Within the world that we have constructed, agents and objects take on discrete states. Agents do not experience the world continuously, but rather, in chunks. For example, when an agent purchases some quantity of a good, very often that good can only be sold in whole units. For example, an agent must purchase some discrete number of computers as defined by an integer. Wholesalers must hold some quantity of goods on hand. Agents and firms must constantly adjust their output to avoid shortages or relieve surpluses of goods and services.
Sometimes economic data changes so quickly that suppliers are unable to avoid loss. Particularly troublesome is a scenario where total demand for goods collapses. This is the bust that comprises the latter part of the boom-bust cycle. After a period of relative prosperity, firms may find themselves holding excess stocks of goods that they can only discard if they lower prices. By lowering prices, the marginal revenue earned by the firm falls. In extreme cases, the firm finds itself subject to an accounting loss. This is a signal to the firm that it has overproduced and must therefore slow production. By slowing production, the firm will also need to cut expenditures on inputs. This is equivalent to a decrease in demand for intermediate goods produced by firms higher in the supply chain. This reduction in expenditures also includes a reduction of the quantity of labor hired by the firm.
The bust represents a cluster of errors by entrepreneurs and firms. A large proportion of market participants find that they have erred in their expectation of the future and face subsequent losses. These losses accumulate such that total demand for goods and services – i.e., aggregate demand – falls across the economy. Losses extend beyond only those agents who had taken large risks. Prices and output plummet as agents seek to acquire money to repay debts and increase the security of their positions. The process continues until agents regain confidence in the market, however, the timing of the rebound is far from certain.
What is the nature of the business cycle and why does it occur? The first of these questions can be answered succinctly:
A business cycle is a cyclical fluctuation in the aggregate economic activity of a nation, or a cyclical change in the rate of economic growth.” Business cycles involve coherent changes in output quantities and prices of consumer goods and capital goods, input costs, employment and wage rates, profits, productivity, investment, total and per capita income, the quantity of money, volume of credit and interest rates. (Wood 1997)
The business cycle represents a recurring pattern of a increases and decreases in the value of goods and services produced across all markets, The cause of the business cycle is not exactly obvious. Many economists have attempted to explain the causes of these fluctuations, but few have adequately explained a substantial number of features of the cycle. The most salient explanation of which I am aware comes from Ralph Hawtrey. Hawtrey describes the elements that comprise aggregate demand:
. . . The consumers’ outlay is the whole effective demand for everything that is produced, whether commodities or services. The trader who buys to sell again is merely an intermediary passing on a portion of this demand to one of his neighbours. The cyclical alternations in effective demand must therefore be alternations in the consumers’ outlay. (Hawtrey 1919, 52)
Consumer outlays fluctuate concurrently with production as incomes of both laborers and capital owners are dependent upon total productivity. In a world where money was super-neutral or in a world where capital could somehow trade costlessly for other capital, the business cycle would not exist as a recurring phenomena. But this is not the world that we live in. Exchange occurs indirectly. Agents sell their goods and labor for money in order purchase goods and services from other agents. This would not be a problem except that there occur periods where either the stock of money, demand for money, or both, fluctuate. Fluctuations in the money stock and income are dominated by changes in total volume of credit extended. In a world with a static monetary base, changes in the volume of credit extended are driven primarily by changes in expectation of the value of goods and services produced. An investor who purchases a bond must expect that the borrower can repay his loan and the interest it accumulates. When businesses borrow, the money soon ends up in the hands of the laboring class.
It may be pointed out that the consumers’ outlay is increased as soon as producers begin to borrow. The producers and their employees have more to spend while the orders are still uncompleted. (Hawtrey 1919, 55)
A increase in consumer income translates to an increase in aggregate demand assuming that agents spend at least a portion of this increase. In industries where the new money is spent to purchase goods that otherwise would not have been purchased, prices will tend to increase and so too will production in the short-run relative to prices given the same scenario absent credit expansion. The reverse is also true. A contraction of total credit expanded promotes a fall in incomes.
The business cycle arises when the expectations of a substantial number of investors and entrepreneurs are upset, meaning that at the time of initial investment these agents expected incomes to be higher than turned out. If enough borrowers are unable to repay their loans, bank who suffer these defaults must begin to slow their rate of credit expansion so as to allow there reserve ratios to recover. An increase in the reserve ratio is equivalent to a decrease in the broader money stock. This contraction leads to a fall in incomes which worsens the problem. With less credit available, firms must begin to rely more on savings for repayment of debt. This further contracts the money stock. Firms whose managers sense that the business outlook has turned for the near future also begin to increase their balances of cash and reduce their reliance on borrowing, both of which lead to reductions in the total stock of credit, and therefore, money. (Hawtrey 1919, 14). As agents sense that the economy is in a state of consolidation, many begin to form expectations of price deflation. Demand falls in the short-run and the fall in prices accelerates. Only after banks have increased reserve ratios to a level that pleases managers, and ultimately depositors, may banks interrupt this fall in prices by expanding credit on net. They must wait to expand credit, however, until businesses feel safe to expand production.
This story of credit expansion and contraction gives the theorist a starting point from which to build an understanding of the business cycle. Credit seems the primary driver, but what drives credit? It is expectation by financiers that will be an increase in production that drives the expansion of credit. The process of credit creation creates a natural oscillation in productivity, and therefore, oscillating expectations concerning productivity. Credit is not the only driver of expectations. Innovation brings new products and increases the efficiency of production. The expansion of production made possible by new technology certainly affects the expectations of financiers and bankers and of producers. New technology raises opportunity for economic profit and therefore serves to attract the funds of perceptive financiers. Not only must entrepreneurs sense profit opportunities, but financiers must be apt to perceive that the entrepreneur is correct. (It is worthwhile to consider how they accomplish this. Consider that as a rule of thumb, successful venture capitalists, which are one class of financiers, are sure to bet on a person, which includes that person’s network, vision, and creativity, not simply an idea.) Thus Schumpeter is to some extent correct when he claims:
We agree with him [Hawtrey], first, in recognizing that the fundamental cause, whilst in its nature independent of the machinery of money and credit, could not without it produce the particular kind of effect it does. (86)
He is incorrect in claiming:
Booms and consequently depressions are not the work of banks: their cause is a non-monetary one and entrepreneurs’ demand is the initiating cause even of so much of the cycle as can be said to be added by the act of banks. (86)
I have shown that there exists a natural fluctuation in credit driven by errors in expectations of entrepreneurs and financiers, the effects of those errors on the position and expectations of banks, and therefore, on the available stock of money and demand for a portion of that stock. The high level of expected profits that emerges from knowledge of an innovation attracts more capital into the market than would otherwise exist. As long as the expectation of economic profit exists, the innovation will increase total credit extended in the market. If expectations of creditors are on average correct, this expansion of technology is responsible for a long-run increase in the volume of production and its real value to consumers. It is possible that a sector centered around a new innovation will attract a large portion of available credit during an expansion, but this would only serve to increase the amplitude of cycles where financiers overinvested in the sector of innovation.
Aside from encouraging credit expansion, innovations that increase efficiency tend also to devalue capital whose role the innovation has displaced. What was the fate of the horse and buggy after Henry Ford began production of the model-T? Was it not appropriate that the mass production of telephones and computers contributed to the waning of the telegram? This capital lost most of its value as agents in society no longer demanded them. This devaluation of capital can hardly be blamed for a tendency toward depression for the whole economy. Neither overinvestment in new innovation or devaluation of obscelescent capital are necessary or sufficient to generate the cycle in its most essential form.
There a number of other models that describe the business cycle, some of them ad hoc. These include, in no particular order, Lucas’s Island Model, New Keynesian theories of market imperfections, Real Business Cycle Theory, and the Austrian Business Cycle. Of special note are modern monetarist theories concerning fluctuations in the money stock and money demand as they are closely related to the creit cycle. I have posted on these before, including in this short summary. For more on the Austrian Business Cycle see here and here.