Introductory Chapter: Boom-Bust Cycles, the Chronic Disease that Plagues World Economy

1. Introduction

There is a consensus in the mainstream that a strong role for the government is necessary to tame the business cycle, because the free market, being unrestrained, will persistently veer into either unemployment or inflation [1]. In stark contrast, the Austrian School of Economics believes that meddling of the government in the credit market is ironically the true cause to the ups and downs in the market economy [2, 3].

According to the Austrian theory of business cycle (see, e.g., [4]), an economic boom begins with excessive investments in physical capital that need long-term financing. Capital, in this sense, refers to real capital such as machinery, technology, factories, premises, land, and plants. Facilitated by fractional reserve banking that the central bank backs, this long-term financing is made possible by credit expansion by commercial banks and the resulting low interest rates. Nonetheless, until a certain point in the expansion, when the backing of bank reserves over bank liabilities depletes, interest rates must be raised, and credit must be tightened or contracted.

The unnaturally low interest rate created by the banking system sends wrong signals to businesses, indicating that the factor, the intermediate, the upstream, and the downstream markets are ready to accommodate their expansions with adequate and affordable supplies of needed resources to complete their investment projects [5]. In reality, however, the supplies of land, capital, labor, and other inputs of production have not increased or been liberated by real savings.

Despite that, more businesses would start competing for the same amount of physical capital, labor, and other inputs. Sooner or later, the market of these inputs will inevitably tighten until it becomes unbearably costly to employ these input goods and labor. As a result, real investments that earlier appeared lucrative will now turn out to be unprofitable or loss-making. Whether by tightening bank credit or not, eventually, uncompleted investment projects must be called off.

Besides the primary- and intermediate-good sectors, the price of labor and other resources for the consumer-goods sector will also increase [6]. This is because consumers have not traded off present consumption for future consumption. There is no increase in real savings nor increase or liberation in the resources for the production of consumption goods. Not only prices of inputs, when newly created bank money gets into the hands of consumers, but also prices of consumer goods will rise as consumption increases without corresponding to offsetting savings.

In other words, the public preference for present consumption has not changed.

Hence, the demand for factors in this consumption-good sector will not change either. Despite the absence of an increased preference for future consumption, newly created credits and low interest rates by fractional-reserve banks will induce firms at different stages of production to embark on investments intended to increase the production of consumption goods in the future.

Ironically, these capital investments would not have been promising and hence undertaken, had it not been for the created credit. Recall that consumers have not refrained from present consumption, or decided to save more for the future, and hence have not saved as much for the future in the first place.

Since there has been no increased demand for future consumption, firms in phases of production further from present consumption will soon learn of the lack of prospects or demand for their malinvestments. And, at the same time, these firms have to confront the rising costs of inputs and resources as competition in those markets rises.

Ultimately, the investment projects must be terminated or paralyzed due to a lack of demand and rising investment costs. Crisis unveils when economic agents find out that the actual value of the loan assets held by the banks since the boom period is in fact very much smaller. Since the value of liabilities and other payables of the banks has virtually not reduced, the fractional-reserve banks are essentially bankrupt when the market realizes the diminished value of the loan assets of the banks.

2. Allocative effects of money creation

Monetary expansion directly affects business cycles by altering income distribution within the population and the corresponding pattern of spending [7]. When credit expansion is generated by central banks and commercial banks, those who receive the newly created money first will obtain greater purchasing power than those who receive the money later. These groups of people can include cronies of government officials who enjoy special privileges from banks that depend on the officials, as well as any individual or businessperson with legitimate reasons and collateral to borrow money from the banks. Since those who get the money first will spend on items according to their preferences, the pattern of prices in the economy will change. The spending of the new money on certain groups of products will bid up their prices.

If newly created money is spent on materials and equipment for the construction of real estate, those prices will be bid up, and resources and labor will be shifted to the activities related to construction. In other words, resources, including manpower in the economy, are reallocated to the real estate sector than otherwise would have been without the monetary expansion by the banking system.

Misallocation of resources and labor created by government intervention can be temporary or permanent, depending on whether the intervention is temporary or permanent. Permanent government subsidies in certain sectors, such as agriculture, fishing, healthcare, and energy, persistently incentivize the movement of resources into those sectors. Similarly, protectionist barriers against foreign competition, such as antidumping laws and tariffs in the steel and automobile industries, retain the capital and labor in those sectors that otherwise would have been utilized more efficiently and effectively in other activities. On the other hand, since monetary stimulus is always temporary, the reallocation of resources into stimulated sectors and the subsequent price increases in these sectors by the injection of money are temporary. As prices of other sectors are eventually bid up, the movement of resources into the initially stimulated sectors will slow down, stop, or even reverse.

This assertion of Austrian business cycle theory, however, receives many objections. According to critics such as the New Classicists, since market players anticipate the subsequent stoppage or reversal in the movement of resources, the initial reallocation of resources into the stimulated sectors would not take place. In other words, the self-reversing process of movement of resources becomes a self-preventing process. Hence, a business cycle can be prevented because the public possesses rational expectations.

This rebuttal against the Austrian business cycle theory that the public are rational and hence will not start the business cycle by investing or bidding up prices in certain groups of goods or assets is weak. Firstly, even if those who receive the newly created money first know exactly that prices will reverse later, there is every incentive for them to invest or speculate in those markets because the money that they receive from the banks in the first rounds of credit expansion has much larger spending power than received later by the rest of the population. If the public is indeed rational and knows that prices will soon rise and, hence, the purchasing power of their money will soon fall, they will invest and hedge against the fall in purchasing power by buying assets whose prices will rise faster than the general price. These assets include gold, silver, real estate, and foreign currencies and assets. Even if the early receivers of credit from banks do not know that they are early receivers of any particular monetary stimulus by the central bank, given the general tendency of rising prices and declining purchasing power of fiat money, these individuals will anyway invest in assets or any productive activities that are expected to yield returns significantly greater than their costs of borrowing and the rate of price inflation.

Secondly, speculative individuals will move into the market and move out in time, reaping lucrative profits before the bubble expansion reverses even if they know that the price bubble of that particular asset will burst one day and that the price will plunge. While long-term-oriented individuals may not be tempted by the possible short-term gains, there are always short-term-oriented individuals who are incentivized by highly risky short-term gains. Individuals who obtain the credit from banks can play the market, for instance, in housing and securities, buying low and selling high before the price increase reverses.

In conclusion, it is now clear to readers that monetary stimulus by the central bank, accompanied by fractional reserve banking, is the real cause of the boom-bust economic cycle. Other so-called explanations for business cycle, such as those that depend on the overproduction and underconsumption theories, psychology shocks, and irregular supply and demand shocks, are descriptions, not explanations, of the business cycle phenomenon. These supposed explanations do not explain why business cycles occur repeatedly. They merely describe the symptoms of the disease. They fail to address the root cause of the problem.

3. The role of econometric analysis

From an applied econometrics perspective, understanding and analyzing boom-bust cycles is essential for policymakers and financial institutions. Techniques such as time series analysis, regression models, machine learning methods, and vector autoregression (VAR) are commonly applied to study boom-bust dynamics. These methods help economists identify the key variables influencing the cycles, for example, interest rates, credit availability, consumer spending, and firm investment. Econometric models can also estimate the effects of policy interventions, like monetary stimulus or fiscal expansion, to reduce the adverse effects of these cycles.

Using econometric analysis to study boom-bust cycles also extends to identifying early warning signs of impending recessions or bubbles. By analyzing historical data and establishing patterns, econometric models can provide forecasts that help policymakers anticipate the onset of downturns or asset price corrections. The latter is important because early intervention can potentially reduce the severity of a bust or even avoid a full-blown economic recession or crisis. However, a challenge often encountered is that the precise timing of these cycles is difficult to predict. Also, external shocks, for example, geopolitical events, global pandemics, or sudden shifts in investor sentiment, often come as a surprise and are not predictable. These latter events can disrupt even the well-calibrated econometric models. Moreover, the complexity of international financial systems, where interconnected markets can amplify shocks, makes disentangling the causes of boom-bust phenomena challenging. Despite these challenges, econometrics remains vital in understanding the boom-bust cycles by providing valuable insights that can help stabilize economies in these tumultuous times.