Comments to come later, I got class now. Main theme is you can't get something for nothing.
Posted by: Borodog
http://forumserver.twoplustwo.com/showthreaded.php?Cat=0&Number=4509063&page=0
What causes the Business Cycle?
No, wait. Back up. WTF is "the Business Cycle?"
The Business Cycle is an economic cycle, characterized by alternating peiods of booming economic growth and recessions, or even depressions. What causes them? One thing, and one thing only: inflation.
There are two definitions of inflation, the original definition and the new definition. The new definition is that inflation is simply a rise in prices. This is a convenient definition from government's point of view because it hides the fundamental problem and shelters terrible economic publics policies from rational analysis.
The original definition of inflation is an increase of the money supply. Notice there are some modern economists (Milton Freidman, Paul Krugman, for example) that claim that inflation (in the new sense) is caused by an increase in the money supply, which is of course true, but again masks the importance of the underlying cause, the increase in the money supply.
As an aside, there are the neo-Keynesians who believe that inflation is caused by economic and political "shocks," like natural disasters. While true that such events can temporarily raise prises, for example if productive capacity is destroyed (recall the refinery problem in the Gulf Coast after Katrina and Rita), but it can't lead to long term elevation in prices unless other factors restrict the replacement of productive capacity. Localized increases in prices cannot lead to economy-wide increases in prices, since short term increases in prices in the affected industries and areas will act as an incentive to shift investment to the affected sectors, which bring production capacity back up to the point where prices will return to equilibrium.
So back to inflation, defined as an increase in the money supply, AKA credit expansion, credit injection, counterfeiting, whatever you'd like to call it. How does increasing the money supply cause the business cycle?
First we have to ruminate on how a person acquires something they want without resorting to simply stealing it. In the honest world, to consume you must first produce. In other words, to acquire something of value, you must first produce something of value to trade for it. This is why voluntary exchanges always increase the wealth of both parties. Each party must value what the other party has more than what he himself has, or else the trade would not occur. Hence voluntary trade is always mutually advantageous.
It follows then that you must produce something before you can trade with someone to acquire something they have that you want, at least without just stealing it. You can argue that stealing might be easier, or the more rational choice under certain circumstances, but that's irrelevent here. One natural consequence of stealing we see is that it results in less over production of wealth. Even though wealth is subjective and can't really be measured objectively, we can at least say that one person producing X and another producing Y produces more wealth than one person producing X and another person taking X from him.
Now in the honest world, money is a commodity, say gold. It's produced by some workers who dig it out of the ground and trade it to others for products or services that they in turn produce. The money moves through the economy, always voluntarily from hand to hand from one person who values the money less than what they are getting in exchange. All of these people must produce to honestly acquire some of the money. This might be cumbersome, so gold is kept in banks, and instead of gold coins, warehouse receipts for gold become the money supply.
Now imagine what happens in this system when a dishonest man begins to print fake warehouse receipts, in other words, begins to counterfeit the money. He hasn't produced anything of value. He hasn't produced gold, which is what people believe they are trading with him to acquire, he has only produced a worthless piece of paper, like the deed to the Moon. He has defrauded them. But he himself benefits. He gets something for nothing. What do we call getting something for nothing? Theft.
This is exactly the process that central banks engage in. They print money from nothing, or simply make an electronic entry in a database and create electronic money from thin air. They then loan this money out as, for example, business loans.
Isn't this a good thing? Isn't it good for businesses to have access to funds so that they may invest and increase production? No! It's horrible, for a number of reasons. Let's take a look.
First of all, when money is printed from nothing and loaned out, it competes with the supply of money that already exists and is available for investment. The increase in the money supply makes money cheaper, it lowers the price of money. What is the price of money? Interest rates. By printing money, the expected return on the investment of already existing money is depressed; real investors lose money because they have to compete with funny money.
When the interest rate is artificially lowered we get what we call "cheap credit." A business that would not take out loans to finance a project that would yield a 6% return on investment if the interest rate on the loans is above 6%. But cheap credit "tricks" businessmen into starting projects they would not normally start by depressing interest rates. If the interest rate is depressed by expanion of the money supply to only 4%, suddenly his project looks profitable. He takes out loans, and begins the project.
Why is this bad? After all, he's investing in some new project that will increase total economic production, right? Wrong. Recall that in the honest world you had to produce to consume. The central bank produced nothing, it simple loaned out a pile of funny money to our businessman, who begins hiring workers, leasing office space, productive capacity, tools and machinery, etc. At first, everything looks great. He buys all of these things at the old prices (we'll see what this means later). But wait. So are all the other businessmen who have been tricked into starting new projects by cheap credit. Everywhere, all over the economy, in all sectors, entrepeneurs are tricked into beginning projects at the same time by the artificially low interest rates. What does this mean? It means that all of these new projects will be competing for resources, with each other, and with existing lines of production. This competition will bid up prices throughout the economy.
So inflation, an increase in the money supply, causes more dollars to chase the available goods, bidding up prices. So what is the effect of this? Well, existing businesses have a harder time of it. They must now compete with all of the new projects chasing the same producer goods and resources they need in the economy, and the resulting higher prices increase their costs. Businesses will have to abandon some projects that were previously profitable but no longer are. The marginal businesses will no longer be profitable at all, and will go out of business all together. The loss of whatever lines they were producing lowers supply and competition and increases prices even more.
But there's a much, much worse effect. Businesses that are profitable in the absence of credit expansion are profitable because they are producing what consumers want, or are producing the tools, machinery, and services that other businesses use to produce what consumers want. But these new projected are often speculative, even kooky. Cheap credit causes productive capacity to be shifted from businesses that serve consumers and the businesses that serve those businesses to speculative projects. Now, there's nothing inherently wrong with speculative projects. All successful business ventures begin with assuming a certain amount of risk. But the credit expansion ticks many businessmen into starting risky, specualtive projects all at the same time, while diverting productive capacity from those businesses known to be successful (they were profitable) and driving some out of business all together (the marginal producers).
During this phase, look what happens to the GDP. New money is being created from nothing, which is then being spent in the economy as all of these speculative projects bid on resources and bid up prices, including the price of labor, so wages are rising too. Unemployment is low because of the high wages. The economy looks fantastic! This is the economic Boom. But it's deceptive. It's all a mirage. Funny money is bidding up prices while resources, labor, and capital, i.e. real productive capacity, is being invisibly diverted from previous successes to future failures.
These are called malinvestments. Malinvestments will accumulate in the economy, masked by cheap credit. Even the real effects of inflation are masked by the continual increase in productivity; after all, if inflation drives the cost of a good up by 10% in a year, but increases in production efficiency drive the price down by 10%, the price will appear stable (when in fact the good should have been getting cheaper and more affordable). Malinvestment will continue with the economy becoming more and more "fragile" until . . . the Crunch.
There are two kinds of possible crunch, the credit crunch, and the real resource crunch.
In the credit crunch, the central bank becomes worried about inflation, and they put the breaks on the credit injection. Suddenly interest rates jump and the malinvestments can no longer be sustained by cheap credit, and they begin to fail. Meanwhile much of the productive capacity is tied up in these failing projects. As they go under they stop demanding goods, services, and resources in the economy, and prices begin to fall. As prices fall businesses that had hired on new workers to meet the boomin demand suddenly become less profitable and have to lay off workers. Unemployment goes up. In other words, there is a recession. If the government enacts policies that make things worse, printing still more money, enacting government spending projects that must compete with production of consumer goods, raising taxes to make businesses (and hence production) even less profitable (driving even more out of business), increasing regulatory burden (that deos the same thing), your recession turns into a depression.
Only as the malinvestments in both labor and capital that are tied up in the bankrupt businesses and non-productive government programs are liquidated and acquired by efficient businesses (i.e. those that actually meet consumer demand) does the economy return to equilibrium.
A real resource crunch occurs when too businessmen have been tricked by cheap credit into more projects than there are actual resources to complete in the economy. Imagine that you and four other builders each want to build a brick house. Cheap credit tricks you all into taking out construction loans to build the houses. You all pour foundations and start building. But now as you all compete for bricks the price of bricks is driven up to the point where the amount of the loans you took out cannot pay for enough bricks to complete the houses. The projects are abandoned because there's not enough bricks in the system for you all to get as many as you need without the cost being driven too high for you all to afford. Real resource crunches result in the same kind of recessions or depressions as credit crunches, and for all the same reasons; malinvestments have to be liquidated, and as that happens businesses fail, and people lose their jobs.
Note that the business cycle doesn't really depend on there being a government doing the printing of fake money. There were business cycles in the United States in the years before Lincoln centralized the money supply by reviving Hamilton's National Bank and began printing "greenbacks" from nothing. The problem was the same though. Banks at the time practiced (and they still do) "fractional reserve banking," which basically means that a bank can loan out notes far in excess of the actual money they have on hand, on the theory that everyone will not demand their money at once. So essentially, they inflated the money supply and caused malinvestments, just as we've seen. Whig party economic policies like "internal improvement subsidies" (corporate welfare that shifted resources and productive capacity from competitive private companies to inefficient companies that profitted through such patronage) and high tariffs (that protected non-competitive, but politically connected, producers from foreign competition at the expense of consumers) exacerbated the problems. See for example the 1837 recession, which was severe, but which was over in about a year after President Van Buren assumed a policy of doing absolutely nothing beyond reducing government tariffs and spending. Contrast this with the hyperinterventionist Roosevelt regime during the Great Depression, which under his expert care lastly nearly 20 years.
Posted by: Borodog
http://forumserver.twoplustwo.com/showthreaded.php?Cat=0&Number=4509063&page=0
What causes the Business Cycle?
No, wait. Back up. WTF is "the Business Cycle?"
The Business Cycle is an economic cycle, characterized by alternating peiods of booming economic growth and recessions, or even depressions. What causes them? One thing, and one thing only: inflation.
There are two definitions of inflation, the original definition and the new definition. The new definition is that inflation is simply a rise in prices. This is a convenient definition from government's point of view because it hides the fundamental problem and shelters terrible economic publics policies from rational analysis.
The original definition of inflation is an increase of the money supply. Notice there are some modern economists (Milton Freidman, Paul Krugman, for example) that claim that inflation (in the new sense) is caused by an increase in the money supply, which is of course true, but again masks the importance of the underlying cause, the increase in the money supply.
As an aside, there are the neo-Keynesians who believe that inflation is caused by economic and political "shocks," like natural disasters. While true that such events can temporarily raise prises, for example if productive capacity is destroyed (recall the refinery problem in the Gulf Coast after Katrina and Rita), but it can't lead to long term elevation in prices unless other factors restrict the replacement of productive capacity. Localized increases in prices cannot lead to economy-wide increases in prices, since short term increases in prices in the affected industries and areas will act as an incentive to shift investment to the affected sectors, which bring production capacity back up to the point where prices will return to equilibrium.
So back to inflation, defined as an increase in the money supply, AKA credit expansion, credit injection, counterfeiting, whatever you'd like to call it. How does increasing the money supply cause the business cycle?
First we have to ruminate on how a person acquires something they want without resorting to simply stealing it. In the honest world, to consume you must first produce. In other words, to acquire something of value, you must first produce something of value to trade for it. This is why voluntary exchanges always increase the wealth of both parties. Each party must value what the other party has more than what he himself has, or else the trade would not occur. Hence voluntary trade is always mutually advantageous.
It follows then that you must produce something before you can trade with someone to acquire something they have that you want, at least without just stealing it. You can argue that stealing might be easier, or the more rational choice under certain circumstances, but that's irrelevent here. One natural consequence of stealing we see is that it results in less over production of wealth. Even though wealth is subjective and can't really be measured objectively, we can at least say that one person producing X and another producing Y produces more wealth than one person producing X and another person taking X from him.
Now in the honest world, money is a commodity, say gold. It's produced by some workers who dig it out of the ground and trade it to others for products or services that they in turn produce. The money moves through the economy, always voluntarily from hand to hand from one person who values the money less than what they are getting in exchange. All of these people must produce to honestly acquire some of the money. This might be cumbersome, so gold is kept in banks, and instead of gold coins, warehouse receipts for gold become the money supply.
Now imagine what happens in this system when a dishonest man begins to print fake warehouse receipts, in other words, begins to counterfeit the money. He hasn't produced anything of value. He hasn't produced gold, which is what people believe they are trading with him to acquire, he has only produced a worthless piece of paper, like the deed to the Moon. He has defrauded them. But he himself benefits. He gets something for nothing. What do we call getting something for nothing? Theft.
This is exactly the process that central banks engage in. They print money from nothing, or simply make an electronic entry in a database and create electronic money from thin air. They then loan this money out as, for example, business loans.
Isn't this a good thing? Isn't it good for businesses to have access to funds so that they may invest and increase production? No! It's horrible, for a number of reasons. Let's take a look.
First of all, when money is printed from nothing and loaned out, it competes with the supply of money that already exists and is available for investment. The increase in the money supply makes money cheaper, it lowers the price of money. What is the price of money? Interest rates. By printing money, the expected return on the investment of already existing money is depressed; real investors lose money because they have to compete with funny money.
When the interest rate is artificially lowered we get what we call "cheap credit." A business that would not take out loans to finance a project that would yield a 6% return on investment if the interest rate on the loans is above 6%. But cheap credit "tricks" businessmen into starting projects they would not normally start by depressing interest rates. If the interest rate is depressed by expanion of the money supply to only 4%, suddenly his project looks profitable. He takes out loans, and begins the project.
Why is this bad? After all, he's investing in some new project that will increase total economic production, right? Wrong. Recall that in the honest world you had to produce to consume. The central bank produced nothing, it simple loaned out a pile of funny money to our businessman, who begins hiring workers, leasing office space, productive capacity, tools and machinery, etc. At first, everything looks great. He buys all of these things at the old prices (we'll see what this means later). But wait. So are all the other businessmen who have been tricked into starting new projects by cheap credit. Everywhere, all over the economy, in all sectors, entrepeneurs are tricked into beginning projects at the same time by the artificially low interest rates. What does this mean? It means that all of these new projects will be competing for resources, with each other, and with existing lines of production. This competition will bid up prices throughout the economy.
So inflation, an increase in the money supply, causes more dollars to chase the available goods, bidding up prices. So what is the effect of this? Well, existing businesses have a harder time of it. They must now compete with all of the new projects chasing the same producer goods and resources they need in the economy, and the resulting higher prices increase their costs. Businesses will have to abandon some projects that were previously profitable but no longer are. The marginal businesses will no longer be profitable at all, and will go out of business all together. The loss of whatever lines they were producing lowers supply and competition and increases prices even more.
But there's a much, much worse effect. Businesses that are profitable in the absence of credit expansion are profitable because they are producing what consumers want, or are producing the tools, machinery, and services that other businesses use to produce what consumers want. But these new projected are often speculative, even kooky. Cheap credit causes productive capacity to be shifted from businesses that serve consumers and the businesses that serve those businesses to speculative projects. Now, there's nothing inherently wrong with speculative projects. All successful business ventures begin with assuming a certain amount of risk. But the credit expansion ticks many businessmen into starting risky, specualtive projects all at the same time, while diverting productive capacity from those businesses known to be successful (they were profitable) and driving some out of business all together (the marginal producers).
During this phase, look what happens to the GDP. New money is being created from nothing, which is then being spent in the economy as all of these speculative projects bid on resources and bid up prices, including the price of labor, so wages are rising too. Unemployment is low because of the high wages. The economy looks fantastic! This is the economic Boom. But it's deceptive. It's all a mirage. Funny money is bidding up prices while resources, labor, and capital, i.e. real productive capacity, is being invisibly diverted from previous successes to future failures.
These are called malinvestments. Malinvestments will accumulate in the economy, masked by cheap credit. Even the real effects of inflation are masked by the continual increase in productivity; after all, if inflation drives the cost of a good up by 10% in a year, but increases in production efficiency drive the price down by 10%, the price will appear stable (when in fact the good should have been getting cheaper and more affordable). Malinvestment will continue with the economy becoming more and more "fragile" until . . . the Crunch.
There are two kinds of possible crunch, the credit crunch, and the real resource crunch.
In the credit crunch, the central bank becomes worried about inflation, and they put the breaks on the credit injection. Suddenly interest rates jump and the malinvestments can no longer be sustained by cheap credit, and they begin to fail. Meanwhile much of the productive capacity is tied up in these failing projects. As they go under they stop demanding goods, services, and resources in the economy, and prices begin to fall. As prices fall businesses that had hired on new workers to meet the boomin demand suddenly become less profitable and have to lay off workers. Unemployment goes up. In other words, there is a recession. If the government enacts policies that make things worse, printing still more money, enacting government spending projects that must compete with production of consumer goods, raising taxes to make businesses (and hence production) even less profitable (driving even more out of business), increasing regulatory burden (that deos the same thing), your recession turns into a depression.
Only as the malinvestments in both labor and capital that are tied up in the bankrupt businesses and non-productive government programs are liquidated and acquired by efficient businesses (i.e. those that actually meet consumer demand) does the economy return to equilibrium.
A real resource crunch occurs when too businessmen have been tricked by cheap credit into more projects than there are actual resources to complete in the economy. Imagine that you and four other builders each want to build a brick house. Cheap credit tricks you all into taking out construction loans to build the houses. You all pour foundations and start building. But now as you all compete for bricks the price of bricks is driven up to the point where the amount of the loans you took out cannot pay for enough bricks to complete the houses. The projects are abandoned because there's not enough bricks in the system for you all to get as many as you need without the cost being driven too high for you all to afford. Real resource crunches result in the same kind of recessions or depressions as credit crunches, and for all the same reasons; malinvestments have to be liquidated, and as that happens businesses fail, and people lose their jobs.
Note that the business cycle doesn't really depend on there being a government doing the printing of fake money. There were business cycles in the United States in the years before Lincoln centralized the money supply by reviving Hamilton's National Bank and began printing "greenbacks" from nothing. The problem was the same though. Banks at the time practiced (and they still do) "fractional reserve banking," which basically means that a bank can loan out notes far in excess of the actual money they have on hand, on the theory that everyone will not demand their money at once. So essentially, they inflated the money supply and caused malinvestments, just as we've seen. Whig party economic policies like "internal improvement subsidies" (corporate welfare that shifted resources and productive capacity from competitive private companies to inefficient companies that profitted through such patronage) and high tariffs (that protected non-competitive, but politically connected, producers from foreign competition at the expense of consumers) exacerbated the problems. See for example the 1837 recession, which was severe, but which was over in about a year after President Van Buren assumed a policy of doing absolutely nothing beyond reducing government tariffs and spending. Contrast this with the hyperinterventionist Roosevelt regime during the Great Depression, which under his expert care lastly nearly 20 years.