Anatomy of a Credit-Induced Boom-and-Bust Cycle

Billy Bob and Planetary Resources, Inc. both want the computer, but there’s only one to go around. They end up bidding against one another, prices have to rise, and that’s what leads to the bust phase of the business cycle.

Come again? What I’ve just described is part of the Austrian theory of the business cycle. Friedrich Hayek’s theory of the business cycle, which builds on the work of Ludwig von Mises and Eugen von Boehm-Bawerk and which finds its best modern explanation in Auburn University economist Roger Garrison’s 2000 book Time and Money: The Macroeconomics of Capital Structure, emphasizes how a government monetary injection leads to a business cycle.

How does this happen? The first thing we should do is ask about "an economy working right" because, as Hayek notes, we have to know how things could go right before we could possibly know how they might go wrong. For John Maynard Keynes and others following in his intellectual footsteps, macroeconomic questions are questions about relationships between very high-level aggregates—aggregates like Gross Domestic Product, Investment, Consumption, and so on. As Hayek argues, however, "Mr. Keynes’ aggregates conceal the fundamental mechanisms of change."

Hayek’s business cycle theory, on the other hand, focuses on those mechanisms of change. Let’s consider two cases. In the first case, we will see how the economy responds to an increase in real saving. In the second case, we will see how the economy responds to a credit expansion.

For simplicity’s sake, we’ll consider a story featuring three characters: there’s the aforementioned Billy Bob, who is considering buying a new computer. There’s Walmart, which sells computers to consumers who use them for email, games, and other stuff. Finally, there’s our other protagonist, Planetary Resources, a firm that wants to earn its income by mining asteroids (seriously, this company exists) and that is investing in developing new technology that might make this possible. Someday.

Billy Bob, after thinking about it, decides that his old computer is good enough. Instead of spending $1000 on a new computer, he decides to put it in his savings account so he can buy something better someday. This increases the supply of loanable funds, lowers the interest rate ever so slightly, and leaves a valuable resource—a new computer—available for someone else to purchase.

In response to the lower interest rate, Planetary Resources decides to expand its R&D operations ever so slightly. In order to do their R&D, they will need…a new computer. They borrow the $1000 that Billy Bob has saved and buy the computer he decided to leave on the shelf at Walmart. There’s a dip in consumption spending, but there’s an increase in investment spending. We get less consumption today, but we also get more investment. The computer Billy Bob decided not to buy, instead of being a $1000 Facebook machine, becomes an investment that a scientist at Planetary Resources uses for research that might not pay off for years. This investment means even higher consumption possibilities in the future. In response to an increase in the saving rate, we get more economic growth.

Contrast this to what happens when the Federal Reserve injects new reserves into the banking system. This injection of new reserves increases the supply of loanable funds and lowers the interest rate, but—and this is crucial—it does not create any new investable resources. In other words, it doesn’t create any new computers, or hammers, or wrenches, or tractors.

In response to the lower interest rate, Planetary Resources decides to invest more. They respond to the credit expansion just like they would respond to Billy Bob’s increase in saving. Billy Bob, however notices that interest rate has fallen and therefore decides to save less, not more. In our example, this means he decides to buy the computer since he wouldn’t earn much interest if he just left the money in his savings account.

Billy Bob and Planetary resources each have $1000 with which they want to buy a new computer. The problem is that there is only one computer on the shelf, so Billy Bob and Planetary Resources end up bidding against one another. This causes computer prices to rise, say to $1100. This wouldn’t necessarily be a problem, but there are firms that have made plans and hired workers or bought office furniture or started new projects based on the expectation that they would be able to buy a computer for $1000. Some of these projects will no longer work out and some firms will no longer be profitable with $1100 computers. Hence, these projects (and firms) have to be liquidated, and we end up with unemployment during the "bust" phase of the business cycle.

The economist Tim Harford wrote in The Undercover Economist about "Competitive Markets and the World of Truth." Indeed, competitive markets are truly spectacular as they assemble and transmit knowledge about consumers’ tastes, available technology, and available stocks of natural resources. The problem with credit expansion is that it means that prices are no longer telling the truth. Billy Bob and Planetary Resources both went to the store with the expectation that they would be able to get a computer for $1000. Both were wrong, at least one of them ended up having plans thwarted, and the economy as a whole experienced unemployment and dislocation as people adjusted to the fact that the prices informing their plans were inaccurate.

An economy works right when the prices are telling the truth, and things go badly when the prices get distorted. When a central bank starts playing fast and loose with the money supply, price distortions are an inevitable result. These distortions in turn lead to the kinds of problems we call on central banks to fix—problems we wouldn’t have if central banks hadn’t created them in the first place.