Business Cycle Primer
by Llewellyn H. Rockwell, Jr.
http://mises.org/article.aspx?Id=606

Sometimes it’s painful to read the business press, and never more so than during an economic slump. Reporters flail about for explanations. They quote stock analysts, politicians, day traders, other journalists, and even, from time to time, academic economists. But they never seem to arrive at anything approaching an explanation.

And what, precisely, are we seeking to explain? At any given time in a regular economic setting, some businesses are succeeding and some are failing. Laborers shift from one firm and sector to another. This is a picture of a dynamic market economy in which resources are finding their way to their most productive uses.

What’s unusual is when the business failures and layoffs occur in a cluster, as if many normally savvy entrepreneurs, in the same interval of time, just happen to make a series of bad judgements. It is the coincidence of these bad judgements—these errors of investment that come together to threaten recession—that cries out for an explanation.

And certainly, if you are purporting to examine the merit of various anti-recession measures, you surely need some explanation of what brings about downturns. Right now, the most common attempt at a theory has something to do with consumer confidence. The press likes this one, probably because this was the Clinton administration’s theory as to why, day by day, the economy became weaker in the last months of 2000.

The idea is this. If consumers believe the economy is headed down, they might save instead of spend. The business sector, afflicted with the same fears, doesn’t invest. The two forces merge to create a decline in overall demand for goods and services, and, next thing you know, it’s straight into the economic gutter.

So is there anything to the "talk theory" of recession? As Frank Shostak has pointed out, this theory implies that underlying economic reality has no meaning. Whether we are rich or poor depends on our collective state of mind. A recession becomes nothing but a national bad mood.

On the same theory, you could also claim that the economic boom of the 1990s was a result of happy talk from government officials. And maybe, based on this idea, the best way to avoid recession is to turn off our radios, televisions, and computers. We should just sit back and meditate on government press releases. That’ll keep the boom going.

Gosh, maybe we can talk our way into perpetual prosperity. If only we knew the magic words, we could print them in a book and ship it to the developing world where they can all talk their way into prosperity too. Maybe there should be jail sentences for naysayers, who, after all, threaten the national well-being.

Does it sound absurd? Of course. But the business press, woefully uneducated in economic theory and relentlessly biased, reports it straight, as if those pushing the talk theory of the business cycle might not have a political purpose in mind. And that purpose is obvious: deny the reality of the situation and promote an illusion.

Another theory going the rounds is that business cycles are like Clemenza’s theory of familial war from Godfather I: "This thing's gotta happen every five years or so—ten years—helps to get rid of the bad blood." And sometimes there seems to be a superficial plausibility to the idea. But to say something happens in cycles is not to explain it; it is only to observe the obvious.

Business cycle theories are legion and they come and go. But the only explanation that has stood the test of time was first advanced in 1912, in Ludwig von Mises’s masterwork, The Theory of Money and Credit. Elaborations on the theory, by Mises and his student Hayek in the 1930s, culminated in the Austrian theory of the trade cycle.

The theory begins by observing the profound effect that interest rates have on investment decisions. Left to the market, interest rates are determined by the supply of credit (a mirror of the savings rate) and the willingness to takes risks in the market (a mirror of the return on capital). What throws this out of whack is manipulation by the central bank.

When the Fed feeds artificial credit into the economy by lowering interest rates, it spurs investments in projects that don’t eventually pan out. In this economic boom, the high-tech and dot com manias resulted from a decade of sustained money growth via lower interest rates. When the Fed stepped on the brakes to prevent prices from rising, it prompted a sell-off, and hence a downturn.

What’s tricky to understand is what can’t be seen. Just because prices aren’t going up doesn’t mean the money supply is in check. Just because people in some sectors are getting rich doesn’t mean that the prosperity is on solid ground. Just because the stock market is going up doesn’t mean that the architecture of investment (to use Jim Grant’s phrase) is in good working order.

This theory is strongly supported by the data. The dot come runup coincided with a money supply runup, beginning in 1995. The money supply (the Fed’s MZM) slightly flattened in 1996 and the begin zooming again in 1997, peaking at a 15% increase in January of 1999. The rate of increase began to fall precipitously thereafter, triggering a much needed sell-off. The money supply as measured by MZM began at $3.2 trillion in 1997 and sits at $4.7 trillion today. Clearly, the judgments of investors and entrepreneurs were being distorted by massive injections of money and credit.

Right now, conventional wisdom says that the Fed should flood the economy with money and credit. But as we can see, it is precisely this path that created the problems to begin with. Besides, Japan tried this trick in the 1990s, even lowering interest rates to zero, without effect.

No Austrian economist was surprised when the Fed’s dramatic interventions produced no lasting effect on the markets. Clemenza is correct to this extent: there is bad blood in the economy and it needs to be drained.

There are ways to make recessions easier to endure. Cutting taxes is one of them. Getting rid of regulations that hinder enterprise is another. The purpose of such efforts is not to stimulate demand (as Bush’s advisers seem to think) but to unshackle entrepreneurship and permit the consuming public more freedom of choice.

But this theory is at once too sophisticated and too clear for most business reporters to grasp. They aren’t interested in reading a dusty old treatise on monetary theory. Neither, I’m afraid, are Bush’s economic advisers. But at least Bush’s intuitions are on track. A big, immediate tax cut won’t stop the slide, but it will help provide the American people a cushion to land on, as well as a foundation for the future.