Best way to argue that the Fed creates the business cycle

Economics Political Theory
1

How should I best respond to my teacher’s question, “How does the Fed create an economic downturn?”

My teacher argues otherwise, believing in Kenyesian economics, saying that things like “overconsumption” lead to the downturn, and that the fed can stop this by pulling policy levers.

I wanted to try to prove my case by showing how commodity based banking works, how fractional-reserve banking works, and how the latter creates the business cycle. Then, I will expand this to the Fed. Here is my current paper; I just want advice, as I need to know more austrian econ.

My article:

For the purpose of this argument, I am going to extensively discuss money, banking, and the Federal Reserve to show how the Fed can create an economic crisis.

Throughout history, money has served an important role. I will demonstrate with an example. Suppose that I was a farmer, and I wanted to trade some of my produce in order to get better tools. In a barter economy, what would I have to do? I would need to find somebody who had these tools that wanted to trade them for some food. If I found this person, I get the tools I want, but suppose I can’t find someone with tools who wants to trade them for food. In order to obtain the tools, I would have to trade the food for some intermediate good that someone else wanted to trade, then trade the intermediate good for the tools. But, which intermediate good would I need, and what if I can’t find somebody to trade tools for the intermediate good? In order to get the tools, I may be required to do a chain of transactions, or increase the price I have to pay to give an incentive for the trade. Money solves this problem, by being a commonly accepted intermediate good. Historically, gold has often fulfilled that role.

Now, as a hypothetical example, lets say we have a town that specializes in the production of iron. It produces so much iron, that it frequently exports it to other places for other goods. Suppose this metal emerges as the commonly accepted currency in the town.

Unfortunately, there is a problem with this. First, it is cumbersome to carry all this iron to trade to other people, especially with large transactions. Second, it requires quite a bit of storage space, in order to save the metal for future use. Third, there is also the problem of securing the metal from outside theft.

After recognizing these problems in the community, a smart entrepreneur starts what the town calls an iron reserve. The iron reserve, for a fee, allows people in the community to deposit metal in the iron reserve’s secure vaults. The depositor then receives a number of notes, depending on how much iron they deposit. For example, if I deposit 10 kilograms of iron at IronStrong, and the iron reserve gives one IronStrong note for each kilogram deposited, than I get 10 IronStrong notes. Someone who deposited 100 kilograms of iron would receive 100 IronStrong notes. These notes can be traded in place of the iron for other goods and services.While the place is open, anyone that has IronStrong notes (even if they never deposited iron at IronStrong) could go to IronStrong and redeem their IronStrong notes for iron, giving back 1 IronStrong for one kilogram of iron from the reserves.

This entrepreneur soon faces competition as other companies enter, hoping to profit by storing people’s iron. They compete over things like the quality of service, security of the iron reserves (to deter robbers), price of the service, and the quality of their notes (how easy are they to counterfeit?). Conversion between the different currencies is easy, as each note represents a certain amount of iron. The wants of the people that hold iron, the problems they face, are solved through iron reserve banking.

One day, however, one iron reserve, Uncle Sam’s Iron Reserve, figures out a way to cheat the system. While keeping its exchange rate at one Sam Note for one kilo of iron, the iron reserve starts creating additional Sam Notes, then lends them out to people to make an additional profit. Unlike IronStrong, which has exactly one kilogram of iron for every IronStrong note, Uncle Sam’s Iron Reserve has less less than one kilogram of iron for every Sam Note.

Any thoughts?

2

“Over”-consumption relative to what?

-Jon

3

Let your teacher know that she’s not looking at the ultimate cause. To be sure, if one wants to use the Keynesian language, you could say that certain goods were overproduced, and that certain goods were overconsumed in the production thereof (aka misallocation of resources). However, that’s merely looking at the end result of the whole credit expansion.

4

Oops, Jon, I meant overproduction.

Sorry about the typo[:(].

5

Then I agree with BAAWA. She is not identifying the root cause.

-Jon

6

I asked him what the root cause is and he responded:

“When businesses see a profit to be reaped by any given situation they will increase production. When more suppliers enter the market, there is often times a glut of products or services, and more than enough supply to meet demand. Businesses then slow production and in the process freeze hiring or slash employment. This is then the downturn we often see in an economy.”

Looks like this still isn’t the root cause. Oh well.

7

The problem with your teacher’s idea is that he isn’t looking at where the funding comes from for those new suppliers. Usually it’s either from venture capitalists or the credit expansion of the central bank.

8

Why should this cause systematic clusters of errors? This isn’t so much an answer as a cop-out. Inefficient entrepreneurs are penalized on the market, efficient ones rewarded. Factors that are released from production are diverted elsewhere.

-Jon

9

Hi Elliot,

Business cycles occurred in the US prior to the creation of the Fed, and also occurred in nations that consistently followed a fairly strict interpretation of the gold-standard (although they did allow fractional banking).

Of course this isn’t to say that the Fed does not or could not do so. Maybe your teacher is only trying to point out that business cycles might also have other causes.

M.

10

I’m not sure if I am helping with this comment, but it is much easier to attack the FED on price stability. Pre-fed, prices were stable, post FED, prices have been consistently inflationary.

In order to mount an attack on the business cycle, you first have to cover Austrian theory on credit.

If possible, my advice would be to attack the FED on price stability, and if given follow up opportunities, make the case for Austrian theory on credit expansion, and then finally how the FED facilitates such expansion without allowing for the natural contractions to maintain price stability, which leads to deep and depressing downturns.

Also, there may be something to be gained by looking into Rothbard and Hayekian analysis of Keynesian theory as it relates to a central bank.

11

Substitute Fed for coercively imposed FRB, and the answer remains the same.

-Jon

12

the best thing to do is to drop the class, that’s what I did[;)]

13

I think the best way to argue this point is to show how central banks can create higher demand for capital goods by lowering real interest rates, which increases the rate of economic growth. Then, you have to show how the low real interest rates are bound to rise because they are not backed up by saving but by monetary creation. It’s inevitable that central bank monetary creation creates a credit crunch.

Basically, if the Fed lowers rates, which in turn makes banks lower rates, the lower real interest rates allow for more investment in capital goods - the source of economic growth. However, the credit creation will undoubtedly raise prices across the board, making the natural interest rate higher for investment in capital goods. Likewise, the real interest rate will raise as banks begin to raise interest rates to hedge for inflation. Another factor is that consumer goods producing businesses will find it more profitable to employ labor instead of capital because inflation will rob labor of its wages and bring in more profits to the employer. Yet another thing is that increased profits in consumer good industries will funnel investment away from capital goods industries and towards the consumer goods industries. This is another contributing factor to the inevitable collapse of capital goods industries that we see at the end of a boom.

ABCT can be essentially summed up like this: Lower interest rates spur a boom in capital goods purchase and production, causing an economic boom. However, the inflation that results from credit creation robs employers from the return they get on capital and makes it comparatively more profitable to employ labor instead of capital. Likewise, inflation causes banks to raise interest rates. This causes capital goods producing businesses to downsize and even shut down, while consumer goods producing businesses cease use of capital goods in favor of labor. This causes a downturn in production and, consequently, a recession.

14

I found it useless to argue with the professor or anyone in my macroeconomics class, that’s why I dropped that class.

I felt like a black man trying to join the KU KLUX KLAN.

plus, you never learn anything useful. It’s a waste of time and money. But

if you really have to take the class, just make sure to get the highest grade you can coz you don’t

have to prove anything to them, for now.

15

could you please provide a more in depth explanation krazy kaju?

16

Someone much more intelligent than myself has already done that (Chapters 5 and 6).

17

Thanks, I am beginning to read it, and it is helping my understanding of Austrian Econ.[:)]