The Essence of the Business Cycle: False Premises

What is the essence of the business cycle? Is it a peculiar aspect of our specific age? Or is it deeply intertwined with human nature?

 

Here, I present the idea that holds the business cycle as a product of widely held false premises. If this idea is correct, then the business cycle (as we know it) isn’t destined to continue forever; rather it is bound to continue only insofar as we hold specific false premises.

 

What is the Business Cycle?

 

There may be specific quibbles about the structure of the current business cycle, but I think that most people would agree that it involves the following stages:

 

  1. A pick-up in business conditions from depressed levels.
  2. Exuberance in business conditions.
  3. Crisis.

 

In his excellent essay, ‘Toward a General Theory of Error Cycles‘, Jörg Guido Hülsmann describes the business cycle as follows:

 

Any business cycle theory is essentially a theory of error. Its aim is to explain the recurrence of the phenomenon that we call crisis; that is, a situation in which the simultaneous economic failure of many people becomes obvious. Thus, business cycle theory not only has to explain the occurrence of error but the recurrence of a cluster of errors as well… When [the errors] gain widespread attention, the business cycle has reached the crisis phase. The supposedly least profitable projects are now abandoned and production continues on a more solid base. However, the source that brought about the systematic error is still operating.

 

Thinking Analogously: The Furnace-worker who didn’t know that fire burns

 

To eludicate the rudimentary structure of the business cycle, consider the furnace-worker that didn’t know that fire burns. Insofar as he didn’t make that crucial connection, can you imagine the disastrous consequences? In all likelihood, the following events would recur:

 

  1. He would go to work for a while
  2. He would get burned and be rushed to hospital
  3. He would recover and get better

 

The key point to note is that this ‘burn-cycle’ would not have to continue forever; rather, it would only have to continue insofar as the furnace-worker held his false premises.

 

Likewise, I contend that we can escape the vicious onslaught of the business cycle; we could be free of it as soon as we connect the dots.

 

What is/are the false premise(s)?

 

Well, if we think about the structure of the business cycle, we should note that variations in money profits determine the ‘health’ of business conditions. My favourite analogy comes to mind: money is to profit-seekers as the sea is to fish. Just as poisoned sea-water would kill all the fish in the sea, corrupted money corrupts the structure of money profits in the economy.

 

We should note that an increasing money supply is typically favorable for business conditions, whereas a decreasing money supply is typically unfavorable for business conditions. This can readily be understood by observing that virtually all businessmen engage in the rudimentary practice of buying stuff (with money), and later selling stuff (for money). If the money supply is increasing in the meanwhile, then businessmen end up owning assets while money is becoming progressively more abundant. Thus, money prices tend to rise in the intervening period. Conversely, if the money supply is shrinking in the meanwhile, then businessmen end up owning assets while money is becoming progressively more scarce. Thus, money prices tend to fall in the intervening period. In the former case (increasing money supply), businesses – almost by default – trade well. Indeed, the ‘harder’ the asset and the longer the intervening period, the better. So businessmen tend to get sucked into long-term, hard-asset industries. In the latter case (declining money supply), businesses – almost by default – trade poorly. Indeed, the ‘harder’ the asset and the longer the intervening period, the worse. So businessmen in long-term, hard-asset industries tend to get hit the hardest during the crisis phase.

 

So, are there any institutional frameworks that violate truthful propositions to enable extended money supply growth and contraction?

 

The Current Monetary System: Fiat Currencies & (Government-backed) Fractional-Reserve Banks

 

As far as I understand, the current monetary system is the perfect candidate: the self-evident truth that each individual owns himself/herself and his/her property is perpetually violated to enable a centrally-planned monetary system. The great economists of the past 300 years (Keynes, Fisher, …) have understood the problems of the business-cycle clearly, but have – ironically – expressed value-judgements to set up institutions that exacerbate it. The current monetary system is basically designed to thwart the ways of the market. Economists have feared the consequences of bank failures, and have set up a system that allows ‘flexibility’ in banks’ assets and liabilities. These days, banks are constantly saved from bankruptcy via decreasing (debauching) their liabilities relative to their assets. Thus, the money supply can continue to grow for a long period of time. Unfortunately, with this, the depth and profundity of the business cycle increases. What might have been virtually undetectable, now affects all.

 

See here for our collection of rare historical economic data.

Posted Mar 28, 2011