Business Cycles

No blog on Austrian economics, written for pleasure or for academia can distance itself from the issue of business cycles. Men and women, irrespective of their knowledge of economics are obliged to know about the current crisis and what created it for no person can live in a world that is beyond them. It is in that interest therefore, I offer the Austrian perspective on business cycles.

Business cycles have just one cause-low interest rates. Or if I have to be clearer, artificially low interest rates. Interest rates are prices. Just like an apple costs some money, money costs something. Interest rate is like a rent. You pay certain amount to stay in an apartment for a month, similarly you pay a certain fee to rent a certain amount of money for a specific period. The fee is proportional to the amount of money you borrow, hence it is a percentage. For all purposes, it may be called "interest rate". This is the price of renting out money. People who have excess money rent out a certain amount of their money while those who find themselves in deficit borrow temporarily at a cost. This is no different from buying apples and oranges. We cannot grow our own fruits, hence we pay a certain fee to that regard, to obtain fruits without having to grow them on their own. We hence buy a good at cost because we cannot produce it. Similarly if we don't have money, we can borrow it at a cost. On the contrary, those among us who have employment, will notice that they provide service to their workplace, which the workplace cannot do without. Similarly, if you own more money than you need it, you  just lend it out for a price.

The problem with bank interest rates is that it is set by a central bank. A central bank is like any central governmental agency that controls prices. Imagine, there is a central apple control board that decides at what price apples must be sold. The board cannot arbitrarily set any price it wants. If it sets the price of apples at a price greater than what its market price is, you will have a surplus of apples, as more people will start producing apples than what is needed and they have to be either destroyed or purchased by the government. At the same time, the board sets it too low then there is a shortage-there isn't enough apples for everybody who can and wants to buy it and the government must come in and produce the rest. Similarly, a central bank creates shortages with lower interest rates and hopes to solve the shortage by printing up money. Unlike apples, money needn't be grown, it can just be printed.

The result of this is simple. Under market interest rates, all money borrowed by people would equal the money saved by others. In these conditions of government intervention however, there is money for people to borrow that isn't even backed by other people's savings. Therefore the only way this can happen is that the central bank lowers interest rates and prints money for otherwise there would shortage of capital in the economy. The government could have also lowered interest rates first, by creating money, thereby increasing supply of money, Irrespective of whether the government increases money first to lower prices or lowers price and then prints money, the consequence is easy to observe. The more of what is there in an economy the less valuable it becomes. Thereby, the value of money depreciates and the price of all other goods in comparison to money rises. This creates an illusion of rising wages and corporate profits. People start buying homes with cheap credit and business start investing in areas that wouldn't have been profitable at a higher interest rate. However soon, people and firms realize that with increased profits, comes increased costs as the cost of raw materials and cost of  consumer goods goes up. They then have to cut back on the production and hence start laying off workers. selling their properties and abandoning business plans for lack of profit.

This is simplest possible explanation for business cycles. Businesses get a wrong impressions of prosperity as the credit becomes cheap and profits go up and hence invest more, creating a boom. But soon they realize that their costs have gone up too and cut back on their investments, creating a bust or as it is popularly known a recession. If there had been market rates, then there would have been no expansion on the part of business without greater saving by households. As they invest more, they demand more of these scarce savings and the interest rate goes up. The high interest rates then discourage other firms from venturing out thereby not creating a boom. Similarly, when there is more saving, because of lack of consumer goods in the market, money becomes more available and the interest rates fall-encouraging investment to produce these consumer goods. There is no depression. Boom and Bust is a product of government intervention. Under pure, unfettered capitalism, there would be no major business cycles, no periodic depressions and no alternative Marxist theories explaining the end of capitalism. Under pure capitalism, there would be business cycles, but so mild that it will not create any kind of economic or psychological stress for anybody, ever.

The Game of Capitalism

I am an unapologetic fan of video games. There is one video game stands out as a hallmark of the Austrian tradition or more broadly of the philosophy called “capitalism”.  The game is called transport giant and as the name suggests it is a strategy game where the player is supposed to build a transportation empire. However before you dismiss this game as just another business strategy game, let me tell you that teaches you one small lesson about capitalism, best  phrased by Ludwig Von Mises in his book Anti-Capitalistic mentality as,

“Those underlings who in all the preceding ages of history had formed the herds of slaves and serfs, of paupers and beggars, became the buying public, for whose favor the businessmen canvass. They are the customers who are always right, the patrons who have the power to make poor suppliers rich and rich suppliers’ poor.”

The game is all about serving your customers by providing transportation services in between cities, delivering items to their cities, delivering their mail and so on. You start with a certain amount of capital and enter the transportation business along with one, two, three competitors or none, depending on your choice. You can start connecting cities by rail, road or build airports depending on which era you are in (it is time based game where you choose to start in 1850 with horses or 2000 with Boeing 747’s). That choice is however is not entirely yours. You cannot connect two cities between which the consumers don’t want to ply. For example, connect city A and B, without anybody in A wanting to go to B and you are rewarded with no revenue and high utility costs in running those trains that are bad for your business. You also cannot ply a train with 10 wagons and hope that all of them will be filled out. If there are only 6 wagons worth of passenger load, you tend to lose money by running additional wagons. If you’re a businessman and you decide how many wagons to operate, you will stop at 6 wagons because running an additional wagon costs money without rewarding you with greater profit to compensate for the cost. Economists call this the efficient point where the marginal cost(the cost of producing an additional good, or running an extra wagon) is equal to the marginal revenue (the money you receive from selling train tickets to consumers). However this efficient point is not decided arbitrarily by nature, it is decided by your consumers who decide whether or not to make use of your service. Provide two little, and you lose out on money that could be earned. Provide more than what your consumers need and you will still lose money thanks to high running costs. Even without any competition you are driven by your consumers and by the profit motive to connect only the cities that need to be and only so much as the consumers needed. In the process, all consumers are served and no resource is wasted (no additional wagons have to be built and sold to you by wagon manufacturers or additional steel to build railroads to connect places that don’t need your service). You also have little choice on what type of transportation you want to use. You can connect two far-off cities by a mud road and ply horses in the year 2000 and very few consumers (in fact none) would make use of your service. The costs of building the road will go in vain and your business would have built roads for nothing. Try building airports and connecting them by air and you will receive many consumers who want to go to this far off city as quickly as possible with minimum pain and maximum comfort.  Therefore you make profits by running a plane service between the two cities. You can initially start with slower planes, but soon enough you will find your profits falling as consumers want a faster service between the two cities. You have to go all the way back, sell your old planes and buy new, faster ones. If you fail to do that, your customers will just reject your service and your planes will fly empty. Also, you must be quick to recognize changing consumer tastes. A city that previously didn’t need connection would need connection as it develops and consumers in those places would want to travel to other cities. Stick with one route for too long, and you start losing money. Also, there is always the fear of competition if you started the game with competitors. They will try to provide the transportation service before you and earn the profit you could have earned. Therefore you have to be on your toes or in the context of the gameplay extremely swift your mouse and build roads and railroads and airports connecting cities even before consumers start demanding it and then hope they’d demand for it. In this case you have to anticipate what your consumer needs or face a heavy loss in terms of money forcing you out of business. As mises put it,

“The only source from which an entrepreneurs profits stem is his ability to anticipate better than other people the future demand of the consumers”

Therefore your profits are directly linked to consumer tastes and future consumer tastes and how well you anticipate this future demand. Anticipate it correctly and you are rewarded. Go wrong and your business is doomed. For the consumer, this means that his demands are met even before he demands it. This is reason you see shops always filled with goods even when you don’t really need them. As a result of this, you’ll soon be building railroad on every tile of the map to connect every city possible. Your drive is just profit. The more consumers you serve, the more money you receive.  You cannot choose to ignore consumer demands for it is through them you derive your money. Fail to connect cities that need connection and your competitor gets the profit. Even after you break even and start making profits in the billions, and you take over your competitors, you can still make more and more profits by stretching your transportation empire. In the game, the more you earn the more retirement money you’ll have when you choose to retreat from the endless game and receive higher ratings. In real life, it is just more money with which you can buy other goods and extend your services and earn an even greater profit. You will also be threatened by other competitors to serve your costumers or lose business unlike in the game where you can just buy them over early on and never be afraid of them again.

Government

Although the game does include certain effects of the government such as subsidies and economic booms and busts thanks to the business cycle, the game is free of any government involvement in your empire. The government doesn’t tell you what to build and what not to and it doesn’t compete with you using tax-payer money. Nor does it build roads and railroads for you. To everybody who thinks that roads and railroads need to be built by the government and when built will have ‘free-rider’ problems, this game, showshim/herthat the case is otherwise. Your transportation company has to build its own roads and railroads to serve its consumers. You cannot ply trains without a railroad. And when built you alone (apart from your consumers) benefit from it. In real life, other train companies may choose to use its railroad but in that case you can ask for money in return. In the game however other people with cars use your roads freely. But that shouldn’t bother the company. The first beneficiary of the road is the company (and the consumers). Conclusion

Although the game Transport Giant is just a game, it teaches its young players the valuable game of capitalism. Unlike other games such as monopoly[1], this game teaches you how to be a good entrepreneur-by serving your costumers quickly and in the way they want it to be. All your decisions are in the end the consequences of their present and future decisions. Everything from the form of transportation to the places where it will extend to is determined solely by your customersyou don’t choose the characteristics of your transportation empire; your customers do that for you. Your job is simple-to serve the consumers. Too bad that you cannot put yourself in the shoes of a consumer in the game; you are bounded into serving them. But making a profit out of the service isn’t a bad trade-off.