Business Cycles: An Email to My Logic/Philosophy Teacher

Economics Economics Questions
1

Anyways, my logic/philosophy teacher is pretty ballin’ and we often have discussions about politics, economics, and other issues relevant to philosophy. Basically, he’s a really cool teacher. Sometimes, I stay after class and talk to him. Today, he asked me how my “laissez-faire” beliefs can respond to the recent economic crisis and how such a crisis would be avoided in a free market society.

I explained the role that Fannie & Freddie regulators at the HUD played (by requiring large amounts of purchases of subprime loans) and how rising housing prices actually create an incentive for banks to give bad loans and people to take them (if you default, the bank gets a house worth more than the loan, if you’re lucky you can sell the house for significantly more than you bought it or you can refinance). I also mentioned ABCT and the Austrian school of economics, but since passing time was close to an end, I told him I’d send him an email.

The email could help some noobs trying to understand the Austrian theory of the business cycle and why credit expansion in all forms (including fractional reserve banking) is bad.

Here it is:

Hey Mr. [redacted],

I’ll start off with some good links on the subject and then provide a shortened

version of the Austrian theory of the business cycle. The so-called "Austrian

school" of economics has a good website dedicated to its chief 20th century

proponent, Ludwig von Mises, at mises.org. The Austrian school had a strong

presence in the academic world in the early 20th century, before the "Keynesian

revolution," when Austrian and classical theories were swept aside without much

debate.

But to cut to the chase, here are some good audio files from the Ludwig von

Mises Institute about the Austrian theory of the business cycle, which is

sometimes called the monetary theory of the business cycle, due to its focus on

the effects of credit on the productive structure of an economy:

http://media.mises.org/mp3/Salerno2/Salerno-10.mp3

http://media.mises.org/mp3/audioarticles/3038_Thornton.mp3

http://media.mises.org/mp3/Thornton-ASSC-11-02-2007.mp3

Some good online books that deal with business cycles, among other things (you

can also purchase them from the Mises Institute store):

Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto:

The Austrian Theory of the Trade Cycle and other essays, edited by Richard

Ebeling: http://mises.org/pdf/austtrad.pdf

Failure of the “New Economics” by Henry Hazlitt:

http://mises.org/books/failureofneweconomics.pdf

Economics for Real People by Gene Callahan:

If you read any of these, I would recommend "Money, Bank Credit, and Economic

Cycles" by de Soto as the first book you read. The first part of the book deals

with the legal implications of fractional reserve banking, but it isn’t really

relevant to what we’re discussing. The part dealing with business cycles starts

around chapter four and five, so that’s where I suggest you begin reading. If

you prefer to read physical copies of books, you can either print the PDF,

purchase the book for $50 at the Mises store or $45 at Amazon, or I can let you

borrow my copy for a while. I also have "The Austrian Theory of the Trade Cycle

and other essays," but it’s such a short book that you might as well read it

online (though you can borrow it if you want to). "Failure of the 'New

Economics’" deals mainly with the failure of Keynesian doctrines, though it does

explain the Austrian viewpoint, while “Economics for Real People” is a really,

really good and readable introduction to basic Austrian th

eory, which I recommend you read some time.

Anyways, on to my own, shortened explanation of why business cycles are not

inherent in free markets:

In order to understand why business cycles occur, I think one first has to

understand how a normal economy grows. A normal economy grows when people defer

consumption so that they can save. Saving takes the form of buying CDs, bonds,

stocks, etc. The more people save, the more loanable funds there are in an

economy, and thus, interest rates are lower. These saved funds have two

functions: they can be used by the saver to purchase “higher order” goods or

they can be used by a borrower who utilizes the lower interest rates to purchase

higher order goods. Higher order goods are goods that require many stages to

plan - things like houses, cars, machinery, factories, etc. Often times,

economists will call these goods “capital goods” because most higher order goods

are capital goods, though obviously houses and cars can’t be considered capital

in the true sense.

In any case, an increase in saving means that there will be an increase in the

purchase of these higher order goods. Likewise, an increase in saving would mean

an acceleration of economic growth, since businesses would have more money to

purchase capital goods via loans and the stock market. Here we see three things

happening:

  1. Interest rates go down/loanable funds increase, causing an increase in the

demand for higher order goods.

  1. Wages and consumer prices begin to depress since less people are purchasing

consumer goods.

  1. Entrepreneurs begin building more higher order goods, due to the higher

demand/profits. By doing so, they begin to bid wages back up to their original

pre-saving levels.

When all of the above happens, consumer prices actually experience deflation*,

first because of a drop in demand, and second because of an increase in capital

goods allowing businesses to produce consumer goods at a lower price than

before.

Keynesians might reply that falling wages are bad, but this is only in an

economy burdened by government regulation. In a free market, wages and prices

are flexible, since there are no minimum wages or unions setting wages above the

market-clearing wage rate. Thus, when consumption falls, wages readjust.

However, in an economy where the government heavily favors unionized workers,

minimum wages and three year union contracts prevent wages from falling, and

thus force employers to lay off their least productive employees, which

obviously isn’t very conducive to increasing economic prosperity.

The above pretty much sums up how a normal economy grows. Everything so far is

just dandy. However, when government steps in by encouraging credit creation,

either by setting up a central bank or by encouraging fractional reserve

banking, the way the economy grows changes dramatically.

Basically, the new money created by banks acts as if it were saving. The real

(inflation adjusted) interest rate falls, thus making certain business decisions

more profitable than before. Since there is an increase in loanable funds,

businesses can purchase more capital goods, entrepreneurs can start businesses

more easily, and individuals can purchase more houses, vehicles, and other

higher order consumer goods. So everything seems dandy: the economy begins to

become better as it becomes more capital intensive, jobs are created, and more

products can be produced.

However, something happens that could not have happened without the introduction

of new credit into the banking system. Prices, instead of falling, begin to

rise. Since consumption wasn’t sacrificed for saving, wages and prices never

actually fall. The new entrepreneurs who produce the capital goods necessary to

feed the expanding economy thus face a problem when the wages and prices they

were originally expecting to pay begin to rise. In order to be able to fund

their projects, they are forced to take even more loans.

Basic economics tells us that the price is where supply and demand meet. An

increase in the demand for loanable funds due to inflation forces banks to raise

interest rates. Before the original credit expansion, real interest rates could

have been something like three or four percent. During the credit expansion,

real interest rates might fall to something like two percent. But as the demand

for loanable funds rise**, interest rates rise, and all of a sudden demand for

higher order goods begins to fall. Why this fall? Well again, basic economics dictates that the

higher the price the lower the demand will be. When interest rates (prices on

credit) begin to rise, less people will purchase less houses, cars, machinery,

factories, etc. This, combined with the fact that now entrepreneurs producing

the higher order goods need more loanable funds to offset price inflation, means

that a large number of investments need to be “liquidated.” Businesses that

produce higher order goods will be forced to either shut down, lay off workers,

or lower wages (or perhaps some combination like shutting down certain plants,

laying off workers at some other

plants, and lowering wages overall, like we’ve seen happen with the auto

industry here in Michigan). This is the start of the recession. Wages begin

rapidly depressing and there also generally occurs a monetary contraction as

banks begin to stockpile higher reserves to pay people who are taking money out

of savings accounts.

At some point (up to a year in the worst case scenario), the businesses that produce “higher order goods”

liquidate enough assets, and the market clears as wages and employment begin to

return to their normal levels. However, this is only in the scenario that

government decides to keep relatively free markets. If, as happened during the

Great Depression, government decides to step in with subsidies, price controls,

bailouts, more regulation, union favoritism, etc., wages and prices cannot fall,

employment will spiral out of control, and it will take more time for the market

to clear.

As a “layman follower” of the Austrian school, I really do hope that we do not

have a new New Deal. Their corporatist/semi-socialist policies, ones that were

based on the failed economic policies of Benito Mussolini, caused the Great

Depression to be truly great. Previous depressions in the 20s never lasted more

than a year because the government didn’t do much to prevent the market from

clearing. But as soon as Smoot-Hawley and a plethora of other legislation passed, the economy took a turn for the worse.

  • It’s important to differentiate between secular price deflation, which is what

I’m talking about, and monetary contraction. Oftentimes, economists say that

deflation is bad, though they are actually referring to monetary contraction,

which is sometimes also called deflation. Monetary contraction is when money is

destroyed, though this does mean a higher purchasing power per monetary unit, it

also means higher interest rates, which hurt the economy. However, secular price

deflation (that is price deflation w/o contraction) is good since it allows the

economy to grow and real wages to rise.

** An increase for the demand for loanable funds is not the only reason interest

rates increase. Banks will often want to hedge themselves for inflation, because

sometimes price inflation is so high that real interest rates actually go

negative - in which case banks will obviously want to raise their interest rates

so they wouldn’t be losing purchasing power. Similarly, people will stop buying CDs, bonds, etc. if real interest rates

become negative or too low, causing a contraction in the actual supply of

loanable funds. At the same time, demand for capital goods might fall even more

than I discussed, not only due to an increase in interest rates, but also due to

an increase in inflation. If price inflation is running high, businesses that

previously purchased capital goods, might find it more profitable to hire

workers instead of purchasing more capital - further causing “higher order”

businesses to go bankrupt.

Sincerely,

Alex
2

Nice. You almost have too much stuff, there, but if he’s a cool guy – and that’s a rare thing as a professor – I would imagine is pretty curious to have all of this new stuff even if this isn’t resolved right away.

Plus, you have a lot of material there that even I haven’t read (which isn’t saying much in terms of economics) so you look to be presenting “the goods” so to speak pretty well and demonstrating a good working knowledge of it.

3

That’s actually pretty good, perhaps Rothbard’s America’s Great Depression would have been good also?

4

Technically speaking, he’s a teacher, not a professor. I’m still in high school (I’m 17, which means it’s my senior year, woot woot!) and he only has a major in philosophy.

But yeah, I didn’t want to put too much. Then again, I really couldn’t have put any less. I mean, if I would’ve left anything out of what I wrote, I would have left a few huge gaping holes in our discussion. He’s been talking about the bailout a bit during the class (for some reason we talk more about economics in my logic class than in my economics class) and he repeatedly states things like “I’m not sure - I’m looking for what the answer is to all of this.” So even the end about the failures of the New Deal was necessary, because I’m trying to point out that imposing rigidities on the free market causes mischief and grief for normal people. Basically, I’m saying: “If we let the markets clear we’ll be fine in a few months, but if we intervene, we’ll prevent businesses that need to go bankrupt from going bankrupt, and thus we’ll simply prolong our problems.”

He is a really cool teacher though, so I think he’ll read it with an open mind. He’ll probably question some specific points and ask me for more evidence, in which case I’ll do so.

5

I knew I missed something. Is Rothbard’s book about the Panic of 1819 available for free as well? Asking because it’s usually pointed out as the first time we had a depression and it is used as an example of why “free markets” are bad.

EDIT: I just found both books online for free. I’ll send them to him later.

6

Wow, I’m amazed that you’re in high school.

For two reasons: you’re incredibly well-read and write so well by any standard. And that they are teaching logic/philosophy of any sort.

7

I also wrestle and run long distance track. Haha, enough of my ego trip. I have not-so-great grades and only a 26 on the ACT (go figure, perhaps I should study once in a while). But yeah, my high school is really good. It scores really high on the ACT, MEAP, MME, etc. Not to mention the 6000 students and scores of different classes one can take.

Oh, and I also have the bad habit of writing in “Midwestern,” not proper English.

8

That’s a little much, haha.

9

Remember that for people to refrain from saving, they resort to consumption, which is another factor bidding up consumer prices during the boom.

Great job. Very impressed that we have such scholarly high schoolers.

10

Nice. I’d be interested to hear if your teacher answers back.

11

He didn’t reply via email, he told me in class that he’s looking at some of the links I provided and whatnot. Today’s topic of discussion was the existence of monopolies in free markets.

My email to him today was:

Well, I might start this email off like I did the others, with links and then
follow up with my own input at the end:

Here is an article from “The Free Market” that deals specifically with
Microsoft:

Here is a quite long article by economist Dominick T. Armentano, adapted from
his two books about antitrust cases:

Here’s an excellent article is by one of my favorite economists, George Reisman,
who has attempted to unify the classical (which included Bastiat, Adam Smith,
Ricardo, etc.) and the Austrian schools of thought:

Here’s one article about antitrust law in general:

This is another article by D.T. Armentano, at the Future of Freedom Foundation
website:

http://www.fff.org/freedom/0592c.asp

Here is a two part article by Gregory Bresiger (the second part is linked at the
top of the webpage):

http://www.fff.org/freedom/fd0609e.asp

Here’s another article on the Mises website:

Since reading things on the internet can hurt your eyes, I’ll spare your
eyesight and provide you with this youtube video featuring Ron Paul and Dominick
T. Armentano before I was even born talking about antitrust laws:

http://www.youtube.com/watch?v=8C4gRRk2i-M

My input is this:

I honestly think that people believe that “monopolies are the natural outcome of
free markets” simply because it’s been drilled into their heads by schools, the
media, etc. I do not think that one can make a reasonable argument proving that
monopolies can exist, nor can one use evidence without proving that governments
often create monopolies, not free markets.

No time in history has a business been able to gain a monopoly. It is, in fact,
impossible for a business to develop to a proper size to actually monopolize the
market. Businesses can only grow so large before they start becoming inefficient
due to “diseconomies of scale” (basically, becoming too bureaucratic). Therefore, businesses cannot monopolize the entire world’s market
for a product. If any business ever tried to achieve anything close to
monopolizing the world market, it would suffer from bureaucratic inefficiencies
and thus lose market share. This leads us to the conclusion that businesses can
only grow so large, therefore, there are bound to be numerous competitors in
various nations (like we have with the auto industry, for example). Thus, even
if a company were able to somehow pull of the miracle of monopolizing an entire
national market, it would face competition from foreign companies as long as
there wouldn’t be prohibitive trade barriers like high tariffs or quotas.

Another thing is that venture capitalists aren’t afraid to lay down HUGE sums of
money for start ups. IIRC, one venture capital firm laid down billions of
dollars when Sun Microsystems first started. If some entrepreneurs have a really
good idea and no established businessman is picking up on it, venture
capitalists are often willing to risk a large sum of money for large future gains.

Let’s take your first example of Microsoft. Consider this:

  1. The only reason Microsoft was in the position it was in was because it
    provided a product that people wanted to purchase. This wasn’t forced upon
    anyone. The businesses that were angry about Microsoft (e.g. Netscape) were the
    ones who were, in fact, uncompetitive and were not able to provide a product
    that consumers desired.

  2. There were plenty of other software companies besides Microsoft that had a
    decent amount of market share (Apple and Sun Microsystems come to mind).
    Microsoft was not able to drive these competitors out of the market simply
    because they were providing higher quality products to specific types of
    consumers, and thus, these companies found their niche in the software industry.
    Microsoft could not hope to completely drive these competitors off of the market
    because they would just become too large and bureaucratic in the process, losing
    their economy of scale, due to the fact that filling so many different specific niches would
    be too much for a single company to handle. If Microsoft began to monopoly
    price, it would simply lose market share to their competitors.

  3. Saying, “but Microsoft had lower quality products” is only a rational
    argument if you are implying that you want to force consumers to buy higher
    quality products. People purchased Microsoft products because they were cheaper
    than their competitors and simply because most consumers didn’t need high
    quality software for their day-to-day work. So unless you want to prevent
    voluntary transactions between consumers and Microsoft from occurring, you
    should not use this argument.

As for your second example of an innovator not being able to gain a market in
the auto industry, please consider this:

You are a big-time stock holder in one of the major auto companies like Ford,
GM, Chrysler, Toyota, Mercedes-Benz, etc. Someone approaches you with a great
new idea you think might be profitable. Will you:

a) Reject his/her offer even though your competitors might get the idea?

b) Accept the offer so you can outcompete the other auto industries and gain
market share?

It’s rational to assume that profit-driven firms will innovate and accept new
ideas in order to be successful competitors. You are right that it is hard to
enter the auto industry today, due to the businesses already present and the
large amount of capital required to create a start-up. However, as Paul pointed
out in class, there are a few small and successful start ups. Also, the reason
it’s hard to enter the market is that the competition is so tough - the big,
successful companies already in the business are competing for market share and
are thus providing goods that consumers want. Since consumers are satisfied with
these products, it makes no sense to argue that government intervention is
somehow needed to prevent these established auto companies from selling their
products.

12

I wouldn’t hold up Microsoft as a good example if I were you.

13

Or Wal-Mart (just in case…)

-Jon

14

Well, obviously, intellectual property is bound to be discussed with the case of Microsoft, but Microsoft definitely wasn’t a monopoly. AND I LOVE WALMART.

15

Yeah but Wal-Mart is known for clamouring for MW increases, eminent domain &c. MS benefits from IP. They’re both firms that use the government to their advantage, even if they’re not monopolies. In fact it’s pretty difficult to think of major firms that don’t benefit in this way from governments.

-Jon

16

So you think it’s just better to argue against IP in the first place?

17

Nah don’t get bogged down in tangential discussions. Just try think of firms that rely little on the state when using them as examples. Ones like MS or Wal-Mart are too controversial for one who is uninitiated (like your professor) to discuss.

-Jon

18

The problem being that everyone always brings up Microsoft when it comes to monopolies.

19

I suppose just say it isn’t one in the way a monopoly is commonly conceived.

-Jon

20

turn it around on them → governments are coercive monopolies over geographic areas. The larger its sphere of influence on society, the more forcefully monopolized society is.

Socialists would turn this around and say that the people desired such a monopoly. Capitalists could use the same argument for non-coercive monopolies, applied to consumer desire. Yet consumers have much more power over a non-coercive monopoly than a commoner does over a powerful socialist state.

A better question is still to ask which socieities produce more refugees? Which societies have more often collapsed? It seems when it comes to economics, voluntarism is preferable to coercion.