 Good afternoon, everyone. My name is Jonathan Newman. My topic today is business cycles. I really like the way this bootcamp has been structured. I'll be relying on a lot of the things that you've learned in the other lectures. In fact, as I was listening to the lectures, I was thinking, yes, I'm glad they talked about that. That's one less thing that I have to cover here with this large topic of business cycles. But human action, fundamentally, subjective value, prices, entrepreneurs and production, intervention, money all have a role to play in telling the Austrian theory that business cycles. So a lot of presentations like to start off with a definition. I'm going to do the opposite. I'm going to say what a business cycle is not. Business cycles are not just regular business fluctuations. So the changes in data and prices and preferences that we see on a day to day basis. So changes happen all the time. And as you heard and hopefully learned in the entrepreneurship or entrepreneur lecture, this is a task for the entrepreneurs to handle and to anticipate and to guess and deal with these sorts of changes. So anytime something is produced, changes occur. Anytime something is consumed, changes occur. Preferences can change all the time. And in producing and consuming things, we build up and decrease our supply of resources. So these sorts of changes are we would not call a business cycle or something that would relate to business cycles explicitly. But just to make a few notes here, if entrepreneurs are guessing these changes correctly, if they're making good choices, profitable choices, then we can say that the economy is growing. That the entrepreneur is taking resources that are less valuable to consumers and transforming them into resources that are more highly valued to consumers. So an economy would be growing in that sense. If entrepreneurs are receiving losses, then we can say that the resources that they are using were more highly valued to consumers than the actual output of their production process. And so the economy would be in decline or wealth is being destroyed if we see losses. And the market has a great way of dealing with this sort of thing. Entrepreneurs who correctly guess consumer desires, consumer demands receive profits and losses for the opposite. So what is a business cycle? It's a general boom followed by a general bust. And so we see these sort of patterns in economic data. And of course all of the data that I'm about to show you come with the caveats of the way that they're measured and how they are appropriately used. But just to get a good picture here, don't worry about reading the axes here. I just want you to see the general shape of the data. So this is a real GDP, so output over time. And this is from 2000-2012. And you see that there's a general rise and then a general fall in the recession period. Here's the unemployment rate, which actually has the opposite sort of shape. So you might wonder why I put it up there. Well, if you do 100 minus the unemployment rate, then you get the same sort of shape here. It's a rise and then a fall. And other economic data has the same sort of pattern. So stock price indices like the Dow Jones and NASDAQ indices, stock prices follow the same sort of trend. And also recently we saw the same sort of trend with housing prices. So this is a house price index. We see a general rise and then a general fall. And so this is the purview of business cycles. This is what we have set out to explain. And I'm in a mainstream program over at Auburn. And so I wanted to do as much data collection as I possibly could to see what might be relevant here when we're talking about business cycles. And I stumbled upon this site called Spurious Correlations. And I found that the number of films that Nicholas Cage stars in actually follows the same sort of trend. We had this increase and decrease. So we might need to take this into account if we're good mainstream economists. We should incorporate this into our theory. The name of the site was Spurious Correlations. And so they actually correlated this with the number of people who drowned by falling into a pool. So let this be a public service announcement. If you see Nicholas Cage films start to more Nicholas Cage films start to pop up. Expect a market crash and stay away from swimming pools. Another phenomenon that we see in business cycles is that consumer prices vary less than factor prices. So the inputs that go into production vary more than the price of the outputs of production. And so just to put some data on the screen for that we see CPI has this nice or it's more smooth than the producer price index, which has much more variation here. And especially in the most recent recession there was this big fall here much bigger than the fall in consumer prices. Again with the caveats for the way that these things are measured. So we have to account for a few different things. When we are constructing a business cycle here we have to account for the shapes. We have this general boom and then a general bust. We have to account for a cluster of entrepreneurial errors. So we see in business cycles all of a sudden entrepreneurs start making all of these errors where we see in regular times entrepreneurs are very good at or should be good at anticipating changes and the ones that do a good job are rewarded with profits. The ones that do a bad job are punished with losses. And so what happens in a business cycle that makes all of this sort of break down and we have this big cluster of errors by entrepreneurs. And also our theory should explain this difference in the variability of the variation in consumer prices and producer prices or the prices of consumer goods and the prices of the factors of production. And so we can have a few suspect areas here. Since it's something that happens to the economy as a whole or the macroeconomy we might look to money as an area where something funny might be happening, if it's causing these phenomena. Also credit pervades the economy and so here I'd be relying on Malavika's previous lecture. And also I mean you saw the data we can't rule out Nick Cage as a possible causal factor here. Alright so I'm going to give away the punchline here. The Austrian theory of the business cycle really hinges around this idea of malinvestment. Malinvestment is investment in unprofitable lines of production induced by artificially low interest rates. So it's unprofitable lines of production because or they invested in these lines of production because of the artificially low interest rates. So we have to explain how interest rates influence production or at least how they're related. We also have to have a good picture of production and the way profits are anticipated exante. So before the good is actually sold at the end of the production process and the profits or losses are actually realized exposed. So we don't really realize that things were malinvestments truly until after the production process. Some of us even among this crowd might have a good eye for picking out what might be a malinvestment. A malinvestment is a good candidate because it explains the boom so there's increased investment and we'll see that there's also increased consumption that goes along with an artificial credit expansion. It explains the bust so all of these malinvestments have to be liquidated which would explain all the downward trend in all the data after the crisis once the bust phase is set in. It also explains the cluster of errors. It's related to money and credit as we'll see and it's also related to capital markets and the reason for this is the reason we know this is because a lot of the funds that are borrowed in credit markets are borrowed by firms the ones that do the producing. So you see this graph here during times of credit expansion in this area here we did see a big increase in the number of commercial and industrial loans. Okay so let's start to get a good picture of the structure of production or Austrian theory of production so that we can better talk about how it's related to the interest rate and time preference. Time preference has been a hot topic today and so I have the joy of explaining it. The Austrian theory of production is that it exists in a structure. It exists across time. Entrepreneurs combine factors of production and some of them are compliments, some of them are substitutes, some of them can be used together to produce things. Some things are interchangeable in production. Either way it's a very complex structure. It's very interwoven. There's a lot of network. Murray Rothbard used the term the structure of production is a lattice work so it's a very complicated big network of capital, laborers, and land working together under the direction of entrepreneurs guessing consumer demand. And also there's this critical feature in Austrian theory that production takes time. So what does the structure of production look like? It's been drawn a few different ways. Wimbledon had these concentric circles where on the inside we had entrepreneurs investing in factors of production and so finally they ripen to consumable output in the outside part of the circle so if you invest more on the inside then you have a larger circle on the outside. Hayek had this strange thing that nobody understands but luckily he gave us a more simple picture of the structure of production where time is moving down and so an investment or spending in the different stages of production is measured horizontally until we get consumer goods at the bottom of the production process. So this is one structure of production and this is another structure of production. One takes more time than the other. Rothbard borrowed Hayek's style here and we had the same sort of thing. You'll notice that there's sort of a triangular shape here and so in modern applications we just sort of retain the essential shape of it, have a triangle and use that instead and Roger Garrison is credited with the development of turning it on its side so that our western minds can see time moving from left to right and consumer spending is on the side. But it really is all the same sort of thing. Production exists in time, capital labors are used in each stage and at the end of the production process we have consumable output. Okay, so hold that in your mind for a second, production and structure production. I'm going to talk about the interest rate and time preference. The law of time preference says that we all prefer a given satisfaction sooner rather than later. We don't really have time to defend practically where this comes from. There's still a lot of debate today but hopefully you can take my word for it. We like to have things sooner rather than later. But even though we all have this sort of universal fact about us that we prefer present satisfaction to future satisfaction we do have a variety of rates of time preference and this is where exchanging present goods for future goods can arise. Whenever there's a variety of preferences, whenever there's a difference in the way we value things then we can trade to make each other better off. So here's a preference ranking. I don't think one has been represented today so let me talk through this really quick. Here's preference ranking. Here's Jeff's preference ranking here. The way I have it set up is that David prefers $1,200 in the future to $1,000 in the present and that is preferred to $1,100 in the future. You might wonder where does time preference come into play here? Well, we see that $1,000 in the future is ranked below all of these and it's particularly $1,000 in the present. We can see that the law of time preferences at work here is that the present $1,000 is preferred to the future $1,000. Jeff has a different rate of time preference. He has a lower rate of time preference. He's more willing to part with this $1,000 in the present. So his highest ranking has $1,100 in the future and then below that $1,000 in the present, $1,050 in the future and then we also see that he prefers the $1,000 in the present to $1,000 in the future. This is where we can see how people have different rates of time preference. You see there's an opportunity for them to trade and make each other better off. Jeff values $1,100 in the future over $1,000 in the present. David would rather have the $1,000 in the present than $1,100 in the future so they can trade the $1,000 today in exchange for the promise that David will pay him the principal plus $100 extra in the future so they can trade at an interest rate of 10% for whatever the period of the loan is and both are satisfying a more highly ranked end. So this is just one transaction between David and Jeff but if we have multiple people and we bring in more preferences for the future in the present then we can construct a market for loanable funds. So we can have a demand curve and a supply curve based on people's willingness to part with present amounts of money. The price in this market would be the interest rate just like the price here was $100 extra or 10% and the quantity would be the number of loans transacted. So this is where one form of interest arises. You'll notice that this sort of thinking also applies to production so we part with money today if we're going to produce something we part with money today to buy factors of production only to realize returns for that expenditure later on and so the same rate of time preference applies here as it does in this sort of transaction. So this is where we pull them together. Since production takes time the cost of production so purchasing factors of production renting capital or renting a plot of land to build a factory and hiring laborers all of those expenditures on cost of production proceed revenues from the sale of output. So anticipated future profits are compared to returns that could be earned by lending and interest. Every individual is comparing the returns that they could make by engaging in different actions like I can lend my money at interest or I can produce something and get another rate of return through production and selling my output to consumers. So I have this example here that hopefully will clear things up. Suppose Nick, I don't know where I came up with that name, could earn 5% interest by lending but has an idea for a product he thinks he could produce and sell for a 7% return. So he has to make this choice am I going to dedicate resources by lending at interest do I just loan this money that I have at interest to somebody else or do I engage in production and earn this 7% return. So obviously he chooses the area where he thinks that he has the higher return he chooses to produce something what he anticipates to be 7% return and in so doing has increased his demand for factors and he engages in production and puts his product on the market. No matter the outcome of this if consumers liked the output or didn't like the output either way because the interest rate was lower than his anticipated rate of return he's increased his demand for factors and thereby bid up the cost of production. So the price of the factors give way to the cost of production and so by increasing his demand for factors he increases the prices maybe just negligibly but you can imagine how this can be applied to the whole economy and so the factors of production get bid up in price and therefore the cost of production get bid up in price. So there's an equalizing tendency here. So the rate of return by lending and the rate of return in production will tend to equal each other over time because of this phenomenon. Imagine the opposite happening and what if there was a 7% return to be earned by lending at interest in a 5% return to be earned by producing something. In this case he would pull out of production, pull resources away from production, pull demand for factors away from production and move towards supplying funds for lending which would push up the interest rate and decrease the price of factors thereby increasing the returns to be made in production. Suffice to say there is an equalizing tendency in the interest rate in lending and the rate of return to be earned in production. All else held equal. Alright so let's walk through a scenario where people's time preferences decrease and so this would be the Austrian theory of an economy growing. At a lower rate of time preference we decide that we value future production more relative to the present so we start to devote more resources for future satisfactions compared to the present and so when that happens we save. The action that is a corollary that is saving, we dedicate resources today for future satisfactions and the only way to increase savings is to decrease consumption. So those are mutually exclusive by increasing savings that means we have to decrease the amount that we consume. Fewer resources are consumed in the present. The supply of loanable funds increases so now all of those existing interest rates, the supply is greater, people will supply more money to be lent in the present in exchange for the promise of future returns. The interest rate falls and here's a critical point here. Production is restructured for longer lines of production so now longer lines of production have become profitable at this lower interest rate. It's easier to buy factors of production, it's easier to borrow and then buy factors of production for longer more productive lines of production. We'll talk about this more in just a moment. Also factor price relationships change as earlier stages see a greater increase in demand than later stages. In fact, late stage factor demand will decrease because as people are decreasing their consumption at the retail end of the structure of production where people are putting stock on shelves, there's less demand for those sorts of workers, less demand for cash registers, less demand for the on the retail end of the structure of production. So what that would look like with this triangle that we have here is that it would get shorter since consumption spending is decreasing but it would get longer because there's more investment going on. There's a diversion, a reallocation of resources away from consumption and late stages of production and towards the earlier stages of production. So I have a sort of rudimentary way of doing this, watch closely, it gets shorter and longer at the same time so this is what happens to the structure of production when we save. The result is that we have greater production in the long run. By devoting resources today for more production today we have more output in the future and also longer lines of production. To ask you to compare this line of production to this line of production washing clothes with a washboard versus washing clothes with one of these new high-tech washing machines is connected to your smartphone. You might think just on the face of it that this is a longer line of production because it takes longer to wash clothes with a washboard but actually if you consider the entire production process this one on the right has the longer production time because you have to take into account all of the work, all of the production that had to go into producing the smartphone, producing the technology to connect the smartphone to the washing machine and also by the way to construct the washing machine. So more capital intensive lines of production have a longer production time so this is why we know that this relationship exists. One more example here, imagine this production process picking cotton by hand versus this production process having this big tractor thing pick all the cotton for you. This one here is the longer production process because you have to consider the construction of this big machine. Also worth noting this line of production could only happen if we have a bunch of savings ahead of time so we have to save to construct this capital and in the process we decrease the interest rate which makes this line of production profitable in so doing. Alright so now to switch gears here so those are the effects of an increase in savings we can talk about what would happen if we have an increase in fake savings. So we've already seen how central banks can increase the supply of money and if that increase in supply of money happens in systems like we have today with fractional reserve banking with fiat money and those banks that are holding reserves in fractions are also financial intermediaries then new money created in the economy enters in through credit markets. So the new money that is printed up and distributed is not tossed out of a helicopter it's not given to angels to distribute to everybody evenly it's funneled through credit markets and we'll see that this is the crucial feature here this is the crucial causal or first cause of what causes the Austrian business cycle story. So central bank can expand credit without an economy-wide increase in savings so independent of what time preferences are they can make it look like there's more savings available by increasing the supply of vulnerable funds. So the result of this is that the interest rate falls but again it's not because of a decrease in time preference at the lower interest rate actually saving decreases so we haven't changed time preference and now all you're saying is that the returns to lending are lower people are going to save less they're going to be lending less on that loan market which means that consumption will increase so before we had an increase in savings that resulted in a decrease in the interest rate this time we have a decrease in the interest rate that results in more consumption so totally opposite directions here also borrowing increases at this lower interest rate and in fact a lot of borrowing would occur just to finance the increased consumption this is what we see in business cycles. So it's not just consumers borrowing those new funds it's also firms take the new funds to increase their production so they invest in new and longer lines of production but remember that this increase in production the new longer lines of production were not dictated by consumer demand it was based on the whims or the ideas of the people making monetary policy not based on consumer demand and consumer or society wide time preferences the result of this is that factor prices are bid up across the board so we have a general increase in the cost of production as we'll see whereas before there was a restructuring of where resources are allocated here money is flowing everywhere so the demand for factors increases therefore factor prices are bid up wages increase employment increases, consumption increases and investment spending also increases so this may sound bad the way I'm describing it it's because I'm here the Ludwig von Mises Institute but actually this feels good this is the boom period wages are increasing, people are consuming a lot people are investing a lot you see a bunch of new projects springing up this feels good for people that are involved it's what happens later on that hurts that's the painful part and so we would call this the general boom all of these increases because of the artificial credit expansion is the boom so the clincher is that consumers did not show that they preferred future output to present output in fact they decreased their saving at the lower interest rate there were other mechanisms at play here and these are widely cited in the literature Dr. Engelhardt who presented earlier has this idea that entrepreneurial quality also decreases so the good entrepreneurs leave and bad entrepreneurs into the market since the credit expansion does not represent an increase in real resources available for consumption or investment all these new projects can't be sustained so we haven't actually increased the amount of resources available in the economy all these new lines of production that entrepreneurs undertake can't be completed because we haven't increased the amount of resources in the economy in fact the amount of resources are being dwindled down as people increase consumption so we have a decrease in the available resources for both consumption and investment when we're trying to increase both at the same time and so factors of production become increasingly scarce their prices are driven up astronomically and it's higher than entrepreneurs expected and so all of those anticipated profits that they thought that they were going to get at the outset when they started this new line of production turned into losses so this as we can already see explains the cluster of entrepreneurial errors in the business cycle so entrepreneurs are led to believe consumers had saved real resources or consumers had saved and that real resources were available production and also that the longer production processes would be profitable alright so just to give you some pictures here so before we had the pictures of savings instead of having projects like this you know sort of a modest house that a consumer can afford instead of having regular office buildings by the way I think this is actually from the office so this is the Dundramiflans side here and I couldn't find a good image of this but instead of students leaving school at some point and getting a job we see these sorts of things we see large mansions being built and instead of modest office buildings being built we see these extravagant high tech skyscrapers and we see students taking on more and more loans to stay in school as credit is cheaper so this would be indicative of artificial credit expansion I should mention that these things by themselves are not bad so whether or not you think mansions are bad or not is a separate question skyscrapers are fine staying in school is good too but what makes these malinvestments is that they were encouraged by artificially low interest rates it's not profitable to engage in these sorts of lines of production yet or at that time so this is the key distinction so the result is depression all these malinvestments have to be liquidated we have to have a restructuring of the way resources are allocated we have to have a restructuring of prices so firms attempt to liquidate malinvested capital they try to make the best of a bad situation so they sell off factors of production they sell off what output they had started to make at lower prices wages decrease and workers are laid off this is where we see the increase in unemployment during the bust phase credit markets dry up it becomes harder to borrow prices readjust to reflect consumer demands which is what we wanted all along and this happens to both inputs and outputs as you heard from one of the previous lectures about imputation theories the price of the outputs change based on consumer preferences being the inputs that go into producing those outputs also have decreasing prices or changing prices and what's critical to note here is that the depression is the recovery phase this is where things go where they should so before things were going where they shouldn't prices were skyrocketing when they shouldn't have the depression is where we have all the corrections this is the market trying to get resources into profitable lines of production getting consumers into homes that they can afford in this sort of thing so the depression should not be avoided we shouldn't try to engage in government policy to avoid the depression the depression should be embraced to an extent that we need to go through this recovery phase to get back on our feet and so just in summary I can contrast this to an alternative theory quickly but just to summarize the shape of the business cycle for Austrians is that it's a boom and then a bust and it's caused by expansionary monetary policy which triggers malinvestments on the part of entrepreneurs the cure is to allow markets to liquidate those malinvestments and to correct all the problems that the expansionary monetary policy caused in the first place and I can restate this cure just to make the distinction between the Austrian theory and the Keynesian theory more clear what this means is letting consumer demand dictate prices and resource allocation as opposed to monetary policy makers or as opposed to the government and to prevent this sort of thing from happening just don't let the don't let non-market institutions into the money production business let money production be done by the market so that there are these natural stoppers natural limits as Malavika noted in her lecture for Keynesians the shape is different the shape for business cycle is that it's a bust and then a boom and the bust sort of comes out of nowhere they say that the cause is this inherent instability in investment spending Keynes use the term animal spirits they're just going every which way and investors don't really know what's going on and sometimes they all make errors at the same time so I said that the bust sort of comes out of nowhere it's because that this causes and really explains things they have to explain first why is investment spending unstable and why is it stable sometimes we see an unstable at other times another common cause that you'll hear is that it's a fall and aggregate demand also associated with the decrease in investment spending which is totally different from the Austrian approach the cure for Keynesians is actually the cause for Austrians so for Keynesians they would like to address this depression phase, this bust phase by engaging in more expansionary monetary policy by doing the same things that got us in the mess in the first place and also expansionary fiscal policy so make work projects it's a ton of government spending to get people employed we can restate the Keynesian cure here let the government dictate prices and resource allocation and prevention for them is the opposite for Austrians as well it's to give the government control of money production in a blank check for spending so in conclusion the Austrian theory really does the best at explaining the phenomenon that we see in business cycles we can successfully explain business cycles using this malinvestment concept so malinvestment is investment in unprofitable lines of production induced by artificially low interest rates by using this key here, this malinvestment concept we've explained all the things that we set out to explain at the beginning so it explains the shape of the cycle the boom and then the bust it explains the cluster of entrepreneurial errors it explains the more dramatic fluctuations in capital goods industries compared to consumer goods industries and it was related to our original suspect areas money and credit thank you very much