Out of every topic in the science of economics, there is none more peculiar than the business cycle. Countless books and articles have been written over the decades on this subject, providing an endless stream of formulations and theories all attempting to explain this seemingly inexplicable phenomenon. The question of the business cycle seems to have a special allure to it for the economics community, more so than any other in the field.
The reason for this special interest can be found in the strangely regular pattern that the business cycle takes. This pattern is the infamous “boom/bust” cycle. During the boom period, everything in the economy seems to be going swimmingly. Confidence is high, and business is good. However, it is not to last. Eventually, there comes a point where economic cracks start to appear, and the optimism of the boom turns quickly into panic and despair. This is the bust, and the economy soon collapses, leading to a period of recovery and return to normal economic conditions.
Along with this boom/bust pattern, there is another reoccurring detail of every business cycle: The “bust” is always concentrated within the capital goods industries. Whenever we say capital goods, all we mean is those goods that are not purchased by consumers, but instead bought by producers to use in production. Hammers, dump trucks, and factory buildings are all capital goods, and it is always in these industries that the sings of the bust first appear.
For evidence of this pattern, all one has to do is look back on the history of business cycles in the past. Here is a short list of the most notable economic crashes in U.S. history:
Panic of 1819: Over the period from 1816–1819, there was a very large speculate bubble in land prices, and upon it’s bursting, the economy entered into a depression.
Panic of 1873: The railroad and transportation industries experienced a large boom post-Civil War starting in 1867, which came to a screeching halt in 1873, upon which the economy collapsed.
The Great Depression: Stock prices experienced a large bubble, and stock prices rose consistently throughout most of the 1920s, finally leading to a famous stock market crash in 1929.
Dot-Com Bubble: Stock prices for tech companies, a relatively newcomer to the financial scene, became massively inflated beyond their true values by the market in the mid-to-late 90s, eventually crashing in 2000 along with the rest of the economy.
The Great Recession: Housing prices experienced unprecedented growth from the early to late 2000s, eventually coming to a catastrophic crash in 2008 which rocked the financial sector and drove the economy into a historic recession.
In all of the examples above, the “bust” that abruptly ended the “boom” started in industries like land, housing, and stocks. In short, all industries that involve capital goods. The regularity of the business cycle pattern is puzzling enough, but why are these industries the first experience the bust before anyone else?
The only theory that can satisfactorily explain the phenomenon of the business cycle, as well as its focus on capital goods, is the Austrian Business Cycle Theory. Developed by Ludwig von Mises and Friedrich Hayek, it places emphasis on one special price in the economy: the interest rate. Generally, the interest rate is viewed as the price of borrowing money. If there is more money to be lent out, that price goes down and vice versa. However, the interest rate is much more important than any other financial instrument. The interest rate is a reflection of society’s time preference.
If people decide to forgo consumption in the present in favor of consumption in the future, they will increase their savings. This represents a low time preference, and if individuals decide to consume more, the opposite is true. As a result, if society decides to lower their time preference and save more, this indicates that society is putting off consumption in the present in favor of consumption in the future. This plays directly into the interest rate, as if more savings are available, then that would push the interest rate down. As with all other prices, an increase in supply reduces price. A lower interest rate doesn’t just mean that borrowing money is cheaper, however. It carries a much greater significance in the form of the capital structure.
As we explained above, capital goods are those goods that are used by entrepreneurs in production processes. The demand for these goods is particularly sensitive to changes in the interest rate, as they are often quite expensive and take a long period of time to produce. As a result, when the interest rate drops, this induces entrepreneurs to invest more in capital goods with the ultimate goal of making their businesses more productive.
This interlocking mechanism demonstrates the importance of the interest rate and the impact it has on the economy. Savings increase, which lowers the interest rate, which increases investment in capital goods. However, it also demonstrates how tampering with the interest rate can cause disaster for the economy at large. What would occur if the government artificially reduces the interest rate through inflating the money supply in the credit markets? Interest rates would be reduced, but not as a result of actual increased savings from society.
The entrepreneurs that are embarking on these new investment projects are doing so on the basis of a deception. They are investing as if more savings are available in the economy, but this is not the case. The government has only made it appear so through its artificial lowering of the interest rate. What happens when the interest rates are allowed to return to their natural rate? The investments that appeared to be profitable as a result of low interest rates are no longer profitable! The entrepreneurs were tricked, as it were, into thinking that these capital goods projects could be completed, when in fact, they couldn’t.
The result is as tragic as it is predictable. The bust comes when the realization that these capital investments are not profitable. Investments in capital goods industries will have to cease, causing massive losses for any entrepreneurs and investors that put money into them. The economy begins the process of recovery and a return to normal economic conditions.
This theory explains to us all of the phenomena that we consistently see within the business cycle. First, the boom and bust are clearly visible. The boom occurs as the new investment takes place, as investment is increasing without a decrease in consumption, giving off an illusion that society is richer than it really is. The bust comes when that illusion is shattered, revealing to everyone that the investments they thought were profitable were not based in reality. The reason why the bust is concentrated in capital goods is because that is precisely where the malinvestments have taken place, at which point the losses from these bad investments spread out to affect the rest of the economy.
Austrian Business Cycle Theory tells us why the business cycle occurs, but it also shows us how to prevent it from happening in the future. All that is necessary to put a permanent end to the endless cycle of boom and bust is to prevent government tampering with the interest rate, and allow for the markets to determine investment purely through supply and demand. We do not have to accept the existence of the business cycle with passive resignation. To abolish it once and for all, however, we must reject the interventions of the state.
