The Economics of Boom and Bust Cycle

Stock markets around the world are collapsing off late. The Indian stock market lost some 5000 points in one month time. The US stock market NASDAQ and S&P 500 erased all their 2018 gains. News headline in Reuters says the world markets are captured by the bears now. The so-called emerging market economies are slowing down considerably.

Why our economies experience these ups and downs. What causes this business cycle phenomenon? And how to cure it? To give answers of these questions we need to understand the Austrian Business Cycle Theory (ABCT).

Business Cycle and Business Fluctuation

Before we discuss the phenomenon of business cycle, we need to clarify the crucial difference between business cycle and business fluctuation. Both these phenomena are vastly different. The distinction between them must be made clear to understand what causes day to day business fluctuation and what causes the business cycle.

Business fluctuations are part of our routine life where prices of individual goods or services fall or rise on daily basis. The rise and fall is due to changes in the market forces of demand and scarcity of the goods or service in question. As made clear by the Austrian economists, price is primarily determined by the subjective valuation of individual human actor. Other factors affecting price are the given circumstances under which the consumer finds himself while choosing the marginal unit and the relative scarcity of the good or service. For example, during a natural disaster such as a flood, the price of milk rises rapidly because the given circumstances of flood make milk scarcer. Similarly prices of individual products rise and fall on a daily basis with the change in underlying economic data. It must be emphasized here that, this rise and fall in individual product prices or even prices in some sector of the economy, like automobile industry or agriculture products etc., cannot be considered as a cycle. These are individual events happening in one or the other sector of the economy. These fluctuations are corrected automatically by the market if left alone to work. For example, during flood, if we let the price of milk rise for sometime then it will automatically induce producers from other areas to start producing and supplying milk to flood affected area because now milk industry is more profitable in that area. Once this new supply enters the flood hit place, it will increase the supply of milk and that will lower its price. Market will automatically resolve the milk problem. So we don’t need any special attention for such daily events. Market sorts out gluts and scarcities. Like the rise and fall of prices of individual products in the market, everyday many businesses silently cease their operations when they make losses. Individual business closures are very normal in the market. Profit and loss is the market mechanism through which inefficient and unproductive businesses are weeded out while efficient and productive businesses remain and continue their activity of serving their consumers most effectively .

But the phenomenon of business cycle is very different. It requires special attention because the cause of business cycle is not in built in the market process. Let’s first understand what business cycle is.

Business cycle is a general boom and bust phenomenon which occurs at the economy wide level. It is a macroeconomic phenomenon having crucial microeconomic roots. The phases of an economic cycle are typical. It starts with a mild boom in economic activity (when everything seems very rosy), then the boom expands rapidly and that starts to result into inflation and then a final slowdown of the economy, the recession . What is very peculiar about the business cycle is the phase of recession. During the recession we see economy wide mass business failures. What seems to be so profitable industries in the boom period suddenly becomes unprofitable e.g., the IL&FS. Due to these business closures, large scale unemployment results. The capital structure of the economy changes where resources start to flow from unprofitable industries to profitable ones. Also, during the boom period the economic activity seems very unusual where most of the goods and services’ prices tend to push up dramatically. Price inflation slowly emerges in the economy and it spreads from one sector to another. This is then is the character of the general boom and bust cycle. It is very different from the daily business fluctuation.

After understanding what business cycle is, it is important to understand its cause. Any good business cycle theory should explain all the phases of cycle within the framework of general theory of economics. It must explain why during the recession period mass business failures result, why the capital structure starts to change (many projects fails and resources flows from these projects to other more viable projects), why unemployment results and why during the boom period economic activity increases dramatically, money supply is continually increasing and in the end it all ends with an inflation and subsequent recession. There are many theories of business cycle in mainstream economics but they all either don’t fit into the general framework of economic theory or fail to explain the business cycle properly. The only theory which successfully integrates itself into economic theory and simultaneously explains the boom bust cycle fully is the Austrian Business Cycle Theory (ABCT) as developed first by Ludwig von Mises and subsequently by Friedrich Hayek and Murray Rothbard.

The Austrian Business Cycle Theory (ABCT)

The Austrian Business Cycle theory is based on many crucial insights of Austrian economics like the capital structure of the economy, the different stages of production, the nature of money, bank credit expansion through the system of fractional reserve banking, time preference of consumers etc. Here I will directly use all these concepts without going into details because of the space constraint.

As I have said, ABCT explains the business cycle completely starting from the artificial boom to its ultimate end in the form of recession. I will now discuss all phases one by one.

The artificial boom starts when the central bank of the country (RBI in case of India) starts to increase the money supply by printing more money and then commercial banks lending this money to the businesses and general public at a lower interest rate. The increased money supply, which is a result of printing of money and the credit expansion activity of banks through fractional reserve banking, lowers the interest rate below its natural market level. During this phase, due to artificially lowered interest rate, many projects appear profitable to an individual entrepreneur which would have not appeared profitable previously. What is important to understand here is how the market interest rate is lowered. There are two ways in which interest rate can be lowered. One is when peoples’ time preferences become low and they look to consume more goods in the future and thus in the present they increase their saving. This increased saving lowers the market interest rate. This low interest rate sends a signal to entrepreneurs that consumers want to consumer more goods and services in the future rather than in the present. In order to fulfill those future demands at a future date entrepreneurs start new long term capital projects which will enable them to produce more in future and thus meet the future demand of consumers. When the investment in new projects is backed by this type of real saving, it results in no boom and bust. The problem starts when the market interest rate is lowered by the central bank by printing more money out of thin air and by credit expansion by commercial banks through fractional reserve banking. This artificially lowered interest rate sends a wrong signal to entrepreneurs about the future demand of consumers. Here, consumers’ time preferences have not changed and thus they are not asking for more goods and services in future. Working under the illusion created by the central bank, businesses start to expand their activities. They start many new long term projects. Resources start to flow into these new ventures. As resources are employed in these new projects, they are less available for producing other consumer items which are required for present consumption. As the newly created money starts to enter market it increases the purchasing power of those in whose hands it goes first. On one side consumers acquire new income and on other side their time preferences haven’t changed and thus they start to spend their money in market for present consumption. On the other side production of present consumer goods is not taking place because resources are flowing in long term production processes. This slowly starts to result in price inflation . Price rise slowly spreads from one sector of the economy to the other with the flow of money from one sector to another.

Now as inflation emerges in the economy, suddenly government becomes concerned about it. To combat this inflationary situation, central bank starts increasing the interest rate by using tight monetary policy. With this increase in interest rate, entrepreneurs realize that the new projects which they started during the boom period are not backed by real saving and are thus not profitable and sustainable. Mass business failures take place. Murray Rothbard called this phenomenon of mass business closure a cluster of errors where many businesses suddenly discover errors in their past decisions. The artificial boom inevitably results into a bust. People employed in those long term capital projects now become unemployed until they find work in activities suited to consumers’ time preferences.

What is important here to understand is that recession is a necessary outcome of the artificially created boom by the central bank. Recession is the process through which market starts to correct the capital structure of the economy. Through that whatever mal-investment has taken place during the boom period now starts to liquidate. Misallocated resources slowly start to flow in correct industries to fulfill consumers’ immediate demand. The whole economy starts to heal itself.

But, if during this healing period government and its central bank again start to intervene in the market adjustment process then the mild recession turns into a deep depression such as the Great Depression of 1929.

The Remedy

After getting the full understanding of the ABCT, it is  clear what we need to do in the short run for a recovery and, more importantly, in the long run to prevent the business cycle from ever occurring. In the short run, we should need to do nothing. Doing nothing sometimes is a more beneficial action than doing everything and making things worse. We need to let the market do its work. The market in a very short period of time will reallocate all the resources in right channels of production and adjust the capital structure of economy in line with consumers’ time preferences. Through recession the market will liquidate all mal-investments. In the short run all the unnecessary projects will shut down, and we should allow these business closures instead of bailing them out one by one as the Indian government is doing right now. People will increase their saving in the recession period and that is good. We should not meddle with consumers’ desire to save more during recession. In fact this saving is necessary because this increased saving can, to some extent, help some of the businesses to survive during the recession. Consumers by making this actual saving available to some of the businesses can help them in avoiding bankruptcies and also preventing them from laying off their workers. It can also prevent the losses of the equity holders. Once the recession period is over, economic activity will return to normal. People will find employment in more viable activities again. Prices will come down to their normal market level which will increase the standard of living of people slowly.

And in the long run if we wish to prevent the business cycle from ever happening then the key lies in taking the control of money back from government and restoring it again to the market. We need to adopt three crucial steps:

  1. Money essentially is a commodity and it should be produced in the market like any other commodity. For restoring the money to the market place and to take back the control of money supply from the government, we need to adopt the market based commodity money. Commodity money can either be gold or silver or both gold and silver, as existed in historical periods. This is what is needed for stopping government from printing money out of thin air. Public mints should give its way to the private coinage.
  2. Secondly, we need to abolish central banks. This means abolishing the RBI from India. Central banks are the root cause of this whole problem. A central bank is just like any other central planning authority which worked under communist/socialist/market socialist countries. Theory and history both show that central planners and their plans never work. They can only create problems for people. Central banks’ monetary policy and its fixing of interest rate is the prime cause of boom and bust cycle. If we want to stop the booms and busts then we need to abolish all the central banks around the world.
  3. Even in the absence of central banks, private banks to a certain extent can distort the market interest rate through the process of credit expansion under a fractional reserve banking system. The whole system of fractional reserve banking is unethical and illegal and thus we need to abolish it too. All banks must operate on a 100 per cent reserve banking norm. This means, if a bank has 100 customers with 100 rupees worth of reserve then that bank must, at all times, keep 100 rupees reserve with it. In short, the money creation process of banks must be stopped. Stock and bond markets are good places for the businesses to acquire investment from peoples’ saving. Banks of credit (as opposed to banks of deposit) will also perform the function of channelizing consumer’s saving to the businesses. In short, 100 percent banking system should replace our present day fractional reserve banking system.

These three steps are necessary for stopping booms and busts from ever occurring. We must let free market work in the very crucial sphere of money. Money is too important subject to be handed over to governments and their central banks who are always eager to exploit it.

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