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IMPORTANT FED Graph Demonstrates Austrian Business Cycle Theory

Discussion in 'Library and Editorials' started by dpong, Jan 4, 2014.



  1. dpong

    dpong Gold Member Gold Chaser

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    In this series of posts, I'm going to go backwards. Instead of posting an exposition of Austrian Business Cycle Theory (ABCT) and gradually working up the explanation so that the graph is understandable in context, I'm going to start directly with the graph and work backwards to explain what it means and how it demonstrates the ABCT in action. When I first saw the explanation, being deeply into ABCT, I was quite taken with it.

    By getting the graph before the explanation, it is a little like eating dessert first.

    First, I will ask you to not worry about what the graph represents. That will come later. For now, simply observe the graph carefully. Notice how very well a dip (downturn) in the graph matches up with official recession periods marked as grey areas.

    Take your time and really check this out. While not every dip in the graph corresponds to a recession, I think that every recession corresponds to a dip in the graph. For this post, that is enough. Observe it.

    More to come, but please take to time to see this correlation before proceeding. It will help it all sink in.
     

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  2. dpong

    dpong Gold Member Gold Chaser

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    Now here is another view of the graph from the excellent blogger Pater Tenebrarum who blogs at www.acting-man.com

    He is the one who exposed me to this graph. He titles it: The ratio of business equipment to consumer goods production.

    The graph stands as a proxy for how much money is being spent producing producer goods (capital goods) versus what is being devoted to consumer goods production. This is a very important concept in the ABCT.

    In the next post, I will provide a more long-winded explanation of the ABCT and the Austrian's view of the importance of the structure of production, but for now here are some brief comments by Pater Tenebrarum regarding how he views this graph:

    We have frequently pointed out here that a rough approximation of what happens to the economy's production structure – the ratio of investment in capital versus consumer goods production – indicates that the economy is becoming increasingly imbalanced. In essence, the current capital structure is one that increasingly ties up more consumer goods than it releases, an inherently unsustainable trend. There must be enough saved consumer goods available to sustain not only pre-boom consumption trends, but also the workers employed in all the new long-run, capital intensive projects that have been started due to appearing profitable on account of artificially low interest rates. Once the ratio of investment in higher order goods production relative to lower order goods production gets so skewed that it extends beyond what Roger Garrison calls the 'production possibilities frontier', an economic bust can no longer be avoided.

    [Note: By "higher order" goods, he is referring to capital goods further away from the end consumer product. By "lower order" goods he is referring to capital goods closer to the end consumer product or the consumer product itself.]
     

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  3. dpong

    dpong Gold Member Gold Chaser

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    For those seeking an understanding of ABCT and the Austrian views of Interest and Capital here is a longer treatment by Robert Murphy. I think he does a good job in this explanation while keeping it fairly short. These are the ideas that give the graph some meaning and context. The graph would not be useful for technical analysis or timing - and that is not the point of this exercise. However it is quite clear how it matches with the Austrian view of the business cycle. From its current position, it appears that some maladjustments need to be corrected before we can be on a firm footing again.

    The full article: http://mises.org/daily/4993


    The Austrians on Capital

    In contrast to mainstream macro models, which either do not possess capital at all or at best denote it as a homogenous stock of size "K," Austrian theory explicitly treats the capital structure of the economy as a complex assortment of different tools, equipment, machinery, inventories, and other goods in process. Much of the Austrian perspective is dependent on this rich view of the economy's capital structure, and mainstream economists miss out on many of the Austrian insights when they make the "convenient" assumption that the economy has one good. (Krugman will be glad to know that yes, I can spell all this out in a formal model — and one that referee Paul Samuelson grudgingly signed off on.[​IMG])

    Krugman and other Keynesians stress the primacy of demand: they keep pointing out that the owner of an electronics store, say, won't have the incentive to hire more workers, and buy more inventory, if he doesn't expect consumers will show up with money to spend on new TVs or laptops.

    But Austrians point out that demand per se is hardly the whole story: Regardless of how many green pieces of paper the customers have, or how much credit the store can get from the bank, it will bephysically impossible for the electronics store to fill the shelves with new TVs and laptops unless the manufacturers of those items have already produced them. And in turn, the manufacturers can't magically create TVs and laptops merely because the demand for their products picks up; they rely on other sectors in the economy having done the prior preparation as well, such as mining the necessary metals, assembling the proper amount of tractor trailers needed to ship the goods from the factory, and so on.

    These observations may strike some as trivial, not worthy of the consideration of serious economists. But that's only because normally, a market economy "spontaneously" solves this tremendous coordination problem through prices and the corresponding signals of profit and loss. If someone had to centrally plan an entire economy from scratch, there would be all sorts of bottlenecks and waste — as the actual experience of socialism has shown.

    Without the guidance of market prices, we wouldn't observe a smoothly functioning economy, where natural resources move down the chain of production — from mining to processing to manufacturing to wholesale to retail — as neatly depicted in macro textbooks. Instead, we would see a chaotic muddle where the various interlocking processes didn't dovetail. There would be too many hammers and not enough nails, too much perishable food and not enough refrigerated railroad cars to deliver it, and so on.

    The Austrians on Interest

    When it comes to explaining the coordinating function of market prices, Austrians assign a very important role to interest rates, for they steer the deployment of resources over time. Loosely speaking, a high interest rate means that consumers are relatively impatient, and penalize entrepreneurs heavily when they tie up resources in long-term projects. In contrast, a low interest rate is the market's green light to entrepreneurs that consumers are willing to wait longer for the finished product, and so it is acceptable to tie up resources in projects that will produce valuable goods and services at a much later date.

    [​IMG]

    In the Austrian conception, it is the interest rate that allows the financial decisions of households to interact with the physical capital structure, so that producers transform resources in the ways that best satisfy consumer preferences. Consider a simple example that I use for undergraduates: Suppose the economy is in an initial equilibrium where households save 5 percent of their income. Then the households decide that they want to have more for their retirement years, because they don't want their standard of living to plummet once they stop working. So all the households in the community begin saving 10 percent of their income.

    In the Austrian view, the interest rate is the primary mechanism through which the economy adjusts to the change in preferences. (It's not that people switched from buying hot dogs to hamburgers; instead they switched from buying "present consumption" to buying "future consumption.") The increased household saving pushes down interest rates, and at the lower rates businesses can start long-term projects. From the individual entrepreneur's point of view, the interest rate affects the profitability of longer projects more than shorter ones (as a simple "present-discounted-value" calculation shows). So a lower interest rate doesn't merely stimulate "investment" but actually gives a greater inducement to investment in durable, long-term goods, as opposed to investment in nondurable, short-term goods.

    How is it possible that the community as a whole can have more income in, say, 30 years? Obviously the households think it is financially possible, because their bank balances rise exponentially with the higher savings rate. But technologically speaking, this is possible because the composition of physical output changes. The households have cut back on going out to dinner, buying iPods, and so on, in order to double their savings rate. This means that restaurants, Apple stores, and other businesses catering to consumption will have to lay off workers and scale back their operations. But that means labor and other resources are freed up to expand output in the sectors making drill presses, tractors, and new factories.

    In 30 years, the economy will be physically capable of much higher output (including the production of consumer goods), because at that time, workers will be using a larger accumulation of capital or investment goods made during the previous three decades. That is how everybody can have a higher standard of living, through savings.

    The Austrians on the Business Cycle

    Now that I've given a summary of the Austrian view of capital and interest, we get the reward: their explanation of the business cycle. When interest rates are pushed down below their market levels (by expansionary central-bank policy, for example), this sets in motion the same processes that would occur if there were an actual increase in savings. In other words, at the lower interest rate, entrepreneurs find it profitable to begin long-term projects; the capital-goods sectors of the economy begin hiring workers and increasing output.

    However, this expansion of the capital-goods sectors isn't counterbalanced by a shrinking of the consumption-goods sectors, the way it would be if households actually started saving more. Instead, the households try to consume more too, because of the lower interest rates.
    An unsustainable boom sets in, a temporary period of illusory prosperity. Because every sector is expanding, there is a general feeling of euphoria; it seems every business is having a "great year," and the unemployment rate falls below its "natural" level.

    [​IMG]

    Unfortunately, at some point reality rears its ugly head. The central bank hasn't created more resources simply by buying assets and lowering interest rates. It is physically impossible for the economy to continue cranking out the higher volume of consumption goods as well as the increased output of capital goods. Eventually something has to give. The reckoning will come sooner rather than later if rising asset or even consumer prices makes the central bank reverse course and jack up interest rates. But even if the central bank keeps rates permanently down, eventually the physical realities will manifest themselves and the economy will suffer a crash.

    During the bust phase, entrepreneurs will reevaluate the situation. If the government and central bank don't interfere, prices will give accurate signals about which enterprises should be salvaged and which should be scrapped. Those workers who are in unsustainable lines will be laid off. It will take time for them to search through the developing opportunities and find a niche that is suitable for their skills and is sustainable in the new economy.

    During this period of reevaluation and search, the measured unemployment rate will be unusually high. It's not that workers are "idle," or that their productivity has suddenly dropped to zero; rather, it's that they need to be reallocated, and that takes time in a complex, modern economy. This delay can be due to simple search, where the workers have to look around to find the best spot that is already "out there," or it can be due to the fact that they have to wait on other workers to "get things ready" before the unemployed workers can resume. (This is what happened in my sushi story.)

    I'll stop the summary at this point in order to address Krugman's objections. The interested reader can see more technical (yet still accessible) expositions in this collection of essays, while those interested in a graphical exposition (using mainstream concepts such as the PPF) should check out Roger Garrison's fantastic PowerPoint presentations.
     
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  4. dpong

    dpong Gold Member Gold Chaser

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    If the above explanation was too long-winded for you, I'll try to pick out the most important conclusions, highlight important statements, and hopefully encourage you to go back and read the whole thing. This is really the kernel of the ABCT and what can be seen happening in the proxy graph.

    ---------

    When interest rates are pushed down below their market levels (by expansionary central-bank policy, for example), this sets in motion the same processes that would occur if there were an actual increase in savings. In other words, at the lower interest rate, entrepreneurs find it profitable to begin long-term projects; the capital-goods sectors of the economy begin hiring workers and increasing output.


    However, this expansion of the capital-goods sectors isn't counterbalanced by a shrinking of the consumption-goods sectors, the way it would be if households actually started saving more. Instead, the households try to consume more too, because of the lower interest rates.


    An unsustainable boom sets in, a temporary period of illusory prosperity. Because every sector is expanding, there is a general feeling of euphoria; it seems every business is having a "great year," and the unemployment rate falls below its "natural" level.


    Unfortunately, at some point reality rears its ugly head. The central bank hasn't created more resources simply by buying assets and lowering interest rates. It is physically impossible for the economy to continue cranking out the higher volume of consumption goods as well as the increased output of capital goods. Eventually something has to give. The reckoning will come sooner rather than later if rising asset or even consumer prices makes the central bank reverse course and jack up interest rates. But even if the central bank keeps rates permanently down, eventually the physical realities will manifest themselves and the economy will suffer a crash.


    During the bust phase, entrepreneurs will reevaluate the situation. If the government and central bank don't interfere, prices will give accurate signals about which enterprises should be salvaged and which should be scrapped. Those workers who are in unsustainable lines will be laid off. It will take time for them to search through the developing opportunities and find a niche that is suitable for their skills and is sustainable in the new economy.
     
    Last edited: Jan 4, 2014
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  5. Goldhedge

    Goldhedge Modal Operator/Moderator Site Mgr Site Supporter

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    Pretty much where we are now. Knocking on the door we are...



    How fast we get there depends upon the Jeeves the butler.

    He's getting rather slow in his old age shuffling down the corridor to answer the bell... and open the door....
     
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  6. dpong

    dpong Gold Member Gold Chaser

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    http://www.acting-man.com/?p=28065

    Some updated comments on the chart from Acting-man.

    As our regular readers know, we like to keep an eye on changes in the capital structure via a ratio of production indexes, as imprecise as they probably are. Note here that the long term trend partly reflects the increase in global trade and the growing global division of labor, but the noticeable medium term volatility in the ratio suggest that the approach is sound: [see chart]...

    The ratio of capital to consumer goods production. In boom times spurred by declining interest rates it tends to rise, while it decreases during the subsequent bust periods.

    While we cannot state with certainty when and where exactly the recent trend will turn, the current height of the ratio suggests that a negative inflection point is probably fairly close (or may have occurred already). If so, then the record high in net corporate indebtedness is likely to end up creating great difficulties – not only for the debtors, but also their recently officially optimistic creditors.
     

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