Why Do we Have Business Cycles?

Discussion in 'Economics & Trade' started by LibertarianFTW, Aug 12, 2012.

  1. LibertarianFTW

    LibertarianFTW Well-Known Member

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    A business cycle (also often referred to as an "economic cycle" or a "boom-bust cycle") is when an entire economy goes through a strong economic period (the boom) followed by a very weak economic period (the bust).

    I did a search for this and there doesn't seem to be a thread on it (at least a recent one). So, I'm making one: why do we have business cycles? What is the explanation?

    Non-controversial factors among economists:
    -When the Federal Reserve lowers interest rates (by printing money and buying bonds), it causes more investments. Of course, this makes sense: if interest rates go down, more people are going to want to borrow. This especially accounts for capital investments.
    -Ceteris paribus, when savings goes up, interest rates go down. When savings go down, interest rates go up.

    The Austrian theory of the business cycle in a quick nutshell (this is the controversial part):
    When the Fed artificially lowers interest rates, not by equilibrium price driven by market forces, but by arbitrary determination of the few in charge, it does not account for the supply and demand: in this case, savings and investment. When the Fed lowers interest rates artificially, savings has not increased. However, more investments are still made, especially capital investments. Thus, there is an economic boom due to the investing of all the industries. The companies allocate their resources into the capital market, people are hired into the capital market, and people invest in the capital market.

    In a free market economy, if the interest rates go up, this means people are pulling money out of savings. So, if investments were made in capital goods, this would pay off due to the boom of spending that was in savings.

    In a centrally controlled banking system, on the other hand, there is no boom of spending after interest rates go up and the capital projects are finished. There was no savings to begin with, so there cannot be savings to be pulled out. Thus, none of those investments pay off. As a result, of course, the economy goes down the tubes.

    The mainstream/Keynesian theory of the business cycle:
    All the businesses randomly decided to allocate their funds into capital investments because they're stupid and there's not enough regulations. The investments don't pay off.

    Keynesians/mainstream economists typically do not focus on how we got in the recession. They focus on how to get out of it. The Keynesian solution is basically to lower interest rates to extremely low levels to get that boom period again. They also advocate for bailouts, government spending, etc...

    The Austrian solution to the bust period:
    For the purpose of this short post, I'm going to ignore tons of policies that Austrians would advocate for and would be very helpful to the economy. The core idea, relating to the business cycle, is to allow those resources to be allocated to the correct markets by the usual supply and demand principles. The Austrians view further artificial lowering of interest rates as perverting businesses into the continuous misallocation of resources. (Bailouts have the same effect, of course.) This boosts the economy to be less severe than it would be without the artificial manipulation of monetary and fiscal policy, but does not allow for the proper correction of the market, and therefore prolongs the recession. The Austrian views this further artificial manipulation as also creating another bubble: thus, the bust that will necessarily follow will be even more severe. The end result is an extremely long recession/depression. The Austrian theory holds that the bust period will be very short, but more severe, if there is no government intervention trying to "help" the economy.

    Take getting drunk as an analogy. In the Austrian view, the drunk stage is the boom, and the hangover the next day is the bust. From the Austrian perspective, the Keynesian is trying to drink more and more alcohol to suppress the hangover as long as he can. The Austrian sees the hangover as inevitable, and better to face now than prolong it and just face it in a worse form later.
     
  2. RedRepublic

    RedRepublic Banned at Members Request

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    Interesting post!

    One of the good things about a planned economy is that the boom bust cycle is eliminated :)
     
  3. RPA1

    RPA1 Well-Known Member Past Donor

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    There are always cycles in businesses however, they are mostly short-lived and in specific markets. Government is the only entity that can affect the economy globally by instituting monetary policies that are not directly tied to production and, since the Board of Governors are political appointees, the economy is tied to the FED instead of the market. The 'mission' of the Fed is to curb inflation however, inflation is mostly caused by an over-supply of money. The Fed typically 'adjusts' interest rates proactively in an attempt to curb inflation. Sometimes it works and sometimes it doesn't. When it doesn't, more Fed 'band-aids' have to be applied on top of previous 'band-aids' and so it goes....
     
  4. LibertarianFTW

    LibertarianFTW Well-Known Member

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    Not to pick and poke, but decreases and increases of prices in specific markets are business fluctuations, not business cycles. A business cycle is when nearly all the markets go through the boom and bust period simultaneously and uniformly, versus a fluctuation is just a specific market. But I agree with your statement.
     
  5. RPA1

    RPA1 Well-Known Member Past Donor

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    Global business cycles are mostly caused by government intervention.
     
  6. LibertarianFTW

    LibertarianFTW Well-Known Member

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    What do you mean by "planned economy"? Have the state cease and control all means of production?

    Agreed.
     
  7. RedRepublic

    RedRepublic Banned at Members Request

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    Well, not the current capitalist state of corse. And not really a state in the sense of what people usually mean.
    A democratically planned socialist economy with real worker's control and workplace democracy is ideal.
     
  8. LibertarianFTW

    LibertarianFTW Well-Known Member

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    Well, I don't want to derail this thread, but I urge you to read Socialism by Ludwig von Mises, or at least his essay Economic Calculation Problem.
     
  9. RPA1

    RPA1 Well-Known Member Past Donor

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    Here is a hard reality for you....Business is about turning a profit...NOT to give workers control and benefits. Workers are there to provide labor where it is needed. The business entity PAYS them for their trouble. Why should a business do any more than that?
     
  10. RedRepublic

    RedRepublic Banned at Members Request

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    The economic calculation problem only applies when you have a lack of information, as you would with a small group of beurocrats planning the economy. Leon Trotsky (co leader of Bolshevic revolution, exiled after Stalin framed him for a murder which we now know Stalin commited) understood that central planners could never have accurate enough information, which is why Trotskyists (of which I am one) understand the need for democratic planning.
     
  11. LibertarianFTW

    LibertarianFTW Well-Known Member

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    Democratic planning has the same effect. No one even knows how to make a pencil.
     
  12. Longshot

    Longshot Well-Known Member

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    But isn't democratic planning just another form of central planning? The only difference is that the central planner is a large group rather than a single individual or small group.

    Edit: It occurred to me that you may be talking either about 1) the entire production of society being planned democratically, or 2) a single "firm" being run democratically. My response assumes the former, so please correct me if I'm wrong.
     
  13. Not Amused

    Not Amused New Member

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    A simple explanation of the business cycle is "The Beer Game".

    In short, the lag between an increase in demand, exaggerates that demand, prices may rise.
    The exaggerated demand is used to justify the capital to create both excess capacity and excess inventory (the boom).
    Inventories are filled rapidly after the excess capacity is built.
    The exaggerated demand reduced to actual demand.
    Suppliers have excess capacity, and debt. Their customers are holding excessive capacity, of over priced inventory (the bust)

    This is a good description of the tech boom / crash.

    An engineer would term this an under damped feed back loop.

    What does it take to make a really big boom, and bust?

    You give two, independent, controls of interest rate, the Fed and savers.

    During the housing boom, the Fed keeps rate low.

    1. Increasing prices increased equity, allowing people to use the profits from a sale to buy a better house. Low interest rates allowed them to afford a bigger loan.

    2. High prices, and low interest rates, created a business justification for building more houses.
    a. The demand form material, which is already high from China's growth, increases even further. Prices and lead times increase.
    b. The demand for county approvals increase, increasing lead times.
    c. The demad for labor increases, low skill labor is moved into construction, wages increase.

    3. Low interest rates, and increased home prices create a huge boom in cash out refinancing. Consumers spend 100's of billions of borrowed money.

    4. Lenders kept bumping into the reserve ratio, the demand for AAA paper increased. New home purchase, and refi's were used to create secure capital, AAA paper, more money lent into existence.

    5. Increasing prices removes the risk of liar loans, foreclosures can be sold for more than the loan. This further increases the number of people entering the housing market.



    As the excess capacity of homes, built in step number two, hit the market, it becomes a buyers market, home price stop rising.

    1. People can't sell their homes, so can't buy another - new mortgages dry up. Those that need to sell, lower their price.

    2. The teaser rate if the adjustable lair loans ends, loans start to default. Foreclosures drive prices even lower. AAA paper become toxic.

    3. The demand for high priced materials, and labor plummets. Spending drops, the economy slows.

    4. Lower home prices kills the cash out refi, spending drops, the economy slows further.

    Hang on boys and girls - it is going to be a bumpy night.....



    Lets look at the housing boom without the Fed. Borrowers for home loans drain bank reserves. Savers pull their money out buy homes, interest rates would rise.

    1. Higher interest rates significantly limit what a buyer can afford, reducing demand.

    2. Home prices increase a little bit.

    3. With higher interest rate, there is little benefit in refinancing.

    Another minor blimp in the housing market - nothing more.



    Did the government plan to crash the economy? Or, was the economy way past their capacity to understand?
     
  14. Not Amused

    Not Amused New Member

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    Can you show us an example this type society, especially one that went through this last boom and bust?
     
  15. LibertarianFTW

    LibertarianFTW Well-Known Member

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    @Not Amused

    Great post. Just thought I'd add a little.

    I would just note that this happens after the Fed raises interest rates. Not to pull a Milton Friedman and say the money supply shouldn't be contracted (the longer the interest rates are low, the bigger the bubble is... and if the rates are low for too long, this will cause hyperinflation).

    I would note here that the resources that were allocated into capital investments (in this case housing) would be reallocated into the proper industries if left to the market forces. Instead, Keynesians further perpetuate the false signals and prolong the recession.

    The interest rates would only go up as much as the savers would pull out, so it would keep demand relatively the same. The difference is that it would shift from investment spending to consumer spending. Essentially, all those investments would pay off due to the increase in consumption.

    Alan Greenspan didn't pick up an Austrian economics book is all.
     
  16. Not Amused

    Not Amused New Member

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    Thanks - good topic.

    True. But, as you noted, it would have happened even if the Fed hadn't increased rates. Just disassociating interest rates from the market.

    Keynes gave politican's the impression they could fix the economy by giving false signals. Politician's can't help promise thing they can't do, and the voters failure to hold them accountable just makes things worse.

    Savers pulling money out reduces reserves, borrowers decrease reserves. Either, or both, increase rates.
     
  17. Liberalis

    Liberalis Well-Known Member

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    Excellent Post. And Not Amused your comments were great as well.

    It all has to do with time preference. Do you want to spend savings now, or spend them in the future? A high rate of savings means people want to spend money later rather than now. This encourages a longer production process, with more resources put into development of longer-term future consumer goods.

    A low rate of savings means people want to spend money now rather than later. This encourages producers to keep producing what they are producing, investing in new capital primarily to replace old capital or to improve upon the existing structure of production.

    Keynesian economists completely ignore the time-structure of production, and view everything as a big aggregate blob of supply and demand. Goods are goods, investment is investment, and spending is spending. Such a simplistic view masquerades behind useless equations and fancy rhetoric.

    The boom and bust cycle is the result of entrepreneurs misjudging time preferences due to the manipulated interest rate. All sectors are effected because what is being manipulated is money, and money (as medium of exchange) is involved at every level and in every sector of the economy. As long as the interest rate is subject to price fixing, the market rate of interest cannot be known, and mistakes will continually be made.
     
  18. Longshot

    Longshot Well-Known Member

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    An excellent and succinct explanation. Well done.
     
  19. geofree

    geofree Active Member

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    All these posts and not one mention of the true cause of depressions, which is land speculation. The two fundamental ingredients required to produce wealth are land and labor. When speculation enters the land market, land prices (rents) are carried above what labor can afford to pay, the result is that labor must sit idle until the speculation subsides and land prices are adjusted downward.

    You can compare the landowner to a tax man. When speculation enters the land market (as it always does under the current systems) the tax man’s demands become too great, producers can not afford the heavy taxation, so they cut back production, and consumption.

    It’s funny how most people are quick to claim that increasing government taxes will stifle production … but when the landowner increases his cut (which has a vary similar effect on producer costs) they turn a blind eye.
     
  20. RedRepublic

    RedRepublic Banned at Members Request

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    Yes, it is still technically centrally planned but when you say central planning most people think of the Stalinist centrally planned economies that because of their lack of democracy and regular input were effected by the economic calculation problem.
    The practical form of this would be everyone filling out a catalog, say, at the start of each week which would go to the producer's agency, the producer's agency would communicate what people want to the various collective workplaces and production would be planned directly for use. The products would either be delivered or you would go to a specific "shop" area to collect them.

    Something that most people don't realise about capitalism is the huge waste and overproduction, for example up to half of crops grown in the US are thrown out before they even get to the stores. We could feed the entire world if things were planned logically, even if we were using farming equipment from a decade ago. Another thing is that even as productivity increases approximately 2% each year, wages for the average worker have remained stagnant since 1970!
     
  21. Longshot

    Longshot Well-Known Member

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    I don't think that would work. Without central planning, people would just order whatever they wanted and production could never fulfill all the orders.

    EDIT: Also, I assume producers themselves would also need to place weekly orders for their factors of production.
     
  22. PabloHoney

    PabloHoney New Member

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    itt we have mises = moses

    which is lololololterribad
     
  23. RedRepublic

    RedRepublic Banned at Members Request

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    You're thinking like producers are a certain group of people - they're you and me, the people who work. Everyone is a producer and a consumer (except those who consume more than they produce, aka the rich - who have no place in the society). Obviously they wouldn't be able to order whatever they wanted, now that's just silly. each item would be worth a certain amount of "labor credits", which you would earn by working. The point is to reward people according to their contribution. "From each according to their ability, to each according to their contribution."
     
  24. Not Amused

    Not Amused New Member

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    Those on the public dole consume more than they produce - do they have no place in society?


    "Labor Credits"? Isn't that the role money plays?

    "From each, according to their ability"? No matter their actual income?

    "To each, according to their contribution."? Isn't that called a pay check?
     
  25. Reiver

    Reiver Well-Known Member

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    They play a crucial role in capitalism: disciplining the workforce such that economic rents aren't threatened.
     

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