The Mechanics of the Business Cycle

0:00I have handed out during the break some articles I've put in the middle of each table, I hope I've put enough, if not there are a few more at the back. And I might explain that one of them called the classic Hayekian hangover is one that Gene Callahan and I wrote in the fall of last year. I couldn't resist including in that article the photo of Hayek that certainly looks hungover. okay but the article was a bit unfortunately timed we wrote it in late August and early September documenting even at that time that the economy was in a downturn and not only in a downturn but in a classic Hayekian downturn and we provide evidence in that paper unfortunately by the time we were ready to Submit it Somewhere, the news was full of nothing but terrorism and we got crowded out in a number of places, but this will appear in this month's issue of Ideas on Liberty issued by the Foundation for Economic Education.

1:12The second handout that I distributed is a review that I wrote of Bob Woodward's Maestro, a popular book published sometime in 2000, probably many of you got it in your Christmas stockings and Christmas of 2000, that's where I got my copy wrote a review of it and I'll draw us to some extent on that review today the title of my topic today is The Mechanics of the Business Cycle it occurred to me that it might be worthwhile to give you two views The mechanics is seen by the Austrian School, which for many of you will be just a reminder, you know what the Austrian theory is, and secondly, the mechanics as seen by Alan Greenspan.

2:00And here's where I draw to some extent on Woodward's account of Greenspan and his thinking and the equations and so on that he used in deciding what the Fed ought to do. And I think I've produced a reconciliation of sorts, in other words, we'll be able to to morph from Greenspan's interpretation to the Austrian interpretation, changing, though, the conclusions dramatically about what the Fed ought to be doing or whether it ought to be doing anything. There'll be a sub-theme in my talk today, and that's Greenspan's role in the recent unsustainable boom, and I'll make it a multiple choice for you. Is it political chicanery or intellectual error?

2:48It's choice A and B. Now, I realize this choice set is not exhaustive. I've left out a few possibilities, including, including, importantly, all the above, okay? So, in fact, we'll draw conclusions that both of these terms have their application. Now, before I get into either view of the mechanisms of the cycle, So let me give you a picture of the landscape here, in terms of the unemployment rate. And I'm going to track it from about 18 or 1989 to the current period. I don't think many of you can see the labeling on the axes very far back. But I'll remind you that there is something called the natural rate of unemployment.

3:35Mises recognized such a rate as suggested by Guido Hulsman in his lecture last night. Conventionally, that rate, which I've portrayed here in yellow, has a bottom of about 5% and a top of about 6%. Arguably, it has changed some over the last several years, but not much, not dramatically, and over quite a long period of time. It's not a rate that's set in stone, and it can change, but it typically doesn't change dramatically in over a short period of time. It certainly doesn't change over the course of a single business cycle, and I think that's the only thing we need to draw from that rate in this lecture.

4:24So, full employment here is shown conventionally between 5 and 6 percent, which rules out the claims of people who thought we'd entered upon a new economy, so-called, and one of whom is Greenspan himself, in which somehow the natural rate of interest had dropped to the 4 percent range. I don't believe it. I don't think we were in a new economy. I think we were in an unsustainable boom. Now, to show you what unemployment has looked like, well first, I'm just labeling the full employment area and if the economy goes much above that, we call it recession or very far above it, depression. If it goes below that, we say the economy is overheated, just means that there's an unsustainable boom in progress.

5:13Okay, let me just show you the unemployment rate over this period. Now, who says the business cycle is dead? Okay, if that doesn't look cyclical, I don't know what does. And it starts, I've got the Bush recession peaking with unemployment at 7.8 and then falling even before the end of the Bush presidency back towards the normal rate or the natural rate and attaining that natural rate in late 95 and maintaining it throughout 96. Then you see the unsustainable boom. You see the unemployment falling clear down to the 4% level and below, 3.9 in the third quarter of 2000. Just to get your bearings here, I'll put in the presidencies.

6:04I'll also indicate, because it's such a momentous event, the September 11th terrorist attack, if only to warn you against the view that it's that attack that's responsible for any large part of our current problems. As you can see from the unemployment rate, unemployment started to rise even at the end of the year 2000 and has continued since that point, undoubtedly accelerated by the terrorist attack, but not basically attributable to it. There is an inconsistency here in the way that economists think about recessions. If you use this criteria, in other words, just look at the rate of unemployment, we see the economy is still fully employed.

6:49It's still within that band, but certainly headed in the direction of recession. The big difference between that reckoning and the one that's more conventionally used is that this focuses on the current situation where the one that's most recently used and reported in the news focuses on the direction of change. In other words, the dating of recessions is based on when the downturn began, and of course you can see from this chart that it began in late 2000, which reinforces some of the things that Frank Szostak told us this morning. Okay, so that's, if you want to date the recession from when it began, when the unemployment rate started to rise and then it goes back to late 2000, but still hasn't yet broken through that full employment range, although undoubtedly will.

7:46Now, I'll ask you to memorize this graph for purposes of interpreting the rest of the lecture, but I'll make it easy for you. for you. I don't think you can even read the years, but if you look at the middle of the graph there, you see in mid 1996, the economy was tapering off in the full employment range, and that's the area I want to focus on, because the economy by this criteria was at full employment with a soft landing in the process or seemingly so, and then it made the downward track clear to 4%, okay? How so? Why so? I believe the critical point was late January of 1996, and mind you, this was the year that Clinton was up for re-election.

8:39It's a point where Greenspan, for the first time during the president, or the Clinton presidency, did something that was at odds with the macroeconomic theory and based on political motivation. You see, when Clinton first took office, the economy was well into recession and what Greenspan was doing was exactly what mainstream macroeconomists would want him to do, keep interest rates low, stimulate the economy and so on, until it gets back down to the full employment range, at which point he's supposed to rein it in and engineer a soft landing. And so only in early 1996 did Clinton face a dilemma. What does he do?

9:25Or I'm sorry, does Greenspan face a dilemma? What does he do? Does he do the politically helpful thing to Clinton, or does he do the macroeconomically sound thing according to mainstream macroeconomists? So it's the context that makes that episode important. And in January of that year, he lowered interest rates, once again. It's also important to note that even at the time, the financial press, and here I mean the mainstream press, reported that reduction as unwarranted and as most likely reflecting political considerations and not economic considerations, okay? So those sorts of actions in a period when the economy was already in the full employment range is what set the economy on that downward trend in terms of unemployment rates and also created the very kind of conditions that caused Greenspan to get his story wrong.

10:18He took it as genuine growth when, in fact, it was bed-stimulated growth. Okay. Now, the Austrian theory of boom and bust, here I'm going to draw, but only lightly, on my own book, Time and Money. And I'm going to present the Supply and Demand for Loanable Funds. is almost an unfortunate term, supply and demand for loanable funds with the loanable funds market. The Austrians, dating clear back to Boehm-Bawerk, have used this market, supply of loanable funds, which is simply people's willingness to save and demand for loanable funds, that's the willingness of business firms to borrow those savings and invest, or acquire those savings through the issuing of equity shares, for instance, and invest.

11:12This is what makes it a misnomer that it doesn't mean literally bank loans, okay? It means any form of saving that facilitates the adding to the capital structure. So I note here that Boehm-Bawerk and even Keynes, this is not really a disputable point. Boehm-Bawerk and Eugen Keynes said that a better name for this graph is the supply and demand of investable resources. In other words, out of current production, a lot of it is consumed. And the part that's not consumed is made available to increase the capital stock or to build on the capital structure. So that's what's meant by investable resources.

11:57The quantity axis there measures both saving, people's willingness to finance those investments through their saving or buying equity shares or whatever, and investment, the willingness of business people to use those savings to undertake investment projects. I'll show that on the graph, supply and demand for loanable funds, and that only at an interest rate shown here as five percent, which is purely for illustrative purposes, we have saving equal to investment, okay, people undertaking investments. That's just right, it's just the amount that income earners are willing to support. I think, listening to Frank Szostak's talk this morning, that that measure, that supply equals demand, saving equals investment along the horizontal axis, is what constitutes the pool of funding. He uses that term fairly often, and I understand pool of funding as to mean just that.

13:01It's resources available to add to the capital structure. Now, it's important that this market be allowed to work, which is to say it's important that the interest rate tell the truth, that the interest rate reflect market conditions in the loanable funds market. And if it does, if the interest rate does reflect those conditions and especially reflect changes in those conditions, then the market will work fine. Investment will be governed by the existing pool of funding or the existing amount of savings available. Things go wrong, of course, when the interest rate reflects, instead, activities by a proactive central bank. All right, so this text tells you that.

13:47I've indicated here that the supply reflects people's willingness to save, and it's important that changes in their willingness to save get accurately reflected in this market. And people can decide to save more than before. It's odd that we as macroeconomists have to emphasize that, that people can change their preferences. But in the face of Keynesianism, who argues the opposite, Keynes argues that the marginal propensity to save is fixed. It doesn't change, depends only on people's income and not on any supposed change in saving preferences. And if they do save, it changes the interest rate and has a direct effect on capital structure.

14:54Let's show that an increase in saving would simply be a rightward shift of that supply of loanable funds curve. So let's let it shift right, reflecting people have decided to save more now. If that happens, of course, it drives down the interest rate from here from 5 to 2.3, the numbers aren't important, and moves the economy down along that demand for loanable funds schedule. In other words, lower interest rates, investors undertake more investment activities, and more importantly, not shown here, but shown in time and money, it affects the pattern of investment. In other words, not only is there more investment made possible by the increased savings, but the lower interest rate that stimulates that more investment also governs the temporal pattern of investment.

15:45It causes investment undertakings to be relatively more long-term, because long-term investments are more sensitive to interest rate changes than our short-term projects, okay? So the economy takes on a longer time horizon, invests for the remote future, and hey, that's perfectly consistent with the hypothetical preference change that brought it about. In other words, when people save, they're saving up for something, they're foregoing current consumption in order to be able to consume more in the future. And the interest rate change that comes out of that will do just that trick, okay? It will cause production activities to be aimed at that further point in the future. Again, I might note here that this gets emphasized in time and money and by Austrian economists generally precisely because Keynes denied it.

16:37But if you remember your Keynesianism, you get the idea that any increase in saving impinges not on investment in a positive way, but rather on income in a negative way, that saving more ends up causing you to earn less, the economy goes into recession, it's called the paradox of thrift. So Keynes has built into his own economics a perversity that forbids increase in saving to get translated into an increase in investment, okay, gets translated instead into depression. This mechanism that I'm showing you here shows how the market can work right, okay, and again This text tells you just what I said, so you don't need to read it.

17:35Now, it turns out that we might have a situation where there hasn't been any increase in saving. Supply and demand conditions are what they are, and they stay that way. The interest rate needs to stay at 5%. The economy's growth rate reflects that, and here, just for illustrative reasons, it shows saving and investment are equal, and equal to 800, probably 800 billion, because this is a macro figure, this is for illustration, actual saving and investment in this economy are about twice that, about 1,600 billion at the current time. Okay? If monetary expansion pushes the economy to grow faster, the increased growth rate is not sustainable.

18:23In other words, now what I want to show you by contrast, what if that supply of loanable funds is shifted to the right, not by people deciding to save more, but by a central bank decision? It's a totally different kind of process. Although it looks for all the world to be very similar. That's what gives rise to the problem. Market signals that look like they reflect an increase in saving turn out to have reflected nothing but some proactive policy position. And I'm not naming names, but it shows you basically different nature of the process.

19:09Because we're not talking here about a market economy at work for you and for me. We're talking about a single institution, a single man, really, who makes decisions to influence the interest rate, okay? And that decision can end up increasing the supply of loanable funds. And so what I want you to note is how similar that graph looks to the earlier one, which which actually showed an increase in saving, okay? This one though is not an increase in saving. In fact, quite the contrary, let's just look here, pumping money through credit markets has the effect initially that are similar to the effects of increased saving, okay?

19:55The interest rate decreases, you can see that. Increased investment is accompanied by a decrease in the saving magnitude because the old savings function is still the right one. And so at the lower rate of interest, people save less, okay? They're not getting as much interest for their money, so they save less, which is to say they consume more. So this is what sets the economy at war with itself. On the one hand, you have investors investing more and investing for a longer term. While at the same time you have consumers Far from making that possible by increasing their saving, cut against it by increasing their current consumption, all right?

20:40So they're draining from the pool of funding, as Frank termed it, at the same time where investors are making decisions that count on a larger pool of funding, right? So this is what sets the economy against itself. The process doesn't play itself out as economic growth, it rather does itself in when it turns And it turns out that those investment projects cannot all be completed. That gives you the bust, the downturn. That's the story of the business cycle. So, look at this little triangle. Memorize it, too. You're moving along the demand curve, increasing investment, moving back along the supply curve, decreasing saving. And, of course, the base of that triangle, the horizontal component, and especially the quantity of money that the Fed created and pumped in through credit markets, all right?

21:32That's what's maintaining the wedge between saving and investment. That's the mechanism as identified by the Austrians. Now, this is what I've just told you about who introduced Ludwig von Mises' own terminology for this, that he says the artificial boom is characterized, and this is a term he used repeatedly in Human Action, malinvestment and overconsumption, okay? So the malinvestment is investment activities aimed at the too far distant future. The overconsumption is the excessive consumption brought on by the low rate of savings, and that explains the bust. Now, in the few short minutes remaining, I want to talk about Greenspan's theory of productivity.

22:20Now why is that funny? It's not a coincidence, by the way, that it almost sounds like Einstein's theory of relativity. Greenspan read Einstein, and he actually thought his theory was the macroeconomic equivalent of that. In mid-1996, after Greenspan had decreased the interest rate, he noticed that things were picking up. The economy seemed to be growing faster, and he came up with a formula that we won't contest directly, except we need to put it on a per unit basis. He says price equals labor cost plus non-labor cost plus profits. Well, duh, okay.

23:06In fact, this was as reported by Bob Woodward, and we can see that if we correct for the per unit basis, it's an accounting identity. Per unit profits equals price minus per unit cost. Yes, okay? And costs equal labor costs plus non-labor costs, okay? I've got my graduate assistant working on that one, okay? So if we put it on a per unit basis, it looks like that. In other words, per unit, I'm dividing by the quantity of output. And Greenspan managed to change this from what really is a truism into an economic profundity, or he thought it was, because he observed, for instance, that profits are rising. That's that numerator in that third term.

23:52But non-labor costs, just the numerator there, are not changing. The wage rate's not changing, and neither was employment at the time. So labor costs are constant, and prices weren't changing much. There wasn't much price inflation. And so he concluded that the only way this equation can hold true, if the mathematicians among you will see it, is if Q is rising. In other words, if you're getting more output for a unit of labor, he declared this an increase in productivity and used it to justify increasing the money supply, because with more output, you can pump in more money without affecting prices. Okay? He actually set his staff to work on documenting this and argued that, well, the staff supposedly thought of their job is a tantamount to the Manhattan Project, okay, documenting.

24:43And I'll just argue, I'll just give you an alternative explanation that squares perfectly with the Austrian theory, okay? I'm gonna write the symbols differently, so the cost of capital or the interest rate times the amount of capital, I'll leave unchanged the other things that Greenspan had observed. But what's happening here, of course, is that the interest rate,

25:07Let me make this thing click, it didn't want to click for me. There it is. The interest rate fell because Greenspan lowered it, and as a result, capital in the industries he was looking at rose as people, as they allocated more capital to those industries, which leaves the non-labor cost relatively unchanged in that period, and that's what gave rise then, That's what gave rise to the increase in quantity, in other words, it was of his own doing and not because we'd ended up on a new economy of some sort. And so the reason that things were happening was because that interest rate fell and not because somehow labor had become inherently more productive.

25:55And I summarize it for you here saying to help Clinton in his re-election bid, Greenspan decreased interest rates even though the economy was already at full employment. Then he misinterpreted the increase in output that characterized many sectors, but not all, of the economy as a general increase in labor productivity. It wasn't general, okay, that would raise output in all sectors. And he concluded that the money supply could be further increased without causing inflation. And so there's the political chicanery, as I reported here, political chicanery leveraged by intellectual air. And so there you have it. OK, thank you much. Thank you very much.