The Concise Guide To Economics
by Jim Cox
24. The Business Cycle
The business cycle is the recurring prosperity and depression seen over economic history. Before the modern age of advanced industrialism the prosperity could be accounted for by events such as good weather yielding bountiful crops or the spoils of war from a military victory. Likewise, depression could be accounted for by harsh weather resulting in poor crops or from a military defeat. In each case the causes were fairly evident.
The modern business cycle, however, needs a more sophisticated explanation as it is a more complex phenomenon. Marxists believed that business cycles were the inevitable collapsing of capitalism, but this theory can be discarded since capitalism has not collapsed though socialism has. Keynesians account for the business cycle by an appropriate level of spending (prosperity) or underspending (depression) but have been baffled by the simultaneous occurrence of both inflation and depression--a condition their theory treats as being as likely as a square circle.
The Friedmanite monetarists appropriately look to the money supply as the causal factor in the business cycle though they fail to realize the ill effects of their favored policy of a slow but steady increase in that money supply. (Friedmanites also fail to consider the ethical aspects of such artificial increases in the money supply which create involuntary transfers of wealth.)
The correct Austrian theory of the business cycle also focuses on the money supply as the causal factor, but does recognize the intervention in the economy that an artificial increase in money and credit in fact is. Basically, the Austrian theory recognizes that there is some voluntarily chosen ratio of consumption to saving by the total of individuals comprising the economy.
When an artificial increase in the money supply through the banks occurs, this increases the available money in savings and depresses the interest rate, thereby encouraging an artificial increase in spending which is highly sensitive to the interest rate--capital spending. This run-up in the capital goods industry is the boom, and the subsequent depression results when consumers reestablish their consumption to saving ratio--thus revealing that the capital goods boom was indeed artificial. The only way to prevent the depression is to pump another dose of new money into the system to maintain the higher savings ratio, but eventually this must end or there will be a runaway inflation.
The artificial increase in the money supply therefore is a government subsidy--through monetary policy--to the capital goods industry. Naturally the subsidy stimulates production in the capital goods industry. Once that subsidy is removed by consumers reestablishing their preferred saving ratio, there is a crash in the capital goods industry.
The Austrians, in contrast to all other schools of thought, do not regard the depression as bad news, for it is the necessary correction to put production back in line with consumers' preferences. This view regards the preceding inflation as the ill setting the stage for the needed correction. Two analogies follow to clarify this theory:
Everyone understands that a drug addict will need higher and higher doses of his drug to get the same kick. This is comparable to the growth in the money supply causing a capital goods industry boom. The addict has the choice of increasing his doses of his drug until it kills him or of going cold turkey and suffering the withdrawal pains. The withdrawal pains are similar to the economy's depression adjustment.
Second analogy: If a person ingests poison into his system he will need to rid himself of that poison, say through vomiting. It's obvious that the unpleasant vomiting is the necessary cure for the evil of the poison ingestion. In this analogy the poison is the inflation and the vomiting the depression.
From the Austrian perspective the cure for the business cycle is a laissez-faire policy for the money supply, letting the money supply be determined by the free choice of individuals in the market. The alternative to this Austrian policy is government involvement in money and banking which inevitably results in special interest pressure to increase the money supply to the benefit of those first receiving the new money--the banking system itself.