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The development of our modern economic life is not an even and continuous growth; periods of rapid progress are followed by periods of stagnation. If we disregard secondary phenomena, like breakdowns, bankruptcies, and panics, the business cycle presents itself as a periodic up and down of general business activity, or, more precisely, of the volume of production. The growth of production does not show a continuous, uninterrupted trend upward but a wavelike movement around its average annual increase.[1]

In the nearly periodic economic crises, the sudden onset was called a "panic," and the lingering trough period after the panic was called "depression." Later on it was called "recession", "downturn," or, even better, "slowdown," or "sidewise movement."[2] The business cycle is sometimes called a "boom-bust" cycle.[3]

See also: Austrian Business Cycle Theory

Business Cycles and Business FluctuationsEdit

It is important to distinguish between business cycles and ordinary business fluctuations. We live in a society of continual and unending change, change that can never be precisely charted in advance. People try to forecast and anticipate changes as best they can, but such forecasting can never be reduced to an exact science. Entrepreneurs are in the business of forecasting changes on the market, both for conditions of demand and of supply. The more successful ones make profits hand in hand with their accuracy of judgment, while the unsuccessful forecasters fall by the wayside. As a result, the successful entrepreneurs on the free market will be the ones most adept at anticipating future business conditions. Yet, the forecasting can never be perfect, and entrepreneurs will continue to differ in the success of their judgments. If this were not so, no profits or losses would ever be made in business.

Changes, then, take place continually in all spheres of the economy. Consumer tastes shift; time preferences and consequent proportions of investment and consumption change; the labor force changes in quantity, quality, and location; natural resources are discovered and others are used up; technological changes alter production possibilities; vagaries of climate alter crops, etc. All these changes are typical features of any economic system. In fact, we could not truly conceive of a changeless society, in which everyone did exactly the same things day after day, and no economic data ever changed. And even if we could conceive of such a society, it is doubtful whether many people would wish to bring it about. It is, therefore, absurd to expect every business activity to be "stabilized" as if these changes were not taking place. To stabilize and "iron out" these fluctuations would, in effect, eradicate any rational productive activity.

But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression—a phenomenon of the true "business cycle." Suppose, for example, that a shift in consumer tastes, and technologies, causes a shift in demand from farm products to other goods. It is pointless to say, as many people do, that a farm depression will ignite a general depression, because farmers will buy less goods, the people in industries selling to farmers will buy less, etc. This ignores the fact that people producing the other goods now favored by consumers will prosper; their demands will increase.

The problem of the business cycle is one of general boom and depression; it is not a problem of specific industries.[3]

Characteristics of the business cycleEdit

A major feature of a depression is a sudden general cluster of business errors. Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting.

Another common feature of the business cycle is the well-known fact that capital-goods industries fluctuate more widely than do the consumer-goods industries. The capital-goods industries - especially the industries supplying raw materials, construction, and equipment to other industries — expand much further in the boom, and are hit far more severely in the depression.

A third feature of every boom that needs explaining is the increase in the quantity of money in the economy. Conversely, there is generally, though not universally, a fall in the money supply during the depression.[3]

Boom and BustEdit

The "boom" is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit's tampering with the free market. The "crisis" arrives when the consumers come to reestablish their desired proportions. The "depression" is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments. Some of these will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816–1818 and deserted during the Panic of 1819); others will be shifted to other uses. In sum, the free market tends to satisfy voluntarily-expressed consumer desires with maximum efficiency, and this includes the public's relative desires for present and future consumption. The inflationary boom hobbles this efficiency, and distorts the structure of production, which no longer serves consumers properly. The crisis signals the end of this inflationary distortion, and the depression is the process by which the economy returns to the efficient service of consumers. In short, and this is a highly important point to grasp, the depression is the "recovery" process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom requires a "bust."[3]

BubbleEdit

A bubble can be defined as activities that spring up on the back of loose monetary policy of the central bank. In other words, in the absence of monetary pumping these activities would not emerge. Since bubble activities are not self-funded, their emergence must come at the expense of various self-funded or productive activities. This means that less real funding is left for productive activities, which in turn undermines those activities. In short, monetary pumping gives rise to the misallocation of resources, which as a rule manifests itself through a relative increase in non-productive activities against productive activities.

When new money is created, its effect is not felt instantaneously across all market sectors. The effect moves from one individual to another individual and thus from one market to another market. Monetary pumping generates bubble activities across all markets as time goes by. Once, however, the central bank tightens its monetary stance, i.e. reduces monetary pumping, this undermines various bubble activities. The bubble bursts. Since monetary pumping generates bubble activities across all markets, obviously the eventual bursting of the bubbles will permeate all markets — including the housing market.

As a rule the act of bursting bubbles, or the liquidation of nonproductive activities, is set in motion by a tighter monetary stance of the central bank. A tighter stance purges various nonproductive activities thereby eliminating past excesses, which in turn lowers the ratio of nonproductive-to-productive activities, so to speak. In short, a tighter stance brings harmony to the structure of production and sets the foundation for a sustainable economic revival. A situation however, can occur where the bursting of bubbles takes place despite an easy stance by the central bank. This can emerge when the pool of real funding begins to shrink.[4]

Business cycles in historyEdit

These are some of the more recognized or outstanding boom-bust cycles and panics recorded throughout history.

Tulip maniaEdit

One of the first and well-known panics was the Tulip mania (1634-37) in Netherlands. The popular flower became a status symbol, the rare bulbs were hard to reproduce and in great demand. A large futures market formed for the seasonal flower and the speculation escalated. At its peak, the prices rose twenty-six times in January 1637, only to fall to one-twentieth of its peak price a week later. Finally, the Court of Holland judged the tulip sales to be bets under Roman law and basically cancelled all contracts. The growers of the bulbs absorbed the most of the damage and the number of bankruptcies increased.

Throughout 17th century, precious metals from the New World, Japan and other locales have been channeled into Europe, with corresponding price increases. As kings throughout Europe debased their currencies, the Dutch provided a sound money policy with money backed one hundred per cent by specie. Free coinage laws (later limited) created more money from the increased supply of coin and bullion, than what the market demanded. Ironically, this acute increase in the supply of money fostered an atmosphere, that was ripe for speculation and malinvestment, and led to one of the first recorded panics or speculative bubbles.[5]

Panic of 1819Edit

In the United States, a monetary expansion led to a boom in real estate prices and speculation, and rapidly growing indebtedness by farmers. The Second Bank of the United States was authorized by Congress to solve the monetary problems and provide a sound and uniform currency. Instead, it has continued and enhanced the expansion. The boom continued for a while, but the banks were soon having problems with the return to specie payments. The Second Bank started a painful contraction and a wave of bankruptcies followed, known as the Panic of 1819.[6]

Before the Panic, specie payments were suspended from August 1814 to February 1817. For two and a half years could banks expand while issuing what was in effect fiat paper and bank deposits. From then on, every time there was a banking crisis brought on by inflationary expansion and demands for redemption in specie, state and federal governments looked the other way and permitted general suspension of specie payments while bank operations continued to flourish. It became clear to the banks that in a general crisis they would not be required to meet the ordinary obligations of contract law or of respect for property rights, so their inflationary expansion was permanently encouraged by this massive failure of government to fulfill its obligation to enforce contracts and defend the rights of property.[7]

Panic of 1907Edit

A severe financial crisis, the Panic of 1907, struck in early October. Not only was there a general recession and contraction, but the major banks in New York and Chicago were, as in most other depressions in American history, allowed by the government to suspend specie payments, that is, to continue in operation while being relieved of their contractual obligation to redeem their notes and deposits in cash or in gold. While the Treasury had stimulated inflation during 1905–1907, there was nothing it could do to prevent suspensions of payment, or to alleviate "the competitive hoarding of currency" after the panic, that is, the attempt to demand cash in return for increasingly shaky bank notes and deposits. This crisis has led to the establishment of the Federal Reserve.[8]

The Great DepressionEdit

The great boom of the 1920s USA (also called "Roaring Twenties") was largely fueled by credit expansion going into time deposits. When the expansion ended the Great Depression followed soon after.[9]

Main article: Great Depression

ReferencesEdit

  1. Gottfried Haberler. "Money and the Business Cycle (pdf) from The Austrian Theory of the Trade Cycle, p.33-57. Referenced 2010-06-25.
  2. Murray N. Rothbard. "Economic Depressions: Their Cause and Cure", The Austrian Theoryof the Trade Cycle and other essays, p.58-59. Referenced 2010-07-08.
  3. 3.0 3.1 3.2 3.3 Murray N. Rothbard. "The Positive Theory of the Cycle" from America's Great Depression, online version. Referenced 2010-06-25.
  4. Frank Shostak. "Housing Bubble: Myth or Reality?", Mises Daily, March 04, 2003. Referenced 2010-07-24.
  5. Doug French. "The Dutch Monetary Environment During Tulipmania" (pdf), Quarterly Journal of Austrian Economics, Vol. 9 Num. 1. 2006, referenced 2009-10-18.
  6. Murray N. Rothbard. "The Panic of 1819"(pdf), online version, Chapter I: The Panic and its Genesis: Fluctuations in American Business 1815-1821. New York: Columbia University Press, 1962. Mises Institute 2007. Referenced 2009-10-03.
  7. Murray N. Rothbard. "A History of Money and Banking in the United States: The Colonial Era to World War II" (pdf), The War of 1812 and its Aftermath, p.72-82. Referenced 2010-06-30.
  8. Murray N. Rothbard. "A History of Money and Banking in the United States: The Colonial Era to World War II" (pdf), The Panic of 1907 and Mobilization for a Central Bank, p.240. Referenced 2010-06-30.
  9. Murray N. Rothbard. "The Mystery of Banking" (pdf), Chapter XVI: Central banking in the United States IV: The Federal Reserve System, p.235-246, referenced 2009-10-03.

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