Business cycles are otherwise known as periods of boom of bust, or the more commonly associated term, recession. While there are numerous theories from the various schools of economics that explain these hazardous cycles, I am inclined to presume they manifest because of entrepreneurial malinvestments spurred by artificially low interest rates. I will begin this analysis by simplifying the structure of the production process in the absence of inflationary monetary policy, and then proceed to explain changes in the process with the injection of credit.
I hope my explanation grants the reader insight, and find it applicable to the cause of modern cycles, such as the Dotcom Bubble and the financial crisis of 2008.
There are various stages of production consisting of the original means of production (land, labor), intermediate producer goods (capital), and finally consumption goods.
After the final sale of consumption goods and designating revenue towards capital maintenance, producers may choose to designate profits towards investment, or instead consume the newly-generated income. Whichever action entrepreneurs choose, consumption or investment, is usually governed in part by the market rate of interest. Entrepreneurs typically invest their profits into expanding their production process if the market interest rate is low, as this reveals that consumers maintain a low time preference, meaning they prefer goods later rather than imminently, thus saving a greater portion of their expendable income. On the other hand, if the interest rate is high, producers will focus on consumer goods, as this reflects consumers having a high time preference and wish to indulge in consumer goods sooner rather than later. The interest rate acts as a signal for entrepreneurs to designate their productive resources to the more profitable stages of production.
Natural interest rate
For this analysis, unless otherwise stated, I will assume there is a “natural” low rate of interest due to saving. Therefore, producers elect to invest profits into future production.
Due to the higher demand for producer goods, reflected by the low interest rate, the introduction of new savings into the production structure commences. Entrepreneurs will seek to increase the lengthening of the production process to more capitalistic “roundabout processes” that take a longer amount of time. This will essentially add additional stages of production, augmenting the process, and will ultimately reallocate intermediate producer goods from the later stages of production to the earlier. On the contrary, if there was an increase in the demand for consumer goods, there would be a reallocation of intermediate goods to be used in later stages of production, reallocating them from the earlier.
With the aforementioned introduction of new savings and a lowered interest rate, there will be an increase in the demand for producer’s goods, thus a rise in the price due to competitive bidding and a decrease in the demand for consumer goods causing a lowering of their price. The change in relative prices tends to cause changes in the available producer goods and at which stage they will be employed, being allocated to the most profitable. There are, for the sake of this particular discussion which may render the terms being used inelegantly, two types of productive intermediate goods: Nonspecific production goods and specific production goods. Nonspecific goods can be utilized in various stages, while specific goods may only be compatible in specific stages. Whichever stage of production appears more profitable, whether it be the earlier or later stage, is where these goods will be allocated for production, abandoning the other stages.
With the increase in the price of earlier stages, due to increased demand, non-specific goods will be reallocated to these earlier stages. This shifting of goods will continue until the profits of each stage equalize (law of diminishing returns), and the price variations in each stage narrows. Regarding the specific goods, a somewhat dissimilar effect occurs. If a specific good is only compatible in the late stage instead of the early stage or vice versa, it may be reduced or completely abandoned. Additionally, if the specific good is compatible strictly in an earlier stage of production, its price will increase.
It should be noted that this expansion of production opens the door for investing in new stages of production, utilizing resources that were otherwise idle or unused.
On the other hand, if there is an increase in consumer good demand, the opposite effect happens. There will be widening price variations between the consumer goods and previous stages of production, and larger spreads all around. Prices in late stages will increase, and nonspecific goods will be reallocated to the later stages. Specific goods in earlier stages will be obsolete, and specific goods in later stages will increase in value. All the earlier stages of production are abandoned as they are essentially unprofitable and unserviceable.
The changes in relative prices caused by a change in demand for consumer or producer goods, cause a shift of goods to different stages of production. This is how the market adjusts for changes in consumer preferences or tendencies, with the origin of entrepreneurs adjusting their production methods being guided by the market rate of interest.
I must emphasize the importance of the interest rate, as it brings about a rise in the prices of factors that are in strong demand in earlier stages (low rate of interest), or increased consumer goods demand in later stages (high rate of interest). The interest rate oversees the allocation of scarce resources among the various stages. If entrepreneurs forecast the price changes correctly, which are to be predicted as a result of the changes in their production methods, the new rate of interest will correspond to the arrangement of prices which in due course will be established.
The interest rate has a purpose, and it is not an arbitrary number that can be set by a central body. Its “natural” rate is an authentic representation of the supply of savings and the demand for savings, both factors being guided by the economic actor’s time preferences.
Injection of new money
The above description of the production structure was explained with the assumption that there was a fixed monetary supply. As I proceed, I will discuss the alterations in the production structure spurred by the injection of new money to buy producer or consumer goods, directed by the central bank.
I will assume the injection is created to credit producers. To ensure producers borrow the money from banks, the interest rate must be set and maintained below the equilibrium rate. In practice, this is fulfilled by the fractional reserve banking system, in which commercial banks keep only a portion of deposited money, vault cash, and loan the remainder out. Simultaneously, the central bank engages in open market operations and lowers the federal funds rate.
With the interest rate being artificially low, producers will now engage in lengthened capitalistic production processes. This does not reflect actual consumer preferences. Consumers may still have a high time preference, mirroring that they prefer consumer goods rather than producer goods. This sends a false signal to producers to engage in lengthened production processes and to reallocate intermediate producer goods into the earlier stages, instead of properly allocating resources to the later and shorter stages of production. While producers invest these new “savings” (credit) into earlier stages, they simultaneously create additional earlier processes. In essence, this will entice producers to spend money on capital goods that are otherwise not necessarily reflective of consumer preference, inciting a “boom.”
This boom is accompanied by rising wages in the earlier stages of production, and an increase in employment in these particular sectors. That being said, although there is investment in more roundabout methods due to the low interest rate, consumption may not change for some time due to the consumer goods of later stages already being in the process of production. However, in due time, there will be a reduced output, and a scarcity of consumer goods will ignite, accompanied by higher prices.
During this time, it is necessary for consumers to reduce their consumption. Unfortunately, this isn’t what ensues and consumers continue to spend income on consumption goods, simply because they never relinquished their high time preference.
In the following diagrams, figure 1(a) represents an increase in real savings in households. There is a shift in the supply of loanable funds from S to S’ which represents a household’s change in preference to one that is low and future oriented, thus lowering the interest rate from i to i’. AB represents an increase in both savings and investment.
Figure 1(b) represents an increase in credit from the central bank, with the injection of new money being reflected by the change in the supply curve from S to S+ /\M. The interest rate is adjusted from i to i’. Where these diagrams diverge is businesses continue to increase investment from AB, while actual saving falls to AC and the entirety of CB reflects over investment, exceeding the actual desired saving.
In due time, there will be an increase in the prices of consumer goods and a decrease in the price of producer goods. When entrepreneurs begin adjusting their production methods, they will begin allocating their intermediate goods to the later stages of consumption goods due to their profitability.
The high prices of consumer goods will lead producers to return to the later stages of production, causing the production process to shrink. This leaves all the capital goods used in earlier stages obsolete, forcing entrepreneurs to either sell them at a loss or allow them to remain idle, garnering no interest. This is also accompanied by an increase in the prices of original factors and intermediate products, particularly nonspecific goods, since they are reallocated to the increased price level of consumer goods, making the longer processes unprofitable. Specific goods will fall in price, and eventually be discontinued. This corresponds with an increase in unemployment, as labor that was used in earlier processes of production is now realized to be unprofitable and superseded. As Frederic Hayek noted:
“When the growing demand for finished consumers’ goods has taken away part of the nonspecific producers’ goods required, those remaining are no longer sufficient for the long processes, and the particular kinds of specific goods required for the processes which would just be long enough to employ the total quantity of those nonspecific producers’ goods do not yet exist.”
This may be summarized as follows: The origin of the trade cycle is rooted in the expansion of bank credit, and artificially lowering the interest rate. Naturally, the interest rate is determined by the supply of savings, and the demand for credit (both being regulated by economic actors’ time preference). A higher interest rate (high time preference) reflects the consumer’s willingness to purchase consumption goods immediately. This signals to producers to concentrate on retail, or higher order goods and shorter production processes. Contrarily, a lower interest rate (low time preference) signifies that consumers are engaging in higher levels of saving, which in turn guides the producers to invest in capital and longer production processes in earlier stages.
In reality, we engage in fractional reserve banking with the interest rate being determined by the central bank. The central bank keeps interest rates low to spur investment and economic growth, accomplishing this through expanding credit or engaging in other inflationary practices such as open market purchases, and this in turn causes the boom phase.
This expansion of the credit supply misguides entrepreneurs to invest in capital and longer production processes to satisfy the misleading demand for capital goods, whereas in reality consumers do not have the necessary savings, rather a preference for consumer goods which would be reflected by a high rate of interest. Essentially, the artificial rate of interest is sending a false signal to producers because the low interest rate doesn’t reflect the real rate of savings, and consumers are still purchasing consumption goods. The central bank can only maintain its policy of low interest credit for a particular length of time, and must cease their monetary policy of discounted interest loans to prevent runaway inflation.
Commercial banks continue their expansionary credit policy by lending out the remainder of their deposits, only keeping vault cash, which in turn keeps the interest rate low. Lenders realize the money supply expanded, now demanding a greater return in the form of a higher rate of interest since the currency’s purchasing power is predicted to decrease. Though their lent credit may appear unsustainable, due to competition from other banks, they are reluctant to lower interest rates for potential borrowers. When a bank steps forth and takes on the burden, other banks follow suit and the interest rate raises to its “natural” level. This is coupled by the central bank’s target rate to suppress unmanageable inflation.
Simultaneously, entrepreneurs begin to realize they invested in productive processes that weren’t actually in demand, and begin to maneuver back to their tendencies before the “boom.” This boom misallocated scarce resources such as employing labor in unneeded sectors that now must be laid off, misdirected capital goods to earlier stages of production, and capital consumption, which are symptoms of the ensuing bust, commonly referred to as a recession.
Although this theory focuses particularly on the production structure and capital goods, the theory of malinvestment due to artificially low interest rates grants a feasible explanation for modern business cycles as well. Its rationale can be applied to over-investment in other assets and other financial instruments that may appear profitable, but do not necessarily represent genuine wealth.