Stumped by the Bust
In the slump of a cycle, businesses that were thriving begin to experience difficulties or go under. They do so not because of firm-specific entrepreneurial errors but rather in tandem with whole sectors of the economy. People who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs.
What has caused the bust? The modern-day economic orthodoxy continues to be unable to provide a tenable and sound explanation for the business cycle phenomenon. Such an explanation does exist though.
Businessmen themselves are confused as to why. They cannot make sense of why certain business practices that were profitable yesterday are losing money today. Bad business conditions emerge when least expected — just when all businesses are holding the view that a new age of steady and rapid progress has emerged.
In his writings, Ludwig von Mises argued against the prevailing explanation of the business cycle consisting of over-production and under-consumption theories, and critically addressed various theories that depended on vague notions of mass psychology and irregular shocks.
In the psychological explanation, an increase in people’s confidence regarding future business conditions gives rise to an economic boom. Conversely, a sudden fall in confidence sets in motion business stagnation.
Observing a Business Cycle vs. Explaining a Business Cycle
Now, there can be no doubt that during a recession people are less confident about the future than during good times. But to observe this is not to explain it.
Likewise, theories that view various shocks and disruptions as the central cause behind boom-bust cycles do not advance our knowledge regarding the boom-bust cycle phenomenon.
Neither explains how the boom and bust come about, or why they are of a recurrent nature. To arrive at a correct explanation, Mises held, we need to trace the change in business conditions back to previously established and identified phenomena, and that is precisely what these theories do not do.
Hence Mises concluded that all these theories do not provide an explanation but rather describe the phenomenon in a different way.
Mises also held that various statistical and mathematical methods are another way of describing, but not explaining events. Statistical methods make it possible to generate charts of data fluctuations but they do not improve on our knowledge of what causes the fluctuations.
A thumbs-up from Ludwig von Mises. Mises dissects the fallacies of non-monetary business cycle theories in Human Action. He inter alia points out that opponents of the monetary theory of the trade cycle have been unable to forward tenable arguments refuting it. Mises concludes that the propagation of non-monetary business cycle theories is primarily driven by political rather than scientific considerations. The goal is to arrive at the predetermined conclusion that the market economy needs to be “rescued” by government intervention and central planning.
Photo via mises.org
“Commodity Credit” or “Circulation Credit”?
Mises made a distinction between credit that is backed by savings, and credit that does not have any backing. The first type of credit he labeled commodity credit the second he labeled circulation credit. It is circulation credit that plays the key role in setting the boom-bust cycle process.
Consider a producer of consumer goods who consumes part of his produce while saving the rest. In the market economy, our producer could exchange the saved goods for money. The money that he receives can be seen as a receipt as it were for the goods produced and saved.
The receipt is his claim on the goods. He can then make a decision to lend the money to another producer through the mediation of a bank. By lending the money of the original saver, the lender transfers his claims on real savings to the borrower.
The borrower can now use the money — i.e., the claims — and secure consumer goods that will support him while he is engaged in the production of other goods (say tools and machinery).
The credit in this case is fully backed by savings and permits the expansion of tools and machinery. With better infrastructure, it is now possible to produce not only more goods but goods of a better quality. The expansion of real wealth is now possible. Once a lender lends his money, he relinquishes his claims on real goods for the duration of the loan.
In an unhampered market economy, borrowers are users of savings who make sure that savings are employed in the most efficient way: generating profits. This means that real savings are employed in accordance with consumers’ most important priorities.
We can thus see here that as long as banks facilitate commodity credit, they should be seen as the agents of wealth generation. In contrast, whenever banks embark on the lending of circulation credit they in fact become the agents of real wealth destruction.
As opposed to commodity credit, circulation credit is not supported by any real saving. This type of credit is just an empty claim created by banks. In the case of commodity credit, the borrower secures goods that were produced and saved for him.
This is, however, not the case with respect to the circulation credit. No goods were produced and saved here. Once the borrower uses the unbacked claims, it is at the expense of the holders of fully backed claims. In this way, circulation credit undermines true wealth generators.
Now, as a result of an increase in the supply of circulation credit money market interest rates fall below the natural rate, that is, the rate that would be established by supply and demand if real goods were loaned directly in barter without the use of money (in his later writings, Mises referred to the natural rate as the rate that would be established in a free market).
This chart compares the true broad money supply TMS-2 (black line) to the sum of currency (circulating currency + vault cash) and bank reserves. Currency (bank notes and coins) represent “standard money” in a fiat money system. Bank reserves are deposited with the Fed and are not considered part of the money supply; in a fractionally reserved banking system they serve as the basis for the extension of circulation credit by commercial banks. However, they can be exchanged for currency (they represent the cash assets of banks and when depositors withdraw deposit money in the form of cash, banks can transform reserves into cash to effect payment) – in other words, together with vault cash, they serve as the “standard money backing” of a portion of the deposit liabilities of banks. Putting it differently, reserves back a fraction of outstanding money substitutes and these are therefore considered covered money substitutes. Thus, everything between the red and black lines represents uncovered money substitutes or fiduciary media. These fiduciary media roughly equal the amount of circulation credit in the economy – click to enlarge.
How Circulation Credit Triggers Business Cycles
As a result of the artificial lowering of interest rates, businesses undertake various new capital projects to expand and lengthen the production structure. Prior to the lowering of interest rates, these capital projects didn’t appear to be profitable. Now, however, as money market rates are kept below the natural rate, economic activity zooms ahead and an economic boom emerges.
The forced lowering of interest rates bring into being production processes that would not be undertaken otherwise. A production structure is now created that produces goods and services that consumers in fact cannot afford.
Instead of using the limited pool of the means of sustenance to make tools and machinery that will generate consumer goods on the highest individual priority list, the means of sustenance are wasted on capital goods that are geared towards the production of low-priority consumer goods.
At some point, the producers of such goods will discover that they cannot make a profit or even complete their plans. What we have here is not over-investment but misdirected investment or malinvestment.
An inter-temporally distorted production structure is established following an expansion of circulation credit (image adapted from Roger Garrison’s “Time and Money: The Macroeconomics of Capital Structure”). Production, consumption and saving/investment are no longer in balance, as investment decisions fail to properly reflect consumer time preferences. Such a capital structure is not sustainable and eventually must fall prey to a bust – click to enlarge.
The expansion of the production structure takes time and the limited subsistence fund may not be sufficient to support the expansion of the capital structure. If the new flow of the production of consumer goods does not emerge quickly enough to replace currently consumed consumer goods, the subsistence fund comes under pressure.
At some point in time, banks discover that marginal businesses are starting to under-perform. This causes them to slow-down the expansion of circulation credit, which in turn puts an upward pressure on interest rates. As a result this starts to undermine various other business activities (non-marginal), and can often be the precipitating event that leads to an economic bust.
Mises wrote that the bust phase of the business cycle process could be precipitated by other events. The expansion in the money supply enriches the early receivers of money. Those individuals who have now become wealthier as a result of receiving the money may alter their pattern of consumption.
This may force businesses to adjust to this new setup. Once the rate of expansion in money slows down or comes to a halt, the new pattern of consumption cannot be supported and the new capital structure that was erected becomes unprofitable and must be abandoned.
Unfinished buildings in Greece. When a boom collapses, one will often see such left-overs: office buildings, residential buildings, factories, shopping malls, etc., that could not be finished as the real resources necessary to fund their completion never existed. Spain was littered with such “ghost developments” after its boom turned to bust in 2007/8.
Photo credit: Norbert Nagel
It is not surprising that Mises was strongly opposed to the idea that central banks should impose “low” interest rates during a recession in order to keep the economy going.
Instead, he believed that policymakers should not engage in the artificial lowering of interest rates, but rather refrain from any attempts to manage the economy via monetary policy.
By curtailing its interference with businesses, the central bank provides breathing space to wealth generators and thereby lays the foundation for a durable economic recovery.
Charts by: St. Louis Federal Reserve Research, Roger Garrison (adapted by J. Philipp for Acting Man)
Chart annotations and image captions by PT
Dr. Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics (AASE), provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, master’s degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.
This article appeared originally at Mises.org
You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- Gold - Ready to Spring Another Surprise
Sentiment Extremes Below is an update of a number of interesting data points related to the gold market. Whether “interesting” will become “meaningful” remains to be seen, as most of gold's fundamental drivers aren't yet bullishly aligned. One must keep in mind though that gold is very sensitive with respect to anticipating future developments in market liquidity and the reaction these will elicit from central banks. Often this involves very long lead times. Blackbeard's...
- Modi’s Great Leap Forward
India’s Currency Ban – Part VIII India’s Prime Minister, Narendra Modi, announced on 8th November 2016 that Rs 500 (~$7.50) and Rs 1,000 (~$15) banknotes would no longer be legal tender. Linked are Part-I, Part-II, Part-III, Part-IV, Part-V, Part-VI and Part-VII, which provide updates on the demonetization saga and how Modi is acting as a catalyst to hasten the rapid degradation of India and what remains of its institutions. India’s Pride and Joy Indians are...
- Global Recession and Other Visions for 2017
Conjuring Up Visions Today’s a day for considering new hopes, new dreams, and new hallucinations. The New Year is here, after all. Now is the time to turn over a new leaf and start afresh. Naturally, 2017 will be the year you get exactly what’s coming to you. Both good and bad. But what else will happen? Image of a recently discarded vision... Image by Michael Del Mundo Here we begin by closing our eyes and slowing our breath. We let our mind...
- The Great El Monte Public Pension Swindle
Nowhere City California There are places in Southern California where, although the sun always shines, they haven’t seen a ray of light for over 50-years. There’s a no man’s land of urban blight along Interstate 10, from East Los Angeles through the San Gabriel Valley, where cities you’ve never heard of and would never go to, are jumbled together like shipping containers on Terminal Island. El Monte, California, is one of those places. Advice dispensed on Interstate...
- A Trade Deal Trump Cannot Improve
Worst in Class BALTIMORE – People can believe whatever they want. But sooner or later, real life intervenes. We just like to see the looks on their faces when it does. By that measure, 2017 may be our best year ever. Rarely have so many people believed so many impossible things. Alice laughed. "There's no use trying," she said: "one can't believe impossible things." "I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for...
- Pope Francis Now International Monetary Guru
Neo-Marxist Pope Francis Argues for Global Central Bank As the new year dawns, it seems the current occupant of St. Peter’s Chair will take on a new function which is outside the purview of the office that the Divine Founder of his institution had clearly mandated. Neo-Papist transmogrification. We highly recommend the economic thought of one of Francis' storied predecessors, John Paul II, which we have written about on previous occasions. In “A Tale of Two Popes” and...
- Trump’s Trade Catastrophe?
“Trade Cheaters” It is worse than “voodoo economics,” says former Treasury Secretary Larry Summers. It is the “economic equivalent of creationism.” Wait a minute - Larry Summers is wrong about almost everything. Could he be right about this? Larry Summers, the man who is usually wrong about almost everything. As we have always argued, the economy is much safer when he sleeps, so his tendency to fall asleep on all sorts of occasions should definitely be welcomed....
- Where’s the Outrage?
Blind to Crony Socialism Whenever a failed CEO is fired with a cushy payoff, the outrage is swift and voluminous. The liberal press usually misrepresents this as a hypocritical “jobs for the boys” program within the capitalist class. In reality, the payoffs are almost always contractual obligations, often for deferred compensation, that the companies vigorously try to avoid. Believe me. I’ve been on both sides of this kind of dispute (except, of course, for the “failed”...
- Money Creation and the Boom-Bust Cycle
A Difference of Opinions In his various writings, Murray Rothbard argued that in a free market economy that operates on a gold standard, the creation of credit that is not fully backed up by gold (fractional-reserve banking) sets in motion the menace of the boom-bust cycle. In his The Case for 100 Percent Gold Dollar Rothbard wrote: I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud...
- Silver’s Got Fundamentals - Precious Metals Supply-Demand Report
Supply-Demand Fundamentals Improve Noticeably Last week was another short week, due to the New Year holiday. We look forward to getting back to our regularly scheduled market action. Photo via thedailycoin.org The prices of both metals moved up again this week. Something very noticeable is occurring in the supply and demand fundamentals. We will give an update on that, but first, here’s the graph of the metals’ prices. Prices of gold and silver...
- Trump’s Plan to Close the Trade Deficit with China
Rags to Riches Jack Ma is an amiable fellow. Back in 1994, while visiting the United States he decided to give that newfangled internet thing a whirl. At a moment of peak inspiration, he executed his first search engine request by typing in the word beer. Jack Ma, founder and CEO of Alibaba, China's largest e-commerce firm. Once he was a school teacher, but it turned out that he had enormous entrepreneurial talent and that the world of wheelers, dealers, movers and...
- Side Notes, January 14 - Red Flags Over Goldman Sachs
Red Flags Over Goldman Sachs Just to prove that I am an even-handed insulter, here is a rant about my former employer, Goldman Sachs. The scandal at 1MDB, the Malaysian sovereign wealth fund from which it appears that billions were stolen by politicians all the way up to the Prime Minister, continues to unfold. The main players in the 1MDB scandal. Irony alert: apparently money siphoned off from 1MDB was used to inter alia finance Martin Scorcese's movie “The Wolf of...