Extra Info: The Business Cycle
Why is the economy sometimes up then down and up and down again? Why does the economy seem to go in circles? Why do many businesses suddenly go bankrupt all at the same time? Today, most people assume that the problem is inherent in capitalism or in the free market, but the problem’s root lies somewhere else.
The Austrian School of Economics developed a reasonable theory considering business cycles. This theory explains why there are many firms in trouble at once in the market when this one only selects the best entrepreneurs to allocate resources and produce the people’s preferences.
This theory basically says that when we save more, the bank has more to lend, and therefore interest rates go down. When interest rates are down, businesses will borrow from the bank to finance long-term projects. If the public is saving more, it will mean that they are buying less. If we are buying less of something, there will be less production of that thing and companies will be able to save the resources they use to create those products or services for the future. Now, why do we save money? The most obvious reason is because we will use it in a time later. Hence, if firms are able to borrow with low interest rates, save resources and use them to create something for the future through a long-term project, the money you also saved for the future will be used on the new things the companies produce for you in the times to come.
This smooth coordination between saving, borrowing, producing, and consuming can only take place when interest rates are real and not messed with. Nevertheless, today there is too much government intervention.
The central bank pushes interest rates down by creating money out of thin air and giving it to banks. The savings of people did not push interests down because they are not saving, but consuming everything today and not postponing it for the future. While some might rebuke this action, it is actually very reasonable to do. As the government produces more money, there is more to bid with and prices rise gradually, like in an auction (highest offer wins). When prices are steadily being raised, our money little by little becomes worth less. Therefore it is more convenient to spend things now, than in the future, where things will be costlier.
When we consume more, we make companies also waste their resources to create the products we want and need, thus they do not save resources for the future. The lower order industries (these create the raw material far away from the outcome product e.g. led to make the tip of a pencil) will not release resources fast enough for firms to use in their long-term projects. Even so, these companies continue to borrow from the bank to enforce their projects. In the end, all businesses will realize that they are misallocating resources and they cannot complete their projects profitably. But it will be too late because there will already be a shortage of material. In other words, resouerces were utilized to make long-term projects, instead of satisfying the present demand of the people. Ultimtely, the economic result in these circumstances will be a recession or a depression.
The economy cannot have long-term production and short-term consumption. Ambitiousness would be the perfect word to describe an economy that attempts to do something like this. Firms do not have sufficient resources to complete their long-term projects and end up owing fortunes to the bank. Resources go to the wrong areas and a recession takes place. The public needs the economy to sort itself out and solve these things alone. However, we find the hand of the government intervening in all things and pushing interest rates artificially lower by printing money based on nothing.
This is what occurred in the year of 2001. The central bank pushed interest rates lower eleven times and caused the economy to continue doing the same thing (borrowing to produce things for the future, while having large consumption in the present). In 2008 the economy almost went into a recession because the interest rates were kept low by the government and were artificially telling businessmen that they could engage their long-term projects. People were not saving money and resources! Wouldn’t that create shortage in the economy a few years later? The economy must be left alone to fix itself, interest rates have to be real and the economy will stop exhibiting a cyclical pattern.