Newbie Q on Understanding the Business Cycle

[Smiling_Dave]

Hi Guys and Gals.

I’m not stupid. However the most technical phrase I can understand is “the Fed”. So although in any case I will make every effort to grasp your replies, which I thank you for, the smaller the words you use, the easier for me to “get it”.

On to the question:

Von Mises as I understand him says business cycles come about when the gov’t starts pumping money to the banks. With all that moolah lying around useless, the banks charge low interest rates to make sure people borrow it. Businesses rush to borrow at these bargain prices. So far I follow him easily.

The business guys say to themselves "Now that I have all this dough for cheap, I can use it for that long term investment in a new factory I always wanted to buy myself. Now is not the time to make consumer goods, but think ahead and spend the money on things that will be ready in a couple of years.

“Besides, where did all this excess cash in the banks come from? Only one source [he thinks erroneously]. Mr John Q Public put it there. Which means consumers have decided to save their money instead of spend it right now. So there is no point in making more consumer goods that will be ready right away. Better to make long term stuff, that will produce consumer goods in a couple of years, just in time for when J. Q. Public is ready to spend.”

I get what he’s saying, but I will have my question on this last part.

The last step: All over the country, land and raw materials and labor is being bought and competed for to buy these new factories [that nobody really needs]. Business is booming. Everyone is happy.

But that land and raw material and labor is not paid for all at once. Mr Entrepeneur only has enough cash to make one payment to the real estate owner and the steel mill and to his workers. “That’s no problem,” he figures. “These guys are consumers, who I know are going to save their money, just like they did last week to get me started. I’ll borrow it right back at a low interest rate from the bank they put it in, and have enough for the next instalment of rent, and purchase of materials, and wages.”

But guess what? The consumers are never going to put it in the bank. They are in the mood to buy huge pizzas instead. Mr Entrepeneur tries to get a loan from the banks, but the cupboard is bare. Uh oh.

Huge half built factories now litter the countryside. The landlord is stuck with a white elephant and no money coming in. The steel mills have more steel lying around than they can sell. The workers don’t get paid, but rather are sent home, now unemployed. Hello recession.

That’s his theory of the business cycle. as I understand it. My question is about one detail. He says Mr Entrepeneur gets fooled by the low interest rates. OK, in 1920 he got fooled. But hasn’t he wised up by now? Doesn’t he know after all these years of getting fooled over and over that it’s the gov’t putting the money in the bank, not consumers? Doesn’t he know that it’s the Fed that determines interest rates as a tool for their own ends, not as a reflection of consumer moods? Hey, even I know that by now, just from TV.

I’m reminded of the Austrian critique of Keynes with respect to unions. Workers won’t take a numerical cut in wages, says Keynes, but you can trick them by creating inflation and cutting their real wages that way. To which I’ve seen Hazlitt counter, “Maybe in 1936, but by now all the unions follow the rate of inflation very closely and insist on wage hikes when inflation strikes.”

Similarly, why cannot one argue with Von Mises and say “Maybe in 1920, but by now businessmen have heard about the Fed and will examine very carefully WHY interest rates have gone down? ‘We won’t get fooled again,’ is their motto. They know it’s the politician, not the consumer, who put the money in the bank.”

Thanks in advance to anyone who will open my eyes on this matter,

David

[Laughing_Man]

@Smiling Dave

That’s his theory of the business cycle. as I understand it. My question is about one detail. He says Mr Entrepeneur gets fooled by the low interest rates. OK, in 1920 he got fooled. But hasn’t he wised up by now? Doesn’t he know after all these years of getting fooled over and over that it’s the gov’t putting the money in the bank, not consumers? Doesn’t he know that it’s the Fed that determines interest rates as a tool for their own ends, not as a reflection of consumer moods? Hey, even I know that by now, just from TV.

That’s a really good question that comes up time to time on this forum. I believe the answer is [ I’m a historian not an economist but I’ve done a little theoritical work, more people who are into economics will either add onto what I say or correct it later today ] that savings and interest rate reductions project the similar economic outlook to the entrepreneur. Therefore in a profit/loss, constant innovation, economy, sitting idol while your competitors take out loans to better their competition against you is not a wise business decision. Maybe more can be added to this.

[Smiling_Dave]

Thank for that surprisingly quick reply. Just knowing it’s been asked before makes me feel better. I’ll try to find it on the search thingy, if there is one.

@Laughing Man

I believe the answer is that savings and interest rate reductions project the similar economic outlook to the entrepreneur.

I don’t grasp what this means. I’m sure it doesn’t mean Mr Entrepeneur never switches on his TV, and so never hears that the Fed has lowered interest rates [“in an effort to fight inflation” or whatever]. That he thinks “Nah, the Fed has no printing press, that money must have gotten there from the consumers.”

Therefore in a profit/loss, constant innovation, economy, sitting idol while your competitors take out loans to better their competition against you is not a wise business decision.

I am not sure what this means either. I’m sure it doesn’t mean Mr E thinks, “Sure it’s stupid of me to build a new factory, and I’ll lose my shirt. But everyone else is doing it. And I better grab the money while I can before someone else does. So what if I’ll be homeless next week?”

Please forgive my facetious tone. It’s hard for me to grasp these subtle abstract concepts without turning them into a humorous story.

David

[Laughing_Man]

@Smiling Dave

I don’t grasp what this means. I’m sure it doesn’t mean Mr Entrepeneur never switches on his TV, and so never hears that the Fed has lowered interest rates [“in an effort to fight inflation” or whatever]. That he thinks “Nah, the Fed has no printing press, that money must have gotten there from the consumers.”

Well from what I understand the Fed pumps in money to spur economic growth. That is why they inflated during the 2001 years because we were going into a recession and the 9/11 ‘go to the mall America’ attacks happened. Easy money is spent quicker. So while the Fed is pumping up monetary base [ giving the false impression of savings ] people are in fact more inclined to spend due to all this new money they accumulated. While this is happening interest rates are coming down, long term capital is being sought, pretty soon consumption is increasing yet investment is in high order goods and not in short term consumption therefore investments have to realign from bad investment in long term [ all during this time of inflation, prices are increasing, supply is lowering ]. I think that sums it up.

@Smiling Dave

I am not sure what this means either. I’m sure it doesn’t mean Mr E thinks, “Sure it’s stupid of me to build a new factory, and I’ll lose my shirt. But everyone else is doing it. And I better grab the money while I can before someone else does. So what if I’ll be homeless next week?”

Well not many business men/women are Austrian economists. They don’t see the boom/bust cycle like Austrians do.

[xahrx]

@Smiling Dave

OK, in 1920 he got fooled. But hasn’t he wised up by now? Doesn’t he know after all these years of getting fooled over and over that it’s the gov’t putting the money in the bank, not consumers?

What’s he supposed to wise up to? I mean if the government fixes the price of oreos below market, everyone knows it’s the government doing it, but oreos still fly off the shelves. Everyone knows it’s a fake price, but what do those who stand by the wayside get? They get no oreos, that’s for sure. How are they supposed to know what the actual price would be? The only possible way to avoid getting screwed is prudence beyond reasonableness, and then watch all your competitors get rich on easy money while bidding up the prices of the resouces you need to buy as well, which means as long as enough people get involved in order to get prices going up, the incentive is for everyone to get involved and get a chunk of the easy riches while they’re still available. Not every investment made will turn out to be a malinvestment. What do they gain by staying out of it? They may know there’s a possiblity of being bamboozled and getting stuck with some useless plant and equipment, but how are they supposed to gauge that risk?

@Smiling Dave

Workers won’t take a numerical cut in wages, says Keynes, but you can trick them by creating inflation and cutting their real wages that way. To which I’ve seen Hazlitt counter, “Maybe in 1936, but by now all the unions follow the rate of inflation very closely and insist on wage hikes when inflation strikes.”

And so the government pulls mortgage payments out of the index to hide its inflation. All unions really know is what they knew before; they want more. Just because they’re indexing their requests to a supposed measure of inflation which arbitrary in the extreme doesn’t mean a thing, except that they have some idea of how things work and what would be needed, if it were possible to get the information necessary, in order to offset the government’s inflation. Truth be told every man and woman in the union would be just as accurate and scientific, if not more so, by developing their own inflation indeces and using them to back each individual demand for higher wages.

In the end nobody can wise up because the information needed to wise up is in the price system, which is the exact thing that’s being distorted.

[Smiling_Dave]

@xahrx

@Smiling Dave

OK, in 1920 he got fooled. But hasn’t he wised up by now? Doesn’t he know after all these years of getting fooled over and over that it’s the gov’t putting the money in the bank, not consumers?

What’s he supposed to wise up to? How are they supposed to know what the actual price would be? The only possible way to avoid getting screwed is prudence beyond reasonableness, and then watch all your competitors get rich on easy money while bidding up the prices of the resouces you need to buy as well, which means as long as enough people get involved in order to get prices going up, the incentive is for everyone to get involved and get a chunk of the easy riches while they’re still available. Not every investment made will turn out to be a malinvestment. What do they gain by staying out of it? They may know there’s a possiblity of being bamboozled and getting stuck with some useless plant and equipment, but how are they supposed to gauge that risk?

[

Thanks for your answer xahrx. I’m going to try and understand your answer. Please remember I am a newbie to this subject and may have a hard time getting to the bottom of things.

Tell me if this is what you are saying: When interest rates go down, Mr E thinks as follows: “Hmm, the money is just lying there, free for the asking. I’m not stupid enough to think it’s positively 100% from consumer savings. I’ve learned by now that some insane fiat of Mr Bureaucrat may be the reason interest rates are down. And of course he may change his mind tomorrow when my factory is half built, and I’ll have to just let it rot there. But hey, that’s life. I’m not sure if building that factory gives me better odds at making money than going to Vegas, but I’ll build it anyway. Maybe I’ll be one of the lucky ones.”

I dunno. Austrian stuff [which I greatly admire btw, real eye openers] about the Great Depression says that one factor that prolonged it was that business people were unwilling to invest due to uncertainty. “Who knows what crazy gov’t law will get passed tomorrow?” So they sat on the sidelines instead of gambling their hard earned money. Makes a lot of sense to me. And makes sense to me that uncertainty for any reason would keep people on the sidelines. Sure if the odds are really good you’ll make money they’ll invest; they don’t need 100% certainty. But if the odds are 50-50 or totally unknown [will he or won’t he up the interest rate tomorrow when I go to borrow a second time to build the next wall of my factory?] I expect smart people who know how to make money will not gamble it away.

In the end nobody can wise up because the information needed to wise up is in the price system, which is the exact thing that’s being distorted.

You said this after quoting my q about wages and inflation. On the off chance that you may have meant it as a summary of your reply as a whole, and applicable to the business cycle, my q would be: Can’t businessmen wise up enough to know they are taking a real big chance which may very well ruin them? Don’t they know interest rates have been distorted and no longer convey information?

[Smiling_Dave]

I spent all day looking around for answers to the q. I found it has indeed been asked and answered by the pros, for example here:

X. COMMENTS ON CRITICISM OF AUSTRIAN BUSINESS CYCLE THEORY - AN AUSTRIAN THEORY...

I dont pretend to get the answer on that site in full. It seems to mention the points raised by the two people kind enough to post a reply here.

My provisional [and partial] understanding of the answer is that when interest rates are low, there is always someone, in fact plenty of people, foolish enough and greedy enough to take the money and build his white elephant half way. He thinks there’s plenty more where that came from, that he’ll keep getting money to invest at the low rate till he finishes his building.

[DanielMuffinburg]

Most people alive today were not alive in the 1920s, while the historians and economists have done a great job at distorting what occurred in the 1920s.

[BioTube]

Plus there are the people who know the bubble will burst, but are betting they can get out before it does.

[Smiling_Dave]

From the replies here it seems there’s a general consensus that indeed Mises’ theory has to be modified in that detail.

Nobody denies that TV declares to one and all the interest rate no longer depends on savings, but on Bernanke’s whim.

So your entrepeneur is no longer misled. The problem now is he’s turned out to be a gambler. He may not go to Vegas, but can’t resist a low interest loan to gamble with in a business deal.

So instead of the masses being driven by Keyne’s animal instinct, they are driven by an urge to gamble with loans easily obtained.

If we assume Martians to be cold calculating totally rational types, there would be no business cycles on Mars based on the replies here, though there would be based on Mises’ original scheme.

[Smiling_Dave]

Finally got it!

Say the interest rate drops really low artificially because of the gov’t. There are two possible outcomes:

1. There is no malinvestment. If that happens in practice, it is probably because people have wised up. They are not fooled [Mises] or tempted [posters here] by the low interest rate to malinvest. Historically, this hasn’t happened yet.

2. There is malinvestment. Which means something about the existence of a low interest rate made people malinvest. What is that something? Answer: It’s many somethings, all the things mentioned by the various posters here.

Next time around, will it be 1. or 2.? Who knows?

[Giant_Joe]

@Smiling Dave

Finally got it!

Say the interest rate drops really low artificially because of the gov’t. There are two possible outcomes:

1. There is no malinvestment. If that happens in practice, it is probably because people have wised up. They are not fooled [Mises] or tempted [posters here] by the low interest rate to malinvest. Historically, this hasn’t happened yet.

2. There is malinvestment. Which means something about the existence of a low interest rate made people malinvest. What is that something? Answer: It’s many somethings, all the things mentioned by the various posters here.

Next time around, will it be 1. or 2.? Who knows?

#1 is unlikely to happen. If it were to happen, it is because people would be aware of the central bank and the fact that it does cause busts, and they would do something about it. the current state of affairs is that most people don’t know what causes booms or busts, and when they see low interest rates, they interpret it as a great deal to get new money, without realizing that the low interest rate is what causes the economic downturn in the first place. They also have to face competition from competitors who also don’t know this and who also choose the cheap financing to expand their company/marketshare.