What Causes the Business Cycle?

[This speech was given at the Mises Institute’s “Austrian Economics and Investing” Conference, Vienna, Austria, May 25, 1988. (Some information has been updated.)]

The greatest mystery in the history of economic theory, and still the most unresolved controversy in the economics profession, is the nature and source of the business cycle. Why do recessions occur and why do booms occur? Why do they tend to follow each other with some degree of regularity?

Solving the mystery of the business cycle is a different task than confronted Adam Smith and the classical economists. They sought to answer the question of how economies grow. They concluded that free exchange and capital accumulation are the sources. But the mystery of the business cycle deals with a far more complex problem of why growth seems to occur intermittently. This is a question that only began to absorb economists in the middle of the 19th century.

Part of the reason is that business cycles simply didn’t exist in the prior centuries. We get a clue to the ultimate resolution of this problem by noting that central banks didn’t exist before business cycles began to be noticed. But it took economists a very long time before they put two and two together to understand that it is the activities of the central bank itself that bring about the trade cycle.

Business cycles raise a particular question. It is not why businesses fail. We know that in a vibrant market economy, businesses do fail. Entrepreneurial forecasting ability is not perfect, innovation disrupts plans, and consumer demand is always changing. The only economies where businesses do not fail are stagnant, socialist ones. Thus, to the question of why businesses start and fail, we already have the answer: the market rewards only those who serve the consuming public, and not all businesses do so all the time.

The question that the business cycle asks is different. Why do business errors often occur in clusters? Why do entrepreneurs make mistakes on an aggregate level? Why, if you look at macroeconomic data, do we see these large swings in economic activity that have come to be called booms and busts?

In Karl Marx’s view, the business cycle was an inherent part of the capitalist economic system and a signal of its fundamental instability. He foresaw cycles worsening, with each recession worse than the last, and ultimately leading to the breakdown of capitalism itself. For decades socialists echoed his forecast, and attempted to reinterpret every cycle as a millennial sign that the capitalist system was being trampled by forces of history.

The cycle theories of Marx were far from the only reason his ideas came to be accepted by intellectuals. The real source of attraction to Marxism was its promise of an egalitarian society, one that operated without traditional restraints on economic and sexual behavior. Envy-ridden intellectuals, forever believing themselves to be underpaid and overworked, were attracted to the idea of expropriating the capitalist class and enjoying the proceeds. Since then, these intellectuals have learned they can do this without bringing about the breakdown of capitalism. They can work through Congress and state legislatures to bring about the same result.

The Great Depression seemed to confirm Marx’s view of the business cycle and gave a boost to the socialist cause. Beginning in the early 1930s, a huge debate ensued between market advocates like Henry Hazlitt, author of Economics in One Lesson, and socialist intellectuals writing in the pages of leftist weeklies like the Nation. The socialists pointed to the declining share of the return on capital enjoyed by the workers and the rising profits of the exploiter class. They said that the Great Depression ensued when workers no longer had the means to purchase products of their own making. The only answer, then, is to redistribute property from the capitalists to the workers, and insure that society, as embodied by the State, and not private owners of capital, would control the means of production.

Here again, over time, the socialists learned that it was not necessary to bring about a revolution to achieve this end. Congress, the executive branch, and state legislatures were all that was necessary to prevent owners of capital from controlling the uses of their own property.

For a time, it appeared that the socialist interpretation of the Great Depression was winning out. And even to this day, the interpretation is underscored in John Kenneth Galbraith’s interesting but wrongheaded book on the Great Depression, and in countless PBS documentaries. The fallacy with all of these accounts is that they deal with the downturn, as if it is the only issue worth examining, but not with the larger perspective of the cycle in general. Only by broadening our horizons to understand the boom phase of the cycle as well can we arrive at reasonable conclusions and solid recommendations for minimizing the role of cycles.

In 1936, John Maynard Keynes came out with his General Theory, which came to dominate macroeconomic thinking for decades following. Though his original work is rarely read by professional economists, and virtually never discussed in the classroom setting, the assumptions behind his theory still dominate much of economic thinking.

In Keynes’s theory, like Marx’s, business cycles are an inherent part of the market economy. But he argued it was not necessary to overthrow property and markets in order to control them. The government, working hand in glove with Keynesian economists of course, could pursue policies that would keep business cycles at bay. The problem, said Keynes, was fundamentally twofold.

First, the price system doesn’t work very well or reflect real economic needs. Prices and wages often do not adjust in ways that coordinate the economy. But by manipulating prices, mainly through inflation, the system could be fixed up. Second, the investment sector is fundamentally irrational. Animal spirits periodically sweep through markets, causing businesses to underinvest in things that are needed and overinvest in things that are not.

Keynes offered two ways out of this problem. We can live with the resulting business cycles, but this creates its own problems since the price system is so deeply flawed. Or we can manipulate the demand side of the economy to force it into coordination with the supply side. As a result of this Keynesian-style analysis, the government now had an intellectual justification for the huge New Deal machinery that had been established to manage the economy. After the war, this Keynesian machinery became a permanent part of government policy.

Economists deluded themselves into thinking they could smooth out business cycles by managing countercyclical fiscal and monetary policies. The idea was this: in an economic downturn, the government could goose the money supply and run a deficit to lift the economy back into normalcy. Once recovered, the government would drive up interest rates again and run a budget surplus. It would be as simple as managing the gears on a stick-shift car while driving through mountain terrain.

The result, of course, was far different. In the postwar period, business cycles became progressively worse, with every attempt to manage them seeming to create its own problems, among them inflation, hyperinflation, enormous government debts, and rising deficits. I think we should also include, as a cost of Keynesian policy, the loss of freedom that Americans experience. No longer did we have a government that largely stayed out of economic policy. Rather, we had a government that regarded itself as all-knowing and regarded the market economy as essentially stupid.

It is often said that John Maynard Keynes and the New Deal saved capitalism from itself. In fact, his ideas radically distorted what we call capitalism. The US government is the biggest, most powerful government in human history. To this day, it is involved in every area of American economic life. It has veto power over the hiring and firing decisions of virtually every business in the country. It tells people how old they must be to work, how much they must be paid, what benefits they must be provided, and taxes a third or more of their income. The government regulates, in minute detail, the architecture of every commercial building in the country. With its antitrust laws and taxing power, it can make or break huge corporations. Recently we’ve seen the Justice Department attempt to guide the direction of software development, even threatening to bar the introduction of newer generations of software.

Yet despite all this, the US is widely seen today as the paragon of capitalism. A century-and-a-half ago, all this would have been seen as the embodiment of wild-eyed socialist experimentation. But a century that has been dominated by the State as much as this one has changed everyone’s standards of what constitutes freedom.

Is the business cycle truly a natural part of the free market? Ludwig von Mises explored this question in his 1912 book called the Theory of Money and Credit. He first explored the possibility that discoordinations in gold flows between countries, caused by bad monetary policies, might be the source of booms and busts. And while he concluded that this is the root of international business cycles, he said this doesn’t explain how a business cycle could be created in a single country. In exploring this issue, he went much further in his analysis than any previous thinker.

His resultant theory is called the Austrian theory of the business cycle. The Austrian theory notes that it is crucial to understand the boom times in order to understand the bust. To generate an economic boom, the central bank artificially lowers interest rates, creating the illusion of increased savings. Faced with new credit availability, the business sector borrows to expand production and begin long-term investment projects. The boom continues for as long as interest rates remain artificially held down. Businesses continue to invest in projects for which there is no real, underlying economic demand or rationale. This type of investment is what Mises called malinvestment.

Note that during this period, the increase in money and credit doesn’t necessarily result in higher prices. The monetary inflation is bringing about a fundamental structural change in the economy, but it is not creating any visible ill effects. Production is expanding, unemployment is down, interest rates are low, the stock market is booming, and everyone appears to be getting richer. We can recognize this in the US and Britain in the 1920s, Asia in the 1980s and early 1990s, and quite possibly the US today.

But this boom is not self-sustaining. When businesses bring products to the market at the end of the production process, they are met with consumers who have neither the savings nor the income to purchase them. Once prices eventually do begin to creep up, the discoordinations between the investment and spending sector begin to be revealed. The central bank raises rates to prevent conspicuous declines in the purchasing power of money, and the boom begins to reverse itself. This process can occur over six months or 15 years (Japan). There is no set formula. The timing is largely unpredictable as well, especially in a global economy.

But these business cycles do terrible damage to the economy. They bankrupt businesses that were only trying to follow the market’s signaling devices. Businessmen could not have known with certainty that the Fed was manipulating the signals. Business cycles throw people out of work, not because managers or the owners of businesses were engaged in inefficient production, but because everyone was dealt a bad hand by the money managers at the top of the central bank.

This is essentially what brought about the Great Depression. Throughout the 1920s, the Fed engaged in an expansionist monetary policy, giving stocks, real estate, and heavily capitalized businesses an artificial shot in the arm. When the stock market finally crashed, and the bubble burst, the exaggerated investment was exposed as a fraud. Thus, we can see that it is not the market that is the source of business cycles. Rather, the business cycle is the working out of a market attempting to correct for the failures of central bankers and the government officials who cheer them on.

The central bank has long felt the pressures of politics to keep interest rates unnaturally low. These pressures come from both the president and the Congress. The president, of course, is concerned about keeping rates low before elections. Quite often, presidents are willing to tolerate a recession after election to their first term. But they will not tolerate one leading up to the election itself. The Fed chairman, who frequently proclaims his independence from politics, is in fact utterly dependent on favors from the White House. In order to maintain the Fed’s much ballyhooed independence, it must do what the president wants.

The central bank also faces pressures from its member banks, who profit from the boom created by lower rates.

Congress also has an impact. If we ever see the Fed chairman threatened with investigations into the Fed’s secrecy, or badgered in front of committees, it is nearly always done in times when interest rates are high. Special interest groups—from large manufacturers to farmers—lobby their Congressmen to intervene. There are very few politicians who call the Fed to complain when it is keeping the lid on interest rates.

Of course, the media play a role in the interest-rate conspiracy as well. They are always ready to tell the public about the sad plight of borrowers who are being squeezed by high interest rates. Telling the story of a structure of production that has fallen into misalignment because of artificially low rates just doesn’t make good copy. The media fan the flames during recessions, especially when every business failure is considered to be a national tragedy instead of part of the natural cleansing process of the market economy.

The media also add to the general sense that the boom phase of the cycle is the good phase and the bust is the bad phase. In fact, looked at from an economic perspective, the boom phase is the one that should worry us. It is during these times that borrowers are being misled and economic misalignments are taking place. The bust represents a period of honesty and decency, when at last reality is catching up to the lies that low interest rates have been telling.

The common misperception that economic booms should go on forever is what gives impetus for governments to intervene. But any intervention designed to soften the blow of a recession can only end up prolonging the agony, just as it did during the Great Depression, and as such efforts are doing today in Asia. What should government do during a recession? The short answer is nothing. It should take care to ensure there are no obstacles to the downward adjustment of wages and that the market is free to generate entrepreneurial opportunities, but otherwise it should stay out of the way.

Compare the actions of Warren G. Harding with those of Herbert Hoover. In 1921, the US experienced a major economic downturn, which was a direct result of the inflationized economy of wartime. Unemployment reached 11.7 percent, even as high as 15 percent, and output crashed. This was after unemployment had fallen to 1.4 percent in 1919. Economists generally rank the severity of this depression more extensive than even the one that would follow a decade later.

There was no shortage of advice given to the Harding administration. Henry Ford and Thomas Edison wanted to create fiat money on a huge scale. The secretary of commerce, Herbert Hoover, wanted a massive public-works program. Labor leaders demanded make-work programs.

In the end, however, before these plans could be implemented, the economy began to rebound. By 1922, unemployment was back down to reasonable levels, output was expanding, and the economy was rebounding across the board. This was laissez-faire at work. The politicians could not act fast enough, and thank goodness. The depression was over in a year.

Compare that to the actions of the Hoover administration. Despite his reputation as a do-nothing president, he did far too much. He attempted to keep wages propped up and to stop business failures. He embarked on a massive public works spending program and erected high tariff barriers. He may have been living out a fantasy first developed when he was secretary of commerce, but the economy was the victim. We did not enter recovery as we should have and could have, and instead we got a national socialist as president for four straight terms.

Let me proceed, then, to an analysis of where we are today [1998]. There is no shortage of New Era thinking. The line you read again and again in the pages of the Wall Street Journal is that the business cycle has been abolished, and that we have entered into a new paradigm of permanent prosperity. This kind of talk worries me. It is precisely what we had heard about Asia for the last several years. And it is what was said in 1920s America.

The bottom line is that there ain’t no such thing as a New Era. As long as we live on this earth, there are certain fixed cause-and-effect relationships at work that cannot be repealed. Among them is this: an economy pumped up by artificial credit will eventually enter recession. When it happens and what the effects will be are open questions. But that it will happen should not be in dispute.

Can we know where we are in a cycle? We can get an inkling by looking at the data, particularly Federal Reserve money supply figures, savings rates, and basic stock indicators. We first have to ask ourselves: where are the excesses? Inflation is low and business investment doesn’t appear to be particularly overblown. But look at the stock market. We’ve experienced astounding increases, with stock prices having quadrupled since 1990. The price/earnings ratios are now at a historic high of 28, from a postwar average of 14. At the same time, personal saving has fallen rather dramatically. In 1992, personal saving was 6.2 percent of disposable income. By 1997, it had fallen to 3.8 percent of disposable income. This is the lowest rate since 1946.

Greenspan has not abolished business cycles. But he has been lucky enough to preside over a new era in monetary affairs, one in which the dollar has been catapulted from a regional currency to the world’s reserve currency. The dollar’s hegemonic reign has allowed him to conduct a reckless policy of socializing investment risk while not paying the price. From the end of 1990 to the end of 1996, the Fed used its open market operations to increase the monetary base (MB), which is currency plus bank reserves, by 55 percent. Currency itself increased 60 percent.

As Jeffrey Herbener of Grove City College has pointed out, the dollar-reserve system of the “global economy” of the 1990s is the resurrection of Keynes’s Bretton Woods system without gold. Under the “gold-reserve” system of Bretton Woods, each country’s currency had a fixed exchange rate against the dollar, and foreign governments could redeem the dollar at the US Treasury for gold at the fixed rate of $35 an ounce.

The linchpin of the Bretton Woods agreement was the fixed rate of redemption between the dollar and gold. The Fed undermined this link by accelerating monetary inflation in the 1960s to help finance expenditures for the Great Society and the Vietnam War. From the beginning of 1960 to the end of 1964, the Fed increased the money base 3 percent per year, but from the beginning of 1965 to the end of 1970, the Fed more than doubled the rate of increase to 6.3 percent. The average annual rate of price inflation went from 1.3 percent in the earlier period to 4.2 percent in the latter one.

After increasing the monetary base 8.7 percent per year from 1971 to 1974, the Fed accelerated the rate to 10.4 percent from 1975 to 1981. But after the debacle of the first half of the 1970s, it was difficult to convince foreigners to hold more dollars as reserve. Accelerating monetary and credit inflation by the Fed led to severe domestic price inflation (average annual rates of 11.2 percent), soaring interest rates (peaking in 1981 at a 14 percent 3-month rate), collapsing capital values (from 1976 to 1982, the Dow lost 22 percent and stood at 774 in 1982), and higher unemployment (peaking at 9.7 percent in 1982, a rate not seen since 1941).

This entire scenario is precisely the reverse of the American economy in the 1990s. From 1982 through 1990, the dollar began to regain its status as the world’s reserve currency. The Fed expanded the monetary base 11 percent per year in the 1980s, but the demand to hold dollars overseas helped soak up the monetary inflation, and the American economy experienced economic growth with low levels of price inflation. The annual rate of price inflation was only 5.9 percent. But the improved performance of the economy in the 1980s was only a foretaste of the renaissance of dollar dominance in the world.

American supremacy in the wake of the collapse of communism allowed the Fed to fully exploit the international dollar-reserve system. The new system opened up a vast new vista for overseas dollar holdings. From Russia and Eastern Europe to China and East Asia, the governments of former communist countries began to soak up dollars to hold as official reserves as they became part of the American, “global” system. From the beginning of 1991 to the end of 1996, the Fed increased the monetary base 9.1 percent per year, while price inflation ran only 3.6 percent annually.

Like Bretton Woods, the new regime depends on foreigners’ willingness to hold dollars and use them as the basis for their own domestic monetary inflation and credit expansion. Only with harmonized monetary policies can the system survive.

But therein lies the great danger of the system to the American economy. A rogue nation will be tempted to defend its currency and stave off devaluation by spending its dollar reserves. Any significant disgorging of dollars would threaten to ignite price inflation in America if the dollars were repatriated. Significant domestic price inflation would, at best, bring a repeat of the 1970s, and, at worst, a hyperinflation.

This danger explains the US interest in promoting IMF austerity policies and bailouts. The bailouts are intended to soften the blow of devaluation and price inflation. In exchange for taxpayers subsidizing banks and large corporations, and other key beneficiaries of the system, the IMF can use the bailout money as leverage to impose conditions favorable for the future of the dollar-reserve system.

In the last three years, the system has faced a $50 billion bailout of Mexico, a $57 billion bailout of South Korea, $43 billion for Indonesia, $18 billion for Thailand, for a total of $118 billion in Asia (some estimate that it will eventually rise to $160 billion) to fend off its own destruction. But by delaying the day of reckoning with bailouts, the international mountain of dollars and debt grows, making the inevitable collapse all the more devastating.

The system will not be able to prevent the disgorging of dollar reserves to fend off Asian-style financial debacles in China, South America, Russia, and a repeat performance in Mexico. If the euro becomes the common currency of the EU, its members replace their dollar reserves with euros. And if Japan recovers, the yen will become the reserve currency across Asia. Global dollar hegemony will be at an end.

The Fed has overseen the best of times for the American economy in the 1990s, a period of rapid monetary inflation and credit expansion with current benefits of low interest rates, high earnings, soaring capital values, low unemployment, and steady economic growth. It has come courtesy of foreigners who have absorbed enormous quantities of dollars and, in so doing, kept the business cycle at bay.

Don’t count on that to last forever.

We could abolish business cycles if we had the will. It would require extreme monetary discipline, an end of risky socialism, the abolition of institutions like deposit insurance and fractional-reserve banking that sustain essentially bankrupt banks and investment houses, and finally, the institution of a true world money based on gold. Until then, we can expect that our troubles are far from over. We can only hope that when the inevitable recession does set in that Greenspan won’t do something stupid like bail out the stock market, attempt to defend the dollar internationally, or keep banks from failing. Sadly, given his close working relationship with the White House, and the fecklessness of the GOP, the next downturn of the business cycle is likely to look less like 1921 and 1922 and more like 1931 and 1932.

[Note: In the recession of 2001–2003, Greenspan has done all of the above.]