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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.

When a central bank starts playing fast and loose with the money supply, price distortions are an inevitable result.

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.

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  |     |   Comment #1
Great post! A couple of thoughts...

When prices are distorted in a higher direction, competition becomes a bad thing because the plans individuals and firms made assuming a (lower) price are no longer viable. What about when prices are distorted in a lower direction? Say, injections from the central bank lead the computer manufacturer to take out loans in order to ratchet up the production of its $1000 computers in order to sell more by offering them at a lower price point that has been determined would generate more profit for the company. Does Billy Bob benefit from that scenario by saving on consumption, or was his purchase unnecessary through and through? I'm not sure why the computer manufacturer doesn't build more computers to meet the increase in demand created by the injection.

I think the thesis of this article is that when consumers delay consumption (unprovoked by government liquidity injections), they increase the borrowing power of businesses who will be more productive with the resources not consumed by individuals, and this is a net good for the economy. 
  |     |   Comment #13
This is a very interesting question. The distortion would take place farther up in the structure of production as computer manufacturers compete for the capital goods and labor they would need in order to actually produce the new computers. The computer company might be able to take further advantage of economies of scale, but they're also competing for labor, capital, and raw materials with other firms that are looking to expand. They will likely find that their expectations about being able to produce at a lower cost are incorrect.
  |     |   Comment #2
Bravo to the guest poster.  It's good to see an article on Austrian economics posted here.  It goes a long way toward explaining the current absurd interest rate environment of today.
  |     |   Comment #3
"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."

Well, Fed. create problems and then proceed to solve their own problems (it is called "make work" in the industry)... and get paid for doing both (creation and solving) with net zero-gain.  A sure win-win for them.
  |     |   Comment #4
This article is missing lots of other things to be credible.
First, it is to idealized and not factual.
Second, there are so many variables connected to the production of an item for sale, that the price can be manipulated from anyone who participated into producing that item for sale.
And finally, but not the least our government influence our boom and bust by shifting policies, money supply, interest rates and psychological lies.
  |     |   Comment #5
While the simplified example is amusing, it is far from convincing.  The Fed has been following easy money policy now for 5+ years.  For all of that time, those like the author of this article have been predicting inflation.  Where is it?  The Consumer Price Index has remained very low throughout; and, ,or the past three months, the producer price index had been negative.  How many years of being wrong does it take before those predicting inflation from easy Fed money start questioning their theories?  In my view, Paul Krugman has been right and all of these inflation hawks have been wrong.
  |     |   Comment #6
Your reasoning is also flawed.  The Consumer Price Index is highly manipulated by the Fed. by picking and choosing what goods and services to base the CP Index on to arrive at the bottom line number they want.  Leaving out such basic things as energy, medical, education, insurances, taxes, etc.  All basic necessities everyone finds hard to do without but are constantly increasing in cost.
  |     |   Comment #7
The inflation is in housing and the stock and bond markets.
  |     |   Comment #15
actually the bond markets show the exact opposite...
  |     |   Comment #17
The easy money from the Fed has been making its way into bank reserves. But we haven't seen inflation because these reserves haven't hit the economy (yet) since there isn't a big appetite for loans. Therefore, $2.4trn of "stimulus" assets are just sitting at the Fed earning 0.25%.

As soon as the economy starts to pick up, and people and businesses demand more loans, you will start to see these reserves unwind into the economy and that's when the inflation will really begin.

The Fed is hoping it will be able to catch this when it happens and reduce the money supply, but if it does so too early it will risk recession, too late and we could see hyperinflation. And let's be honest, which central banker wants to be the cause of a recession by tightening too early?
  |     |   Comment #8
Then explain Europe? Their central bank is not regulated and look at Europe? 
  |     |   Comment #9
While this article describes a hypothetical case, it just doesn't reflect the actual experience of the US economy over the past five years.  As comment #5 points out, data continues to show the low inflation of a liquidity trap predicted by Keynes, not the high inflation called for by the Austrain school.  And history does not show central banks causing credit booms and busts like 2008, but instead enacting policies to counteract them.  Admittedly the Bernanke Fed could have done a better job slowing down the housing bubble by raising rates faster, and later overdid it by lowering rates beyond the point where they have much effectiveness.

Like the Fed, economic statistics are certainly imperfect but the trends over time are meaningful.  Comment #6 is mistaken, headline CPI includes all the expenses mentioned (only Core CPI excludes food and energy) and is produced by the Bureau of Labor Statistics, not the Federal Reserve.  And if there is skepticism about data compiled by government career civil servants, inflation measures are also published by numerous private firms.  They show similar trends - low inflation despite increased money supply due to insufficient demand - consistent with a Keynesian liquidity trap.
  |     |   Comment #10
This is not a normal economy, this is not a market driven economy, this is manipulated economy, therefore, this article can not be applied as an example of current, past or future booms or busts. Obama changed all of that, we live in a make believe economy, big unemployment, interest rates and health care are centralized and this is the beginning of the fall of USA.
The long term interest rates can not rise until USA runs deficits year after year, if they rise, the taxes must go up on everyone or USA must default on its debt, there is no third solution to the present problem. Printing money will destroy the dollar and all of our dollar denominated assets.
  |     |   Comment #11
Greenspan's new book tells how he and all the economists were wrong. OH NOW HE KNOWS after everything fell apart! He was a big follower and friend ( lunched regularly) with Ann Aynd. (sp) 
  |     |   Comment #12
Exactly, Greenspan and many other right wing economists continue to be disciples of Ayn Rand.  She is of course the Russian born atheist (check her bio) who argued that the rich and powerful are being exploited by the little guy.
  |     |   Comment #19
Yes I'm sure Jamie Dimon, the Koch brothers et al
cringe in fear at the mention of your name.
  |     |   Comment #14
Thank you all for excellent comments. This is a stylized example I’m using to explain some of the central logic of Austrian Business Cycle Theory. Andrew Young at West Virginia University has done some of the best empirical work on the issue. Among the hats I wear, I’ve done a few videos for the Institute for Humane Studies’ LearnLiberty project (disclosure: I was paid to appear in them, but I don’t get paid to promote them). They have a series of very nice, very short videos featuring Tyler Cowen explaining different business cycle theories here: http://learnliberty.org/speakers/tyler-cowen A few specific thoughts:
To AbeKuyper: The computer manufacturers would have to compete with other firms looking to expand, as well, so I doubt they will be able to produce at lower prices (the inputs--labor, capital, and raw materials--would likely get more expensive.

To gcomfort & Anonymous: The absence of inflation predicted by a lot of people who were concerned about various rounds of quantitative easing is definitely a point in (say) Krugman’s favor. There are a lot of things that go into explaining recessions, and the housing bubble was almost certainly caused by Austrian factors.

Thanks again for reading and commenting. I look forward to continuing the conversation in a future post.
James Leonard Hudson
  |     |   Comment #16
You write:  “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.”  Why ‘but’?  You are contrasting a saving/investment scenario with a money-creation scenario, but *neither* involves the creation of *new* resources.  In the saving/investment scenario, Billy Bob did not create anything; he simply refrained from consumption; and Planetary Resources has not yet created anything (though it *may* do so in the future—that, at least, is its intention).  And why ‘ínvestable’?  Injecting new fiat money into the system does not (directly) create *any* new resources, for investment *or for consumption*.

In your further description of the second (money-creating) scenario you assume that the money-creation was *unexpected*.  You should have mentioned that right away, in the initial description, since *expected* money-creation has none of the bad consequences that you attribute to the *unexpected* kind.  Also, you should have mentioned that unexpected money-*destruction* (or -*withdrawal*) can have similar disruptive effects on the economy.

The lesson seems to be that the fiat-monetary authority should avoid surprises; it should create a definite expectation about how much base money it is going to provide, and then it should provide just that amount, neither more nor less.  It should function by rule, eschewing discretion; its monetary policy should be fully pre-committed.

Does it matter which rule the monetary authority commits itself to?  That is a question that would have been, and is, worth addressing.
  |     |   Comment #18
Those of you who like Austrian Ecomomics might also enjoy gaining expertise in
pre-Copernican theories on teh center of the universe.
  |     |   Comment #20
This is a correct analysis but has been distorted in my view in recent years via labor arbitrage. Yes the Fed through cheap money and credit discourages savings and promotes consumption and or asset bubbles. Here is another distortion created as mentioned above via so called free trade agreements. When savings are high as they have been in the past, a new pardigm has emerged. American Corporations and others have borrowed the money to manufacture "off shore" abandoning the American worker for greater profits using cheap labor. What does this do? It shifts GDP, Gov.tax base, Federal, state and local municipalities to the outsourced countries. All this money lost to off shoring of our manufacturing is a loser to America and profits the Global executives only. To add insult to injury, we buy the products made by others that were once made by us here in the U.S. Guess what else!...those same banks that we put our savings and loaned to Manufactures that used these savings for outsourcing our jobs are happy to loan us the money to purchase these products.

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