Visit me on Seeking Alpha where I publish exclusive articles.

Tuesday, 11 March 2014

Boom and Bust

By Gene Callahan (published August 2000)

Imagine that you are a bus driver at the edge of a desert, about to take a busload of passengers across it. You have left all gas stations behind, and are now faced with a decision. There are a number of towns on the other side of the wasteland before you, each a different distance away. The farthest away of these towns also happens to be the closest to your final destination. You can try to reach any of them, but there is a trade-off: the farther away the town, the less the passengers can use the air-conditioning to alleviate the desert heat, as running the AC will use up the gas more quickly.

In order to make your decision, you look at your fuel gauge and determine how much gas you have. You tell the passengers that they must now make a trade off between comfort on the way and distance traveled, as the more air conditioning they choose to use, the faster the bus will consume fuel. Then you collect votes from the passengers on what temperature to keep the bus. You perform some calculations on mileage, speed, and fuel consumption, and pick the farthest city you can reach given the amount of gas you have and the passengers' vote on the use of air conditioning.

The passengers had to decide whether to cross the desert in greater comfort but arrive farther from their final destination, or in less comfort but with a closer arrival. The science of economics has nothing to say about the combination that they picked, other than that it seemed preferable to them at that moment.
However, also imagine that, before you began your calculations, someone had sneaked up to the bus and replaced the passengers' real votes with a fake set that choose a higher temperature, in other words, less fuel consumption. You made your choice as if the passengers would tolerate a temperature of, say, 80 degrees, whereas in reality they will demand to have the bus cooled to 70. Obviously, your calculations will prove to have been incorrect, and the trip will not come out as you had planned. Your plans will be overly ambitious. You will begin by driving as if you had available more resources than you really do, and end by phoning for help when the deception is revealed by the sputtering of your engine.

I offer the above as a metaphor for the Austrian theory of the trade cycle, which offers an explanation of why the economy swings through boom times and recessions. You, the driver, represent the entrepreneurs. The gas is the stock of capital goods. The trip across the desert is the next "round" of production. The passengers represent the consumers, and their choice on how much to use the air conditioning is analogous to how much consumers are willing to put off consumption today in order to save for the future -- their time preference for current consumption over future consumption. The ultimate destination is the satisfaction of as many wants as possible. And it is the central bank -- in America, the Federal Reserve -- that has sneaked up and tampered with the consumers' votes.

What the central bank tampers with is the outcome of the consumers' "votes" on time preference, which is the natural (originary) rate of interest. Consumers' time preferences tell us how much capital will become available through consumers' saving, or, in our metaphor, cutting back on the AC. When the central bank artificially lowers the rate of interest, entrepreneurs make their plans believing that consumers are willing to delay consumption and save more than they really are. As the bus driver, you think that the passengers are willing to endure the heat enough to reach Phoenix, but, in reality, they will force the bus to consume gas so rapidly that you should have planned only to reach Albuquerque instead. Your attempt to reach Phoenix will fail, leaving you "out of gas" in the middle of the desert.

The natural rate of interest, or that rate that would exist on the unhampered market, measures consumers' time preference because it reflects what borrowers must pay lenders to persuade the lenders to delay their own consumption. If I have $100, I could spend it today on a nice dinner with my wife. Or, I could lend it out for a year, at the end of which I could spend it on a somewhat nicer dinner. Exactly how much nicer a dinner I must expect to receive before I will lend the money is an expression of my preference for current consumption over future consumption. If I demand a rate of interest of at least 5%, this means that a $105 dinner next year is marginally more valuable to me than a $100 dinner this year. On the other hand, if my friend Rob demands 10% interest, he is demanding a $110 dinner. He values current consumption compared to future consumption more highly than I do.

Continue reading...