Protect Yourself by Learning the Boom-Bust Cycle Symptoms

Do you find the subject of economics to be…boring?  If your answer is yes, I have to admit that it wasn’t that long ago when I, too, felt the same way.  I couldn’t care less.  It wasn’t because I was lazy or I didn’t care.  It’s just that every time the talking heads on my TV screen would bring it up they made it appear like it was rocket science.  It seemed so complicated, so hard to digest, so above my level of intellect.  But to be honest I wasn’t a bit worried that I knew little to nothing about inflation or the intricacies behind the interest rate movements because surely the government and the reputable economists were on top of things.  After all they really care about us and they have our best interest at heart, right?

Well, not so it seems!  It didn’t take me long to figure out that something just didn’t seem right in 2008, when real estate went bust and our politicians were scrambling idea after idea on how to implement more regulations and bail out the entire collapsing financial system.  I knew I wasn’t educated with a PhD in economics but my common sense was rather alert to the wrongdoings of the government’s plan to rescue the collapsed economy even if they acted like they knew what they were doing.

The first writings that made me curious about economics were described in Ron Paul’s phenomenal little book “The Revolution, a Manifesto”.  In it there is a chapter titled The Forbidden Issue in American Politics in which Mr. Paul describes with easiness and clarity our monetary policy, our banking system, and the free market that we don’t have.  I marveled reading how a sound dollar that was once backed by gold had been debased by the printing of so much paper and electronic money (there isn’t enough gold in the world to back it up.)  I also got intrigued by the perverse system of credit and money creation out of thin air known today as the fractional reserve banking system.

But most importantly it helped me answer the question of “Why did the economy collapsed?” And it was this little chapter that introduced me to the Austrian School of Economics, www.mises.org, and the Boom-Bust Cycle, probably the most essential economic event so easily explained by the Austrian scholars.  I was thrilled.  I was starting to shed light on previously ambiguous economic events.  I was escaping the intellectual darkness with such a wonderful feeling of relief and a newly formed thirst for even more knowledge.

So what is the Austrian business cycle? 

The following is a short and very simplified version.  Artificial expansion of money and credit (inflation) leads to suppression of the interest rate.  Such expansion is not the result of people’s savings but an artificial addition – by the central bank – to the already existing money supply.  It is created through the printing of paper money and electronic ledger input.  Creation of new money does not create a natural demand, instead it leads to creation of an artificial demand.

The low rates entice people and businesses into long term unsound investments, investments which would have not been undertaken if the money supply would have not been tampered with and the rates were dictated by the free market.  The newly created money and credit distributed via bank loans find their way into various sectors of the economy causing a rise in the price of certain assets.  Buyers of such assets ultimately bid up prices thus creating an artificial demand and inviting speculation from additional investors, many of which are unqualified.  Businesses engage in long term production as a direct result of the low rates and the newly created artificial demand.

But such monetary expansion cannot last indefinitely.  When the central bank stops the process the interest rate begins to rise while asset prices are brought to a halt.  The first round of investors and borrowers  – typically the weakest and most marginal ones – fail.  The assets in the artificially inflated economic sectors are now in larger supply than there is demand for.  There are no more buyers to bid up their prices.  As a matter of fact a reversal process is now triggered.  As more borrowers default there are more buyers/speculators looking to sell (discard) causing a deflationary event.  In the meantime, businesses that have engaged in long term production find themselves with goods for which there is little to no more demand for and loans which are now harder to be repaid.  These businesses are forced to restructure their activities with layoffs being among the first to occur.

What is the cure and can it be prevented?

In Austrian terms the cure to the boom is to allow market forces to freely adjust without government or central bank intervention.  Prices would adjust to natural levels, malinvestments would be discarded, unsuccessful businesses – that produce goods that are no longer in high demand – would be allowed to fail thus allowing resources to be used in sectors that are in higher demand.  Under such circumstance the depression – or recession – would be short-lived and the economy can get a fresh new start.

Of course, this is not exactly what happened with the most recent real estate boom-bust cycle.  The Keynesian formula was – and still is – to keep unsuccessful ventures alive, new resources still directed (squandered) in malinvestments, and asset prices still kept artificially at higher than market levels (stocks and real estate).  Newly created money – by the Federal Reserve – is being used to sustain such detrimental (to the people) activities at the taxpayer expense.  This is moral hazard, an event in which businesses are engaging in risky (and wasteful) ventures knowing that the government will be there to save them from collapsing.

Can such a calamity be prevented?  Absolutely, and all it takes is for the central bank to stop the expansion of the credit and money supply, for the government to not engage in moral hazard activities, and for the banking system to stop lending money they don’t have (full reserve banking system).  May I recommend Thomas Woods’s excellent easy to read Meltdown?  “Austrians” understand that economies have seasons.  There are seasons when people save and their consumption is minimal at which times businesses engage in long term production.  And there are seasons when people engage in high consumption while savings are minimized, a trend that the free market reverses via the natural rise in the interest rate.  All it takes is for the government and the central bank (Federal Reserve) to not interfere.

Those who understand the morality and ethics of the free market have no doubt that the Austrian school is the best equipped to handle the largest economy in the world.  They also recognize the direct relationship between a free economy and the individual freedom.  Because if we are to live in a free society we should then appreciate such correlation and vote for the free and unhampered market.

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  1. #1 by Michael E Picray on April 16, 2012 - 6:05 pm

    There is another factor that adds to the inflation/deflation being created by the Fed. This is our banking system – which is set up as a “Fractional Reserve system”. The Fed sets reserve requirements. (That percentage of a bank’s customer deposits that the Fed requires the bank to have on hand/on deposit with the Fed so that the bank has enough cash to cover variations of demand on the bank’s deposits, ie to cover daily cash needs of their depositors.)

    Once the bank sets aside the required “reserve” the bank can loan out a percentage/fraction of that original deposit. A borrower then deposits the funds borrowed into their checking accounts, etc, or pays for something and the payee/merchant will deposit those funds in a bank. Then THAT bank can loan out a fraction of the second deposit which will in turn be deposited somewhere… etc. If the first loan was for $100 with a 4% reserve requirement, then the second banker could loan out $96 of that original $100. The third banker meets the reserve requirement, and can loan out $92 (96% of $96), the 4th banker could loan out $88 (96% of $92), and so on. And all this loaning out of “money” is created by the existence of only $100 in Federal Reserve Notes. Thus what is known as the Fractional Reserve system of Banking can be seen as the PRIMARY fiat currency creator. To increase or decrease the amount of currency in the system (causing either inflation or deflation) all the FED has to do is adjust the bank’s reserve requirement.

    • #2 by carmenalexe on April 16, 2012 - 6:20 pm

      Thank you, Michael! Great point, indeed. Murray Rothbard has an an excellent book on the subject titled “What Has Government Done to Our Money? and The Case for a 100 Percent Gold Dollar”.

      • #3 by Michael E Picray on April 16, 2012 - 7:16 pm

        But historically, gold currency has problems too!

        If you compare the history of the Roman Empire’s adventures in finance and gold money to the current manipulation of the fiat currencies, you will see that gold is not a magic cure. :-)

        http://www.cato.org/pubs/journal/cjv14n2-7.html

      • #4 by carmenalexe on April 16, 2012 - 7:24 pm

        I agree with you that there is no perfect system but a specie backed currency along with a full reserve banking system is the closest to a sound monetary policy that in my opinion exists so far.

  2. #5 by Anonymous on April 11, 2012 - 10:18 pm

    So true and accurate it is uncanny and beyond that disturbing in that those in charge must see and understand what they are doing. So the next question is what is the motivating factor that causes such illogical and irresponsible actions. To me there is always a reason for a particular situation. We just need to identify who it is that benefits by this specific set of circumstances? In my opinion it is the governments that use the funds to satisfy their own misuse of debt to by elections. But as we are now seeing there is a upper limit to the constant increase in printing paper that carries the promise to pay.

    • #6 by carmenalexe on April 11, 2012 - 10:31 pm

      I certainly agree with you 100%. I may add that in addition to the governments which benefit from such events, there are special interests in the corporate sectors which are big and powerful enough to encourage corruption. It is, in my opinion, ultimately the people’s responsibility to learn the truth and hold their government and representatives accountable for the wrongdoings.

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