Tuesday, October 6, 2015

The Business Cycle and the Current State of the Economy

I continue to see many commenters here at EPJ, and at other web sites, that discuss the economy in a manner that doesn't fit the facts and certainly doesn't fit Austrian school business cycle theory.

Let me begin with a very short explanation of what the Austrian business cycle states:

Austrian business school states that when a central bank increases the money supply, it does not increase the money supply to all economic actors at the same time. The sectors of the economy that experience receipt of the newly created money first will experience a boom period. If the central bank, stop supplying money to the boom sector, this sector will experience a bust. During the bust period there will be increasing unemployment as the boom sector no longer can support the previous amount of employment funded by central bank money supply expansion, and the workers must find jobs outside the bust area.

That is it, in a very simplified fashion. There is nothing more to the theory. There is nothing about prolonged unemployment. There is nothing about a central bank "running out of bullets." Unless an economy has entered the crack-up phase where the currency is completely destroyed, a central bank can always supply more funds to the "boom sector." Beginning and end of story.

To be sure, there are many reasons an economy can see a decline in employment, but outside of the transition period during a bust phase (which in itself should probably clear in less than 6 months) the unemployment will have nothing to do with central bank money manipulations.

An increase in those not employed can occur because of an increase in minimum wage laws, payment of "unemployment insurance" to those out of work, highly government-subsidized financing for college attendance versus work, those retiring, etc.

But here are some of the things I am seeing in the comments at EPJ:
RW, based on your own statistics cited in numerous articles, is it beginning to look like maybe Krugman and the Keynesians are right after all? Employment is growing, tax receipts are growing, the stock market isn't tanking, etc. And while it may crash in a heap one day, it doesn't look like it will be anytime soon. It could keep going on for many decades.
No, what I am discussing is not Keynesian theory nor that of Krugman (Remember, Krugman wrote a book End This Depression Now!, when I argued we were already out of the Great Recession.). The current situation is pure Austrian theory as far as the stats are concerned. It is exactly what you would expect when the Fed is pumping money as aggressively as they generally are now.

As for the length of time the boom period can go on, Austrian theory does not address a length other than to say, it will end when the Fed stops printing money (or is less aggressive in its money printing) for whatever reason, or the crack-up is reached.

Another commenter writes:
 Employment in the prime-age population is way down, tax receipts really don't matter (they looked great during the Tech Bubble too), and the stock market is only about 5-6 years into expansion (and it shows serious signs of cracking right now). The idea that this expansion will last decades is laughable (and more or less unprecedented). The fed was too nervous even to raise rates by 0.25% in September, for fear of ruining the "expansion".
If you don't take your eyes off the stock market, everything is rosy.

First, employment in the prime age population is not way down:

Second, there is absolutely nothing in Austrian theory that suggests that employment  will be way down outside of the period of adjustment following the boom.  That's exactly what the chart above shows. If there is less employment far beyond the initial bust, the factors are outside of the boom-bust cycle. I have listed some of the reasons this can occur, above. Anyone hinting that the Fed "can't get the economy going," i.e., has failed to reignited the boom sectors, doesn't really understand Austrian business cycle theory and is not looking at the data..

As far as tax revenue, that has nothing to do, necessarily, with the boom-bust cycle.

If the stock market is "showing signs of cracking" (doubtful) that only means the Fed needs to pump more money into the sector, if it wants the boom to continue. That's it. To imply they can't suggests confusion about Austrian theory. Who says the expansion can't go on for decades? The Fed tends to stop printing aggressively when price inflation hits about 5% to 10%, but there is nothing in theory that says they have to. Further, there is no theoretical argument that says productivity can't climb rapidly for an extended period, keeping price inflation tame, and thus allowing a prolonged period of Fed money printing (Though in practice that has not been the case.) If the Fed continues to accelerate money printing for an extremely long period, the crack-up, i.e., hyper-inflation, will occur, but there is no set period of time by which this must occur.

The commenter than writes:"The Fed was too nervous..." Who says the Fed knows anything about business-cycle theory? As I made clear in The Fed Flunks: My Speech at the New York Federal Reserve Bank, they don't.

"If you don't take your eyes off the stock market, everything is rosy." Well, according to Austrian theory, it is the capital goods sector that is at the heart of the boom phase, and the stock market is a big part of the capital goods sector, so that is exactly where you should be looking.

Another commenter writes:
Low interest rates work temporarily, until they don't. When sufficient consumer demand doesn't materialize 5-10 years into capital investment, i.e when malinvested capital doesn't garner the return it's artificially low cost signals it will, then businesses and jobs collapse. When revenue is so low even payments on principle can't be made, 0% interest rates do not continue to stimulate..

We have total confusion here, First it is not "low interest rates." It is the amount of money being pumped into the capital goods sector. This can  still occur at "high interest rates" if the price inflation rate is high. Second, it has nothing to do with "consumer demand not materializing in 5-10 years into capital investment." The bust phase is actually the switch from a distorted capital favored structure to more of a  consumption structure, when a central bank stops printing money into the capital goods sector.  In other words, the bust phase is spending moving into the consumer sector.

It doesn't matter what the level of interest rates are on an absolute level;the Fed can still pump money into the capital goods sector. It's about the interest rate level relative to where rates would be without Fed intervention. (And we have never been at zero rate on the key Fed funds rate. Indeed, the Fund's rate has  most recently doubled, climbing from 0.07% to 0.14%) If money is going into the capital goods sector, regardless of the interest rate, it will cause prices to be bid up in the capital sector.

Another commenter:
I can't imagine Schiff being wrong about how the Fed is trapped on rate hikes, and that is much more likely to expect QE4. 
Labour participation is down, most "new" jobs are part time, temporary, and in low wage industries. Yellen has said over and over that she will raise rates when the labor market improves, but it is a disaster. 
Furthermore the economy is addicted to credit and CPI is low. Production is trending down too. Raising interest rates will lead to massive layoffs.
As I have already pointed out, Quantitative Easing is a scam term invented by Ben Bernanke. It is simply another way to print money. Indeed, it is a subset of the Fed's greater ability to  purchase assets via open market operations. The Fed can explode the money supply without ever doing another QE, Indeed, as I am reporting in the EPJ Daily Alert, the Fed is now rapidly accelerating money supply growth, This is being done without any QE. Anyone obsessed with QE is just buying into Bernanke shuck and jive.

As I have pointed out above, employment changes, including labor participation.can change for many reasons. There is simply zero reason for unemployment to be high outside of a very brief period (6 months?) when there is a shift from the boom phase to the bust phase. Any greater than normal changes in employment beyond that period suggests other factors other than Fed manipulations of the boom-bust cycle.

And, there appear to be very good explanations that show the decline in the participation rate has nothing to do with central bank money manipulations.

Another commenter writes:
By your closing statement, am I to think Ron Paul isn't an Austrian? Last Friday, in the Liberty Report, he sees the participation rate as a significant indicator of a recession ... not a boom. https://www.youtube.com/watch?v=tq6mW_5Qebk

First, I never said the falling participation rate was a part of the boom phase. It, I believe, is currently occurring outside of the boom-bust cycle. If you see the Fed accelerating money printing (which they are)  and the price of capital goods, such as stock prices and real estate. are generally climbing, then according to Austrian business cycle theory, that is a boom phase. Here is the link once again to the seemingly legitimate  explanations as to why the participation rate is falling and it has nothing to do with the boom-bust cycle.

I haven't listened to the YouTube that the commenter provides a link to, but if Dr. Paul is stating that the current drop off in the participation rate is a signal we are in a new recession, I do not believe he is accurately applying Austrian Theory. The current economic environment doesn't fit the facts of a recession in terms of what Austrian theory describes, if you look at the climbing capital goods prices and accelerating money growth. The alternative Fed explanations for the fall in the participation rate seem to be quite reasonable explanations.

One further note, during an earlier post, many accused me of making a hidden attack on Peter Schiff by not naming him. As this commenter points out by bringing up Dr. Paul, those trying to force feed the idea that the Fed can't  create a new boom period or that they are responsible for all changes in unemployment, goes beyond Peter.

And, there are others beyond Peter and Dr. Paul. Indeed, one current litmus test to see who may be improperly applying Austrian theory is to see who is blaming the Fed for the current decline in the participaton rate. In my view, they are ignoring the fundamentals of Austrian theory when they do so----and even more denying the basic principle that markets clear. Unless there are specific factors causing a decline in the participation rate, and once again there are, you are not going to see a decline in the participation rate for anything but a short period at the start of the bust phase, as workers seek out jobs in the newly structured economy. This does not take years after the bust. If the participation rate is falling years after the bust it is for reasons other than the bust, and the Fed has nothing to do with it. Markets clear.


Also see: The Business Cycle and the Current State of the Economy (Part 2)


  1. Hi Robert,
    I do get what you are saying about the U.S. being in a boom phase per ABCT. However, your faith that the FED will raise interest rates may be unwarranted. The CPI is going nowhere, in fact the last couple of months there has been a decline. Though the total unemployment figures are down, Peter is correct that they are definitely not on par with the rate of growth the market was expecting. To me, I think the U.S. is in a similar position like that of Japan. Where they are pushing on a string. Almost text book scenario of what’s happened and is still occurring there, where the Central Bank is seeing no growth in terms of GDP, low unemployment, and stock market speculation. Yes, the Central Bank is propping up the market and creating a bubble through the credit markets, but I doubt they will take the punch bowl away anytime soon. Why should they? They will destroy the one thing they have going up…the stock market.
    I only foresee the FED really raising interest rates when they REALLY need to. And that’s to either curb galloping inflation or to protect the dollar from total collapse neither of which we have. So, I do think Peter is correct in his analysis.

    1. RF, if the Fed increased the target range of the federal funds rate, it doesn't necessarily "take the punch bowl away". This rate is simply the rate at which banks loan reserves to each other overnight. If the banks decided they simply wouldn't loan to other banks at this rate, the Fed would have no choice but to raise the target range.

      The focus, as RW points out, should be on the money supply. While the Fed asset sheet has (at least for now) leveled off, money supply growth continues. This new money is flowing into the capital goods sector, keeping the bubble inflated. The growth of money supply has been fairly steady for the last four years, and quite high (though that's a relative term).

      If the Fed were to increase the target range, they could simultaneously increase money supply growth. The fed funds rate is a distraction.

    2. Ad Libertati,

      I think the FED has several tools at their disposal to decrease the money supply, IF THEY WANT TO. I think my point as well as Peter's point is that that FED although has increased the amount of money in reserves just sitting with them from the banks. Has produced almost hardly any noticeable consumer inflation. The money/fiat money has not trickled into the economy. You can print all you want but if the Demand for money has not declined by general public there will be no depreciation in the currency.

      An increase in the money supply does not = inflation 100% of the time all the time. Never has...the price of goods and services goes up when the public DEMAND for money decreases. Increasing the money supply does not mean = prices will increase 100% of the time. Robert knows that! He's read, Rothbard's book on Great Depression. In that book the money supply did not increase the CPI significantly. It just inflated the credit market and stock market. This is where ABCT gets misunderstood. My point as well as Peter Schiff's point is that although the FED has increased the money supply and inflated a bubble in the stock market. The real economy has not significantly increased output nor increased income, wages, or prices.

      If there hasn't been any significant increase in any of those things, what makes Robert think the FED will raise interest rates? Peter is right...no real need to raise rates at the moment. The FED is pushing on a string.

    3. RF, I believe there are a few clarifications that need to be made (or perhaps I'm being a bit too pedantic with the terminology).

      1) Monetary inflation does cause price inflation every time. In a progressing economy, if the money stock was kept constant, prices have a tendency to decrease. This is due to the fact that as more goods are produced, the same amount of money is chasing a greater number of goods. If instead we held the economy static (ie same number of goods), but increased the quantity of money, we would see the reverse. Prices would increase because more money is chasing the same number of goods. In a dynamic economy during the boom phase, these two processes are working against each other (money supply increases, but so does then number of goods produced). This is the reason that the prices of CPI goods (or any other goods, for that matter) may remain the same (or even go down). But, and this is key, it is still price inflation (even if the prices go down). This is because the prices are higher than they otherwise would be, absent monetary inflation.

      2) Disregarding a bit of what I said in the point above, new money has an entry point in the economy. And, it will then find its way into new areas, as the money is spent. Those first recipients spend the money before prices increase, while those who receive the new money last (or never receive it at all) see their prices increase prior to any wage increases. The former benefit, the latter are harmed. Certain sectors (in particular luxury goods, but also rent, real estate, etc) have already had their prices increase. Just because we do not see the prices increase in whole grain oats (or whatever) doesn't mean that prices haven't increased in other areas or that wages in those areas haven't been driven up as well.

      3) A decrease in the demand for money is not necessary for price inflation. If the money stock remains constant, but the demand for money increases, the value of money increases and prices of goods decrease. If the stock of money increases, but the demand for money remains constant, the value of money will decrease (and prices will increase). If both the stock of money increases and the demand for money decreases, then prices of goods will rise. If both the stock of money decreases, and the demand for money increases, then prices fall. But, if the stock of money increases, while the demand for money increases (or the reverse), then it is not possible to determine whether prices will rise, fall, or remain the same without additional information. You can have a situation where price inflation occurs while the demand for money increases (due to it being outweighed by the increased money supply).

      I believe RW's view (in conjunction with the ABCT) is that as this new money makes it way to other parts of the economy, we will see price inflation (in nominal terms). This price inflation with force the Fed's hand, and they will then need to tighten a bit by increasing the target range. But, because they may not understand the real cause of the business cycle, they will keep increasing the money stock.

      In a way, Schiff and RW are saying similar things. Schiff's view is that the Fed has no interest in tightening while RW's saying that even if they increase the target rate (not because they want to, but because they have no choice), they can still be loose with the money supply. In this way, Schiff's view is partial, while RW's gives a complete perspective using the ABCT. A person can disagree with the timing, but that's about it.

      My own view is that the Fed is too illogical to predict. I don't bother trying.

    4. AL,
      I’m not arguing any of your points, they are all true. However, we may have strayed a bit from Robert’s assessment of the economy and what he thinks the FED will do or was supposed to do according to his prognostications back in September. Pardon me for paraphrasing, but I believe Robert’s view has been that the economy is overheating and the FED was going to raise interest rates back in September baring a Stock Market Crash. True, there was a major correction, but no crash occurred, yet the FED didn’t raise rates. Robert is still in the belief that the FED will raise rates by this year. He and all other FED watchers are wrong. There has been no major growth in the economy for the FED to raise the interest rates.
      Schiff’s argument as well as my own is that the FED’s low induced interest rates has only served to prop-up the market. These low interest rates have yielded little real economic activity. Schiff will be proven correct, in that the FED in December will not raise rates, even then. I think Robert is still holding on to the notion that they will.
      Schiff is in sharp contrast to Robert’s view. Where he Robert sees rampant growth enough to warrant Open Market Activity, Schiff sees stagnation with little to no growth, which will tie the FED’s hands. The FEDs at this point I don’t think want to slam the brakes on the economy.

  2. The late Gordon Tullock was the typecast (from several angles) critic of the ABCT from a free market perspective. A sample of his views are here: https://mises.org/library/why-austrians-are-wrong-about-depressions . This analysis led to an excellent rejoinder by Garrison: http://www.auburn.edu/~garriro/c3modmac.htm. It seems to me clear that Tullock was wrong about how if ABCT is true, shrewd businesspeople would have figured it out and that would stop the cycle. And Garrison is right that anytime we are in a boom the end is not necessarily nigh. Tullock is right that the "new monetary order" was not anticipated by Mises. These should add to Mr. Wenzel's 3rd paragraph summarizing the theory. Timing is the issue: how do you profit from the boom without getting wiped out in the bust?

  3. Market clear, but are we really dealing with markets?

    1. Hampered markets are still markets. They're just ... hampered.

    2. @Donxon

      Exactly. Agglomerations of transactions bludgeoned in various directions with compensations, escape valves, or competitors all systematically prohibited by law are not markets and don't behave like markets. With enough force backed by enough resources applied for long enough, distortions may never clear, just progressively grow worse until such time as participants give up on the system as a rigged farce and walk away.

  4. Perry Mason: I am reasonably sure that quote comes from Rothbard himself, without attribution to Keynes:

    The Russians, after trying an approach to the communist moneyless economy in their "War Communism" shortly after the Bolshevik Revolution, reacted in horror as they saw the Russian economy heading to disaster. Even Stalin never tried to revive it, and since World War II the East European countries have seen a total abandonment of this communist ideal and a rapid move toward free markets, a free price system, profit-and-loss tests, and a promotion of consumer affluence.

    It is no accident that it was precisely the economists in the Communist countries who led the rush away from communism, socialism, and central planning, and toward free markets. It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a "dismal science." But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance. Yet this sort of aggressive ignorance is inherent in the creed of anarcho-communism.

  5. " if Dr. Paul is stating that the current drop off in the participation rate is a signal we are in a new recession, I do not believe he is accurately applying Austrian Theory."

    This is a brave statement and I applaud you for it. No one can know the truth 100% of the time, and on those occasions when wise men are wrong(and in this case it could be you or Ron Paul) it's important to look at the larger body of work as none of us are infallible.

    I also appreciate the clarity you bring to the ABCT and your study of the money supply. Intuitively I think the ABCT makes sense and I focus on money supply....so I lean towards your argument- but I hold Ron Paul in high esteem, so I always listen and think about what he's saying.

    I've disagreed with both of you from time to time, but in the big picture you are both well reasoned people and that doesn't change my respect for either of you. I've also found that on occasion I'm the one wrong when I do disagree, & I find that exceedingly annoying.


  6. Thanks for the thorough response. Appreciate your teaching.

  7. "First it is not 'low interest rates.'...It doesn't matter what the level of interest rates are on an absolute level...It's about the interest rate level relative to where rates would be without Fed intervention."

    Totally agreed. I used the term "low interest rates" sloppily. I should have said, artificially lowered interest rates.

    "Second, it has nothing to do with 'consumer demand not materializing in 5-10 years into capital investment.' The bust phase is actually the switch from a distorted capital favored structure to more of a consumption structure, when a central bank stops printing money into the capital goods sector."

    This seems to miss something important. Malinvestment does have an inherent lifespan of viability - a burning fuse. Left unchecked malinvestments will explode, and that explosion will begin to counteract the artificially stimulative effects of artificially cheap credit by causing escalations in loan risk premiums and bankruptcies across heavy capital investors.

    Normally interest rates are supposed to reflect savings levels for future consumption…the only source for money in a market that is not manipulated. This perfectly balances cost of capital and timeframes of capital projects such that they later release funds for spending on consumption back into the hands of consumers at exactly the time needed for consumers to purchase the incremental consumer goods produced by the capital projects. Dollar-for-dollar match-up over time.

    By contrast, the Fed manipulates money time-value rates to 0% causing over-investment amidst businesses but under-saving amidst the public. Knowing people’s time-valuations of money are historically a lot more than 0%, we can surmise the quantity of money saved by consumers at 0% is miniscule compared to the quantity of money borrowed by producers at 0%. And that loan : savings amount disparity is further exacerbated by a 10:1 fractional reserve multiplier. This supply-demand imbalance for money between consumers and producers is a chicken that must later come home to roost when long term capital projects reach completion and associated loans come due. Only then will it be exposed that 0% was _not_ a real market clearing price for money. Because sufficient consumer savings don’t exist to buy the products produced, producers will be forced into liquidation
    Now I agree that rather than let this be the beginning of a healthy bust, the Fed can pay for the malinvestment it created by printing up ever-increasing amounts of money and giving it to consumers to spend on the newly produced goods. Or giving it to producers to pay off their loans. Or buying up goods itself and throwing them into the ocean. Essentially making the malinvestment financially viable by virtue of paying for its terrible cost with printed money. This keeps the bubble inflating.

    But otherwise I don’t see how keeping rates at 0% alone could continue to stimulate. Malinvestment is called malinvestment precisely because it’s unsustainable in relationship to actual consumer time preferences and actual consumer savings levels. Some injection of wealth other than free credit must be employed to bridge the savings gap when it is exposed.

  8. I'm confused. I confess I haven't hit the primary sources on this subject; I've only listened to as much material on Mises.org that I've had time for, like the Mises boot camps for instance. What I've heard the Mises.org type Austrians emphasize about ABCT doesn't jive exactly with what EPJ-ABCT seems to emphasize. I'm writing this comment with the hopeful intention that I will be schooled.

    My understanding was that ABCT tries to explain GENERAL behaviour across the economic spectrum, and not that of outliers. It's not primarily or necessarily about more debt or less debt, but rather about longer-term debt as opposed to shorter term debt.

    From what I thought I heard from the Mises.org types the gist is that non-market derived interest rates -- artificially low interest rates -- cause businesses to invest in projects that will either take too long to realize a return on the investment or will never finish because of insufficient resources -- material and labour being finite. It's not about more borrowing, it's about borrowing for a longer term than would have been the case had interest rates been market-driven. Meanwhile, all this long-term business activity -- on projects that will never yield a profit to the producer -- is what constitutes the boom. The bust is when the resources used/created during the boom are returned to the market, and put perhaps to better use.

    Additionally, artificially low interest rates also reduce the consumer's desire to hold cash, since there is insufficient return on simple cash deposits in banks to incent consumer savings. So in the boom therefore there is also a general increase in consumer spending. In a non-fiat, non-fractional-reserve financial system this consumer behaviour should correct the interest rate problem, because banks would lack sufficient capital to fund lending to customers.

    At any rate, none of this implies that there is any specific industry that is more or less susceptible of malinvestment, or that there are quantitatively higher levels of increased economic activity in a boom. "Idle resources" notwithstanding, since there is a finite supply of material and labour to draw upon, lower-order factors can only be neglected, if artificially low interest rates induce firms to invest in capital projects that favour the higher factors of production. Since firms must produce net earnings or perish, however, ABCT predicts that they will ultimately stop long-term money-losing projects or they will go bankrupt and release their resources.

    I'm not sure if I'm reading RW correctly, but is counting M2 really THE distinguishing characteristic of ABCT? Does classic ABCT specify particular metrics for quantifying money supply against some tangible, independent benchmark? Would that imply empiricism?

  9. Landru, you are confusing ABCT with Austrian Economics. While Austrian Economics covers the entire economic spectrum, ABCT is simply the application of Austrian Economics to explain the boom-bust cycle.
    The ABCT is exactly as RW has described it. He has previously recommended Rothbard’s “the Great Depression” as the best explanation of this theory. However, if you are constrained for time, I would recommend that you go to Mises and download (or buy) Rothbard’s pamphlet “Economic Depressions: Their Cause & Cure”. It is only 45 pamphlet pages (about 25 – 30 normal pages) and is a great starting point.
    The ABCT is not necessarily about more or less debt or about long or short term debt.
    I’ll do my best to explain this. Under Austrian theory, people devote some of their money to savings and some to consumption. The savings goes to investment (either directly or through the banks they house their money in). Each person has their own savings to consumption ratio. And if you combine all of these in an economic area you get the aggregate savings to consumption ratio. Savings (which you can use interchangeably with investment) is simply money to be used for FUTURE consumption. So, if people decide to devote more money to savings, what they’re really doing is postponing their consumption spending.
    When you look at the aggregate, if the savings:consumption ratio changes (in favor of more savings), then this signals that people want to consume less now and more in the future. With more money available for investment, interest rates drop. The result is that entrepreneurs get this signal and invest in higher order capital goods (ie longer processes of production for the final consumption good).
    However, new money (M2 growth), or artificial interest rate drops (by the Fed) mimic this signal. It tells entrepreneurs that more money is available for investment. But it’s not (at least in real money terms). Peoples’ consumption: savings ratios have not changed. So, when they get the new money, they go ahead and spend it in the same ratio amounts as before. The entrepreneurs who invested in consumption goods get out comparatively unscathed, but those who invested in higher order capital goods production find out that theirs were malinvestments.
    This is the reason that the capital goods sector is hardest hit.
    As for the importance of money supply growth (and M2 is just one metric): even if the Fed didn’t control the target range for federal funds rate (the rate the press always harps on), creating new money would still artificially lower interest rates, and trick entrepreneurs into believing that peoples’ consumption:savings ratios had changed. The boom-bust cycle would still occur as long as the Fed is printing more money.
    I hope this helps, though, I haven’t specifically addressed all of the things you’ve said (as there is a length limit on comments).

    1. Ad Lib...this is precisely the schooling I was hoping for. Very clear and enlightening explanation. Thanks very much for being so generous with your knowledge and time.