8th August 2012
And now for the correct explanation of the business cycle
I have now seen Tyler Cowen's vidoes (here), and can safely state that none of these four theories are correct. Tyler Cowen is particularly wrong in his assessment that Keynesian aggregate demand shortfall concepts can explain anything!
If Tyler Cowen is wrong, then why is a business cycle caused?
First of all I'm excluding from my analysis those "cycles" (temporary falls in production) caused by negative shocks. These are pure accidents (e.g. oil shock of 1973). If your car crashes, it will have go to the garage. That doesn't require any explanation.
For ALL other "cycles" the answer lies in STRUCTURAL (i.e. UNAVOIDABLE AT ANY EXPENSE) GAPS IN INFORMATION that are aggravated by chronic government failure.
The greatest miracle of an economy is that, by and large, ALL production decisions (taken well ahead of consumption decisions) come true. That means there is someone at the end of the production chain, willing to buy the produced goods .
For instance, a doctor studies for seven years to become a doctor without knowing whether there will be any need for his service. His information at the time of joining a medical college is that there wil be a demand for doctors after seven years. But he can NEVER know the true demand after seven years. Miraculously, in most cases, he gets a job after becoming a doctor.
But not all investments go to plan. You may become a doctor after seven years, but in the meanwhile five more medical colleges have come up and now there are now another 1000 doctors as well in the market. In addition, people are suddenly living disease free because of a new drug. There is therefore both an unanticipated increase in the number of doctors, AND an unanticipated reduction in demand for doctors – AFTER you've qualified as a doctor. You can now become either a nurse or a hospital sweeper, but if you are fussy, and you choose to beg (from the government). That's your choice. Unemployment has now increased but not because there was no job as sweeper, but because you, an MD, don't like the idea of cleaning someone's toilet.
Doesn't matter what happens to you now. The point being that is it VIRTUALLY IMPOSSIBLE for all production plans to go well. There will ALWAYS be mismatches. That is because of structural gaps in information.
Note carefully that Keynes was wrong. Very wrong.
a) Production COMES FIRST.
b) There is NEVER any shortage of "aggregate demand" (whatever that meaningless concept means). It has never happened that man's needs are satiated. It is possible that his needs CHANGE as situations change, or he is not fit to be lent money by the market, but his needs are NEVER satiated. If people now don't get small pox because of a vaccine, they won't need small pox doctors, but they'll buy a costly golf set with the money they now save.
c) Due to information gaps, it is ALWAYS production decisions that go wrong. Demand NEVER slackens. However, if you trained as a doctor but are now employed as a toilet sweeper, then you have spent a lot of money on your education and are now indebted. So you'll not be able to buy a lot of golf sets. Therefore your poverty will transmit to the golf market and they, too, will suffer. At this stage there is no slackening of demand (you still want to buy a golf set, and would definitely buy with borrowed money, if you could) but you are unable to borrow money to buy the golf set. You are NOT suitable to be lent money to. The demand did not dry up. Your ability to BORROW dried up.
Let me repeat. What was the underlying issue here? The issue was the STRUCTURAL GAP IN INFORMATION. It is structural because it is IMPOSSIBLE to get accurate information about the future.
MAN IS NOT GOD. That's it. That's the explanation of the (normal, i.e. mild) business cycle.
[I won't go into the "recovery" stage. That is self-evident. As you now work hard as a sweeper, you become the owner of a large sweeper hiring business and become a millionaire. A new set of production decisions is now taken by the economy].
But we rarely see mild cycles. We often see DEEP cycles. Aggravated cycles.
Because governments, by dabbling with money supply and regulation (hence with production), and through poor governance (e.g. poor infrastructure), AGGRAVATE the information gap.
Markets are best placed to signal information (including through futures markets). Governments CAN'T. They are ALWAYS IGNORANT. No exception. They don't have and can't have the information necessary to even find out what's the problem, leave alone resolve it.
The typical way governments tend to dabble with economies is through Keynesian/monetarist policies. ALL of these are wrong. In each of these governments/central banks are trying to second-guess the market. They cannot. They will ALWAYS fail. No exception. And in doing so, they will accentuate the information gaps and create even greater uncertainty.
It is, in the end, public choice (including public choice analysis of central bank behaviour) that can explain the CHRONIC failure of governments to "smoothen" business cycles. They ALWAYS aggravate them, instead.
In the diagram (that I've sketched) above, the black line represents the NORMAL, MILD fluctuation of a normal free market (with free banking). The red line represents the AGGRAVATED business cycle caused ENTIRELY by governments (e.g. interventionist fiscal/monetary and bad regulatory/welfare state policies).
Almost all "economists" including Friedman, Keynes, and Cowen, WILL necessarily aggravate the business cycle.
They SIMPLY don't have the information that the market has. Their fatal conceit is to pretend that they can somehow "fine tune" the business cycle. They CAN'T. The sooner all economists become HUMBLE, the better for the world.
By the way, the presence of "sticky" wages NEVER STARTS a recession. Such "features" are a natural part of the anticipated production plan, and are FULLY anticipated. It is ridiculous for economists to imagine that producers don't know that wages are "sticky". They KNOW that wages are sticky. That's part of pre-designed production plans A, B, and C. They don't know what the future will bring. When the future forces a new production plan D, then they sack workers. The fact that workers get sacked is NOT the cause of the change in plans (Keynesians pl. note). It is the symptom of the underlying change in plans, and underlying ABILITY (or, rather, inability) to service loans.
That's the point.
Clear? Mr. Cowen! (with due respect, for I agree with most of what you write!)
In the end, let's become very clear about this: It is government/central bank intervention or regulatory blockage that prevents market signals from transmitting, and therefore aggravates mild recessions which naturally and periodically arise from HUMAN production mistakes.
Because we are not Gods.
And neither (in case you wish to know this shocking fact), dear "economists", are you.
[Btw, this explanation is partly based on Austrian economics, but mostly on public choice theory and the inevitability of government failure. Each time there is a different kind of government failure, but it is ALWAYS there.]
A more "realistic" graph. Note the tiny random movements of the natural market that is not disturbed by bureaucrats.