cont. ec. issues lecture 2

Contemporary Economic Issues LECTURE 2: 5 MARCH 2017

Essay 1: The Great Depression Reference: Rothbard, Murray Newton. America's great depression. 5th Edition. Ludwig von Mises Institute, 2000.

THE PROBLEM: THE CLUSTER OF ERROR

Another common feature of the business cycle also calls for an explanation. It is the well-known fact that capital-goods industries fluctuate more widely than do the consumer-goods industries. The capital-goods industries—especially the industries supplying raw materials, construction, and equipment to other industries—expand much further in the boom, and are hit far more severely in the depression. A third feature of every boom that needs explaining is the increase in the quantity of money in the economy. Conversely, there is generally, though not universally, a fall in the money supply during the depression.

THE EXPLANATION: BOOM & DEPRESSION

• The “boom-bust” cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. What is bank credit?• Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production.

The proportion of consumption to saving or investment is determined by people’s time preferences—the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society.

للنقود الزمنية القيمة مفهومما مبلغا تستلم ان األفضل من انه بمعنى للنقود، زمني تفضيل هناك

لعدة وذلك زمنية، فترة بعد المبلغ نفس تستلم ان على اليوم: منها أسباب

في- 1 ترغب ال والتي به الملحة حاجاتك من جزءا تشبع ان تستطيع انك. بعد لما إشباعها تأجيل

عائدا- 2 يعطيك بحيث بأخر أو بشكل المبلغ تستثمر ان تستطيع انك أو. نهايتها في أكبر فيصبح الفترة خالل ما

نوعا- 3 تعطيك يدك متناول في جاهزة نقود لديك يكون ان تفضل انك أو. طارئة أمور من يحدث قد ما لمواجهة واستعدادا بالنفس الثقة من


• A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. • Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption.


• The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components.• The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.


Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business?


• The new money pours forth on the loan market and lowers the loan rate of interest. It looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. • Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in “longer processes of production,” i.e., the capital structure is lengthened, especially in the “higher orders” most remote from the consumer.• Businessmen take their newly acquired funds and bid up the prices of capital and other producers’ goods, and this stimulates a shift of investment from the “lower” (near the consumer) to the “higher” orders of production (furthest from the consumer)—from consumer goods to capital goods industries.


• If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. •But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, people will rush to spend the higher incomes in the old consumption–investment proportions. •In short, people will rush to re-establish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.


In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption–investment proportion is re-established, and business investments in the higher orders are seen to have been wasteful. Businessmen were led to this error by the credit expansion and its tampering with the free-market rate of interest.


• The “depression” is actually the process by which the economy adjusts to the wastes and errors of the boom, and re-establishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments.


• In sum, the free market tends to satisfy voluntarily- expressed consumer desires with maximum efficiency, and this includes the public’s relative desires for present and future consumption. •The inflationary boom hobbles this efficiency, and distorts the structure of production, which no longer serves consumers properly. The crisis signals the end of this inflationary distortion, and the depression is the process by which the economy returns to the efficient service of consumers. •In short, the depression is the “recovery” process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, requires a “bust.”


why don’t all booms come quickly to an end?• The reason is that the banks come to the rescue. Seeing factors bid away from them by consumer goods industries, finding their costs rising and themselves short of funds, the borrowing firms turn once again to the banks. If the banks expand credit further, they can again keep the borrowers afloat. The new money again pours into business, and they can again bid factors away from the consumer goods industries.

• Clearly, the greater the credit expansion and the longer it lasts, the longer will the boom last. The boom will end when bank credit expansion finally stops. Evidently, the longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment.


What, specifically, are the essential features of the depression-recovery phase?• Inefficient firms must be liquidated or have their debts scaled down or be turned over to their creditors. Prices of producers’ goods must fall, particularly in the higher orders of production— this includes capital goods, lands, and wage rates. Just as the boom was marked by a fall in the rate of interest as well as the loan rate, so the depression-recovery consists of a rise in this interest differential. In practice, this means a fall in the prices of the higher-order goods relative to prices in the consumer goods industries. Not only prices of particular machines must fall, but also the prices of whole aggregates of capital, e.g., stock market and real estate values.


• Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be.• Unemployment will progress beyond the “frictional” stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed.

SECONDARY FEATURES OF DEPRESSION

DEFLATIONARY CREDIT CONTRACTION

• Deflation (Lowering Money Supply): In the first place, the inflation took place as an expansion of bank credit; now, the financial difficulties and bankruptcies among borrowers cause banks to pull in their horns and contract credit.• Under the gold standard, banks have another reason for contracting credit—if they had ended inflation because of a gold drain to foreign countries. The threat of this drain forces them to contract their outstanding loans.• Furthermore the rash of business failures may cause questions to be raised about the banks; and banks, being inherently bankrupt anyway, can ill afford such questions. Hence, the money supply will contract.



• An increase in the demand for money. This “scramble for liquidity” is the result of several factors: (1) people expect falling prices, due to the depression and deflation, and will therefore hold more money and spend less on goods, awaiting the price fall; (2) borrowers will try to pay off their debts, now being called by banks and by business creditors, by liquidating other assets in exchange for money; (3) the rash of business losses and bankruptcies makes businessmen cautious about investing until the liquidation process is over



• With the supply of money falling, and the demand for money increasing, generally falling prices are a consequent feature of most depressions. A general price fall, however, is caused by the secondary, rather than by the inherent, features of depressions. • Furthermore, the demand for money will decline again as soon as the liquidation and adjustment processes are finished. For the completion of liquidation removes the uncertainties of impending bankruptcy and ends the borrowers’ scramble for cash. A rapid unhampered fall in prices, both in general (adjusting to the changed money-relation), and particularly in goods of higher orders (adjusting to the malinvestments of the boom) will speedily end the realignment processes and remove expectations of further declines. Thus, the sooner the various adjustments, primary and secondary, are carried out, the sooner will the demand for money fall once again. This, of course, is just one part of the general economic “return to normal.”



• Deflation of Money Supply: Deflationary credit contraction greatly helps to speed up the adjustment process, and hence the completion of business recovery.

• Credit contraction will have another beneficial effect in promoting recovery. For bank credit expansion, we have seen, distorts the free market by lowering price differentials (the “natural rate of interest” or going rate of profit) on the market. Credit contraction, on the other hand, distorts the free market in the reverse direction. Deflationary credit contraction’s first effect is to lower the money supply in the hands of business, particularly in the higher stages of production. This reduces the demand for factors in the higher stages, lowers factor prices and incomes, and increases price differentials and the interest rate. It spurs the shift of factors, in short, from the higher to the lower stages. But this means that credit contraction, when it follows upon credit expansion, speeds the market’s adjustment process. Credit contraction returns the economy to free-market proportions much sooner than otherwise.



May not credit contraction overcompensate the errors of the boom and itself cause distortions that need correction?

• It is true that credit contraction may overcompensate, and, while contraction proceeds, it may cause interest rates to be higher than free-market levels, and investment lower than in the free market. But since contraction causes no positive malinvestments, it will not lead to any painful period of depression and adjustment.

• Furthermore, in the nature of things, credit contraction is severely limited—it cannot progress beyond the extent of the preceding inflation.14 Credit expansion faces no such limit.

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cont. ec. issues lecture 2

Economy & Finance