Why There's A Boom-Bust Cycle

A week ago, I challenged newly empowered Republicans to learn economics. Educating ourselves on this oft-ignored subject is necessary if we want to prove our worth to voters. So let's talk about the most enigmatic economic phenomenon there is: the business cycle.

Sun flares, harvests, and vague "animal spirits" have all been proposed by respected economists as possible causes for the "boom-bust" cycle--that mysterious wave of countless entrepreneurs who all make similar mistakes at the same time, followed by the equally mysterious wave of business failures brought about by the nearly simultaneous exposing of these errors.

Business errors are normal. Everyone makes mistakes. But why isn't there just a more-or-less steady flow of entrepreneurial mistakes? Why do we constantly see tons of businesses making the same errors at the same time, and why do businesses realize their errors at the same time? Where do bubbles come from, and how do they get so big?

Since this is a problem that affects the entire economy, we ought to turn our focus on the institution that can affect the entire economy in one fell blow: the Federal Reserve. The Federal Reserve (the "Fed") is a central bank that can create money and manipulate interest rates. What happens when the Federal Reserve injects money into the economy?

Well, the first obvious point is that prices go up. But all prices don't rise to the same extent when new money is printed. Prices first rise to the greatest extent in the area of the economy that first receives the new money. If the Fed gives new money to Person A, then Person A goes to the store and spends the money on certain goods, causing the prices of those goods to go up, while the prices of other goods still remain the same. Other prices may rise as the new money disperses itself throughout the economy, but the effects of new money are felt most strongly in the areas that the new money first touches.

What happens when the Fed injects newly printed money into the loan market, where entrepreneurs go to get loans with which to build factories and machinery and buildings and such? Well, the price of loans (i.e. the "interest rate" on loans) is going to go down, because there is more money available to loan out. The same thing happens when there are more apples to sell: the price of apples goes down.

Since it becomes easier to get loans, businessmen tend to take out more loans to use on projects they wouldn't have been able to afford before. However, businesses don't just build for the sake of building stuff. They build things to satisfy consumers' demands. Has consumer demand changed? No. Businessmen aren't building more things because consumers are demanding more things, but merely because the Fed has made business loans artificially easy to get.

Normally, when consumers are ready for bigger projects that take more time to complete, they save more money. Because there's more saved money available to be loaned out, the price of loans (the "interest rate" on loans) falls. In this case, consumers have legitimately provided entrepreneurs with the resources to build bigger things that take more time to produce. But in the case of the Fed, because consumer saving has not provided entrepreneurs with an increase in actual resources with which to build things, entrepreneurs must eventually hit a wall, where they realize that there's not enough resources with which to finish their projects. They realize that consumers were not ready for these projects in the first place.

This is like a house builder who uses too many bricks on the foundation, and runs out of bricks when he's building the upper part of the house. This can be seen, literally, in buildings like the Dubai Tower or the abandoned home construction projects in America.

Entrepreneurs hit this wall when the flow of free dollars from the Fed slows down, usually due to fear of price inflation. When this point is reached, the Fed must either stop printing money, causing these malinvestments to crash... or they can try to print more money to keep the bubble expanding, but they do so with the ever-increasing risk of hyperinflation--runaway price rises that eventually cause people to abandon the currency and revert to a barter economy until a new currency can be established.

Republicans must understand how the boom-bust cycle works, and why inflation is not the answer to our problems. The bust is not the problem. The bust is the correction of the problem. The boom is the problem. To avoid artificial booms (i.e. "bubbles"), we must limit the ability of the Fed to inject money into the economy as much as possible (and, of course, the most complete limitation of the Fed's ability would be to abolish the Fed entirely).

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Published at RightOSphere.