Boettke on business cycles

Below is my attempt to explain my view of the business cycle as simply as possible:

Table

The above table shows supply and demand for some product at varying prices. At $100 many units are supplied but none are sold; at $0 no units are supplied but many are demanded. In both cases there is no profit to be made, because either nobody buys or nobody sells. Under normal conditions the price would move toward $50. If the price is higher, then suppliers have too much inventory, and if the price is lower, then they are turning away potential customers. It is more profitable for suppliers to adjust the price toward $50.

Sometimes sellers are prohibited from setting prices. A politician passes legislation to control the price and decides upon a price ceiling of $30. What would then occur? A quick glance at the table above tells us that 700 units will be supplied and 1300 demanded, creating a shortage of 600 units. At $30 nobody sells after 700 units have been bought, even though more are demanded. Suppose that each buyer purchases 1 unit at $50 and 2 at $30 (each buyer purchases more of the product when the price is lower). When the price is $50 there are 1000 people who buy 1 unit each; when the price is set at $30 there are only 350 people who buy 2 units each. With the price ceiling fewer people enjoy more product at lower prices, but at the expense of a greater number of people who must go without.

An important role of prices is to ration resources. Shortages and surpluses are created when politicians interfere, and scarce resources are thereby misallocated. When products are made which nobody wants to buy, resources have been directed away from making products that people want to buy more. When products are not made when there are willing buyers, resources have been directed toward making products which people want to buy less.

Interest rates are the price of credit. Like the anonymous product above, when the price is high more is supplied and less is demaned, and vice versa when the the price is low. If a politician passes legislation to enforce a price ceiling below what would otherwise prevail, then a shortage will be created. A shortage of credit induces a boom and bust cycle. With an interest rate ceiling fewer people enjoy more credit at low prices, and a credit supply that would have been issued over a ten year period might instead be depleted in half that time. After which there will be a sudden credit crunch. Extra money is enjoyed in the present at the expense of the future.

While it would be misleading to suggest that suppressed interest rates cause economic bubbles alone, they do create a situation in which bubbles more easily arise. Investors are less cautious when the price of borrowing money is low, and the value of their investments seems to keep on rising as more borrowed money enters the economy. Add to this some favourable government regulation and the economy is primed to create a bubble. All this sets off the boom and bust cycle, a series of malinvestments followed by a painful corrective recession.

One qualification: the Federal Reserve does not actually set interest rates by enforcing a price, but instead manipulates the price by changing the money supply. When more money is available at banks for lending the price of credit (i.e. the interest rate) declines, and when less money is available the price of credit increases. But the eventual consequences are very similar to just setting a price ceiling, and perhaps even worse.

I began thinking about this in early December and am pleased that learn that it lines up so nicely with the Austrian theory. Good Econtalk this week!