Live After Quit

How to Think about Monetary Intervention

[Chapter 8 of Per Bylund’s new book How to Think about the Economy: A Primer.]

The Boom-Bust Cycle

The economy’s constant flux is not random change but adjustments to the production apparatus in the pursuit of creating value. Value is a moving target because consumers want change over time and innovations and new opportunities. The constant adjustments mean the market is best understood as a process.

There are two fundamental tendencies in this. First, there are the adjustments made to existing production intended to keep efforts aligned with expected consumer value. Without these, production would become ever more misaligned with what consumers want. We would see falling living standards as a result.

Second, entrepreneurs try innovations that they imagine will create new value for consumers. When these are successful, they disrupt and replace already existing production. When production is revolutionized in this way, the economy grows and our standards of living rise.

The overall process is dependent on a functioning price system, which provides economic actors with the information they need to respond rationally to changes (we saw how this works in chapter 7). However, if prices are manipulated and give false information, entrepreneurs will make decisions on that faulty information. This means entrepreneurs are more likely to fail in their undertakings, but it also means entrepreneurs’ actions introduce errors into the production apparatus. The economy, as a result, becomes distorted.

The boom-bust cycle is a particular type of distortion in which manipulated price signals bring about malinvestments that produce an artificial, unsustainable boom followed by a bust as the errors in production become apparent.

The Rate of Return and Capital Investments

For any investment, it is important to think of the expected return as a rate rather than an amount. Why? Because it is the relative outcome that determines how good the investment is. A $1 million profit is not much if it comes from a billion-dollar investment. But $1 million is an enormous return if the original investment was $100,000. The profit in dollars is the same, but the latter is ten thousand times as much as the former.1

Thinking of profit in terms of rates of return makes it easier to compare different projects. It means an entrepreneur—and investors in the entrepreneur’s business—can compare alternatives that are different in every way. For example, a new airline would require a massive capital investment to acquire the planes, hire crews, and get access to airports, whereas a new lawn service requires a much smaller initial investment. But it could be that the larger investment is still expected to provide a much higher rate of return, which means that it makes more economic sense—even though it requires much more capital.

As we’ve discussed, market profits correlate with consumer value. An investment earns a higher return because of its greater value to consumers. This means we are all better off if the investments made get as high returns as possible.

A higher rate of return also means an entrepreneur can more easily borrow investment capital. Consequently, very capital-intensive projects (such as an airline) can still get the needed financing even though they are very expensive up front. And the entrepreneur can easily calculate whether the cost of capital is worth it. For example, if a project’s return will be 7 percent and a loan from the bank can be had at 5 percent interest, then the expected net gain is 2 percent. It means the entrepreneur can also compare this net 2 percent with, for example, what a much less capital-intensive investment (such as a lawn service) would earn—even if he would then not need external financing. If the lawn service is expected to provide a net return of 4 percent, the entrepreneur would not choose to start an airline. Its rate of return is only half of what he can make from his lawn service (2 instead of 4 percent).

But imagine if the interest rate were only 1 percent. Now the airline’s return is 50 percent higher2 than the lawn service’s, even though nothing else has changed. In this situation, we would expect entrepreneurs to start airlines rather than lawn services because that is where they will make more money—despite taking out loans for the investment. It takes more productive capital to start an airline, but this is not an issue at the lower interest rate.

If the difference between the rates of return is high enough, we might also see entrepreneurs sell or discontinue their lawn services to instead run airlines and other more capital-intensive businesses. This would be an appropriate economizing shift in investment because the airline industry provides more expected value to consumers (reflected in its higher rate of return). The existing capital would be invested where it can be used most productively in the service of consumers.

A higher rate of return is not only due to lower costs. It can also be the result of higher value creation. Lower costs and higher value creation can both increase the rate and vice versa. It is the expected bottom line relative to the investment needed that counts when making investment decisions.

However, even if the projects’ expected net rates of return are the same, their economic situations may not be. This is another example of how the market empowers actors by lowering the bar: an entrepreneur does not need to know why the rate of return is high to make an investment. But it makes a difference when we try to understand the economy. For example, when the interest rate is 5 percent, an 11 percent expected return on highly capital-intensive investments in air travel makes their net return 50 percent higher than the 4 percent return on lawn services.

But the economy is different. In the case of an 11 percent return and a 5 percent interest rate, the high rate of return is due to high expected value creation. The high interest rate suggests capital is scarce, which is why banks can charge a high interest rate. To attract investments—and therefore capital—airlines are expected to create more value. We saw this above: when airlines’ rate of return was only 7 percent, lawn services earned a higher net rate of return. When airlines’ rate of return rose to 11 percent, lawn services earned a lower net rate of return than airlines. Investors were then incentivized to pull their money from lawn services and other investments and put it in airlines to earn higher profits. This activity shifts capital that is already in use toward better (more value-creative) uses: consumers gain as more value is produced using the same resources.

In the case of a 7 percent return and a 1 percent interest rate, the interest rate is lower because there is more capital available for investments. There is more capital available because people have chosen to consume less and instead save more for the future. So production of consumption goods also falls. The economy therefore can support more investments in addition to those that are already underway. Consumers gain as more capital is invested toward producing goods (which will be available in the future). The lower interest rate allows unused capital to be put to use, although this does not preclude shifts from other lines of production. The added investments increase the overall output of the economy.

The rate of return is simply an indication of an investment’s added value. It does not matter whether this rate changes due to fluctuations in cost (lower interest rates) or in value (higher expected ticket sales). What matters to the entrepreneur is the expected rate of return, which approximates the relative value added to the economy. Higher value production and lower production costs both benefit consumers.

The Cause and Nature of the Artificial Boom

Imagine that the interest rate falls, as above, from 5 to 1 percent but there is not more capital available to invest. How could that happen? If banks create new currency and offer it as loans, then the interest rates they charge will be competitively bid down, pushing the market interest rate below where it otherwise would be (for example, 1 percent instead of 5 percent). But this is not a matter of different economic conditions—there is not more capital available, only more money in the form of loans, to buy the resources that entrepreneurs need to start and finish their production projects. So, the interest rate signal that entrepreneurs rely on for economic calculation is artificially low. Therefore their decisions and actions will be based on this faulty signal.

As above, the lower interest rate means more investments. In our example, entrepreneurs will create new airlines (and expand existing airlines’ operations), as this industry appears more profitable, relatively speaking. As entrepreneurs with borrowed purchasing power (the new money) flow into the market and attempt to establish new production, they increase demand for capital and bid up prices. As these investments happen primarily in the capital-intensive airline industry, demand increases specifically for planes, crews, and other resources used in this industry. Thus, airplanes’ price tags are higher and airline employees, pilots, and flight crews will earn higher salaries.

Their customers’ increasing willingness to pay signals airplane manufacturers to ramp up their production. As the manufacturers place orders for aluminum and other materials, and start hiring more engineers, their bids for those resources increase their respective prices as well. This causes a boom in investments, and prices go up across the stages of production: airlines, then plane manufacturers, then aluminum producers, then miners. Each stage sees increased demand, which means producers can charge higher prices and earn higher profits, which motivates them to further expand their operations. These conditions also motivate other entrepreneurs to invest in these industries to capture part of the profits. These increased investments are all appropriate, given the signals: the prices go up, suggesting the supply was inadequate; producers underestimated the demand.

The new and expanding airlines, which are more willing and able to pay, outcompete other users of those resources. Other commercial aluminum users, such as soft drink producers, face higher prices and lower availability, which affects their profit margins. In response to the higher prices, these producers re-evaluate their plans to economize on their aluminum use and consider alternatives. As a result, soft drink prices could go up or soft drinks might start to appear in glass or plastic containers instead of aluminum cans.

That the aluminum that would have been available to soft drink producers is being redirected toward airplane manufacturing is not as crazy as it might seem. This is where the aluminum, according to the market’s price signals, should create most value for consumers.3 We would expect proper market prices to shift production toward where it does most good as entrepreneurs compete to satisfy consumers (as we saw in chapter 7).

But there is a problem: the higher prices in airplane production result from the artificially low interest rate brought about by banks’ creating new money and expanding credit—not greater availability of capital. Therefore, the whole shift in the economy toward airplane production, including all investments made to support this production, and therefore away from other lines of production that appear relatively less profitable, constitutes malinvestment.

Malinvestment means that investments are structurally distorted: some areas of the economy see over-investment whereas others see underinvestment. The overinvestment in airlines also means overinvestment in airplane manufacturing, aluminum production, and mining, intended to meet expectations of higher demand. These investments are made to increase production capacity to meet the expected greater demand for air travel (due to its greater anticipated value). As investments soar and prices go up in anticipation of the higher demand, these industries experience a boom.

These same industries, at least in our example, also expanded in the same manner when the interest fell due to greater availability of productive capital. The difference is that this new expansion is using resources that are not readily available but rather are being shifted away from other industries where consumer demand remains largely unchanged. The change is therefore not a matter of the economy shifting from one line of production to another in response to expected changes in what consumers value. Instead, there is a greater demand for productive capital and labor overall as entrepreneurs establish new lines of production, motivated by the artificially lower interest rate.

From the perspective of consumer value, this boom is caused by overinvestment, in response to the faulty signal, in airlines and those higher-stage production processes that support expanding air travel, and, therefore, relative underinvestment in other lines of production. Artificial booms like this, caused by the expansion of credit, can occur in longer production projects in general. Such overall malinvestments distort the economy’s production apparatus: the outputs are no longer aligned with what consumers want most (as imagined by entrepreneurs).

The Turning Point

The boom is unsustainable because it largely consists of malinvestments, not because the economy grows rapidly. What we call the business cycle is the sequence of an unsustainable boom followed by the inevitable bust—a bubble that then bursts. This is different from the sound progression of an economy. It helps to contrast the two.

First, let us look at sustainable growth. We saw above that the interest rate reflects the availability of capital for productive investment. When more capital is made available, the interest rate falls, and vice versa. Specifically, this happens when consumers are less eager to buy and consume goods in the present and prefer to save a greater portion of their wealth for the future. Their time preference is lower, meaning they have longer time horizons in their valuations—they look more to the future than before. As a result, entrepreneurs that produce consumer goods face falling demand and lower profitability, and therefore have an incentive to scale down their operations and look for other opportunities. Some of them may go out of business. As a result, entrepreneurs overall reduce the production and sale of consumption goods.

This frees up productive capital for new investments, which are now feasible and increasingly profitable, as the increased savings force the interest rate down. So entrepreneurs invest more in production processes that produce goods that will be available for sale in the future. Overall, this shifts productive capacity away from production for present consumption to production for future consumption. Entrepreneurs are responding to price signals and abandoning production with low profitability to seek the higher expected rates of return in production for the future. This is quite in line with consumers consuming less and saving more (they are postponing consumption). In fact, the shift in production is a matter of adjusting production to where it is expected to produce greater benefit for consumers.

The unsustainable boom is different. Here, entrepreneurs increase investments in production for future consumption based on the artificially lowered interest rate. In other words, there has been no corresponding shift in consumer behavior—instead, the lower interest rate makes consumers less eager to save (they earn lower interest on their postponed consumption) and thus encourages consumption in the present. This causes tension in the production structure, between production that serves present consumption (which is going up) and investments that serve future consumption (which is expected to go up).

On the one hand, entrepreneurs producing for present consumption see no falling demand because consumers have not shifted away from consuming. Their products’ profitability is not falling so why would they cut back their activities? Thus, these entrepreneurs continue to compete for inputs and keep placing orders for them.

At the same time, the lower interest rate causes an increase in investments for future production. The higher stages of production experience greatly increased demand as they receive orders from both the production processes serving consumers in the present and those undertaken to serve them in the future. Remember, all of this is based on the faulty signal. As there is not more capital available but there are many more buyers, the prices are bid up to very high levels. This is sometimes called an asset price bubble.

Although competition between the new future-oriented and the old present-oriented may seem like a good thing, the faulty signal pulls the economy in different directions. The prices of production factors are bid up as a result of the overinvestment in the higher stages of production (in our example, airplanes, aluminum, mining). These price increases are based on the faulty signal and therefore detached from genuine expected future demand for air travel. These price increases include wages for workers in these stages, who then have more money to spend on present consumption. With an artificially lowered interest rate, there is less incentive to postpone consumption. Therefore, a greater fraction of earned wages, which are now also higher because of the boom, is spent on consumption goods—increasing demand for goods in the present too.

In sum, sustainable growth is caused and supported by a shift in consumer behavior: decreased demand for consumption in the present that makes capital available for investment in the higher stages of production. In the unsustainable boom, in contrast, there is no shift but rather added investments without additional productive capital. Thus, the production structure reflects higher demand for consumer goods both in the present and the future, based on the assumption that there are sufficient capital goods available to complete all these new production projects. Another way of putting this is that the economy, through the actions of entrepreneurs who were deceived and misled by the artificially low interest rate, both consumes and invests the capital that is available. It should be obvious that this is not possible. There is not enough productive capital to support both.

The unsustainable boom is thus based on production that requires resources that do not exist. Many of those production processes, especially in the higher orders (far from consumers), cannot be completed because the capital necessary is too scarce. This does not mean that factories suddenly find themselves without resources, although shortages may occur. More likely, asset prices are bid to such high levels that many investments no longer appear profitable. Entrepreneurs then discover that they have made significant errors in their calculations and are forced to abandon their investments.

Entrepreneurial error is commonplace in the market, but the errors do not usually cause boom-bust cycles. What is unique to the business cycle is that there is a massive cluster of simultaneous entrepreneurial errors. The reason, as we saw above, is that entrepreneurs have been misled into acting as though there were capital available for their production projects. But there is not. The expansion of credit, not availability of capital, lowered the interest rate to a level that does not reflect the real availability of capital for investment.

This raises the question of why entrepreneurs allow themselves to be fooled. Do they not realize that the interest rate is artificially low? Maybe they do. But this does not matter because they still expect to benefit from the lower cost of borrowing. Why would they not pursue projects that they expect to be profitable? Even if they were familiar with business cycle theory and knew that the economy is in a bubble, the bubble is in fact highly profitable. To not expand one’s business as the bubble inflates is akin to turning down profits. This may not sound like a huge problem, but a business’s investors will likely feel differently. Also, competitors cannot be expected to turn down profits, so inaction could allow them to expand their market share. As a result, not expanding during the bubble is to risk one’s business.

There is also the issue of the inflow of entrepreneurs during a bubble. As prices rise, more people see an opportunity to earn profits—and a reason to leave their current employment. Thus, the boom lures those who would otherwise not enter the market as investors. Their lack of experience suggests they are more prone to make errors and thereby contribute to overall malinvestments.

The Corrective Bust

The bust comes quickly. Even though the bubble itself might be easy to spot, it is difficult to predict exactly when it will burst. The actual turning point can be triggered by seemingly unrelated events that put additional strain on specific malinvestments and cause them to fail. As the production apparatus is already strained by high demand yet firmly high prices, one failing business can easily drag down its customers and suppliers, who can no longer expect to be paid for services rendered. This causes a cascade of failures that reveals the extent of the malinvestments in the economy.

The mass of failing investments, and therefore failing businesses and jobs lost, is the bust. But note that the bust is not a separate phenomenon: it is already embedded in the boom, whose investments are unsustainable. This is why we refer to the boom-bust sequence as a cycle: the malinvestments that cause the boom must be undone for the economy to get back on track. It is not the case that the boom is a sound development and that the bust is avoidable; the boom is not real economic growth but an illusion. Consumers expected something else. Entrepreneurs made investments that were not motivated by genuine value expectations but facilitated by a corrupted signal of capital availability: the artificially low interest rate.

The bust releases the capital goods malinvested in processes that do not serve consumers so that they can be invested where they can do more good. In other words, other entrepreneurs get a chance to acquire the capital to pursue consumer value—the failures are necessary for the malinvestments to be revealed and then replaced by sound productive investments.

For the bust to restore sound production, however, the interest rate must be allowed to increase. If it is kept artificially low, this will only prolong the corrective process, as the new entrepreneurs will also be misled and structural errors therefore persist.

1. A profit of $1 million from an investment of $1 billion is a 0.1 percent return, but on a $100,000 investment, it is a 1,000 percent return. Thus, if the $1 billion were instead invested in smaller projects at a 1,000 percent return, it would generate $10 billion in total profits. That’s ten thousand times the profit of the large investment. 2. The return on the lawn service remains 4 percent, whereas the airline’s expected rate of return is now 7 percent less the cost of the capital at 1 percent. That’s 50 percent more than the lawn service (6%/4%=150%). 3. Our example assumes soft drink producers do not expect sufficient (higher) demand to expand production, but if they did, they too might exploit the lower interest rate to invest in expanding output through, for example, automation. This would further increase demand in the higher stages of production, as both airplane manufacturers and soft drink producers bid to acquire more aluminum.