Introduction to Economics Part 9 - The Business Cycle

Of all topics in macroeconomics there is none so widely misunderstood as the business, or boom-bust, cycle.  By the end of this note you will understand its nature, its cause, and how to end it forever.


Change in GDP Growth 1923 - 2008

If you look at various economic charts - employment, GDP growth, average salaries, etc., you will notice a pattern.  The economy seems to move in the shape of a wave, with tremendous growth for several years followed by a collapse.  During the boom, many jobs and much wealth are created.  When it peaks, employees are laid off, businesses close, and the economy enters a recession.  While many make tremendous profits during the booms, the busts can be absolutely crippling, particularly for the poor.  The most devastating bust to date was the Great Depression, due to its length.

Since the Great Depression was so devastating, a movement began in the western countries to find ways of minimizing these booms and busts and provide some predictability to their otherwise chaotic economies.  To the rescue came perhaps the most widely renowned economist today.

John Maynard Keynes was a British economist and intellectual who rose to prominence in the early to mid 20th century.  Keynes argued that the business cycle was an inherent quality of capitalism.  Booms are caused by unions and businessmen bidding up prices to increase their profits.  Busts are caused when the prices get so high that consumers simply refuse to purchase any longer, thus causing a collapse.  In order to save capitalism from itself, the government must intervene.

Keynes' theories met with a great deal of optimism, in large part thanks to the reports from traveling intellectuals citing the communism of Russia as a glorious success.  If the business cycle was indeed an inherent quality to capitalism, it was pretty damning.  "Our system has these crazy oscillations motivated by greed.  It subjected us to bank runs for decades before plunging us into the Great Depression, and the only reason we got out of it was by fighting the most terrible war in the history of the world."

So how does one regulate this beast called capitalism?  The best and most direct way to alter economic incentives is to manipulate the one product all economic actors have in common - the money supply.  During the booms, the role of the government is to increase taxes, thus reducing the enormous, uncontrollable surge upwards, preventing inflation.  The government saves its extra revenue to be spent later on.  When the inevitable bust arrives, and the consumers refuse to continue purchasing, the government is to serve as their replacement.  The government spends its savings in place of the consumers, thus preventing employees from having to be laid off and businesses from collapsing.  In this way you can see that rather than these obscene rolling hills of boom and bust, the intervention of the central planner allows for a level, consistent economy.

This way of thinking was adopted by neoclassical economists and remains the pervasive economic belief structure today.  In the 1970s, however, the United States entered a period considered impossible by this economic theory.  The US economy experienced stagflation, which is when there is both inflation and rising unemployment at the same time.  There is no lever to pull in such a situation.  You cannot tax, or you will cause more unemployment.  You cannot spend, or you will cause more inflation.  Ultimately the situation was "solved" by Ronald Reagan through an enormous increase in spending funded through national debt.  He solved nothing, but merely delayed the disaster to be endured by a future generation.

The events of the 1970s demonstrated that Keynes's theory of the business cycle was nonsense.  First of all, people in government are no different from any other group of people.  They are not separated from the profit motive as neoclassical economists claim.  They are motivated by greed just as the capitalists are.  They do not save money during the booms, and they go into debt or print money during the busts.  They are no more able to understand how to regulate the economy than any other capitalist in the economy.  As we learned in lesson four about the wisdom of crowds, individuals can only be aware of their own desires and of those with whom they directly interact.  All cases for centrally-planned economies necessitate the existence of a god-like omniscient regulator.  Lacking this, there are errors, and the result is economic disaster.

If we can't use central planning to manage the business cycle, are we doomed?  Are we condemned to endure these horrific waves of greed and destruction?  Fortunately no.  Keynes made a critical error.  The business cycle is by no means an inherent quality of capitalism.

THE AUSTRIAN THEORY OF THE BUSINESS CYCLE

If you were studying the life forms in a lake, and one day you arrived to find 40% of the population dead, what would you suspect?  Would you conclude that there was some inherent quality of organisms to spontaneously eliminate 40% of the community every so often?  Or would you suspect there was something wrong with the environment they all held in common, specifically, the lake water?  You would probably first suspect the latter, and check it for acidity, bacteria, or pollution.

As I mentioned in my discussion on Keynesian economics, the one thing all economic actors have in common is the currency.  Since the business cycle is an economy-wide phenomenon, would it not make sense to first suspect that it may have something to do with the currency?  When you investigate this, you find that is precisely the case.  The business cycle is a monetary phenomenon, possible only because we have a single organization forcing a monopoly on a single currency.

As I mentioned in the previous lesson, fractional reserve banking causes a dramatic expansion in the money supply.  This expansion is equal to 1 / Reserve Rate, and can vary depending on the whims of the Federal Reserve.  The printing of money also causes an expansion in the money supply, and is multiplied many times over if this printed money is distributed into the economy via the fractional reserve banking system.

As money floods into the system, economic actors mistake it for increased productivity and wealth.  And why wouldn't they?  If your business doubled its revenue over the course of several years, you would believe your business's real profits were increasing dramatically, and that the demand for your products was rising.  Unfortunately, this new money does not represent an increased number of goods and services.  It is just devalued currency, and thus only represents a fraction of the goods and services which already exist.

Entrepreneurs, believing their future prospects are bright, hire new employees, rent new offices, buy more capital, and so on.  Everyone else does the same.  As the demand for their products rise, they think "There's an enormous amount of demand for my products.  I can raise my prices," and do so.  At some point everyone finishes raising their prices and reality strikes.  Entrepreneurs, who once believed their futures looked bright, find themselves unable to afford their office buildings, capital, and employees at the higher prices.  They are forced to lay off employees and liquidate capital, or even close down completely.  The economy enters the bust.

The business cycle has nothing to do with free market trading and everything to do with expansions and contractions in the money supply.  It is precisely because the government forces everyone in the United States to use a single currency, and because of the passage of the National Banking Act of 1862 requiring banks to use fractional reserve banking, and the manipulations and expansions performed by the Federal Reserve, that the business cycle occurs.  If participants in the economy were permitted to utilize multiple currencies, or if laws were designed to prevent fractional reserve banking, the business cycle would not occur.  The very disasters Keynes believed could only be solved through central planning are a direct result of central planning.  The state breaks your leg, hands you a crutch, and tells you that without its help, you couldn't walk.

There was no business cycle before the 1860s because expansions in the money supply of this kind were impossible.  Inflation was practically nonexistent for all of recorded history until the introduction of fractional reserve banking, and exacerbated after the creation of the Federal Reserve.  By forcing the population as a whole to endure the inflation caused by the predatory practices of banks, the Federal Reserve and United States government have established a permanent dependent underclass and enslaved workers all over the country.  This, more than any other reason, is why families across America require both parents to work full time to achieve a fraction of what a single income achieved in the 1950s.

This is the final chapter of my Introduction to Economics series.  You now know everything you need to understand economics in the real world.  I hope you enjoyed learning what I had to share; I certainly enjoyed writing it.  Thanks for reading and have a great day!