The Boom & Bust Cycle: Simple as ABC(T)

By Jason Riddle

In March of 2000, the tech-heavy NASDAQ peaked at over 5132 for a gain of nearly 500% in five years.  Soon after, the dot-com bubble burst and erased millions in paper gains.  To stave off the painful, but necessary, economic consequences of resource misallocation during the dot-com craze, the Federal Reserve dropped the Federal Funds Rate from over 6% in 2000 to under 2% by 2002.  The rate dropped again to near 1% where it remained until the middle of 2004.  During this period, real estate prices soared and a new asset bubble formed.  The Federal Reserve began steadily raising interest rates from 2004 to 2007, but the damage had already been done. We now know the collapse of the artificially inflated real estate bubble was the proximate cause of the 2007/2008 financial crisis.

The ensuing economic panic and prolonged recession has led many previously disinterested citizens to beg the question: What causes these cyclical economic booms and busts, and is the cycle avoidable?

Why do industrialized nations seem to experience periods of elevated prosperity followed by recession?  Is there any characteristic in the market process itself that makes periodic economic recessions unavoidable?  Is this a failure of capitalism?

History tells us there are a number of extra-market forces that may unexpectedly plunge an economy into recession or depression.  A few examples include war, political trade sanctions, and natural disaster.  However, there is nothing in the inherent nature of a market or price system that would lead to rapid increases or decreases in aggregate prices.  Nor is there any characteristic of an unhampered market that would cause or encourage individuals to widely misallocate resources on the nation-wide scale we witnessed in the real estate market during the middle part of the last decade.  Free market factors alone cannot account for these wild booms and busts.

To explain the pattern of unnatural economic expansion followed by recession, economists Ludwig von Mises and F.A. Hayek developed a theory that has since been termed the Austrian Business Cycle Theory.  Both Hayek and Mises characterized the business cycle as a period of boom caused by artificial expansion of credit followed by an inevitable bust as market forces work to correct the misallocation of scarce resources.  Austrian theory demonstrates that it is precisely the introduction of artificial credit by the central bank, misrepresenting the availability of resources in an economy, that causes widespread malinvestment and subsequent asset bubbles to form during the boom.

Austrian Business Cycle Theory provides an excellent framework for making sense of our recent financial crisis.  Here are the ABC’s of the Austrian theory.

Artificially cheap credit creates a false signal.

According to the Austrians, the business cycle is fueled by artificially cheap credit.  The engine is the central bank, and interventionist public policy is the ignition.  For various political reasons (including creating the perception that a benevolent government is giving the public something for free), the central bank intervenes in the credit market by increasing the money supply.  This artificial increase in the money supply (or expansion of credit beyond market levels) tends to lower the interest rate below the level that would occur naturally in the market.  This sets the business cycle in motion.

We live in a world where we are limited by the scarce resources of time, materials, and labor.  We must choose how we want to allocate our scarce resources to best satisfy our needs.  Investing in capital goods may increase future output, but in order to invest in the future we must either decrease current consumption or consume real savings during our period of investment.

The market interest rate indicates the amount of resources that may be devoted to the production of capital goods without impacting current consumption based on available savings.  Because capital investment requires the postponement of current consumption, it signals to entrepreneurs the availability of real savings accumulated to undertake capital investment projects.  The interest rate is essentially a measure of the market’s preference of present goods in relation to future goods.

An artificially low interest rate distorts this vital signal to consumers, producers, and investors.  Entrepreneurs are led to believe investments in the production of capital goods can be undertaken without frustrating current consumption.  Investors commence capital projects under the misguided assumption that sufficient resources are currently available to complete the projects and that consumer demand will exist in the future to support their investment decisions.

As a result, scarce resources are diverted away from useful projects that would have otherwise satisfied consumers’ true time preference.  The housing boom from 2002-2007 is a perfect illustration.  Artificially cheap credit sent the false signal to entrepreneurs that the market had sufficient savings necessary to undertake substantial real estate investments.  This misinformation created by the Federal Reserve has left the economy fraught with foreclosures, short-sales, and half-built homes all over the country.

Boom time is a period of pervasive economic damage.

The boom is a time of growth and prosperity, right?  Not exactly.  Sure, prices are rising.  People think that real wealth is being created at an accelerated rate.  Society is living a lifestyle fueled by artificially generated ‘economic progress.’  It is true that as a result of increased capital investment, the prices of capital goods are bid up by investors competing for the use of these scare resources and many people are making money.

However, this only fuels the malinvestment as entrepreneurs perceive the continued investment of capital will pay off.  Scarce resources are taken from productive uses and employed in projects that the market is not ready to undertake.  It is actually during the period of boom (a period that lends the perception of wealth creation) that the real damage to wealth occurs.

The faulty assumption that capital can be created by artificially increasing the supply of paper money only gives the illusion that the savings available for investment are real.  Of course, real savings must exist before capital projects can be completed, and the notion that capital can be created by a printing press is false—no matter how many times Paul Krugman tries to tell you otherwise.

Increasing the money supply may temporarily increase consumption, fueling the good times during the boom, but only at the expense of consumed capital.  As scarce resources are devoted to new investment projects, valuable capital is consumed in order to meet the current consumption demand levels.

To fully appreciate the extent of the damage caused during the boom period, it must be understood that all capital goods are not identical in nature.  Although mainstream economists like to treat all capital investment as homogeneous items to be input into complex economic models, capital goods exist as individual pieces of an intricate system of individual plans.  The structure of production is such that capital production can only exist to the extent by which the factors of production are available for use.  Not only is there massive overinvestment during the boom period, but also there is entrepreneurial investment in the wrong areas.

Valuable capital is diverted to unsustainable projects during the boom in pervasive malinvestments in what economists refer to as a “cluster of errors.”  Valuable capital is consumed to sustain desired consumption levels.  It is during the boom time that real wealth is destroyed.

The existence of real savings and investment in capital is the reason that America became an economic powerhouse.  Over the last half a century, we have actually been consuming our savings and saved capital at an alarming rate to sustain our desired levels of consumption.  We are no longer a production economy.  We are a consumption economy.  This is not sustainable.  Our standard of living seems to be high, but our destruction of capital and savings is actually making Americans relatively poorer each year.

Correction is the painful, but necessary, healing process.

The illusion that real savings exists can only go on for a finite period of time.  Once it is determined that production expansion cannot be completed with the available resources, a correction must occur.  The severity of the correction required to liquidate malinvestments and appropriately reallocate resources is determined by the duration and intensity of the central bank’s interference in the market.

The solution is not as simple as switching from the malinvestment back to previous levels of capital production.  Production requires capital.  The boom period damaged our capital structure.  Consumption must be deferred and real savings established before there can be investment in new production.  The medicine is painful, but the recessionary period is the economy’s way of healing itself from the harm caused by the government and the central bank.

If the mistakes caused by central bank interference in the market can be identified early on and stopped, the damage caused during the boom period can be fixed by the market relatively quickly during a brief period of recession.

Unfortunately, the Federal Reserve is showing no signs of stopping.  It continues to pursue the same monetary policies that caused the problem in the first place.  By propping up a false economy, the Federal Reserve is prolonging any chance of real economic recovery while inducing further damage to the production structure of our economy.

If the central bank continues to fuel the market with cheap credit, as it does today, the consequences may be dire.  Consider the following warning in Thomas Taylor’s An Introduction to Austrian Economics:  “To continue easy-money policy in order to avoid the otherwise inevitable depression must bring about an even harsher fate: the collapse of the monetary system and the market economy.”

Like most perceived ‘market shortcomings,’ the business cycle is not a failure in capitalism.  The cycle of boom and bust is yet another example of the unintended consequences of misguided attempts to centrally plan an economy.

Additional Suggested Readings:

Jason Riddle is the editor of and co-hosts a free market radio show in Atlanta’s Talk920 called Butler on Business.  He previously served as a manager for a leading global risk consulting firm.

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