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.
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.
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