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ABCT in a few minutes

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Peter Sidor posted on Sun, Sep 26 2010 10:54 AM

A friend of mine asked me about the following simple scenario - a guy on a party approaches you, and asks about that Austrian Business Cycle Theory he heard of somewhere. How do you explain its basics within a few minutes, to somebody who may not be steeped in economic theory and doesn't want too much involved talk.

Your ideas are welcome. :)

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1280 words... Taken from the end part of an essay by rothbard: http://www.lewrockwell.com/rothbard/rothbard183.html

Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop. But then government through its central bank stimulates bank credit expansion by expanding central bank liabilities and therefore the cash reserves of all the nation's commercial banks. The banks then proceed to expand credit and hence the nation's money supply in the form of check deposits. As the Ricardians saw, this expansion of bank money drives up the prices of goods and hence causes inflation. But, Mises showed, it does something else, and something even more sinister. Bank credit expansion, by pouring new loan funds into the business world, artificially lowers the rate of interest in the economy below its free market level.

On the free and unhampered market, the interest rate is determined purely by the "time-preferences" of all the individuals that make up the market economy. For the essence of a loan is that a "present good" (money which can be used at present) is being exchanged for a "future good" (an IOU which can only be used at some point in the future). Since people always prefer money right now to the present prospect of getting the same amount of money some time in the future, the present good always commands a premium in the market over the future. This premium is the interest rate, and its height will vary according to the degree to which people prefer the present to the future, i.e., the degree of their time-preferences.

People's time-preferences also determine the extent to which people will save and invest, as compared to how much they will consume. If people's time-preferences should fall, i.e., if their degree of preference for present over future falls, then people will tend to consume less now and save and invest more; at the same time, and for the same reason, the rate of interest, the rate of time-discount, will also fall. Economic growth comes about largely as the result of falling rates of time-preference, which lead to an increase in the proportion of saving and investment to consumption, and also to a falling rate of interest.???

But what happens when the rate of interest falls, not because of lower time-preferences and higher savings, but from government interference that promotes the expansion of bank credit? In other words, if the rate of interest falls artificially, due to intervention, rather than naturally, as a result of changes in the valuations and preferences of the consuming public?

What happens is trouble. For businessmen, seeing the rate of interest fall, react as they always would and must to such a change of market signals: They invest more in capital and producers' goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable now seem profitable, because of the fall of the interest charge. In short, businessmen react as they would react if savings had genuinely increased: They expand their investment in durable equipment, in capital goods, in industrial raw material, in construction as compared to their direct production of consumer goods.

Businesses, in short, happily borrow the newly expanded bank money that is coming to them at cheaper rates; they use the money to invest in capital goods, and eventually this money gets paid out in higher rents to land, and higher wages to workers in the capital goods industries. The increased business demand bids up labor costs, but businesses think they can pay these higher costs because they have been fooled by the government-and-bank intervention in the loan market and its decisively important tampering with the interest-rate signal of the marketplace.

The problem comes as soon as the workers and landlords – largely the former, since most gross business income is paid out in wages – begin to spend the new bank money that they have received in the form of higher wages. For the time-preferences of the public have not really gotten lower; the public doesn't want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don't save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers' goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods. Business had been seduced by the governmental tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there. As soon as the new bank money filtered through the system and the consumers reestablished their old proportions, it became clear that there were not enough savings to buy all the producers' goods, and that business had misinvested the limited savings available. Business had overinvested in capital goods and underinvested in consumer products.

The inflationary boom thus leads to distortions of the pricing and production system. Prices of labor and raw materials in the capital goods industries had been bid up during the boom too high to be profitable once the consumers reassert their old consumption/investment preferences. The "depression" is then seen as the necessary and healthy phase by which the market economy sloughs off and liquidates the unsound, uneconomic investments of the boom, and reestablishes those proportions between consumption and investment that are truly desired by the consumers. The depression is the painful but necessary process by which the free market sloughs off the excesses and errors of the boom and reestablishes the market economy in its function of efficient service to the mass of consumers. Since prices of factors of production have been bid too high in the boom, this means that prices of labor and goods in these capital goods industries must be allowed to fall until proper market relations are resumed.

Since the workers receive the increased money in the form of higher wages fairly rapidly, how is it that booms can go on for years without having their unsound investments revealed, their errors due to tampering with market signals become evident, and the depression-adjustment process begins its work? The answer is that booms would be very short lived if the bank credit expansion and subsequent pushing of the rate of interest below the free market level were a one-shot affair. But the point is that the credit expansion is not one-shot; it proceeds on and on, never giving consumers the chance to reestablish their preferred proportions of consumption and saving, never allowing the rise in costs in the capital goods industries to catch up to the inflationary rise in prices. Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit. It is only when bank credit expansion must finally stop, either because the banks are getting into a shaky condition or because the public begins to balk at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, then the piper must be paid, and the inevitable readjustments liquidate the unsound over-investments of the boom, with the reassertion of a greater proportionate emphasis on consumers' goods production.

Thus, the Misesian theory of the business cycle accounts for all of our puzzles: The repeated and recurrent nature of the cycle, the massive cluster of entrepreneurial error, the far greater intensity of the boom and bust in the producers' goods industries.

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I've struggled with this as well.  My explainations get very long and I get glazed over looks from listeners very fast.  Unless they are truly interested or humoring me, I don't often complete the explaination.

This is the two minute, layman's breakdown I usually give these days (510 words): 

Interest rates matter.  They aren't arbitrary numbers we are free to bend to our wishes.  They play a vital coordinating function in the economy.  Tinker with them and you introduce discoordination.

Interest rates coordinate investment and consumption across time.  When they are artificially lowered as they have been over the past 20 years, they introduce malinvestment and overconsumption.

When you look across the time horizon, investments and consumption more long term in nature are more interest rate sensitive and will demonstrate the problems of interest rate manipulation more clearly.  Even small rate changes can have a dramatic effect on people's analysis of their economic viability.

Think of the three areas of an average American's life that is the most interest rate sensitive.  Their home mortgage, their car loan, and their bank/credit lines. 

Are we to believe the fact that all three industries collapsing at the same time is merely a coincidence?  It isn't hard to see the role interest rate policy played in their problems.

When interest rates come down naturally it is because people are saving more.  Banks become flush with cash which causes them to lower rates to stimulate loans. 

Entrepreneurs are receiving two signals from the market when this happens: 1. That new resources are available to make new investments. 2. That demand exists that is not currently being satisfied (people are forgoing purchases for the future).

When investment is made in this environment, it has the important backing of actual saved resources to be utilized as well as the support of pent up consumer demand to make it profitable upon completion.

Compare that to what happens when interest rates are brought down artificially by the fed.  Entrepreneurs still receive and act upon the same economic signals, but no new investable resources exist to complete the new projects, and no pent up demand exists to justify their undertaking.

But the situation actually becomes much worse than that.  The lower rates encourage people to take out what savings they have and spend it now.  As a result actual demand will be even lower when the completed projects are ready to enter the market than even accurate economic information would have originally predicted.

This is what is meant by malinvestment and overconsumption from changing interest rates.  It creates an artificial boom in economic activity followed by a bust when the economic realizes the errors it made.

During the past 20 years the U.S. economy got hooked on these artificial booms.  Alan Greenspan led the public to believe he could jumpstart the economy any time it needed it by simply cutting the rates and increasing the level of investment in long term projects.  But there is no free lunch.  All of those rate cuts have to eventually be increased, at which point all of the stimulative forces reverse and the bad investments reveal themselves.  People criticize Greenspan for increasing rates too soon and ending the party, but the rate increases are inevitable unless the public is willing to endure inflation from all the cash being printed keep them forced down

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That was actually a pretty good summary, e_room_matt, economic but also very down-to-earth! I think I'll use it for something...

Thanks!

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xahrx replied on Mon, Jan 17 2011 10:05 AM

"A friend of mine asked me about the following simple scenario - a guy on a party approaches you, and asks about that Austrian Business Cycle Theory he heard of somewhere. How do you explain its basics within a few minutes, to somebody who may not be steeped in economic theory and doesn't want too much involved talk."

Think basics.  It's all about price controls really.  I use Oreo cookies.  If the government put a price control on Oreo cookies below market they'd star flyin off the shelves, and concurrently there would be less incentive to manufacture them.  The people who got to the stores first would get a lot of cookies and get fat, other people would go without, eventually the shelves would be empty and there would be no more Oreos, and now we have a problem.  There are a lot of people who were planning on having Oreos to eat at a certain price, they're going to need to readjust their behavior and do withou for a while.  The people who were making Oreos stopped and sold their plant and laid off all their labor.  Until the market price for Oreos is allowed to re emerge that labor will likely stay stagnant and there will be no Oreos except at extremely high prices to very few buyers.

Oreos are the same as money and credit.

Or I've used this one too:

Bill Maher is a pot head.  He likes weed.  Say The Fed decides to get some more money and credit into the system and decides to do so by giving it to Bill Maher; they up the money supply by ten percent and give it all to Bill and his friends.  Bill and his friends start buying shitloads of weed.  Farmers make more money growing weed than corn, they switch over some of their fields.  Laborers make more money picking weed than corn or fruit, more of them head over into the weed market.  Manufacturers make more money making weed harvesters, they start doing so and forego making wheat and corn harvesters, etc.  Steel suppliers sell more to those manufacturers than anyone else.  As a side effect, the market for Doritos explodes and since people are making less corn and they need even more of it than before to make Doritos, all other corn uses start to fall by the wayside because people can't get it and even if they can, no one is willing to pay the price except the stoners.  The whole economy starts to shift from serving all consumers to serving BIll and his friends due to their artificially high buying power.

Eventually, Bill and his friends get stoned enough and prices for weed start to get too high even for them, they stop their spending spree.  The market for weed collapses.  Farmers now have too many fields devoted to weed.  There's too much labor looking to pick weed.  There are too many weed harvesters and no weed to harvest.  The manufacturers of weed harvesters aren't buying anywhere near as much steel anymore.  The Doriots market plummets.  At this point there are two options: keep feeding money to Bill and his friends and hoping the buy enough weed to keep things going as they currently are; stop feeding them money and let the demands of all consumers reassert themselves to the market.  This means the farmers will have to figure out how many fields should be devoted to corn vs weed vs wheat, etc.  It won't be the same as before most likely.  Same for labor allocations.  Same for the haresters, and damn, looks like the corn harvetsers haven't been maintained.  We're likely going to need more of them, but that means manufacturers will also have to retool to make them again because they were concentrating on weed harvesters.

Because of where the new money and credit entered the system, the entire economy was rearranged to serve the demands of those consumers: the ones who got the new money first.  The entire economy to varying degrees shifted to delivering those goods and services.  Now the economy needs to shift back, however the new levels of production need to be rediscovered.  You can't just dial the clock back.  People may want more weed now than before, or less corn than wheat, or more wheat than weed, and that needs to be figured out, along with how much equipment is needed, labor, etc.  And until that is figured out, prices will drop until people are willing to take up those resources and do something with them.

And there's the business cycle.  More or less.  Getting it all across in a few minutes isn't possible.  Concentrate on one key point and illustrate by fun analogy.  If they want to learn more they'll ask or look it up themselves.

"I was just in the bathroom getting ready to leave the house, if you must know, and a sudden wave of admiration for the cotton swab came over me." - Anonymous
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I actually had to summarize the theory in about one minute, while waiting on a train with a guy I had a discussion with. We talked before about the frequent confusion between money and real goods (capital, labor, etc.), which became a prerequisite for this:

Our beef is with the expansion of credit, Fractional Reserve Banking or whatever else you want to call it. It creates new money, but more real stuff doesn't just magically appear. You pretend to create values, but the result is a pretend prosperity, a.k.a. the boom. But you will get something real in exchange: a real economic crisis. And since we do it over and over again, we get what we know as the business cycle: fake prosperity followed by a real crash.

It's a summary, not an explanation. But it at least shows what it's all about.

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Peter Sidor:
Our beef is with the expansion of credit, Fractional Reserve Banking or whatever else you want to call it. It creates new money, but more real stuff doesn't just magically appear.

Only thing is I would distinguish between general money creation and FracRB.  There is a difference, and it's not "whatever you want to call it."

 

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Gold and silver are commodities, so an increase in the supply of actual gold or silver, while an increase to the money supply (if they are money) is also an increase in useful commodities. The uses for paper bank notes outside of the monetary realm are limited. If gold and silver ever became too plentiful (say, through science it became east to convert water into gold/silver) then it would not create a crisis; individuals would instead adopt a different commodity to serve as the monetary unit of account.

 

Credit in a commodity money regime would expand and contract but be limited by the amount of the commodity existence. I have no beef with expansion of credit per se.

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Put together an example here (thanks to an inspiration from David Veksler!) with our favorite practical economist Robinson Crusoe:

 

Imagine an economy with just one actor: Robinson Crusoe on an island. Crusoe loves fish, so he spends half of each day fishing so he can enjoy fish in the evenings. Additionally, Crusoe spends one day mornings maintaining his fishing dinghy and nets. In order to have fish on that day, he must fish for an extra hour every other day of the week. In economic terms, Crusoe has a savings rate of one hour per day. His savings rate is also his investment rate, or the percentage of present income he sets aside to maintain or increase future consumption.

Crusoe doesn’t have a fridge, so he preserves his catch by throwing it in a small, dark pond. He can’t see how many fish are in the pond, so he keeps a stack of small rocks near it. Every time he adds a fish, he adds a rock, and every time he eats one, he removes one. The rocks are his money supply.

Suppose that Crusoe shares the island with some mischievous monkeys, who see Crusoe adding rocks to his pile. They decide to imitate him, so every time Crusoe ads a rock, they sneak in and add one as well. The monkeys are inflating the money supply by injecting currency into Crusoe’s investment fund.

One day, Crusoe suddenly notices that his "savings rate" of fish is larger than he thought - double the usual. He concludes that he really is a great fisher and decides to take a day off each week, eating some of the fish he caught before. This is the consumption-side of the boom phase of the business cycle. Crusoe also decides to take some extra time each day to start building himself a new hut. This is the investment-side of the boom phase of the business cycle.

Crusoe now believes that the cost of saving fish is half the usual, while in fact his savings rate is too low for the investments he is planning.

And one beautiful day, when it comes time to eat his midday meal, Crusoe suddenly realizes that he’s out of fish – despite having a surplus of rocks. He’s exhausted his investment capital because the additional currency snuck into his money supply did not represent a real increase in his productivity or savings rate. He doesn’t have the capital (fish) to maintain his previous consumption rate, much less increase it. He is forced to cut his investment rate (he must spend some of his day off fishing) just to have some fish for dinner. He must also abandon his incomplete hut because he does not have the time to finish it. The abandoned hut is an extravagant expenditure that represents a loss of capital. This is the bust phase of the business cycle.

To review, here’s the overall impact of the monkey’s trickery: Crusoe catches the same number of fish, but consumes more and invests more, and therefore saves less. That’s the boom period. Then, Crusoe has to consume less fish, and spend less time for maintaining his nets (capital). Some of his investment/consumption time must now be spent in production. That’s the bust period. If Crusoe’s initial savings rate allows him to just break even each week, his nets will gradually get worse and worse and he will eventually go hungry.

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That sounds like the worst party.

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Well, you know, we Austrians don't get out much. :D

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Marginal Interest:
That sounds like the worst party.

What's the relevance here? Go cry us a river.

And suggesting your own answer - oh you're so humble!

The keyboard is mightier than the gun.

Non parit potestas ipsius auctoritatem.

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Neodoxy replied on Fri, Nov 25 2011 10:59 AM

 

"What's the relevance here? Go cry us a river.

And suggesting your own answer - oh you're so humble!"

 

Dude,

At last those coming came and they never looked back With blinding stars in their eyes but all they saw was black...
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"Dude", why should I?

The keyboard is mightier than the gun.

Non parit potestas ipsius auctoritatem.

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Wheylous replied on Fri, Nov 25 2011 11:26 AM

Tom Wood's Meltdown explains it quite nicely with good examples and analogies. I cannot seem to find a link to it online, but getting the books from a library would be useful, imho.

Edit: Whoopsies. Did not see that this is a really old thread.

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