I have written a short, personal version of the business cycle. It has to be as short, understandable, clear, straightforward, but precise as possible. Can someone give any comments for improvement? Can somebody point to flaws in my version? Is it 100% correct what I assert?
Many thanks!!!!!!!!!!!
The Austrian Business Cycle Theory, which was first explained by Ludwig von Mises (19??), argues that artificial credit expansion to business generates the trade cycle. Each consumer makes a tradeoff between present and future satisfaction, which represents the time preference of that individual consumer. From this follows that the interest rate is determined by the time preferences of all consumers in an economy. A lower time preference results in more savings and thus more investment relative to consumption. But when credit is artificially expanded (i.e., through fiduciary media, which are money substitutes not backed by actual money), the natural interest rate tends do decrease below its natural level. A lower interest rate boosts the present value of capital goods, “since the flow of rents they are expected to produce increases in value when discounted using a lower market rate of interest” (Huerta de Soto, 1999, p. 349). This will stimulate investment from nondurable consumer goods to capital goods industries and durable consumer goods (i.e., production temporarily further away from current consumption). As a result, this shift causes “overinvestment” in the stages furthest from consumption (e.g., R&D, computer hardware, refining, construction, etc) and “underinvestment” in the stages close to consumption (e.g., retailing, fast-moving consumer goods, etc). Eventually, this newly created liquidity ends in the hands of the consumer who spends it on nondurable consumer goods. Accordingly, prices of natural and human resources rise (with more entrepreneurs bidding up prices) and, subsequently, the price of consumer goods and the interest rate also rise. Additionally, real wages decrease due to higher consumer prices. As a result, long-term projects that earlier seemed profitable with a lower interest rate, now appear to be unprofitable with higher interest rates, exposing malinvestments. Furthermore, lower real wages creates a shift from labor-replacing capital goods to labor, intensifying the malinvestment. Eventually, this will lead to companies that produce further away from consumption begin to incur heavy financial losses and a general economic downturn that affects the entire market place.
As far as I can tell, absolutely perfect.
Since you posted this here specifically asking for feedback, I'm going to be honest. And since you said it has to be "understandable, clear, and straightforward", I have to say, honestly if I wasn't already familiar with the theory I would not have been able to follow that. And it certainly wasn't easy to get through. Even for someone familiar with and interested in economics, that passage may be much more cumbersome than you'd wish it to be...but I can say with a great deal of certainty you don't have a prayer with a layman. Even if they are smart enough to follow it, it is too boggy, and it gets to a point where you just don't feel like following it. (At least a small part of this could be rectified by the simple task of actually using paragraphs...but that's only a small part).
I would highly recommend consulting some other explanations that are geared toward the layman and see what you can pull from them. There was a thread about this some time ago...you can find it here: ABCT in a few minutes
And you may check out Economics for Real People and Common Sense Economics (both of which you will find links to free downloads there), as they each cover the subject quite well. But perhaps the best source I can offer is the talk below given by Tom Woods. It's one of the best overall introductions I've ever heard. He actually begins the lecture by giving some insight into the nature of money and its origins and inflation. But if you jump to 15:48 you'll hear his rundown of the business cycle, and it's a brilliantly simple, understandable, and straightforward explanation. All you'll have to do is condense it down to make it possibly a bit more concise...which shouldn't be too hard, as you'll be writing, and he was giving a talk.
Thanks for your honesty!!
Let me first give you the context. This outline of the ABCT is aimed for an academic audience since it will be part of my academic paper. Further, I have to account for the jargon of the field. It will be a paper focused on marketing. For example, a GOOD in Austrian Economics could be both a physical product or a service, while a GOOD in marketing generally refers to a PHYSICAL GOOD. Further, they tend to refer to resources instead of "factors of production". So there are certain things i have to take in account.
I think Thomas Woods does a great job in explaining the ABCT as clear as possible, so I should take a look into that. I think that the speech by Woods, logically, doesn't capture the fact that wages are bid up creating a shift from labor to capital-goods, since labor competes with capital-goods.
I think, if I follow his outline, it would be something like this:
If interest rates go down, businesses are most likely to invest in long-term projects. A lower interest rate boosts the present value of capital goods, “since the flow of rents they are expected to produce increases in value when discounted using a lower market rate of interest” (Huerta de Soto, 1999, p. 349). The more longer-term an investment, the more interest-rate sensitive it will be. The Austrian Business Cycle Theory distinguishes between higher-order and lower-order stages of production. Higher-order stages of production (e.g., R&D, mining, manufacturing) are farther removed from consumption, while lower-order stages are closer to consumption (e.g., retailing, services). The reason that businesses invest in long-term projects when interest rates are low is twofold. Firstly, consumers are saving more, increasing the supply of loanable funds. Secondly, when consumers abstain from present consumption, (scarce) resources are freed up to be used in production for future consumption. Thus, the interest rate coordinates the structure of production. However, when the supply of loanable funds is interfered with by an expansion of credit, interest rates are artificially surpressed. In this case, businesses in higher-order stages of production will expand production, but at the same time consumers do not abstain from present consumption. This creates a time mismatch. The factors of production are scarcer than the businesses in higher-order stages realize. Firms will bid the prices of these factors of production up, making their investments unprofitable and exposing the grave errors which managers have been led into by artificially low interest rates.
What do you think? Should I combine the two and re-write it? What should I emphasize?
Olav:What do you think? Should I combine the two and re-write it? What should I emphasize?
I can understand needing to appeal to mainstream and/or field-specific terminology. And there's nothing wrong with using common terms, as it's not as if Austrians don't have any use for them. The only difference is Austrians are going to use extra terms sometimes to describe details of things that other schools of thought will not. For example, as I was saying here (#5 in that post), other methodologies do not recognize capital structure. In fact they do not really have much of a capital theory at all. Where Austrians understand there is a structure at work (i.e. higher and lower order stages of production), and that goods don't just appear out of nowhere just because there is a demand, mainstream models just clump everything together into a "capital" category. This is why Woods elects to use the more descriptive and specifc term "factors of production"...because he's not just talking about "raw materials" (aka "resources"). It refers to not only the resources, but it implies their link in a chain of stages.
And regardless of whether your audience recognizes this facet of the economy or not, it exists, and they should. Just because the mainstream doesn't incorporate it into their models doesn't mean you shouldn't be talking about it with them or should be apprehensive about using terminology they may be unfamiliar with. This is the entire point of sharing these ideas...because most of these people have never even heard these explanations. (I don't know how well-aquainted you are with mainstream academia, but you may be surprised...even members in here could recount story after story of guys they know who've received PhD's in economics from top schools who've never heard of Mises. They get handed a copy of Prices and Production or Theory of Money and Credit and come back and say "wow...I wish they would have taught me some of this." I knew a top economics professor at one of the largest universities in the country who had never heard of F.A. Hayek. I may be preaching to the choir, but obviously the point is people need to be introduced to this stuff, and just because they have credentials doesn't mean they've even been exposed to it...let alone understand it.)
So the point in all this is, don't be too apprehensive about using terms that may only be familiar within Austrian explanations. Even non-economists need to have a basic economic understanding. And I can understand if you need to throw in some marketing terminology or whatever will help engage your audience and help them understand, but use that language to help bring them closer to your world...don't try to shrink yours to fit into theirs. As Mises said: "Economics must not be … left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of man's human existence."
As for your draft there, it seems out of order. And some things don't seem to add up the way you're saying them. For example, your first reason for why businesses invest in long-term projects when interest rates are low, really isn't one. Or at least the reason isn't clear from your answer. In fact that whole twofold thing almost comes out as a non sequitor. I would put it something more like this:
As interest rates go down, businesses are more likely to invest in long-term projects. The reason for this is, as Huerta de Soto notes, when interest rates are lower, "the flow of rents they are expected to produce increases in value when discounted using a lower market rate of interest" (1999, p. 349). This means a decrease in the interest rate results in an increase in the present value of capital goods...meaning they are a more attractive investment. In other words, the cost of capital is lower, so the expected returns are of greater value, which means the capital goods themselves can be viewed as more valuable. And as would be expected, the more long-term the investment is, the more interest rate-sensitive it will be...which means even slight movements in the cost of funds can have a significant impact on the perceived profitability of such an investment.
The Austrian Business Cycle Theory distinguishes between higher-order and lower-order stages of production. Higher-order stages of production (e.g., R&D, mining, manufacturing) are farther removed from consumption, while lower-order stages are closer to consumption (e.g., retailing, services). When individuals in the market consume less and save more, the pool of loanable funds grows, driving down the interest rate. This serves as a signal—in the form of the increased profit potential mentioned above—to the market that resources are being freed up from the lower order stages. (If we recognize that savings=underconsumption, it can be understood that an increased pool of loanable funds equals an increased amount of available (scarce) resources that can now be used in some other area...namely, a higher order stage in the production process...farther removed from consumption.) Put another way, the time preference of consumers for present goods has lowered, and they are now more willing to forego current consumption in return for an expected increased satisfaction in the future.
Thus, the interest rate coordinates the structure of production between the time preference of consumers in the market and the producers at various stages in the supply chain.
However, when the supply of loanable funds is increased artificially by an expansion of bank credit, interest rates are artificially surpressed. In this case, consumers have not expressed a preference for future goods over current ones. They have not abstained from present consumption, and therefore have not freed up any resources from the lower order stages. However, there is no way for producers of the higher order stages to know this. There is virtually no way to distinguish between this artificial credit expansion and a geniune increase in the pool of available resources. As a result, businesses in these longer-term sectors will move to expand, just as they normally would in a lower interest rate environment. The issue is, of course, in this case the resources necessary to facilitate this expansion have not been freed up at all. They are still in commission in the lower stages where consumers are focusing their shorter (aka higher) time preference.
As can be expected, the result is a large degree of what Ludwig von Mises called "malinvestment"...which is an investment in wrong lines which leads to capital losses. In short, projects are undertaken for which the physical factors of production necessary to complete them are not available. It is akin to beginning construction on a house in a situation where there are not enough bricks to complete it. But these mistakes historically go unnoticed for quite some time, and the artificial increase in credit allows firms to bid up the prices of these assets to high levels, creating a bubble, in which a sector of the economy is grossly overvalued. These errors are generally revealed when the central bank that created the credit expansion "turns off the spigot" so to speak, and interest rates are allowed to rise...leading to the inevitable "bust" part of the cycle in which the malinvestments are exposed and a restructuring of the economy begins to take place.
You may need to shorten that some but I think if you put it in that order it flows more smoothly and allows for a more linear progression through the cycle that is easy to follow...especially for a non-economics audience. Lemme know what you think.
Minor tip: Never put "ly" on the end of your "first, second..." kind of list. It just sounds pedestrian and those aren't really words. The only reason you might find them in a dictionary is because "rather than defining words as some experts thought they should be used, dictionaries have moved toward defining words as people actually use them.” But that doesn't mean everyone has to sound uneducated. ;)
You see the confusion? :)
Resources in marketing do not specifically refer to raw materials, but basically to "factors of production", or the factors that a firm deploys to earn a profit. There is a bunch of literature also interesting for Austrian economists (such as a famous article by Lusch & Vargo, where they basically argue that mainstream economics is bulls***). For example, they argue that all economies are service economies, something I guess Mises already implicitly argued.
So, just for the sake of clarity I might need to adjust some things.
Thanks for the help!! Really appreciate it. Now its up to me to come up with a better version. I think your last version is helpful but simply too long! But ill think about how to create a nice outline. And i'll remember your tip. In my country we get this kind of things taught, so don't blame me ;)
Yeah I figured it would be too long, but I figured it would be easier for you to decide what to cut out than to end up having to come up with important things to fill in gaps. I wanted to make sure everything was explained in a way anyone should be able to follow it, so there's quite a bit you might cut out that simply recaps what was just said in a concise way.
Where is it you are from?
I'm from The Netherlands :)
Ill follow up on this post soon!!
Hey cool...have you met Niels?
Don't worry!! We met :)
One question, is there anyway to substitute "capital goods" in your explanation? I know its typical but it would be better for the audience to put it in different terms. It would be easier to understand if its explained from the business-side instead of a macro-economic perspective.
A firm's productive resources for example?
"This means a decrease in the interest rate results in an increase in the present value of capital goods..."
Are there any synonyms for consumption goods vs capital goods?
FWIW. If you look at this here, you'll see there are three unanswered questions at the end. You could show how the ABCT is actually all about answering those three q's, and what answers it offers.
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It's easy to refute an argument if you first misrepresent it. William Keizer
"Are there any synonyms for consumption goods vs capital goods?"
For a business audience, you could go with 'consumer goods' and 'capital'.
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Olav: One question, is there anyway to substitute "capital goods" in your explanation? I know its typical but it would be better for the audience to put it in different terms. It would be easier to understand if its explained from the business-side instead of a macro-economic perspective. A firm's productive resources for example? "This means a decrease in the interest rate results in an increase in the present value of capital goods..." Are there any synonyms for consumption goods vs capital goods?
Sure, you can use some synonym, or at the very least give a definition. But like I was saying earlier, you don't want to just avoid using the most proper terms just because the audience might not be familiar with them. If you always avoid using words or talking about things that people don't know about, how exactly are people supposed to learn? Don't be afraid to pull people into new things. Sure you want to pay attention and make sure that they are following and keeping up with you, but that doesn't mean you can't lead them anywhere.
So sure, define what you mean, but I would still use the term at least once. More than half of education is just exposure. Work this down to the right length: "This means a decrease in the interest rate results in an increase in the present value of capital goods—and of course by 'capital goods' we mean 'produced factors of production'; stuff that is made, just for the purpose of making other stuff. Like a hammer, or a fishing net, or backhoe. Those are 'capital goods'."
In situations like this you really want to stay away from using nebulous terms like "capital" because there are so many ways that word is defined it will only confuse things. Not to mention, there is a difference between "capital" and "capital goods". Just because many people incorrectly use a word, doesn't mean you should keep doing it just because you think it might help them understand.
If you really want to get into it, here's a list of resources for details on "capital" and "capital goods"