Wednesday, June 16, 2010

The Business Cycle: A Brief Overview

Discussing finance and the economy requires a brief discussion of the business cycle. Roughly speaking, a recession happens when an economy falls below its productive capacity and leaves many resources unused. Inflation occurs when the economy strains against its productive capacity. The study of why the economy falls below or strains against its capacity is called demand-side economics. Supply side is the study of how total economic capacity can be expanded. (It has largely been hijacked since Ronald Reagan's time by people who believe the most effective way to expand total capacity is tax cuts at the top).

The various theories of the business cycle see themselves as rivals, but an Enlightened Layperson can see them, in many ways, as complementary and freely use all of them at once.

Keynesian economics. This was (mostly) what I learned in college. It has the advantage of being the easiest to understand because it ignores finance and focuses entirely on the real (material) economy. The economy is divided into three categories, consumption, investment (defined as actual building, rather than financial investments), and government. Consumption is considered non-problematic. Most people, given money to spend can reliably be counted on to spend (most of) it. The problem is with investment, "a flighty bird" subject to great fluctuations. Furthermore, when investment falls, consumption is imperiled. People lose jobs and income, which causes a reduction in consumption. The loss of consumer spending is a loss of income to businesses, which in turn hire and pay less, and so on down the line. This process is known as the multiplier.

Keynes' remedy for a drop in investment is for government to step in and temporarily take over investment until the private economy recovers. Keynesian economics also favors forms of assistance like unemployment insurance, which blunt the effect of the multiplier by allowing people who lose jobs to cut consumption less.

The concept of a multiplier effect from falling investment is not too controversial, although there is hot debate over how large the multiplier effect is. The more obvious problem with Keynesian economics is that it makes no attempt to explain why investment goes through such wild gyrations. Other economics theories do address that issue, and their answer usually lies with the system of finance.

Monetarism. This theory was developed by libertarian economist Milton Friedman during the 1960's when the Great Depression was a safe distance off and problems with inflation were beginning to ignite. Monetarism sees growth and inflation mostly as products of the money supply. If the money supply grows too quickly, inflation results, and the money supply should be tightened. If the money supply becomes to constricted, it causes recession and the money supply should be expanded.

Everyone understands why printing too much money causes inflation. Buy why does printing too little cause recession? And won't trying to fight recession by printing money just cause more inflation? Well, central banks "print" money by buying treasury bonds from banks and un-print it by selling the bonds back. (Banks apparently do not have the option to refuse). Central banks also lend money to regular banks. The point is that the more money central banks pump into regular banks, the more money banks can lend out to get the economy rolling.

Thus business cycles are caused by either central banks pinching too tight (causing recession) or overdoing it (causing inflation). The remedy is to move in the opposite direction, to tighten the money supply in case of inflation or expand it in case of recession.

But this, too, doesn't really explain how the business cycle gets started. After all business cycles existed without central banks as well. There are two main attempts to address that issue, both sub-categories of the "credit cycle" theory of the business cycle, but with very different perspectives.

Debt-deflation theory: This theory was developed by Irving Fisher during the Great Depression. A growing economy relies on credit and therefore creates debt. When the debt load becomes excessive, people begin paying debts off. But when everyone pays off debt at the same time, economic activity slows and prices fall (because sellers outnumber buyers). Deflation sets in, which makes debts even more onerous, which leads to more attempts to pay them off, and a vicious cycle ensues. Although this theory was long neglected in favor of the views of Keynes and Friedman, it is making a comeback because the current crises looks very much like a debt-deflation cycle at work.

Because of its emphasis on the dangers of deflation, the debt deflation theory is sympathetic to expansionist monetary policy to prevent deflation, or even to inflate one's way out of debt. It is also sympathetic to a Keynesian stimulus; government running up debt to compensate for private parties paying it off.

Austrian theory. Originated by Ludwig von Mises (an Austrian), the Austrian theory of business cycles holds that they are caused by too-easy credit, which leads to careless and bad investments. Eventually the bubble bursts, the bad investments fail, and recession sets in. Given the mess too much easy credit has gotten us into today, all of this is hard to deny. But the Austrian School is regarded by most mainstream economists as a bunch of kooks, although they have many right-wing political followers, including Ron Paul, Glenn Beck, and most of the John Birch society. (Many of my Google searches in researching this post led to Austrian tracts).

So what's wrong with the theory that too-easy credit leads to a dangerous boom-and-bust cycle, given that it is obviously true? For one thing, other theories of the business cycle seek the golden mean. Keynesian economics seeks just the right level of economic activity, that neither strains economic capacity (causing inflation) nor falls below it (causing recession). Monetarism seeks to expand the money supply at the right speed, neither too fast nor too slow. Debt deflation warns against the buildup of excessive debt, but also that running too little debt leads to stagnation. But Austrian economics only warns against the dangers of too-easy credit and never considers the possibility that too-tight credit might also cause problems.

This leads to bizarre consequences. For one thing, Austrians do not accept easy money policies as a way of relieving a recession. Even in the depths of the bust, their first fear is re-igniting the boom. Another is that they do not accept any sort of intervention at all as appropriate. Recessions, even depressions, are not seen as a problem, just a flushing-out of bad investments. Only the boom that preceeds the bust is a problem.

It also leads to some extreme suggestions on how to prevent the boom-and-bust cycle. All involve abandoning central banking and the entire modern system of finance. And by the modern system of finance, I mean not just the fancy financial instruments that caused the current crash, but banks and paper money altogether. All want to return to the gold standard, allowing government to issue only gold coins as money. Some want an unregulated system of banks, with each bank free to issue its own gold certificates (bank notes). Of course, we had just such a system from 1837 to 1913. The result was that banks frequently over-issued notes and loans leading to too-easy credit and exactly the boom-and-bust cycle the Austrians predict.

Some therefore respond by proposing to abolish banks altogether, or rather, to allow banks as vaults for storing money, but forbid them from lending it out. So where would credit come from? Well, people would be perfectly free to lend their own money, just not anyone else's. Home purchases would presumably be financed by direct installments to the seller, corporations by bonds and -- well, I don't know enough about modern finance to understand the full implications, but I could say this much with confidence. Such a system would, indeed, eliminate any problems caused by too-easy credit. But the Austrians really need to think of the dangers of too-tight credit strangling an economy to death. We are dealing with them now.

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