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Good Business to Start in a Recession

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Good Business to Start in a Recession Powered By Docstoc
					Business Cycles
for Introduction to Austrian Economics


By Paul F. Cwik, Ph. D.
Mount Olive College &
The Foundation for Economic
Education
Questions a Good Business Cycle
Theory Needs to Answer:
1.   Why do a “cluster of errors” appear in an
     economic crisis?

2.   Why are there greater swings found in the
     earlier production stages and not in the
     production stages that are close to
     consumers?
Business Cycle Theories:
1.    Non-monetary Theories
     1. Keynesians
     2. Real Business Cycle Theorists

2.    Monetary Theories
     1. Austrians
     2. Monetarists
     3. New Classicals
Sources that refute Non-Monetary
Theories:
 Monetary Theory and the Trade Cycle by
  Friedrich A. Hayek, [1929 (1933 English)]
 The Failure of the “New Economics,” by
  Henry Hazlitt [1959]
 America’s Great Depression, by Murray
  Rothbard [1963]
Austrian Business “Cycle” Theory?

 Some say that the Austrian Theory of the
  Business Cycle is a bit of a misnomer.
 Why?
 The theory has primarily focused on the causes
  of the downturn through the upper-turning
  point.
 Nevertheless, it is a theory of the whole
  business cycle.
Before we can show how an
economy fails, we need to see it
functioning properly.
“Magic” Formula for Growth:
Savings   Investment   Capital Accumulation

    Higher Productivity More Stuff

          Higher Living Standards
Original Factors of Production:
1.   Labor

2.   Natural Resources

3.   Time
Categories of Capital:
1.   Capital Equipment

2.   Intermediate Capital (Goods-in-Process)

3.   Financial Capital
Structure of Production
                                                                          Value


 Resources and                                                             Output / Consumer
 Labor                                                                     Goods

                    Raw Materials

                                    Manufacturing


                                                    Wholesale
                                                                         Markets




                                                                Retail
             Time
Structure of Production
                      Value

                      Output /
                      Consumer
                      Goods

                     Markets


       Time
Production Possibilities Frontier Curve

      Consumer
      Goods           A
                  5       B
                              C
                 10
                 15               D

                 25
                                      E


                 50
                                          F


                                              Investment
                                              Goods
Production Possibilities Frontier Curve

     Consumer
     Goods

                              A2
                C2
                C1
                     A1




                      I1 I2
                                   Investment Goods
Market for Investible Funds
    Interest
    Rate
                             S


               im



                                 D


                    Qm   Quantity of Investible Funds
Putting the Model Together:
                            Consumer
                            Goods
                            C0   C0




  Time                                    I0      Investment Goods
                            Interest
                            Rates                S = Savers
    This model comes              i0
    from the work of
    Roger Garrison (2001)                             D = Borrowers


                                       S0 = I0      Investible Funds
Let us suppose that people become
more patient.
 How   does this change affect the
  model?
 What happens to consumption and
  savings decisions?
 How do investors and entrepreneurs
  react?
                  Consumer
                  Goods

                  C0     C0
                  C1     C1




Time                          I0    I1   Investment
                                         Goods
                   Interest        S = Savers
                   Rates                  S’
  Suppose that
                         i0
  people become          i1
  more patient.                           D = Borrowers


                              S0   S1    Investible
                              =    =     Funds
                              I0   I1
Now, let us suppose that government
places a price ceiling on interest
rates.
 How   does this change affect the model?
 What happens to consumption and
  savings decisions?
 How do investors and entrepreneurs
  react?
                    Consumer Goods

                       C1     C1
                       C0     C0




Time                                 I1    I0            Investment
                                                         Goods
                        Interest
                        Rates                     S = Savers
 Suppose that a                i0
 price ceiling is
                              ic
 placed on                                              D = Borrowers
 interest rates.
                                     S1 S0 = I0   I1   Investible
                                                       Funds
                Amount actually            Credit      Amount businesses
                available                 Shortage     want
Phases of the Business Cycle:
       Artificial Credit Expansion
       “Artificial Boom”
       Crunch
         Credit Crunch
         Real Resource Crunch
       Recession
       Recovery
The Unsustainable
Malinvestment Boom
 Suppose that the interest rate is 5% and the
  firm is considering a project that will yield 4%.
 Will it engage in the project?
 Suppose the Central Bank lowers the interest
  rate from 5% to 3%.
 What will the firm do now?
Malinvestment Boom continues
 During the course of the artificial boom,
  malinvestments are built up.
 Consumers reduce savings with lower interest
  rates.
 So we have an increase in consumption and an
  increase in investment.
 Ivan and the Brickyard.
The Initial Boom Phase of the Business Cycle
                      Consumer Goods
                       C1    C1
                                                       Unsustainable
       Dueling         C0    C0
                                                       Boom
       Structure of
       Production


    Time                                   I0     I1       Investment Goods
                         Interest
                         Rates
                                                        S = Savers
                              i0                           S + New Money
                              i1
                                                          D = Borrowers

                                         S0= I0          Investible Funds
                                    S1            I1
The Fed has a Choice:
   As the firms compete for resources, input prices are driven up
    making them look for more funding.
   Short-term interest rates rise from the firms’ actions.
   The central bank has a decision to make:
     either halt the expansion or
     expand the money supply at a faster rate.
   The central bank may choose to halt the expansion and
    increase interest rates out of a fear of rising price levels. The
    effect of this policy is a credit crunch.
   If, instead, the central bank continues along an expansionist
    policy, input prices rise and reflect the real resource crunch.
The Crunch:
   When the crisis hits, there are two problems facing
    the entrepreneur:
     increasing interest rates   and
     rising input   costs.
   With an increase in interest rates, there is an impact
    on both working capital and fixed capital.
   The longer lived the capital equipment, the greater the
    impact on its value.
   Interest rates will rise, but short-term rates will
    increase more than long-term rates.
                                            Yield Curve Spreads Between 1953-2009

5.00
4.00
3.00
2.00
                                                                                    Recession
1.00
0.00                                                                                Spread 10 year - 1 year
        1953-04
        1955-04
        1957-04
        1959-04
        1961-04
        1963-04
        1965-04
        1967-04
        1969-04
        1971-04
        1973-04
        1975-04
        1977-04
        1979-04
        1981-04
        1983-04
        1985-04
        1987-04
        1989-04
        1991-04
        1993-04
        1995-04
        1997-04
        1999-04
        2001-04
        2003-04
        2005-04
        2007-04
        2009-04
-1.00                                                                               Spread 10 year - 3 month
-2.00                                                                               Spread 20 year - 3 month
-3.00
-4.00
-5.00   Re c e ssions a re da t e d a c c ording t o t he NBER.
        The da t a for int e re st ra t e s we re obt a ine d from FRED
        II.
The Liquidation Phase:
   Only through the process of converting the
    malinvestments into productive capital can the
    foundation for growth be achieved.

   Only the Austrian School argues that
    Liquidation is a necessary condition for
    recovery.
The Liquidation Phase: Continued
   The firms that invested during the artificial boom suffer the
    economic losses.
   They sell their capital equipment at a discounted rate to other
    firms.
   These other firms can turn an economic profit even at the
    previous prices because these firms have purchased the capital
    equipment at a discount.
   This liquidation process is how the malinvestments are
    converted into new fixed capital equipment.
   This process is necessary for normal economic growth to
    occur.
The Recession Illustrated:
            Consumer Goods
             C1      C1
             C0      C0
              C2     C2



  Time                       I2   I0   I1         Investment Goods
               Interest
               Rates                        S’
                                              S
              i2 =   i0                            S + New Money
                     i1
                                                   D
                                              D’

                            S1 S0= I0         Investible Funds
                          S2= I2      I1
So what happened in 2008?
   Each Business Cycle is unique.
   2001 dot.com bust led to another bubble.
   Money flows into Real-Estate.
   Community Reinvestment Act encouraged banks to take on more risk.
   Fannie Mae and Freddie Mac rules changed and encouraged them to buy
    mortgage-backed securities. (GSE’s only needed 3% held in reserve.)
   Sub-Prime Market Emerges—In 2006, 20% of all mortgages were sub-
    prime. 81% of those were securitized.
   Toxic Assets and Troubled Asset Relief Program (TARP): Of the $700b,
    $350b bought equity (preferred stock), not assets.
   The Fed led a massive increase in the money supply by buying anything
    and everything it wanted.
   FASB 157: New Mark-to-Market accounting rules are go into effect June
    15th, 2009.
   Stimulus Package, Bail-Outs and a huge Federal Budget adds to the fire.
Recovery:
 Recovery is through the same process of
  normal growth.
 In other words, the “Magic Formula”


Savings Investment Capital Accumulation
     Higher Productivity More Stuff
          Higher Living Standards
Implications:
1.   Keynesian Policy cannot pull an economy
     out of a recession.
2.   Expansionist Monetary Policy cannot pull an
     economy out of a recession.
3.   Downturns are created by increasing input
     prices, not just increasing interest rates.
4.   Fixed capital equipment has to be sold-off.
5.   Increasing savings is needed for the
     transformation to occur.
Keynesian Policy cannot pull an
economy out of a recession
   Keynesian policies are designed to keep aggregate demand
    high.
   Any increase in aggregate demand will put pressure on input
    prices to also rise.
   The problem illustrated above is that after the crunch phase,
    the return on capital has fallen considerably.
   In order to maintain profitability by increasing output prices,
    the output prices have to either keep pace with or outstrip
    the increases in the input prices.
   The output levels cannot be maintained due to the real
    resource crunch that is pressuring input price increases.
Expansionist Monetary Policy cannot
pull an economy out of a recession
   Expansionist monetary prescriptions for curing a
    recession are to stimulate investments by keeping
    interest rates relatively low and stabilizing the growth
    of the money supply.
   Such prescriptions also cannot pull an economy out
    of a recession, since it ignores the malinvested capital
    that is locked into unproductive arrangements.
   The case study of the failure of employing both
    Keynesian and Monetarist prescriptions is Japan since
    1990.
Implications:
   Fixed capital equipment has to be sold-off at reduced prices
    in order to transform the malinvestments does not seem to
    explain the duration of the recession phase.
   Capital’s specificity is a stumbling point that tends to reduce
    the smooth transition of the fixed capital into productive
    structures.
   Capital is not an amorphous mass, a homogeneous blob of
    “K.”
   Capital goods have differing degrees of specificity,
    complementarity and substitutability. It is not simply a
    question of lowering the price and then plugging the
    machine into another production process.
   Typically, projects need to be integrated into other existing
    firms. Austrians have long argued that merely investing
    capital does not lead to economic growth, but correctly
    arranged capital structures guided by the market process are
    the mechanism for growth.
   Rearranging prices is simply not enough to pull an economy
    out of a recession. Some of the more specific capital may have
    to be thrown away—scrapped—if no other firm could make a
    profit from it.
   A liberalization of merger and acquisition laws could improve
    the situation.
   Furthermore, the elimination of other obstacles found in
    bankruptcy laws could help expedite the transfer of
    malinvestments into productive ventures.
Increasing savings is needed for
the transformation to occur
   In order for the second firm to purchase the capital equipment from
    the first firm, the purchaser will need funds.
   Newly created credit will only start the boom/bust cycle again.
    Only real savings can allow the transformation process to occur.
   A government interested in helping an economy out of a recession
    has to then do the following:
        first, not interfere with the price adjustment process;
        second, not reinflate the money supply;
        finally, try to increase the amount of savings in the country. It could do
         this through liberalizing its laws to allow for increased savings to flow
         in from abroad and it could also cut taxes on domestic savers.
   By increasing the amount of savings, the amount of malinvestments
    that could be transformed into profitable investment increases.
    Increasing the amount of savings available for investment quickly
    can shorten the duration of a recession.
Conclusions:
   The most significant point is that the Austrians were correct to
    spend so much energy explaining the cause of the business
    cycle.
   It is only an understanding of the cause that allows us to
    determine the best policies to follow to generate an economic
    recovery.
   If the government follows policies that are contrary to the
    Austrian prescription, the situation will not only fail to
    improve, it will worsen.
   The lesson is that as long as output prices stay up (through
    Keynesian policies) or if the Monetarists keep interest rates
    from rising (or maybe push them lower), or if input prices are
    rising (a real resource crunch), we will have a recession.
   The only way out is through the painful but necessary
    liquidation process.
Conclusions:
   The best means to transform malinvestments into viable
    economic activities is through increasing savings.
   This means that one of the government’s most effective
    policies is to cut taxes on the savers. Those who are savers are
    usually labeled as “the rich.” Unfortunately, the prescriptions
    of “get government out of the market” or a “tax cut for the
    rich” tend not to be politically popular. Nevertheless, it is the
    duty of the economist to present the truth.
   The economist cannot state that the government should do
    nothing. Such a strategy was tested in the 1930s. The modern
    economist needs to present the case that the government
    caused the recession and only by removing the government
    from the equation can the economy truly recover.
Business Cycles

By Paul F. Cwik, Ph. D.
PCwik@moc.edu

				
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