business cycles - jonathan newman

Business CyclesJonathan NewmanMises Boot Camp 2015

What is a business cycle?• What it is not: Business fluctuations• Changes happen all the time and are necessary for a

functioning market economy (production, consumption, preferences, resources)

• Entrepreneurs have the task of dealing with and anticipating these changes by putting resources on the line in such a way to satisfy consumer demands.

• Good choices mean growth, bad choices mean decline• But, bad entrepreneurs suffer losses and good

entrepreneurs gain profits

What is a business cycle?• General boom and general bust• We see patterns in economic data like this

What is a business cycle?• General boom and general bust• Consumer prices vs. factor prices• Rothbard, America’s Great Depression p. 9: “capital-goods

industries fluctuate more widely than do the consumer-goods industries”

What is a business cycle?• General boom and general bust• Consumer prices vs. factor prices• Rothbard, America’s Great Depression p. 9: “capital-goods

industries fluctuate more widely than do the consumer-goods industries”

What is a business cycle?• General boom and general bust• Theory must account for these phenomena:• The “shape” or stages of the cycle: boom then depression• The cluster of entrepreneurial errors• The more dramatic fluctuations in capital-goods industries

compared to consumer-goods industries• Suspects:• Money• Credit

compared to consumer-goods industries• Suspects:• Money• Credit• Nick Cage?

Malinvestment• Investment in unprofitable lines of production induced by artificially low interest rates• Profits anticipated ex ante• Profits/losses realized ex post• Need to explain how interest rates influence production

• Good candidate because…• Explains boom (increased investment)• Explains bust (liquidation)• Explains cluster of errors• Related to money and credit• Related to capital markets

Structure of Production• Factors of production are employed together to make consumer goods• Requires laborers using land and capital• Complex, heterogeneous, interwoven, “latticework”• Takes time (stages)

• What does it look like?

Böhm-Bawerk

Böhm-Bawerk Hayek

Böhm-Bawerk Hayek Rothbard

Böhm-Bawerk Hayek RothbardGarrison

Time preference• We all prefer a given satisfaction sooner rather than later• Variety of rates of time preference, and so there is an opportunity to trade

David$1200 F$1000 P$1100 F

:$1000 F

Jeff$1100 F$1000 P$1050 F

:$1000 F

interestrate

Production and the interest rate• Since production takes time, the costs of production (purchasing, renting, and hiring factors) precede revenues from the sale of output• Therefore anticipated future profits are compared to returns that could be earned by lending at interest• Suppose Nick could earn 5% interest by lending, but has

an idea for a product he thinks he could produce and sell for a 7% return.

• Nick increases his demand for factors, engages in production, and puts his product on the market.

• No matter the outcome (profit or loss), Nick has pushed up the price of factors because the interest rate was lower than his anticipated rate of profit.

• What about the opposite?

Saving and growth• We save more at a lower rate of time preference because we discount the future less.• When we save, a few things happen:• First, and most obvious, we decrease consumption. Fewer

resources are consumed in the present.• The supply of loanable funds increases. More people are

willing to part with more of their money in the present in exchange for the promise of future returns.

• The interest rate falls, and production is restructured for longer lines of production.

• Factor price relationships change as earlier stages see a greater increase in demand than later stages. Late stage factor demand will decrease as consumers consume less to save more.

Saving and growth

Saving and growth• Result: greater production in the long run• Saving today frees up resources for productive uses which yields more output tomorrow

Artificial credit expansion• Central bank can expand credit without an economy-wide increase in savings• Newly created money enters the economy through credit markets and so represent an increased supply of loanable funds• Interest rate falls, but not because of a decrease in time

preference• At the lower interest rate, saving decreases• Consumption and borrowing increase• Firms take the new funds and try to invest in new, longer

lines of production• Factor prices are bid up across the board. Wages increase,

employment increases, consumption increases, investment spending increases.

• In short, we have a general boom.

Artificial credit expansion causes overconsumption and malinvestment• Consumers did not show they preferred future output to present output, in fact, they decreased saving at the lower interest rate.• The credit expansion does not represent an increase in real resources available for consumption or investment.• Factors of production become increasingly scarce• Prices are bid up higher than entrepreneurs expected• Costs increase: expected profits turn into losses

• Entrepreneurs were led to believe consumers had saved, real resources were available for production, and that longer production would be profitable.

Artificial credit expansion

Depression• Firms attempt to liquidate malinvested capital• Wages decrease and workers are laid off• Credit markets dry up• Prices readjust to reflect consumer demands • Inputs and outputs

• Depression is a recovery phase as people try to find profitable uses for capital and labor

Contrasting business cycle theoriesAustrian Keynesian

Shape Boom-bustCause Expansionary monetary

policyCause #2 MalinvestmentCure MarketsCure, restated

Let consumer demand dictate prices and resource allocation

Prevention Don’t give money production authority to non-market institutions

Shape Boom-bust Bust-boomCause Expansionary monetary

policyCause #2 MalinvestmentCure MarketsCure, restated

policyInstability of investment spending

Cause #2 MalinvestmentCure MarketsCure, restated

Cause #2 Malinvestment Fall in aggregate demandCure MarketsCure, restated

Cause #2 Malinvestment Fall in aggregate demandCure Markets Expansionary monetary

policy and fiscal policyCure, restated

Let the government dictate prices and resource allocation

Give the government control of money production and a blank check for spending

Conclusion• We can successfully explain business cycles using malinvestment concept• Investment in unprofitable lines of production induced by

artificially low interest rates• Theory must account for these phenomena:• The “shape” or stages of the cycle: boom then depression• The cluster of entrepreneurial errors• The more dramatic fluctuations in capital-goods industries

compared to consumer-goods industries• Original suspects:• Money• Credit

business cycles - jonathan newman

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