Question

Business Cycles (Booms and Busts): Their Causes and Cure

Keynesian Approach to Business Cycle: If there is inflation, then the cause is supposed to be “excessive spending” on the part of the public. The alleged cure is for the government to step in and force people to spend less through increased taxation. If there is a recession, then the cause is insufficient spending on the part of the public. The cure is for the government to increase its spending, undoubtedly through deficit spending.

If it is true that business cycles are rooted deep within the free-market economy, per Keynes; some form of government planning is needed, if we wish to keep the economy within the stable bounds of the boom and bust. Right? However, “general economic theory” teach us that supply and demand always tends to be in equilibrium or strive for such a point.

The economic thought process that there is something wrong with a free-market economy, and this causes business cycles stems from Karl Marx. Marx saw that before the Industrial Revolution (late 18th Century) there were no regularly recurring booms and busts. However, with the start of the Industrial Revolution, there were recurring cycles. Marx concluded that business cycles were part of the free-market economy.

                David Ricardo and David Hume (early 19th Century) came forth with an analysis of the business cycle. Essentially, these economists saw that another crucial institution had developed in the mid-eighteenth century, along the industrial system. This was the institution of banking with its capacity to expand the money supply. The Ricardian analysis went something like this: Natural moneys of the free market are useful commodities like gold and silver. If the money were confined to gold and silver, then the economy would work in the aggregate as it does in any market through adjustment to demand and supply. However, these institutions issued certificates in amounts more than what was in deposit in the form of gold and silver. Therein lies the problem. Banks have issued more notes than the reserves backing these notes. Therefore, the Ricardian theory of the business cycles grasped the essentials of a correct cycle theory.   The cause of business cycles was due to excessive monetary expansion in lieu of the resources to support such expansion.

However, two problems were yet unexplained. Why the sudden “cluster of business errors,” which was a failure of the entrepreneurial function, and why the vastly greater fluctuation in producers’ goods than in consumers goods industries?

Mises expanded upon the Recardian theory to address the two remaining problems. According to Mises, bank credit expansion through the central bank artificially lowers the rate of interest in the economy. On the free and unhampered market, the interest rate is determined by the “time-preference of all the individuals who make up the market economy. People’s time preference determines the extent they save and invest, as compared to how much they consume. If one’s time preference falls, then, consumption falls and savings and investments increase. Economic growth comes about largely as the result of falling interest rates.  

But what happens when the interest rate falls, not because of lower time preferences, but from the Federal Reserve System that promotes bank credit expansion? Trouble. For businessmen, seeing the interest rate fall, react to such a change and invest more in capital goods as compared to their direct production of consumer goods, because they believe that one’s time preference has changed. They invest more in capital goods because as rates decline these long-term projects are more profitable than short-term projects that are closer to the consumer end. During this process, businesses bid-up prices of wages, raw materials, etc. Since the factors of production are limited in any given time period, there is a resource allocation away from the consumer end to the capital end because of the higher wages in the capital goods area.

                The problem comes as soon as the workers begin to spend the new bank money that they received in higher wages. For the time preference of the workers have not changed. So the workers spend most of their new income, in order to reestablish the old consumption/savings ratio.  

                Since the workers receive the increase money in the form of wages rapidly, how is it that booms can go on for years without having their unsound investments revealed? The answer is that booms would be very short lived if the bank credit expansion and subsequent pushing of the rate of interest below the free-market level were a one-shot affair. However, it proceeds on and on with the direct assistance of the Federal Reserve System trying to keep interest rates below the free-market level, never giving consumers the chance to reestablish their ratio and never allowing the rise in costs in the capital goods area to catch up to inflationary rise in prices. It is only when bank credit expansion must finally stop, either because the banks are getting into a shaky condition or the public begins to balk at inflation

                Mises (Austrian Economics) blames the cycle on inflationary bank credit expansion propelled by the Federal Reserve System.   What should be done? Nothing. What the economy needs is not more consumption but more savings, in order to validate some of the excessive investments of the boom. The Austrians maintain that we do not have a lack of consumption. We have a lack of savings/investments.

                Quantity Theory: Mises agreed with the classical quantity theorist that an increase in the supply of money would lead to a fall in its value (inflation). But he refined its approach. For one thing, he showed that this movement of increasing the money supply is not proportional. That is, a 10% increase in the supply of money does not increase prices by 10% at the same time. Mises showed that the great attraction of inflation is precisely that not everyone gets the new money at the same time. Therefore, inflation is a process of taxation and redistribution of wealth.

Now, after reading the attached article, what kind of policy would an Austrian economist recommend during a boom phase (inflationary gap)?

Answer 1

A boom phase is addressed when an economy is working at full or near full capacity and which also faces strong consumer demand and thus usually accompanying high prices.

In such a period, the Bank must follow some stringent policies so that the consumer prices do not reach high levels and there is no room for inflationary pressure. According to Austrian economist Misses, what the economy needs to prevent such situation is not consumption rather investment. The amount of money that shall be in circulation shall be keenly monitored such that  excessive investments during a boom period are validated.

The Fed shall not lower interest rates for a one shot time period as that brings unrest in the economy. As interest rates fall, business men increase investment in capital goods and thus increase wages, raw material etc as it becomes more profitable to invest now. The workers start believing that their income has increased due to time preferences and they start spending it more to balance previous saving-consumption ratio. However, this can continue if Fed keeps on lowering the interest rate. However, this may lead to a bad situation if there is bad condition of the banks. Thus, banks must keep the interest rate at low levels only and look at the situation of the bank and react accordingly. Thus the best policy during a boom period for an Austrian economist is to reduce interest rates and at the same time redistribute and tax income according to the needs.