Oct
21
The worst recession in 25 years
What I am trying to explain you here is called Austrian theory of business cycle, the only theory which consistently explains every recession and economic boom. If you want detailed and exhaustive discussions on it, you are free to surf through Mises Institute’s forums.
Lets presume a family of 4 people, Steve’s family. Steve’s father works in a Multinational firm on a regular salary with performance based bonus. Steve every week gets some weekly allowance from his dad, so his sister.
Every week upon receiving the allowance of $100, Steve goes on his usual to spend on his needs, he is a very economically efficient person, he budgets all the money he receives very accurately with no wastage of money.
The Booming Years
One day, his father’s boss calls his father into his office and tells him that they are going through a business deal which will get them massive amount of profits, and his father will receive 50% increment on his yearly salary. That is, instead of receiving $50,000 that year, his father will now get $75,000 every year.
Steve’s father is really excited about this news. Since the Boss assured that the deal will go through, Steve’s dad goes to the local bank and takes a loan of $25,000. He plans that as soon as he will get the increment he will pay the loan back.
He walks back to his home, and tells the news to everyone. Since he already has the cash in hand, he gives the proportional extra allowance to Steve, his sister and Steve’s mom.
Now this small economy of 4 people has extra cash flow(which technically nobody is sure of), and people are ready to spend. Steve’s father goes and buys that new car he wanted. Steve’s mom, gets new cell phone connections and hands the phone to Steve, his sis, and herself.
Steve on the other hand, is now able to make a flashy girlfriend, since now he realizes that he can clearly afford to take her to expensive restaurants, to holiday on a beach, etc etc. He also gets a used Car for himself since now he will be able to afford the monthly fuel and maintenance expenditure.
Months pass by, but there is no sign of deal going through. And soon a year passes by. The family has done large amount of expenditures, all perfectly economically calculated, adjusted for the $75,000 salary of Steve’s dad.
Since Steve’s dad’s boss ensures that the deal will pass through and he will get his deserved increment, his Dad goes to another bank and takes another loan for $25,000. Now the total loan on the family is $50,000 + Interest from the first loan.
The family consistently gets another extra $25,000 this year. So everything continues the way it is. Another year passes by, and now Steve’s dad is worried about the financial liquidity of the family. The bank which gave his dad the first loan got in touch with him and somehow Steve’s dad convinced them that he will be able to pay their loan back to them.
The Bust
Now at the end of third year, when Steve’s dad gets his salary of $50,000, he needs $25,000 immediately to adjust the family budget, but now his Credit history has gone so bad that he cannot get any more loans from any bank. So his Dad is now only able to allocate $100 per week to Steve, similarly, the rest of the family gets less money. This $50,000 is simply not sufficient to cover the various ventures, and new investments family has started. For example, there is no way the Cell phone bills can be paid now. Steve cannot fuel his Car anymore, he cannot spend on his girlfriend anymore.
The Meltdown
And just when they thought that they have faced all the problems, they seem to be just started. The banks from which Steve took loan, are now knocking on their doors demanding their money back. Steve’s family is now in big trouble. After days of consideration, Steve’s Dad comes up with two possible solutions.
1) Cut back all the excess expenditures, sell Steve’s car(that means Steve must dump his girlfriend), sell his Dad’s car, cancel all the Cell phone subscriptions, mortgage the house they live in, for Loan, return all the previous loans, and slowly buy their house back over the years.
2) Go to the local Mafia boss/Loan Shark who does not need credit checks, take $75,000 loan from them and continue on their life and hope that they will pay the loan back once their life goes back to normal. This way Steve gets to keep his car, girlfriend, his cell phone, and nobody cuts down any expenditure. Steve terms it as the “Bailout Plan”.
Steve’s Mom’s arguments
We cannot go to the local Mafia boss for loan, there is no way we will be able to pay that much amount of loan with our current expenditures. We must go for the first plan, let Steve’s car be sold, his girlfriend dumped, cell phones connection canceled, and over the years we will be able to pay all our loans back.
If we choose the “Bailout option” we will not be solving the problem but only postponing it to eventually come back at us at even bigger level.
Steve’s arguments
You have gotta bail us out Dad. I need more liquidity. I have to pay my gas bills, phone bills, restaurant bills. If you don’t pay me, I will have no social life ever, I will become the most unpopular kid in the school, and surely you don’t want that, do you?
So bail me out dad please, you know that I will pay you back that money as soon as you get that increment, and my allowance actually increases.
If you don’t bail me out, then my social life will go to hell, I will be much more stressed, and won’t be able to concentrate on my studies, so I will not be able to become a successful man in future, if you don’t bail me out right now.
Steve’s Sister’s arguments
This problem is all a result of Steve’s greed. Only if Steve was less greedy. What was the need for him to go and get a new girlfriend, and a car.
Look at me, whenever I needed the car I just used Steve’s car. Whenever I had to dine out somewhere, I just tagged along with Steve on his date. Look how much savings I have done. We must choose the first option.
…..
[After she does some thinking that if Steve gets to keep his car she will also benefit from this]
…..
On second thoughts I support the Bailout option. Lets bail Steve out with his situation, after all we need to maintain our social status too.
Well here the story ends.
Now lemme explain you who is what in real world. Steve’s Dad is the Government. Steve’s Boss is Federal Reserve. Steve is the Market. Steve’s sister is the general public.
So what really happened?
The Federal Reserve inflated the money supply believing that it will result in more economic growth. It does not. So all that extra money resulted in massive economic malinvestment. When all that investment eventually failed to balance the books all hell broke lose.
Now the only solution is to let these companies fail and lets start from scratch, but as you might know what has happened, that govt has taken EVEN MORE loan, they are going to sustain all those malinvestments by pumping even more money in the economy.
Its like solving the problem by overdoing the cause of the problem.
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anarcho-mercantilist Says:
October 22nd, 2008 at 1:25 amMalinvestment and underinvestment already exist, since the state enforces regulations and taxes that undermines the economy. More generally, the state exists, then distortion and malinvestment must exist. So one should also call the “boom” phase of the business cycle as increased malinvestment.
Inflation, per se, does not cause increased malinvestment. The lower real interest rates than the “equilibrium” rate causes malinvestment. The lower real interest rates encourage firms to invest in long-term assets than short-term assets, distorting the “optimal” ratio of long-term assets and short-term assets. Thus, the un-“optimal” equilibrium would result in more opportunity costs for individuals.
Only in the “boom” phase of the cycle, malinvestment occurs. In the “bust” phase, the “adjustment” occurs. The ratio of long-term assets to short-term assets approaches the “optimal” level during the bust. Therefore, the bust phase makes consumers wealthier! Then why do some consumers get poorer in the “bust” phase? The individuals who has a loan during a monetary contraction would not have enough money to pay back to the banks.
The Misesians misnamed the terms such as “boom,” “bust,” “growth,” and “recession.” Actually, the only variables that defines the boom and bust phases include lowering and increasing interest rates, respectively. Monetary expansion has nothing to do with “booms” and “busts.”
Note that during a bust phase, one should not view the two concepts: malinvestment and unpayable loans, as related or correlated with one another. In a “bust,” malinvestment may occur without a loan crises, and vice versa.
Lower than “optimal” interest rates causes malinvestment. Monetary contraction causes unpayable loans. Monetary expansion, per se, does not cause increased malinvestment. Lower interest rates actually does.
Without monetary expansion, malinvestment may still occur by lowering real interest rates. Conversely, without lower interest rates, loan defaults may still occur due to not enough money to pay the loan from monetary contraction.
renegade_division Says:
October 22nd, 2008 at 4:24 am@Anarcho-Mercantalist
Isn’t lowering the interest rates a form of monetary expansion? When the govt lowers the interest rates, it forces people’s savings out, it encourages people to take more loans, and all these loans come from the Feds.
I mean take for example the inverse situation, the creditory contraction, now Federal Reserve does not really recalls the currencies it has printed, nor it abolishes the credits it has given to the various banks. All it does is it increases the various interest rates, and people start depositing the money back into the banks, and Banks back to the Federal Reserve.
Without actual creditory expansion, the Federal Reserve has to be really rich in order to cut down the Interest rates.
Alan Greenspan in 2001-03 to deal with the then Recession, slashed the Federal Funds target(the overnight interest rates paid to the banks) to really low 1.5%. That clearly increased the active money supply in the Market.
KP Says:
October 22nd, 2008 at 12:46 pmgood try to explain the crisis….keep up the work…
Credit Check On Credit Speak » Economic meltdown explained Says:
October 22nd, 2008 at 10:06 pm[…] Economic meltdown explained Lemme explain the readers of this blog, the current global economic meltdown in simplest examples. I […]
anarcho-mercantilist Says:
October 23rd, 2008 at 4:01 amRenegade, lowering interest rates does not necessarily cause monetary expansion, nor vice versa. Central banks seem to do both at the same time, so some see them as correlated.
I do not think that the OP presented an accurate version of the Austrian Business Cycle Theory. Malinvestment did not cause loan defaults, as the OP appeared to claim. Malinvestment starts in the early phases of the business cycle, and ends in the “bust” phase. In the “bust,” the allocation of capital goods would reflect consumer preferences. Therefore, the bust benefits consumers rather than hurts. Then why do some consumers get mortgage defaults during the bust phase? Actually, monetary contraction caused the mortgage defaults, since the borrower does not have enough supply of money to pay back the loans.
More info here: http://anarcho-mercantilist.blogspot.com/2008/10/15-mistakes-by-austrian-economists.html
renegade_division Says:
October 23rd, 2008 at 4:07 amI am sorry but who is “OP”, I am clueless.
kp Says:
October 23rd, 2008 at 5:20 pmalready commented….
strongwalker Says:
October 26th, 2008 at 12:04 amgood post,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,
RINZU SUSAN RAJAN Says:
November 7th, 2008 at 10:48 amit is a pleasureto read ur posts…coz it involves a lot of thorough research…and u have wnderfully potrayed economic bane with a story…
keep up the good work…
:)
anshumita singh Says:
December 30th, 2008 at 4:46 pmthe stuff was really good atleast for clearing the concepts of the laymens like me
renegade_division Says:
December 30th, 2008 at 6:06 pmThanks! I highly appreciate your response.
Tor Says:
March 12th, 2009 at 6:41 pmThanks.Have never come across such an illustration.it appears simple but its actually profound.pls,send it in my email box.
Kashif Says:
April 13th, 2009 at 7:04 pmThank you very much for a the wonderful analogy. No one else has been able to explain it to me in such a wonderful way.
But your writing has confused me a little bit as welll. At the start you have mentioned that Steve’s father worked and had a boss (there is no mention of Steve himself working). But towards the end you have written “Steve’s Boss is Federal Reserve”.
I think it is a mistake if not, can you please shed some more light.
renegade_division Says:
April 13th, 2009 at 7:58 pmHi Kashif,
Thanks for pointing out at the mistake. Yes you are right, it should be Steve’s father’s boss.
Basically, Federal Reserve throws in easy credit in the economy, everybody borrows, and it makes everybody(even those who are smart enough to be not fooled by this easy credit) a fool thinking that the whole economy is booming, they start businesses which have no prospect in a real world.
Take for example because of easy credit people pay more and more money to buy good cars, now the increasing prices of Cars fools me(a car manufacturer) that there is a market for flying cars in the economy. So I go ahead and borrow a LOT of money to establish and startup a Fly Car Company. Maybe I even sell a few cars here and there, but eventually people run out of the borrowed money and I find out that there are like less than 2% people capable (and/or willing) to buy a flying car.
So now my business of flying cars goes bust, at the same time my conventional car making subsidiary also gets bust, and now I have to go to Federal Govt to grant me more loans to continue my operations(like what happened with GM and other Detroit based Car manufacturers). The only difference is if someone gives me a loan, I will totally shut down my flying car subsidiary, and fully focus on my conventional cars, but the way American govt is working right now, they are paying huge amount of money to the people who bought cars on mortgages(aka homeowners bailout), they are bailing out flying car subsidiaries reduces taxes on them and trying in ALL the possible ways to ensure that the company still remains(in real world US govt is trying really hard to keep the House prices UP).
ma Says:
May 10th, 2009 at 5:01 amOMG that was the most well explained article out of the 50,000 articles ive read!!!!!!!(jk)
y cant all the articles be like that?!?!
renegade_division Says:
May 10th, 2009 at 6:00 am@Ma
Thanks for your appreciation.
You can read similarly example-oriented articles written by me:
Why Speculation is indispensable in Free market?
http://www.reasonforliberty.com/reason/why-speculation-is-indespensible.html
Why is the understanding of money so mysterious to modern day economists?
http://www.reasonforliberty.com/reason/the-mystery-of-money.html
Rational argument for Interest
http://www.reasonforliberty.com/ethics/reason-for-interest.html
Rational argument behind Rents
http://www.reasonforliberty.com/reason/labor-behind-rent-and-interest.html
Busting the myth of Capitalist Exploitation
http://www.reasonforliberty.com/reason/the-myth-of-capitalist-exploitation.html
TO Says:
May 27th, 2009 at 7:38 pmI shall let a number of my friends read this. I was hoping I could share it readily on my facebook page. Cool.