Download Money, Inflation and the Business Cycle

Business Cycles
for Introduction to Austrian Economics
By Paul F. Cwik, Ph. D.
Mount Olive College &
The Foundation for Economic
Education
“Prepare to get schooled in my Austrian
perspective.”
—Fear the Boom and Bust
We should probably start
with, “What does a Business
Cycle look like?”
Questions a Good Business Cycle
Theory Needs to Answer:
1.
2.
Why do a “cluster of errors” appear in an
economic crisis?
Why are there greater swings found in the
earlier production stages and not in the
production stages that are close to
consumers?
Business Cycle Theories:
1.
Non-monetary Theories
Keynesians
2. Real Business Cycle Theorists
1.
2.
Monetary Theories
Austrians
2. Monetarists
3. New Classicals
1.
Sources that refute Non-Monetary
Theories:
Monetary Theory and the Trade Cycle by
Friedrich A. Hayek, [1929 (1933 English)]
 The Failure of the “New Economics,” by
Henry Hazlitt [1959]
 America’s Great Depression, by Murray
Rothbard [1963]

Austrian Business “Cycle” Theory?
Some say that the Austrian Theory of the
Business Cycle is a bit of a misnomer.
 Why?
 The theory has primarily focused on the causes
of the downturn through the upper-turning
point.
 Nevertheless, it is a theory of the whole
business cycle.

Before we can show how an
economy fails, we need to see it
functioning properly.
Recall the “Magic” Formula for
Economic Growth: We start with…
Savings
Investment
Higher Productivity
Capital Accumulation
More Stuff
Higher Living Standards
Recall the Structure of Production
Value
Output /
Consumer
Goods
Markets
Time
Production Possibilities Frontier Curve
Consumer
Goods
5
10
15
25
A
B
C
D
E
50
F
Investment
Goods
Production Possibilities Frontier Curve
Consumer
Goods
A2
C2
C1
A1
I1 I2
Investment Goods
Market for Investible Funds
Interest
Rate
S
im
D
Qm
Quantity of Investible Funds
Putting the Model Together:
Consumer
Goods
C0
C0
Time
I0
Interest
Rates
This model comes
from the work of
Roger Garrison (2001)
Investment Goods
S = Savers
i0
D = Borrowers
S0 = I0
Investible Funds
Let us suppose that people become
more patient.
 How
does this change affect the
model?
 What happens to consumption and
savings decisions?
 How do investors and entrepreneurs
react?
Consumer
Goods
C0
C0
C1
C1
Time
I0
Interest
Rates
Suppose that
people become
more patient.
What happens?
I1
Investment
Goods
S = Savers
S’
i0
i1
D = Borrowers
S0
=
I0
S1
=
I1
Investible
Funds
Now, let us suppose that government
places a price ceiling on interest
rates.
 How
does this change affect the model?
 What happens to consumption and
savings decisions?
 How do investors and entrepreneurs
react?
Consumer Goods
C1
C0
C1
C0
Time
Suppose that a
price ceiling is
placed on
interest rates.
Now, what
happens?
I1
I0
Interest
Rates
Investment
Goods
S = Savers
i0
ic
D = Borrowers
S1 S0 = I0
Amount actually
available
Credit
Shortage
I1
Investible
Funds
Amount businesses
want
Phases of the Business Cycle:
Artificial Credit Expansion
“Artificial Boom”
Crunch
1.
2.
3.
•
•
4.
5.
Credit Crunch (and/or)
Real Resource Crunch
Recession
Recovery
The Unsustainable
Malinvestment Boom
Suppose that the interest rate is 5% and the
firm is considering a project that will yield 4%.
 Will it engage in the project?
 Suppose the Central Bank lowers the interest
rate from 5% to 3%.
 What will the firm do now?

Malinvestment Boom continues
During the course of the artificial boom,
malinvestments are built up.
 Consumers reduce savings with lower interest
rates.
 Thus, we have an increase in consumption and
an increase in investment.
 Ivan and the Brickyard.

The Initial Boom Phase of the Business Cycle
Consumer Goods
Dueling
Structure of
Production
C1
C0
C1
C0
Unsustainable
Boom
Time
I0
I1
Interest
Rates
Investment Goods
S = Savers
S + New Money
i0
i1
D = Borrowers
S0= I0
S1
Investible Funds
I1
The Fed has a Choice:



As the firms compete for resources, input prices are driven up
making them look for more funding.
Short-term interest rates rise from the firms’ actions.
The central bank has a decision to make:

either halt the expansion or
 expand the money supply at a faster rate.


The central bank may choose to halt the expansion and
increase interest rates out of a fear of rising price levels. The
effect of this policy is a credit crunch.
If, instead, the central bank continues along an expansionist
policy, input prices rise and reflect the real resource crunch.
The Crunch:

When the crisis hits, there are two problems facing
the entrepreneur:
 increasing interest rates
 rising



and
input costs.
With an increase in interest rates, there is an impact
on both working capital and fixed capital.
The longer lived the capital equipment, the greater the
impact on its value.
Interest rates will rise, but short-term rates will
increase more than long-term rates.
Yield Curve Spreads Between 1953-2010
5.00
4.00
3.00
2.00
1.00
Recession
Spread 10 year - 1 year
-2.00
-3.00
-4.00
-5.00
Recessions are dated according to the NBER.
The data for interest rates were obtained from FRED II.
2009-04
2007-04
2005-04
2003-04
2001-04
1999-04
1997-04
1995-04
1993-04
1991-04
1989-04
1987-04
1985-04
1983-04
1981-04
1979-04
1977-04
1975-04
1973-04
1971-04
1969-04
1967-04
1965-04
1963-04
1961-04
1959-04
1957-04
1955-04
-1.00
1953-04
0.00
Spread 10 year - 3 month
Spread 20 year - 3 month
The Liquidation Phase:

Only through the process of converting the
malinvestments into productive capital can the
foundation for growth be achieved.

Only the Austrian School argues that
Liquidation is a necessary condition for
recovery.
The Liquidation Phase: Continued





The firms that invested during the artificial boom suffer the
economic losses.
They sell their capital equipment at a discounted rate to other
firms.
These other firms can turn an economic profit even at the
previous prices because these firms have purchased the capital
equipment at a discount.
This liquidation process is how the malinvestments are
converted into new fixed capital equipment.
This process is necessary for normal economic growth to
occur.
The Recession Illustrated:
Consumer Goods
C1
C0
C1
C0
C2
C2
Time
I2
I0
I1
Interest
Rates
i2 =
Investment Goods
S’
S
i0
i1
S + New Money
D’
S1 S0= I0
I1
S2= I2
D
Investible Funds
So what happened in 2008?



Each Business Cycle is unique.
2001 dot.com bust didn’t liquidate enough malinvestment and led to
another bubble.
Expansionary Monetary Policy was adopted to stimulate the economy.


The Fed funds rate in 2001 is at 6%.
In 2003, it is at 1%.
 However, to fight the bubble, the Fed raised rates, and in 2006, it was at 5.25%.





“The basic point is that the recession of 2001 wasn’t a typical postwar
slump…. To fight this recession the Fed needs more than a
snapback…Alan Greenspan needs to create a housing bubble to replace the
NASDAQ bubble.”—Paul Krugman, 2002.
Community Reinvestment Act encouraged banks to take on more risk.
Fannie Mae and Freddie Mac rules changed and encouraged them to buy
mortgage-backed securities. (GSE’s only needed 3% held in reserve.)
Money flows into Real-Estate.
Sub-Prime Market Emerges—In 2006, 20% of all mortgages were subprime. 81% of those were securitized.
“The Fix”?





Toxic Assets and Troubled Asset Relief Program (TARP): Of
the $700b, $350b bought equity (preferred stock), not assets.
The Fed led a massive increase in the money supply by buying
anything and everything it wanted.
FASB 157: New Mark-to-Market accounting rules went into
effect June 15th, 2009.
Home Affordable Modification Program (HAMP) was
supposed to allow people to “renegotiate” new (smaller) loans.
Stimulus Package, Bail-Outs and a huge Federal Budget adds
to the fire.
Today the NBER and the news
Whenfocus
we also
need
to
They
on
media
focus
onthis.
the recession,
but
focusare
on still
this. tough after the
times
Technically,
is
bottom
of thethis
trough.
They
focus on GDP.
the
recession.
However, GDP is the
Keynesian
C+I+G+X-M;
and, a 1% decrease is
greater than a 1%
increase.
FEE's Distress Index
100.00
It can be found on FEE’s
FEE’s web
Newpage:
Distress Index helps us to
look atfee.org/distress-index/
more than just the recession.
90.00
80.00
70.00
60.00
Recession
50.00
Distress Index
40.00
30.00
20.00
10.00
2009-01
2007-01
2005-01
2003-01
2001-01
1999-01
1997-01
1995-01
1993-01
1991-01
1989-01
1987-01
1985-01
1983-01
1981-01
1979-01
1977-01
1975-01
1973-01
1971-01
1969-01
1967-01
0.00
Recovery:
Recovery is through the same process of
normal growth.
 In other words, the “Magic Formula”

Savings Investment Capital Accumulation
Higher Productivity More Stuff
Higher Living Standards
Implications:
1.
2.
3.
4.
5.
Keynesian Policy cannot pull an economy
out of a recession.
Expansionist Monetary Policy cannot pull an
economy out of a recession.
Downturns are created by increasing input
prices, not just increasing interest rates.
Fixed capital equipment has to be sold-off.
Increasing savings is needed for the
transformation to occur.
Keynesian Policy cannot pull an
economy out of a recession





Keynesian policies are designed to keep aggregate demand
high.
Any increase in aggregate demand will put pressure on input
prices to also rise.
The problem illustrated above is that after the crunch phase,
the return on capital has fallen considerably.
In order to maintain profitability by increasing output prices,
the output prices have to either keep pace with or outstrip
the increases in the input prices.
The output levels cannot be maintained due to the real
resource crunch that is pressuring input price increases.
Expansionist Monetary Policy cannot
pull an economy out of a recession



Expansionist monetary prescriptions for curing a
recession are to stimulate investments by keeping
interest rates relatively low and stabilizing the growth
of the money supply.
Such prescriptions also cannot pull an economy out
of a recession, since it ignores the malinvested capital
that is locked into unproductive arrangements.
The case study of the failure of employing both
Keynesian and Monetarist prescriptions is Japan since
1990.
Implications:




Fixed capital equipment has to be sold-off at reduced prices
in order to transform the malinvestments does not seem to
explain the duration of the recession phase.
Capital’s specificity is a stumbling point that tends to reduce
the smooth transition of the fixed capital into productive
structures.
Capital is not an amorphous mass, a homogeneous blob of
“K.”
Capital goods have differing degrees of specificity,
complementarity and substitutability. It is not simply a
question of lowering the price and then plugging the
machine into another production process.




Typically, projects need to be integrated into other existing
firms. Austrians have long argued that merely investing
capital does not lead to economic growth, but correctly
arranged capital structures guided by the market process are
the mechanism for growth.
Rearranging prices is simply not enough to pull an economy
out of a recession. Some of the more specific capital may have
to be thrown away—scrapped—if no other firm could make a
profit from it.
A liberalization of merger and acquisition laws could improve
the situation.
Furthermore, the elimination of other obstacles found in
bankruptcy laws could help expedite the transfer of
malinvestments into productive ventures.
Increasing savings is needed for
the transformation to occur



In order for the second firm to purchase the capital equipment from
the first firm, the purchaser will need funds.
Newly created credit will only start the boom/bust cycle again.
Only real savings can allow the transformation process to occur.
A government interested in helping an economy out of a recession
has to then do the following:




first, not interfere with the price adjustment process;
second, not reinflate the money supply;
finally, try to increase the amount of savings in the country. It could do
this through liberalizing its laws to allow for increased savings to flow
in from abroad and it could also cut taxes on domestic savers.
By increasing the amount of savings, the amount of malinvestments
that could be transformed into profitable investment increases.
Increasing the amount of savings available for investment quickly
can shorten the duration of a recession.
Conclusions:





The most significant point is that the Austrians were correct to
spend so much energy explaining the cause of the business
cycle.
It is only an understanding of the cause that allows us to
determine the best policies to follow to generate an economic
recovery.
If the government follows policies that are contrary to the
Austrian prescription, the situation will not only fail to
improve, it will worsen.
The lesson is that as long as output prices stay up (through
Keynesian policies) or if the Monetarists keep interest rates
from rising (or maybe push them lower), or if input prices are
rising (a real resource crunch), we will have a recession.
The only way out is through the painful but necessary
liquidation process.
Conclusions:



The best means to transform malinvestments into viable
economic activities is through increasing savings.
This means that one of the government’s most effective
policies is to cut taxes on the savers. Those who are savers are
usually labeled as “the rich.” Unfortunately, the prescriptions
of “get government out of the market” or a “tax cut for the
rich” tend not to be politically popular. Nevertheless, it is the
duty of the economist to present the truth.
The economist cannot state that the government should do
nothing. Such a strategy was tested in the 1930s. The modern
economist needs to present the case that the government
caused the recession and only by removing the government
from the equation can the economy truly recover.
Business Cycles
By Paul F. Cwik, Ph. D.
[email protected]