In the previous post, A Fundamental Exposition of Interest Rates, we described where interest rates originate in the economy. Due to its locus, we inferred that loan interest rates, that is the interest rate determined in the loan markets, is not the original place where interest is birthed. Yet, machinations in the credit market have the power to alter resource-allocation, and consequently, cause mal-investments. The process by which these mal-investments are formed are fondly remembered as booms, and the painful forgettable process by which they are unwound and reversed, are called busts.

Despite the clear linkages of credit-creation in causing economic cycles, the under-emphasis of this in economic literature and more particularly in mainstream discussion is not by mistake. Except for central bank intervention in credit markets, every other explanation is given credence and mostly accepted by people.

For most economists and commentators there is but only one interest rate which is the loan market interest rate. Interest is the price paid for obtaining a quantity of money. Therefore, interest is merely an institutional (man-made) hurdle, that with a little more 'empathy' towards economic needs, should be reduced substantially.

Lower interest rates are better than higher interest rates.

Accordingly, the causes for business cycles, recessions or depressions lie elsewhere than in the level of credit-money created and attendant interest rates. Such economists don't contend that the general tendency of prices to rise in the absence of a drop in production and supply of commodities happen only if the supply of money has been increased. The previous post, Understanding Inflation in Greater Detail, explains the side-effects of inflationary policy.

The facts in opposition to the above non-monetary causes of cyclical fluctuations don't deter advocacy of continued manipulation of credit-markets. If prices drop and wage rates correct, it implies that there is an onset of a recession, therefore counter-cyclical measures are necessary to offset this phenomenon. Apart from the manipulation of credit-markets, some forms of fiscal intervention in the markets also follow - such as subsidizing producers, declaring minimum wages, raising minimum purchase prices, increasing consumption taxes on the consumer etc.

When political belief systems seek to get in the milieu, there is an easy path to the obfuscation of facts and causes of cyclical fluctuations. The perma-sceptics view recessionary cycles as conditional collateral of free-market capitalism. If means of production are privately owned, the dis-coordination results in up and down movements. Government control of money must not be replaced, but must be extended to all factors of production. This is the tragic solution proposed by some thinkers.

State-economists have gone to mind-numbing lengths to explain causes of cycles. Arthur C Pigou (of the famed Pigouvian tax) and William Stanley Jevons floated the sunspot and corn-hog theory. These theories pinned extraneous causes, such as the spots on the sun, to economic recessions. However, subsequent studies debunked these. If rhythmic weather patterns were so clearly visible to the 'philosopher' economist, why don't farmer-entrepreneurs adjust activities and change plans suitably?

There are plenty of other arguments from the socialist camp. They allege that free markets are 'anarchistic' and their directionless behavior is the root cause for flareups. The crux of the argument is that the entrepreneur fails to get a top-down view of the economy - which is the favorite view for planners - resulting in over-investment in pockets of the production structure. It is a claim of disproportional supply, created by misinterpreting demand signals.

But, these explanations fail to account for all the dimensions of the free market. While it is true that some businessmen miscalculate, and commit investments above future demand, one cannot make a sweeping generalization of the same. Not all businessmen are random speculators, myopic, and mechanistic in their demand projections. Nor do they lack the eagerness to avoid pitfalls. Certainly, few make mistakes that result in financial losses. When an entrepreneur fails, the message is read by a few others, who adjust their plans, if there is a lesson worth learning.

If the failed businessman expanded too soon in a sector, the space he vacates is picked up by another, who may produce the same or different variety of goods. The market is a continuous space for new entrepreneurs to enter and for bad ones to be weeded out.

The socialist explanation, which is one of mass delusion on the part of entrepreneurs, is therefore unacceptable. Those economists who theorize about entrepreneur errors, that is, those  smart enough to identify other's errors, wish they were given dictatorial powers to redirect businessmen to more profitable ventures. Yet, we know by now, with sufficient worldly experience, how the socialist planned economies have fared.

One funny anecdote lays the pitfalls of centralized planning. Once, in a centrally planned country, there was a dearth of appropriately sized screws for hanging chandeliers, because to meet production targets by shortcut, producers produced many giant-sized screws which no one demanded but added to the total production targets set by the planning board. This left many chandeliers unable a find a perch on the ceilings!

Despite this rather 'envious' track record, State-economists continue to attribute business cycles to the lack of broad thinking that the planners supposedly have. The only way to escape recessions is to assume platonic powers, create a Utopian state of planning and allow a recession-proof economy to function in the hands of bureaucrats. The futility of such an argument is obvious just by reading their claims.

Durability argument

One such argument is based on the nature of the durability of goods. Once a durable item is purchased by vast majorities of the population, the long useful life of the product essentially renders the producer without any function in the intervening period. He has to wait until the product's life expires and then he has to re-engage in production. If his factory assets are 'specific', that is it can be employed to produce only one type of commodity, then for the entire duration of the product's life span, the factory needs to be run idle and maintained; lest it will gather dust and begin rusting.

The only saving grace being the recurring maintenance required for such end products. The producer will have to offset his factory maintenance with the earnings from product maintenance revenues. The revival in his fortunes is predicated on the complete wearing out of those products in the hands of the consumer; examples of such products include cars, refrigerators, television, mobile phones etc.

All this are simplistic, fallacious arguments and typically made by a novice economic thinker. An entrepreneur who invests his money in a venture in a durable good industry can be credited with a slightly better level of thought and action. He knows that his products have a certain life span and he understands there are other entrepreneurs who are looking to attain market-share in the same product line. He adjusts his production plan and sizes up his factory layout to meet a certain, sustainable level of consumer demand. He would be foolish to think he can expand so large, and yet be successful in selling the entire output to meet demands eternally. We will see why thinking is impractical and foolish.

A vegetable vendor, who put in a certain amount of capital, at the beginning of each day, knows the daily requirements of the housewife customers that he meets. It would be illogical for one to think in the following manner: since everyone eats vegetables every day, he should strive to meet the needs of all consumer eternally by buying and selling all available vegetables on earth.

Similarly, a baker bakes bread in required numbers that would clear the shelves by the end of the week. A coffin-maker wouldn't make coffins the size of the population on the indisputable claim that all people will anyway die sooner or later. He would make only so much that he thinks is necessary for supplying for about a month.

Therefore the vegetable vendor adjusts his cart size accordingly, the baker his oven capacity and the coffin maker, the number of wood cutting machines; all adjusted for production capacity as the entrepreneur in each case can reliably estimate. It's a fallacious argument to describe trade cycles in terms of product life since production linkages evolve over  time adjusting to incremental sales.

Again, this doesn't make mistakes don't happen. There may be some entrepreneurs who ambitiously build new industries only to abandon them when demand would vaporize. But nothing in this theory explains secular rise and fall in economic performance. The familiar boom-bust cannot just be explained by product life cycle theory or entrepreneur mistakes.

Acceleration theory

Another infamous theory is the acceleration theory. As an analogy, the oscillation generated at the end of a bullwhip is greater than at the generator's end where the acceleration is provided. This is also called the bullwhip phenomenon.

In consumer-facing durable businesses, as retailers see increasing demand it places back-orders with the original equipment manufacturers. Those manufacturers in turn place back-orders for material and equipment. As one walks through the production structure, the 'tunnel' becomes narrower in terms of capacity. Higher-order capital goods such as those that aluminium, steel etc are usually capacity-constrained. But, according to the acceleration hypothesis, even the capacity-constrained higher-order production businesses elastically expand in proportion to rising end-consumer demand.

This creates the following phenomenon.

A fall in consumer demand, for instance by 10%, results in a 50% drop in capacity utilization of an intermediary staged capital goods manufacturer, and a 100% drop in a more remote, early-stage capital goods producer.

This is not a tenable argument.

The proposition of acceleration theory seriously jeopardizes the important role that entrepreneurs play in an economy. The theory paints the businessman as a mechanical engineer who simply draws up the requirement for production - purely from a techno-engineering perspective - with no cognizance of the real market place.

An entrepreneur understands, speculates on future demand, and also has strong individualistic opinions about the happenings in the industry, competitors and consumer behavior. It is not true that his actions are merely impulsive, and that quantitative requirement of production schedules are all that drives his behavior. There is more to his behavior than can be squarely pegged using mechanical formulations.

An early-stage higher-order producer would not merely double his capacity because of increasing purchase orders placed by the next stage producer. A prudent producer would raise prices first, produce under waiting period conditions and wait-out to see evolving competitor and consumer behavior. While this is the normal entrepreneurial instinct, there might be exceptions.

Some entrepreneurs might get ahead of themselves by risking capital in positions where the maximum effect of the bullwhip would be predictably felt. Such gullible behavior can be squarely placed on the entrepreneurs themselves. This, however, doesn't mean it is the prime feature of free markets and capitalism. Free markets, in fact, help weed out these entrepreneurs who won't be rewarded with capital in future.

Both, the acceleration theory and over-investment hypothesis, don't adequately explain business cycles. The general upswing in prices, wages, investment activities, followed by a corrective period of falling prices, investments and wage rates can only be caused by distorting money-supply through credit markets.

As we had described in a previous post, A Fundamental Exposition of Interest Rates, entrepreneurs do get misled by interest cost calculations arising out of cheap credit. He expands operations and enters higher-order capital industries where necessary complementary factors of production are not fully built. When his products eventually reach the markets, he finds that there is a lack of demand as well.

The lower interest rates exhibited by credit markets did not arise out of postponement of consumption. Ultimately, consumer valuation is expressed in originary interest rates; which is the ratio of immediate want-satisfaction over distant want-satisfaction. A high originary interest rate (high time-preference) means low savings. It infers that higher-order production can be undertaken only at high costs which may not be profitable. The high originary interest rate in the commodity market is masked by the low interest rates in credit market as a result of the excessive money supply.

The unmasking takes place when projects become marketable products. The entrepreneur finds his cost of production has been high. And, consumer demand is lower than he had estimated. Consumer demand is low because there was no matching saving by the consumer. He had already signalled high time-preference (high originary rates) which the entrepreneur failed to heed. These are the real phenomenon and causes of business trade cycles.

Credit expansion only facilitates acceleration and over-investment by misleading entrepreneurial cost calculations. In the absence of distorting money-supplies, these mal-investments would not take place. As the businessman expands into higher-order production, he bids resources away from late stages, bidding up prices for the limited factors of production in existence.

It's a pertinent point to note that there was no expansion of the factors of production just before the creation of new credit-money; which means more money chases the same set of investment goods.

The bidding up causes project cost overruns. This requires more credit, thereby creating a vicious cycle of credit-high prices-more credit. When entrepreneurs realize that the cost of factors of production are now out of line with product prices that consumers would be willing to pay, the unwinding begins.

The unwinding of credit is merely a correction of previous excesses. With the onset of a recession, however, the same economists and commentators now blame low money supply. Rather, the blame should lie in the first place on credit-money injection in magnitudes which were several times the actual and autonomous needs of the economy.

By attributing economic cycles to changing demand, the discussion of actual causes of cycles has been evaded. Demand, as a terminology by itself gives no real insight. Excessive credit creation is the primary cause of boom-bust phenomenon resulting in mal-investment in several branches of the production structure.

Subsequent pullback in credit creation only helps reveal these mal-investments. A long period of liquidation begins with this new level of money supply. To alleviate the pain of correction, if momentary accelerations in the supply of money are caused, then the unwinding just takes much longer.