End of the business cycle? Revise your classics

August 7, 2009

As I read my way through the Deepak Lal book* I mentioned yesterday, I find an exposition on “The Classical Theory of the Business Cycle”. He wrote the book in 2004-2005. The text should have been a warning: never ever forget your classics! Please see this and this article as background to discussions of what went wrong with economics in the last years. One of these issues is the recent belief often expressed here pre-2008 that business cycles, or boom-and-bust cycles, had disappeared (at least almost).

I will allow myself to take Lal by his words – “While there may be a case for patents for industrial products because of the large required investments in R & D, does the argument also apply to pure research, books, music and films? (…) There was no patent when Pythagoras discovered his theorem or Newton his law of gravity” – and upload a pdf of a page in his book to make it available online for free [follow the link here: Deepak Lal Business Cycles]. In  these paragraphs one is reminded that the work that triggered Friedrich von Hayek’s nomination for the Nobel Prize for Economy was his theory of the business cycle developed in the 1930s and 1940s. Lal tells us:

“At the center of the business cycles in this classical […] view are interacting movements in business profits, investments and credit. Recurrent fluctuations in a privte enterprise economy are caused by the changing outlook for profits. When it is favourable, investment and production increase, and conversely when it deteriorates. Rising investment fuels growth, which ceteris paribus will produce more profits and further investment. But, the whole process is uncertain, as any act of investment is based on expectations about future relative prices. Every act of investment is thus necessarily a gamble (…).”

What happens when in the process the money supply increases [read: excessive credit growth/central bank policies…]? This triggers the “injection effect”, i.e. the distortionary effects of how the money supply is increased.

“If the injection of money is through the credit markets, then even if the total ensuing increase in the money supply is proportionate to the increase in economic activity and hence noninflationary [read: global liquidity boom due to globalization, and China’s rise and accumulation of reserves], the changes in interest rates induced by the expansion of credit could lead to false signals in the patterns of intertemporal prices and thence to a misallocation of resources.

For changes in the interest rate [read: cheap money due to abundant liquidity not disciplined by a tightening of money supply by the Fed in the boom years following 2001] will have a systematic effect on the pattern of prices which allocate resources among different stages of production. In modern terminology, a fall in the interest rate due to credit expansion will lead to businesses undertaking relatively more capital-intensive investment projects with lower prospective rates of return [read: “subprime” for “low prospective rates of return”]. The artificially low rate of interest induced by injecting money through credit expansion will also lead to an unsustainable boom as more investment projects are undertaken than can be completed [sounds just like the housing boom, doesn’t it?], and as the accompanying resource scarcities emerge, the boom will turn into a bust [yessir]. The economy will only recover once the “malinvestments” are liquidated [we’re not quite there yet, the banks still have toxic assets sitting around waiting to be disposed of] and resources reallocated in line with intertemporal consumer preferences [right now US Americans are learning to save] and resource availabilities [they are currently broke].”

“But even with appropriate monetary policy, a private capitalist economy will inevitably have booms and busts. Unlike many contemporary theories of the business cycle which believe that shocks of various kinds are the true “causes” of business cycles, this older view sees the business cycle as being an endogenous self-sustaining feature of private capitalist industrial economies (…)”

Can public policy do anything to alleviate this boom-bust cycle? The simple answer is: very little. (…) They can perhaps soften the blow by easing monetary policy in the downturn. But, as the basic problem is the bad investments and excess capacity created in the boom, the only solution to this structural slump is to allow these distortions to be worked out, so that another period of expansion can begin.”



*the politics of this book are sometimes quite dubious. While the language in his passages on economics is relatively sober and certainly very professional, when it comes to his politics, we enter a realm of caricature and point-scoring. Anyway, at least it is entertaining. An interesting perspective coming from a conservative Indian, trained in Oxford (read: a lot of English Tory scepticism) and living in America. Here an example: What he thinks of the European Union? “The aim is to recreate a new Holy Roman Empire”. It is run by the French ENArque elite which “has seen its only hope of global influence in a Europe in which they would jointly exercise hegemony with the Germans”. Why the Mediterraneans and the Irish joined in the 1980s? “they have looked upon the subsidies, through the Common Agricultural Policy and other regional schemes they have obtained from Europe, as a drunk given free access to a liquor store”. Voila!


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