Hi. I’ve written an economics piece called Of Time and Marshmallows that goes into time preference, interest, investment, and the business cycle. Before it goes out to a wider audience, I’d like to ask any here familiar with these subjects if they could take a look at it, and offer feedback.
Thanks much.
Including a quick explanation of autistic exchange might be helpful. The first paragraph of that section of human action is probably enough to describe the concept. This way, the reader doesn’t have to take the concept in the abstract, or follow the link and read a page of text to get the idea.
The reference to the comic for explaining marginal utility works well. As opposed to autistic exchange, the law of marginal utility is a little more complex and (I believe) fundamental to understanding economics.
Otherwise, the example is great and so is the writing. I don’t have a problem following it.
For people who do have problems following it, diagrams could help.
Lilburne,
I cannot offer a critique as you ask, but I do offer something for your review. I drew this diagram several months ago, and when I read For Civilization, It is Mises or Bust and, now Of Time and Marshmallows the diagram seems to present visually what is being discussed. My OP, and my reply to the first critique explains what it is I am trying to present. I am biased, but this diagram, and the accompanying diagrams really click with me. Am I the only one or does a diagram like this have value in presenting these ideas?
My original post is here: Structure of Production Diagram - Please Critique This
My diagram is here: https://forum.freecapitalists.org/members/chloe732/files/structure-of-production0003.jpg.aspx
Of course, there must be a trade-off between the understandability and the accuracy of an analogy (a perfect analogy would scarcely add to anyone’s understanding). However, I noticed two disanalogies that may be worth addressing.
Why is it necessary to specify that the new seashells are different from the old ones? In real life, the newly-created money is simply spent into the economy and is completely identical to all of the other money. Indeed, it’s unlikely that anyone would accept the plaster shells as money, since they are easily distinguished from the normal shells. (Otherwise, why can’t anybody just take a bunch of random objects, declare them to be money, and proceed to spend them?) The new money will be accepted in the marketplace only if there is a widespread expectation that it will be accepted, and (in most cases) this expectation can only be established if the new money can piggyback upon the acceptability of the old money.
From this, it’s not clear why there is the appearance of prosperity during the time of the credit expansion. (If no new wealth is created, why does everyone enjoy an increased standard of living?) My understanding is that the creation of new money has two effects: the interest rate effect (which stimulates investment in higher [more remote] stages of production) and the derived-demand effect (which stimulates consumption, and, by extension, investment in lower stages of production).
Without credit expansion, the increased high-stage investment by Craig is accompanied by decreased consumption by Carolyn; however, when credit is expanded, Carolyn can maintain or even increase her consumption. In visual terms, the Hayekian triangle’s hypotenuse becomes flared out towards the corners - remote investment has increased, and people enjoy a higher standard of living.
Now, the resources that are being used to keep Carolyn and Craig well-fed must have been diverted from somewhere - the middle stages of production*. So when it comes time for Craig to attach ropes to his trebuchet (a middle-stage process), he finds that the existing rope is already tied up in slings and bows (low-stage capital, which was overproduced because of the derived-demand effect). Either the trebuchet or the slings/bows must now be liquidated, but either choice is a net loss of value.
*I’ve also read that the diverted resources come from those being used to maintain existing capital. (Murphy explores this in detail here.) I’m not entirely sure if maintenance is just a special case of middle-stage activity, and how it fits into the model.
If you haven’t already, I recommend you check out Roger Garrison’s writings on the business cycle. Here’s the specific article I referenced. He also has some helpful slideshows.
That diagram looks intriguing, although I don’t fully understand it. Could you explain the placement of “demand for money” part after “subsistence”?
Giant Joe and Zavoi,
Thank you so much for taking the time to read my piece and give feedback.
Giant Joe,
It’s great to hear that you like the ideas and the writing.
I thought about making this story a comic, but I’m having computer issues, and anyway, I’m miles away from covering money economies in my comic series. Diagrams would be a good compromise, if I can think of good ones, and find the time to make them.
Yeah, I’m kind of modelling a hard money economy, trying to represent Mises’ distinction between money substitutes and fiduciary media without going into the details of fractional reserve. I don’t want to present fiat money as the natural order of things, but at the same time I don’t want to explain how fiat money comes to be, because that would make the pedagogical load of the piece too heavy.
I guess one can imagine that most people aren’t involved in the industrial use of the seashells; only jewelers are. So most people won’t test the seashells’ qualities. In other words, the indirect exchange component of the money’s demand won’t impel cash holders to be scrutinizing. But you’re still correct, because the underlying industrial component of the money’s demand would indirectly impel such scrutiny, just as fake gold eventually gets found out. Thanks for this feedback, Zavoi. I think I’ll have to go ahead and model a fiat money economy like our own after all.
Are you saying that he finds that every single inch of rope on the island is tied up in slings and bows? That doesn’t make sense. In an economic bust, it’s not that an entrepreneur gets a loan at the same sweetheart rate as always, but then goes to his suppliers and finds empty shelves. As Mises wrote, the bust reveals itself when the “gross market rate of interest rises because the increased demand for loans is not counterpoised by a corresponding increase in the quantity of money available for lending,” which is what I’m trying to model.
Thanks again Zavoi.
Lilburne - Thanks for taking the time to review this. I fear I may have unintentionally highjacked your thread, in which you asked forum users to critique your essay. I hope I am not causing a mash up, it certainly was not my intent. As a Mod, I believe you can delete my replies on this thread. Please feel free to do so. I answer your question regarding the “demand for money” on my own thread. I certainly hope you and I can continue this discussion over there. Thanks.
Well, not literally all of the rope is unavailable, but there still isn’t enough for Craig (and everyone else like him) to finish all of their projects. Hence the price of rope will be higher at this point than if there had been no credit expansion.
When Mises says that the interest rate will rise, is it because demand for loans increases, or because supply of loans decreases? If the former, then I think this is just another way of looking at the same situation. Without credit expansion, the price of rope would have been (say) 2 shells/foot, but now the price has jumped to 4 shells/foot. So when Craig goes to the supplier and sees how expensive rope is, he realizes that he needs to borrow a lot more money from Carolyn in order to buy the rope he needs. The combined effect of everyone doing this drives up the interest rate.
However, this raises another question: If everyone knows that this is going to happen, then why isn’t the effect of the credit expansion immediately canceled by speculation in the rope market? Or, along similar lines, why don’t people anticipate the future spike in interest rates and adjust their business plans accordingly? My guess - I’m now firmly into speculative territory here, so don’t take my word for it - is that there is a prisoner’s-dilemma problem: it profits the individual most to go along with boom, even though this is harmful on the aggregate level (see the article by Carilli and Dempster, Expectations in Austrian Business Cycle Theory- An Application of the Prisoner’s Dilemma). For example, if I have a stash of rope, I will find it more profitable to use it for slings/bows now rather than to save it and sell high later. In any case, this is probably beyond the scope of your article (but perhaps useful for the sake of completeness).
Well, following the start of the ongoing process of money being dumped on the lenders, the rate of interest would dip immediately. Commodity price inflation would only come after. But even if Helicopter Ben stopped dumping before the prices of higher order goods had a chance to get bid up, this would still cause a bust, because the cessation of the flow of loanable funds would immediately raise the rate of interest. This is what I’m trying to model in my example. Reflecting on this, I added the following…
“The effects of other imbalances also play out in the bust of a business cycle. But my focus in this article has been to show the reader the distorting impact that any ephemeral, artificial dip in the rate of interest will have on investment.”
Check yield curve inversion… Usually sometime before recession, yield curve inverts - loans of shorter maturities get more expensive than loans of longer maturities. It’s interesting from the point of ABCT, as it would suggest demand for short maturity loans is raising because companies are left with no money to finish current projects. They spent too much already, so their funds are depleted - prices are starting to rise. Also, since price raise is now visible, people start to talk about inflation, newspapers report protests against raising prices etc. That signals to lenders that CB will have to raise interest rates to fight inflation. That means short maturities interest rate will get hit hard. But only that expectation of interest rate raise is enough to raise the rate. Liquidity crunch appears.
OTOH, it’s very hard to predict moment when this will occur. When interest rates are low and you are leveraged 1:40, profits are so great. 1% of spread with 1:40 leverage means 40% return on equity in a year. And it can last for years… Additionally, CB is always promising endless liquidity and bailouts. Because profit is so great, trade is crowded. Everybody thinks there will be enough time to close positions. But I’m convinced everybody knows the music will stop eventually.
Additional bonus is real interest rates hitting negative numbers, which generally happens around same time. You can borrow 100 apples and return 95 in a year and the profit is yours. Commodity speculation will hit from everywhere. It pays to speculate, no wonder. You can easily spot such time by checking oil futures - they revert from usual contango to backwardation. Contracts that expire sooner cost more than distant contracts. Usually it’s the other way around. Oil producers require premium for getting oil out of the ground. Opportunity cost of holding cash during negative real interest rates is high.
Thanks for the feedback everybody. The piece is up on the Mises front page today. Thanks especially to Zavoi, whose feedback made me realize I needed to include the following crucial paragraph…
“The manner in which the above allegorical business cycle plays out models a “bust phase” which is triggered by only one of the five “bust-impelling” factors elucidated by Jesus Huerta De Soto in his brilliant treatise Money, Bank Credit, and Economic Cycles. As this piece features the phenomena of time preference and interest rates, I have only modeled this one factor, which is most directly concerned with interest rates. A study of all five factors playing out in a “marshnut economy” would merit its own separate article. Aside from that degree of incompleteness, the above, in simplified and fanciful form, is basically what happens every time the Federal Reserve stimulates an economic boom by throwing new money onto the loan market.”
