings, prices for factors of production used for the longer term will rise. The stock market, it being the main market for factors of production, will see a price increase, primarily in those stocks for businesses whose projects yield a later output. In particular, a lot of businesses incorporate, that are currently not producing anything, nor plan to produce immediately, but are rather aiming to turn out goods a few years down the road, after spending time on roundabout research and production processes. As a tendency, the labor force of society becomes employed in roundabout, long-term projects.

The same holds true if the credit instruments that are purchased are largely used to finance a specific consumption good, such as owning a home. By purchasing home credit instruments, the central bank will create an environment where many individuals who have not produced enough to exchange against a home will nonetheless obtain a home. Prices of homes will rise since the credit expansion has not at all expanded the amount of homes produced on the market. It is only after this initial expansion that more and more entrepreneurs will begin employing more and more workers in the home construction business.

The Credit Crunch

The labor force, however, at the same time represents the bulk of the consumers whom those products are intended to be produced for. But their time preferences have not changed in reality. While being employed in very roundabout projects and processes, they still desire present goods over future goods more strongly than the entrepreneurs expected based on the lowered interest rates. After the credit expansion is completed, consumer spending and saving habits will not be in line with those expectations. They demand more present products than are available and hence bid up their prices. Due to their shortage, an overall tendency towards rising prices for present consumption goods, such as food and gasoline, ensues. People will need most of their money to buy these consumption goods and hence cut back on spending it elsewhere or making it available in credit transactions. Market interest rates will now readjust in accordance with real time preferences again, based on real savings. They will move up to the market level again. Incorporation of companies with overly roundabout projects will decline. Some entrepreneurs, who are in the middle of overly roundabout projects will not immediately realize this. They will keep employing factors of production in these projects.

However, when they announce their new earnings expectations they will have to take into consideration the fact that most consumers will not have enough money left to purchase their products. They will have to let the capitalists know that their capital will not yield the return expected. This will cause a downward pressure on the prices of those factors of production used for overly roundabout processes. Correspondingly the prices for shares in such companies decline. They will be sold at prices that reflect true time preferences again. However, the time that resources have been employed in overly roundabout projects has been wasted. The true yield of their output did not match the capitalists’ expectations. The capitalists have suffered a loss.

Some of the factors of production and workers will have to be released from their current employment and need to be employed in new lines of production where they contribute towards the production of more urgently demanded consumer goods. Flexible resources will be aligned accordingly and the supply of those goods will increase again and hence their prices will drop back to market levels. Other resources however, which are fixed and specific to one particular project and are merely half finished may be forever lost, in particular this will be the case for huge construction or manufacturing projects that involve the erection of factories, machinery, etc. which have turned out to be useless. A credit contraction will occur and the money supply will be reduced to lower levels in a healthy deflationary process which induces people to save and spend as time and value preferences mandate. The market, once again, returns from an inflationary, regressive resource misallocation to progress and a move toward market equilibrium.

Depending on the amount of excess credit channeled into the market and depending on the duration of the credit expansion, the repercussions can be anything between mild and disastrous.

It is a fact that the correction of the allocation of labor and other factors of production is highly unpopular with the populace. As a rule, individuals, in particular entrepreneurs from businesses employed in unprofitable lines of production, will be in favor of continuing the credit expansion. The positive term “correction” will be replaced by the unpopular word “recession”. A prudent government should not fall for this fallacy. If the process of readjustment is not hampered with, the problems caused by the credit expansion will be within limits. The market will quickly recover, albeit, at a level that is less desirable than where it could have been at without credit expansion. If, however, the government doesn’t allow for the correction to occur, the misallocation of factors of production will be kept up and aggravated until it all culminates in a devastating collapse.


The objective of credit expansion, namely to ensure that more capital is generated in order for the market to provide more of what consumers demand, fails. In fact, it has the opposite effect. It skews the entrepreneurs’ judgment and makes them align resources to produce products that consumers are not demanding and makes them use factors of production for processes that turn out products later than consumers are demanding them while withdrawing them form those production processes that would have been in compliance with consumers’ time preferences.

Historical Relevance

The policy of credit expansion has been pursued by governments time and time again. It has become prevalent in the United States under President Woodrow Wilson after the establishment of the Federal Reserve Bank under the Federal Reserve Act during the Christmas Holiday of December 1913. Since then, it has caused major credit booms and crunches in the form of asset booms and subsequent crashes and economic booms and subsequent recessions. In particular this has been the case in the years of 1929, 1987, and 2001, and will be visible in 2008 and the following years. It has always precipitated precisely the effects outlined above. Its workings and effects have been fully explained by this theory of the business cycles. No one has ever refuted the correctness of this theory.

Yet, to date economists and politicians appear completely riddled as to what causes booms and crashes. It is claimed to still be a matter of discussion amongst experts. It has been attempted to impute it upon humans’ greedy nature and natural exuberance. Whenever a crisis emerges the pundits, experts, central banks and politicians will try and regulate the market to stave off the impending crunch. They forget or don’t have the intellectual capacity to understand that it has been their own policy that has caused the crisis in the first place.

As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs. Neither is there any need to be surprised about the fact that all countermeasures taken by the government will turn out to be utter failures that will accomplish nothing but aggravate the crisis. For if the cause of the problem has been too much government intervention, then more government intervention will only add to it.

Update: I refined the process and added much more detail in the post The Business Cycle.

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