The Economic Cycle
Why does the economy fluctuate so widely, regularly moving from boom to bust, almost as if some higher power were in control? Economists, and a few crackpots, have long pondered that question, one of the latter even suggesting that it had something to do with sun spots. But correlation does not necessarily mean cause.
In my opinion, one economist, Ludwig von Mises, founder of the Austrian school of economic thought, got it right. In his book Human Action he pointed out (the generally accepted fact) that boom times come about as an effect of increasing investment in entrepreneurial enterprise. As the boom strengthens the capital base increases, that is, more and more money becomes available for investment. But -- and the “but” is critical -- the number of viable and worthwhile enterprises does not and cannot keep pace. There are only so many good ideas for new profit-making ventures. As the quality of new ventures decreases, the capital deployed in them becomes more and more at risk, until, finally, as the fledgling enterprises begin to fail, the incurred losses shrink the capital base, and the cyclic downturn begins.
The last two great burst bubbles in the American economy perfectly illustrate von Mises’ point. The dot.com and housing bubbles both burst because the number of potentially successful ventures in those two areas dried up. The dot.com bubble sucked up hundreds of billions of loose capital, with risk increasing as the number of new businesses increased. The real estate market produced trillions, not just billions, of risky investments, with the riskiest of the risky being leveraged by the formation of derivative pseudo-assets, securitized bonds and credit default swaps. In retrospect, the derivatives generated by the housing bubble look like stop-gap measures designed to delay the collapse of the dizzy house of cards that had been built on risky mortgages. In any case, both bubbles demonstrated von Mises’ explanation of the economic cycle; as a market grows, the chance for survival of new ventures lessens. (Classicists would refer this to "the law of dimishing returns.")
Von Mises’ theory applies to more than bubbles and to more than the weakening of the capital base. It is also illustrated by the emergence of entirely new products lines, some of which ought properly be recognized as frippery, Thoreau’s word for the bevy of unnecessary merchandise with which we surround ourselves. It’s not that we do not obtain personal value from expensive toys, all-occasions greeting cards, and similar niceties, but from an economic point of view, they constitute consumer products that will be speedily sacrificed when the economic curve bends downward. Looked at as an aggregate, the real value of frippery decreases as the size of the market for frippery increases. New niceties enter the market as more and more money appears in the pockets of the consuming public, and (generally speaking) the real value of each new product moves further from the baseline of necessity.
What happens next is relatively obvious. As the capital market for new ventures dries up, and as the weak sisters that came into being near the peak of the curve begin to fail, a snowball begins to form and to roll downhill. Von Mises thought that the capital goods market (goods used to make other goods) would be the first to suffer, and for very intelligible reasons he was right. And because the information available to the buying public is not nearly so good as the information available to businesses, the market for frippery would perhaps be the last to feel the effects of the bust. When the pain finally reaches the flesh and blood of ordinary humans, it’s already too late. The economic cycle is already over the hump and well on its way to the bottom.
John Maynard Keynes, writing during the worst of the Great Depression, suggested that history had reached the point where it was no longer a certainty that the “elevator” would hit bottom and subsequently begin to rise. I’m not sure he was right. I may be making a post hoc argument (like attributing the economic cycle to sun spots) but it seems to me that the economy had always risen after a bust, only getting stuck during the 30s when the government took a Keynesian hand in providing a boost to the market. Unemployment was 25% in 1932 and was still 19% in 1939. Roosevelt/Keynes (with a dollop of Marx) had not solved the problem, had perhaps made it worse. FDR’s claim that we have nothing to fear but fear may have been right, but a strong case can be made that fear is not lessened but increased when the only new jobs being opened are in government financed make-work projects. Our new president ought to think long and hard before he makes mistakes similar to those our government made in the 30s.
In my opinion, one economist, Ludwig von Mises, founder of the Austrian school of economic thought, got it right. In his book Human Action he pointed out (the generally accepted fact) that boom times come about as an effect of increasing investment in entrepreneurial enterprise. As the boom strengthens the capital base increases, that is, more and more money becomes available for investment. But -- and the “but” is critical -- the number of viable and worthwhile enterprises does not and cannot keep pace. There are only so many good ideas for new profit-making ventures. As the quality of new ventures decreases, the capital deployed in them becomes more and more at risk, until, finally, as the fledgling enterprises begin to fail, the incurred losses shrink the capital base, and the cyclic downturn begins.
The last two great burst bubbles in the American economy perfectly illustrate von Mises’ point. The dot.com and housing bubbles both burst because the number of potentially successful ventures in those two areas dried up. The dot.com bubble sucked up hundreds of billions of loose capital, with risk increasing as the number of new businesses increased. The real estate market produced trillions, not just billions, of risky investments, with the riskiest of the risky being leveraged by the formation of derivative pseudo-assets, securitized bonds and credit default swaps. In retrospect, the derivatives generated by the housing bubble look like stop-gap measures designed to delay the collapse of the dizzy house of cards that had been built on risky mortgages. In any case, both bubbles demonstrated von Mises’ explanation of the economic cycle; as a market grows, the chance for survival of new ventures lessens. (Classicists would refer this to "the law of dimishing returns.")
Von Mises’ theory applies to more than bubbles and to more than the weakening of the capital base. It is also illustrated by the emergence of entirely new products lines, some of which ought properly be recognized as frippery, Thoreau’s word for the bevy of unnecessary merchandise with which we surround ourselves. It’s not that we do not obtain personal value from expensive toys, all-occasions greeting cards, and similar niceties, but from an economic point of view, they constitute consumer products that will be speedily sacrificed when the economic curve bends downward. Looked at as an aggregate, the real value of frippery decreases as the size of the market for frippery increases. New niceties enter the market as more and more money appears in the pockets of the consuming public, and (generally speaking) the real value of each new product moves further from the baseline of necessity.
What happens next is relatively obvious. As the capital market for new ventures dries up, and as the weak sisters that came into being near the peak of the curve begin to fail, a snowball begins to form and to roll downhill. Von Mises thought that the capital goods market (goods used to make other goods) would be the first to suffer, and for very intelligible reasons he was right. And because the information available to the buying public is not nearly so good as the information available to businesses, the market for frippery would perhaps be the last to feel the effects of the bust. When the pain finally reaches the flesh and blood of ordinary humans, it’s already too late. The economic cycle is already over the hump and well on its way to the bottom.
John Maynard Keynes, writing during the worst of the Great Depression, suggested that history had reached the point where it was no longer a certainty that the “elevator” would hit bottom and subsequently begin to rise. I’m not sure he was right. I may be making a post hoc argument (like attributing the economic cycle to sun spots) but it seems to me that the economy had always risen after a bust, only getting stuck during the 30s when the government took a Keynesian hand in providing a boost to the market. Unemployment was 25% in 1932 and was still 19% in 1939. Roosevelt/Keynes (with a dollop of Marx) had not solved the problem, had perhaps made it worse. FDR’s claim that we have nothing to fear but fear may have been right, but a strong case can be made that fear is not lessened but increased when the only new jobs being opened are in government financed make-work projects. Our new president ought to think long and hard before he makes mistakes similar to those our government made in the 30s.
posted by Benedict S. at 7:13 AM
1 Comments:
Hello Mendacious. I realize I'm responding to an old post here. But I figure you still think along the same lines.
That crackpot who blamed sunspots lived in a time when the advanced world was still mostly agrarian, and if sunspots affect the weather they affect the harvest and they affect the economy. But I'm not sticking up for the sunspot theory.
I'm always looking for an interesting discussion. You write: "the number of viable and worthwhile enterprises does not and cannot keep pace. There are only so many good ideas for new profit-making ventures."
Okay, that makes sense. It doesn't feel like economics to me (though I'm not an economist) but it does make sense. But I have a question.
"Why," you ask, "does the economy fluctuate so widely, regularly moving from boom to bust...?" You didn't emphasize the regularity but you do note it.
Would you say the metering-out of "good ideas" is "regular" enough to create the "regularness" of the business cycle? Would you say there are larger and smaller versions of the cycle of good ideas, that would account for the various business cycles -- Juglar, Kondratieff, Kuznets, etc??
I just don't see it myself.
I've not read von Mises. Will you have a go at convincing me of the merit of his work?
Oh: "The real estate market produced trillions, not just billions, of risky investments, with the riskiest of the risky being leveraged by the formation of derivative pseudo-assets, securitized bonds and credit default swaps."
Yeah... My view is that the reliance on credit is itself the factor that drives the cycle. Every time the reliance gets excessive, we have a recession and the growth of credit-use tapers off -- but does not really fall. With recovery, the use of credit expands again, reaching new heights via financial innovations like those you observe. Ultimately we reach a breaking-point. And then there is a Depression.
That's when the debt gets swept away, perhaps via inflation, or perhaps swept away along with the existing government. Oops!
Peace, and Happy New Year.
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