Is this how the business cycle works?

Economics Economics Questions
1

Hello everyone, I have been studying Austrian Economics for a while now, mostly through audiobooks especially Thomas Woods (who is amazing). I also have been reading Hazlitt’s works which are also excellent. Anyways, I have just recently started researching the Austrian theory of the Business cycle and i have listen to a few podcasts on the subject and usually what i try to do after i listen to a lecture or read a chapter is to summarize the subject matter in my own words. However as far as putting the business cycle in my own words i am less then confident. So I would love it if someone could correct could confirm or correct me on my understanding of the business cycle.

So basically my understanding is that our current banking system consists of a hybird of loan/checking banking. These banks also operate on a fractional reserve standard of 1/10, signfying that they are only required to have 1/10th of the loan reserves on hand. So if i deposited $100, they would keep $10 on hand and loan out the rest of the $90. Creating $90 out of thin air, and then that $90 is redeposited into another (or the same) bank and 10% of that is kept on hand then loaning another $81 then so on. This multiplies the money supply in the given area by up to 10. Although actually it is only 2-3x because some people dont place their money in the bank.

Also the only way banks are able to operate on this fractional reserve standard is the Federal Reserve. This is because, when a individual removes his $100 from the bank, the bank loses reserves for up to $900 in loans. So the Fed loans these banks money and earns interest, which is determined by the discount rate.

While this is happening, lets say the interest rate is 10%. People and investors will only take out so many loans at a 10% interest rate. So the banks reduce the interest rate to lets say 7% to entice people to borrow more. So investors and private individuals now see profit in investments that previously were not profitable. So these investors, invest there money usually into durable goods and capitol goods. Such as a new sky-scraper or other long term investment projects. (This is where i get iffy) Now, because lots of people see profit in this new founded interest rate, many people enter into the capitol goods market. Due to the new founded demand for capitol goods, these industries expand, by raising wages to get more workers (siphoning off workers from consumer goods industries). These capitol good industries start producing more and their workers then spend more money on consumer goods , stimulating that industry well. Now, because demand has increased, prices increase as well and investors that had previously seen these investment as profitable realize that they are in fact not profitable. Also, because the banks have heavily inflated the money supply in the given area, domestic items become more expensive. So people buy more foreign goods and these domestic businesses suffer. Eventually, these investments become unsustainable and they collapse, starting the recession process. The recession becomes in fact a correctional process adjusting the economy to its equilibrium status and liquidating all the malinvestment. Once the recession is over the process repeats itself.

A Few Questions:

Why exactly doesn’t the business cycle occur more often? You’d think that if this was true, it would happen every couple of years or so. I’ve heard that this is because the Federal Reserve is constantly pumping more funds into the economy, is this correct?

If the capitol good industries started producing more, wouldn’t that effectively increase supply and lower prices? Wouldn’t this compensate for the influx of new investments in the capitol goods industries?

So is this correct? Is there more involvement of the Fed? Are their any other reasons for the influx of failed investments? Please tell me components that i left out or got wrong in my explanation, don’t worry about hurting my feelings, I just want to further my understanding, so any commentary or criticism is welcomed.

Also any suggested reading or media would be weclomed. I prefer audio lectures/books because im constantly on the road, but I read when i have the chance. Although im in my first year of undergraduate school so i’m already doing alot of reading. Direct answers are prefered then to suggested reading though, thanks in advanced!

BTW: Sorry for any spelling or grammar errors i’m in a rush and need to get to class soon.

2

Yep, exactly. Imagine you’re a businessman and the fed is creating money to pay for the newest war, or is increasing the amount of credit given out in order to boost the economy. You look at the books and notice that you’re making more and more money each month and demand for your products has increased. You decide to open up a new business and hire new labor to meet the demand. This is when the fed decides to stop its money-printing or credit-inflating policies for whatever reason. So the increased supply of the dollar lowers the value of the dollar, and the you realize that after the dollar stabilizes you’re making no profit, so you shut down the store and release your labor. This is the recession and correction process of the market.

It occurs as often as the fed allows the market to fix its own monetary mistakes. If it keeps up its inflation-happy policies it can postpone a recession for a really long time, until the federal currency becomes inconvenient, makes profit calculation impossible, makes long-term contracts impossible, becomes nearly worthless, and makes market predictions impossible. Then people demand honest money.

Yes, supply will increase, but after that is where keynesians get it wrong. During an inflation demand increases faster than supply can, this in turn increases prices, supply will increase but not as fast as the fed prints or gives out credit. If the the inflation stops, then increased demand ceases, while the newly increased supply of products cannot find consumers, so prices drop dramatically. This leads to under-consumption and overproduction.

Many things the fed and gov’t do can lead to investments failing, but the fed inflation is what leads to businesses, in general, around the affected area, to fail.

3

They use 10% to explain it because it’s easy to calculate in your head. In reality, the reserve ratio is somewhere around 2%.

The best, most detailed, explanation I’ve come across is in Money, Bank Credit, and Economic Cycles (chapters 4-6 - that’s around 400 pages, but many of his pages have only two or three lines of text (the rest is footnotes, which you can ignore); better to read that than try to get an explanation here)

4

Let’s think of an example. I want to create an internet start-up in 1999. At an 8% interest rate, I take out a loan of $760,000. I plan a 1 year project of investment before production. I obtain an office lease for $60,000 annually. I hire 10 employees, each at $60,000 annually. I purchase $100,000 of computer equipment and office supplies. Thus, there is an up-front cost of $100,000, plus annual costs of $660,000.

Well, 6 months in, 5 of my employees quit because they can get better salaries at another IT company. I must hire 5 more at $100,000 each annually. I attempt to renew my 6 month lease, but now it is $100,000 annually. My first 6 months I spent $460,000, including equipment costs. The next 6 months I will spend $450,000, just on rent and labor. I am now $150,000 over budget.

If no credit is available, or is too expensive, I will fail. Why would credit be too expensive? Because by artificially setting the price of interest below the natural rate, people will change their consumption to production ratios to favor consumption. This bids up the price of consumer goods, which forces interest rates up to retain real profits.

As I fail, and businesses like mine fail, and we must sell off our assets to pay our debts. Yet, as such specialized goods are auctioned off on the market in a short time-frame, and demand decreases as people see they are not useful in profitable investments, the current prices are pushed far below their initial price. Banks see even bigger losses than expected on defaulted loans. Banks fail, other banks reduce credit, and money supply shrinks. Then the opposite process occurs until an equilibrium is found (virtually found).

But can more artificial credit save me? Maybe. If the interest rate can remain artificially low, I can borrow the $150,000 I need to complete the project, and start earning revenue. However, we may experience the same problems. Will $150,000 be enough? And what about the ultimate payoff: was demand for such products supportive of real profit, after paying down greater debt burdens?

Also, in doing this, we are further pushing down the real savings rate - production greater than consumption. If real savings were to become critically low, the whole system would break down. You would effectively get hyperinflation.

So…if we are to cure an artificial bubble with more artificial credit, how will we know when we’re past the rough part, and we can start to allow the market to control the rate of interest without choking off credit and causing a downturn? The line between downturn and hyperinflation becomes narrower and narrower the more intervention occurs.

How do you increase production of labor and land? Some things must have limits. I believe most business costs are labor.

The most important thing to remember is that real credit is based upon real savings. That means that if credit is created when there are absolutely no real savings, all investments will fail, unless people are willing to be flagrantly taxed for other people’s investments. There would be more attempted consumption than production, which is impossible. Basically, some people will have to be priced out of essentials like bread, electricity, etc. More likely, most people will abandon such a sytem of money and credit, leaving the borrowers of such credit unable to purchase anything. Once the money/credit is abandoned, it makes no difference how much is created.

5

I’m confused about this part, this seems to totally contradict my poor understanding of the ABC theory.

My interpretation was that artificially setting the interest rates low through monetary expansion policy is what made credit cheap, and too easy to get for people who couldn’t actually afford such loans in the free market. Also, I thought the mal-investment in capital goods was a result of the low interest rate + high inflation sending the wrong price signals to investors when in fact the savings and consumption preferences of the population had not really changed.

Help me understand why I’m wrong..

6

The most important thing to remember is that real credit is based upon real savings. That means that if credit is created when there are absolutely no real savings, all investments will fail, unless people are willing to be flagrantly taxed for other people’s investments. There would be more attempted consumption than production, which is impossible. Basically, some people will have to be priced out of essentials like bread, electricity, etc. More likely, most people will abandon such a sytem of money and credit, leaving the borrowers of such credit unable to purchase anything. Once the money/credit is abandoned, it makes no difference how much is created.

Why exactly is that? Can’t the banks operate on the checking accounts to fuel credit? Why will all investments fail if their is no real savings? I’m thinking that it will be because the loans will have no actualy backing, however my understanding from what i read is that these banks get most of their loaning funds from checkings accounts.

7

This will answer your questions: http://mises.org/daily/3127

8

Murph, the FED sets target rates. To get banks to loan to each other at those rates, it attempts to increase or decrease the money supply. The increase in money supply takes the form of credit, making all credit cheaper. Indeed, both entrepreneurs and debt consumers will increase their borrowings when the central bank artificially lowers interest rates by inflating the money supply through credit expansion.

Over time, this increase in the money supply will raise consumer prices, which will force interest rates to become more expensive, provided the supply of credit remains the same. For loans to remain profitable in real terms, real interest rates must be positive. This means the nominal rate of interest must be greater than the rate of inflation. So if you have 4% inflation in prices, the nominal interest rate will most likely be over 4%.

Lowering the rate of interest on credit must change the savings and consumption preferences of the population. They will consume more in proportion to what they produce. This, in addition to the increase in money supply, is a factor in bidding up consumer prices, and it cannot be met by increased production, because many productive resources are simultaneously being put to work on the lower order production stages. Something has to give, and it’s usually the capital goods industries, who lose employees to the consumer goods industries.

Investors face rising wage costs not only due to the influx of investors due to low interest rates, but also to the increased consumption demand.

9

Matt, your hunch is correct - the loans aren’t backed by real savings. IE - the expected purchasing power of the loans does not correspond to the stock of real goods. Consider this:

2 men are on an island, catch fish and place them in a pond, and take a stone from the side of the pond in exchange for every fish they put in it. If they catch about 2-3 fish per day total but only eat 1 each, they both save 0-1 fish a day total. Let’s say it takes one of them 4 days to make a fishing pole, which would increase the number of fish they can catch per day. They would need to both fish until they have saved 4 fish total. Then, one man could borrow however many stones from the other needed to provide him with 4 fish, one per day, while he crafts the fishing pole instead of fishing. Real savings would work, and they would both see good returns on their investment.

If, however, there were only 1 fish saved, and one guy simply picked up 4 stones, claiming to have access to 4 fish while he crafts the fishing pole, there will be much more serious problems. When they each go to exchange a stone for a fish, they will find a double claim to the same good. In the spirit of fairness, they decide to both pay a stone to split the fish. The next day, a similar event happens. The man still fishing catches only one fish, which he takes 2 stones for. That night, again, they each attempt to spend 2 stones for the same fish. Again, prices are bid up, and they each spend 2 stones for a half of a fish.

At this point, the man who catches fish decides not to save anymore. What’s the point? Each day he catches 1 fish and eats 1/2, without any unpaid debts due to him. He is better off eating his catch immediately. And even if he didn’t, with the new price of fish, the man making the fishing pole will run out of stones before completing the fishing pole.

The man making the fishing pole must suspend the investment until he has collected enough real savings to complete it, or go hungry and possibly die. It doesn’t matter how many stones he has if there are no fish in the pond. Also, he cannot avoid the higher prices from destroying his investment plan.