The Business Cycle: A Brief Introduction

My interest in economic theory stems from a desire to learn about what is commonly called the "business cycle". Since the beginnings of the "Subprime Crisis" in the housing market and the credit market problems that have become associated with the meltdown in many structured investment products I've tried to familiarize myself with what were the causes of these problems. Was it a fundamental, though necessary, defect inherent to capitalism? Was it government mismanagement as many free-market propenents are wont to blame? Does the crisis represent a need for more regulation and intervention by government?

Unfortunately I haven't determined precisely what were the causes of the recent economic crises. I became sidetracked reading about economic theory. I began by reading Schumpeter and became acquainted with his book Business Cycles: A Theoretical, Historical, and Statistical Analysis (though the abridged version). Schumpeter's book is a suberb history of capitalism. Starting at the beginnings of industrialization up to the early 20th century when the book was published, Schumpeter applies his theory of cyclical waves that are inherent to the capitalist system and are caused by how fast (or slow) new innovations are adopted by the system and how the effects of these innovations cause adaptations in surrounding industries.

The Schumpeterian theory does not coincide with what I found elsewhere, like in the work of von Mises, and the man who expounded upon the Misesian conception of the Business Cycle, F.A. von Hayek. In Prices and Production, Hayek argues that the cyclical fluctuations that have been experienced throughout the history of modern capitalism up to that point were not caused by anything inherent to the capitalist system, but instead were products of what Mises termed in his 1912 monetary treatise, "Fiduciary Media", ie. credit. Hayek's chief new contribution in the book was his insight into the stages of productions. After Bohm-Bawerk, Hayek and Mises combated a misconception found in the work of American economists F.H. Knight and John Bates Clark, where they argued that "capital" was a homegeneous fund, a flow of goods that is for all intents and purposes perpetual. The Austrians view "capital" as being heterogenous, with differing capital goods according to their relative specificities. Some elements of capital are relatively easy to transfer from industry to industry, but others, such as specific machinery equipment, are basically fixed in their employment in a specific industrial pursuit. Hayek also built upon Bohm-Bawerk's roundabout process of production by explaining that a longer period of production represents more capitalistic (capital intensive) methods of building and creating things.

According to the fiduciary media argument, the business cycle is caused by monetary inflation, this monetary inflation distorts economic calculation depending on where it is injected within the economic system. Typically, new money is introduced through the banking system, with the newly created funds appearing on the loan markets (because that is the main business of banks--to loan money) the rate of interest is artificially lowered below the "natural rate of interest". The Natural Rate is an insight credited to the Swedish economist Knut Wicksell, in which he explained that the natural rate is derived from the relative time preferences of individuals in society, reflected in how willing or unwilling they are to save money. More savings implies a lower natural rate of interest and, therefore, a lower time preference, and vice versa. If the rate of interest is artificially lowered below the natural rate, then the more capital intensive industries will mistakenly believe that it is now profitable (and it temporarily is) to construct more specific capital goods. A lower interest rate implies a lower time preference, which tells entrepreneurs that it is now potentially profitable to lengthen the period of production. For a while this will cause booms in the prices of many raw materials and other resources needed in the construction of this new plant equipment. Unfortunately, once the newly created money has worked its way upon the whole system through the payments of wages and spending habits of those recieving them, as well as through the purchases of the companies that recieved the new money, the interest rate will tend to rise toward the rate that was previously present before the inflation (though its rare for it to be precisely the same rate, for reasons too detailed to get into here). Since the time preference of those in society did not shift radically enough to justify the construction of much of the newly created capital goods, they are no longer as profitable as previously thought (if profitable at all), and this then calls for a liquidation of many of the enterprises that were created during the boom, with the more non-specific capital goods being shifted toward enterprises that are closer to consumption. The economic crisis that creates the notion of the "business cycle" is essentially this process of liquidation of pursuits that were altogether unsustainable, and these pursuits would not have been pursued had there been no monetary inflation in the economic system that served to distort the economic calculations of entreprenuers. Some capital is forever squandered and workers employed in the unsustainable enterprises must find new jobs. This is the view of Hayek and Mises.

This just touches the surface of the varying opinions about what causes the business cycle (I neglected to mention the Keynesian view). To be sure, there is much more worth investigating. In a later post I'll write about Mark Skousen's book The Structure of Production and what it says about the Business Cycle and the many theories that attempt to explain it.

Confused As Ever: The Theory of Interest

Continuing along with the Mengerian theme, I just finished reading his chapter on the theory of value. I must say that it is a supurb analysis, though dense at times, but an altogether essential passage for aspiring economists. My one problem originates from his brief references to the interest phenomena and its requisite causes. Menger echoes the views of the 20th century American economist F.H. Knight as he writes "Some economists represent the payment of interest as a reimbursement for the abstinence of the owner of capital. Against this doctrice, I must point out that the abstinence of a person cannot, by itself, attain goods-character and thus value." (p.156) and later on pages 158-59 and 172-74 Menger emphasizes interest as a type of price for the services of capital.

This view seems to be at odds with what I have already found in the writings of Ludwig von Mises, among other more recent Austrian economists. Mises writes that the interest phenomena originates from intertemporal preferences, ie. people prefer present consumption to some future consumption, and in order to forgo present consumption there must be some higher consumption possibility in the future. The interest rate, according to Mises, reflects the price at which it takes the marginal person to forgo present consumption in favor of consumption in some far-off future period. And off of this formulation of the interest concept Mises concocted the famous Austrian theory of the trade cycle. So if Mises' theory is the less acceptable version, then this could have far reaching effects on my views of a whole host of very important concepts (Hayek's work on the trade cycle, the idea that capital is heterogenous and not, as F.H. Knight and J.B. Clark argued, a homogeneous fund).

Perhaps this incongruity in Menger and Mises views on interest merely reflects the fact that Menger was writing a pioneering work, and like every work that blazes a newly divergent intellectual trail, there is likely to be some errors or misconceptions, which then need to be reformulated and expounded upon by future scholars. Regardless, what this discovery means for me is that I now must investigate F.H. Knight's conception of capital theory and all its attendent implications for the interest phenomena and the structure of production in a capitalistic economy. I hear Milton Friedman's conception of capital ran along the same lines as Knight, so it's not a completely bogus viewpoint.