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International Business

Conjunctures

Courses 6-9
II. A Detailed Explanation of the
Depression/Boom-Bust Cycles
Bank Credit Expansion
Economic Consequences of Bank Credit
Expansion
The Depression

A Detailed Explanation of the


Depression/Boom-Bust Cycles
Major topics
Bank Credit Expansion: Fundamentals (1)

The Structure of Production


Time Preference and the Rate of Interest
Banking: Fractional Reserve and 100%
The Expansion of Credit

Bank Credit Expansion: Economic Consequences (2)


Inflationary boom
Distortions in the Rate of Interest and Structure of
Production

The Depression (3)


The Occurrence of Crisis
Mal-Investments
The Recovery: Deflationary Credit Contraction

Bank Credit Expansion (1)


The Structure of Production
Time Preference and the Rate of Interest
Banking:
Reserve

Fractional

Reserve

The Expansion of Credit

and

100%

The Structure of Production (1)


The structure of production is composed of economic goods (they are
scarce therefore they must be saved)
note!: both production and consumption take place in world with given
general conditions of human action like the law of gravity, the structure
of Universe, air etc. (which are not scarce and dont need to be saved);
these are premises of economic activity

Two general types of economic goods: capital goods and consumption


goods
higher-order goods/superior goods/capital goods/intermediate goods
(more distant relative to consumption) (e.g.: a frying pan)
lower-order goods/inferior goods/consumer goods/final goods (more
closer to consumption) (e.g.: a cheese cake)
note: their feature is given by the position in the structure of production
(closer or distant relative to consumer)

Production takes place in time which is a scarce resource (it must be


saved); people have different time preferences which impact the social
structure of production

Time Preference and the Rate of Interest (1)


At any given time, the supply of money is composed of:
money spent in consumption + the rest in
savings/investments
The existence of time divides satisfactions in present and
future; time preference is the proportion to which people
prefer present for future satisfactions (present goods vs.
future goods)
Time preference determines the proportion of
savings/investments (future consumption) to present
consumption as follows
Lower time preference = people prefer less in the present and
more in the future (they save/invest)
Higher time preference = people prefer more in the present and
less in the future (they consume)

Time Preference and the Rate of Interest (1)


The rate of interest is determined by the time preference
The lower time preference => lower pure rate of interest
The higher time preference => higher pure rate of interest

Final market rates of interest reflect the pure interest rate


plus/minus entrepreneurial risk and purchasing power
components
In a static world (no uncertainty and no change in PPM): the pure
rate of interest = market rate of interest
In the real world (with uncertainty and variations in PPM): the
market rate of interest = the pure rate of interest, risk adjusted,
PPM adjusted

There is a connection between time preference, rate of


interest and the structure of production
Lower time preference => lower interest rates => higher
savings/investments to consumption
Higher time preference => higher interest rates => higher
consumption to savings/investments

Banking: Fractional Reserve and 100% Reserve (1)


Money and banking
Deposit and credit banking
Metallic money (transport inconvenience =>
depositing) the emergence of monetary substitutes
(receipts, bank notes)

Free banking vs. state controlled banking


Free banking with 100% reserves (monetary
certificates)
Free banking with fractional reserve (fiduciary
media/fiduciary money)

Banking: Fractional Reserve and 100% Reserve (1)


Deposit banking
The bank (depositary) receives an amount of money but
not the property right; the money remain the depositors
property; on demand or at the permanent disposition of
the later
The bank does not pay interests, but a fee for managing
the account

Warehouse receipts ensures the depositor of the existence


of money; deposit receipts are used as money

Banking: Fractional Reserve and 100% Reserve (1)


Credit banking
Population/individuals loan money to the banks; they
transfer the property right over an amount of money
for a limited period of time or term deposit
Banks pay interest (depositors income for the loaned
capital; i1)
Banks loan further these money by charging interests
(i2)
I2-I1>0: banks receive profits

Banking: Fractional Reserve and 100% Reserve (1)


Free banking with fractional reserves
The depositary (bank) holds in deposit/as reserves only a part (a
fraction) of the money received or issues unbacked deposit
receipts (which become fiduciary media)
Discussion: Robinson Crusoe and the monkey

There is no clear distinction between the deposit activity and


credit activity
Economically, such a bank is insolvent thus bankrupt
The illusion of double availability of some money (Cosmin knows
that deposited 100 ron on demand, and the depositary bank takes
from these 80 ron and gives credit to Clin; they both have the
sensation that own 100 ron, respectively 80 ron; at this moment
the restitution of money to Cosmin is impossible, although money
are on demand)

Banking: Fractional Reserve and 100% Reserve (1)


The Central Bank
Is the consequence of a banking system based on
fractional reserves
Acts as lender of the last resort for the inherent bankrupt
banks (therefore bankruptcy is not a feature of a fractional
reserve system); the necessary funds originate from
taxation (=> opportunity cost)
Is the state monopoly on the money production; controls a
cartelized banking system (bankers dont have the exit
option and would not probably desire it; e.g.: American
federal reserve system)

Is not necessary in a banking system with 100% reserves

Banking: Fractional Reserve and 100% Reserve (1)


Free banking with 100% reserves
All monetary certificates are 100% backed
Net distinction between deposit activity and credit
activity
No systemic risk of bank panics
No illusion of double availability of money

The Expansion of Credit (1)


Banks supply the market with an additional/new created quantity of money
which enters the economy through loans; cheap credits (decrease in interest
rate) => entrepreneurial projects/investment that before did not seem
profitable know they are (expansion phase) => an inter-temporal discoordination in the structure of production
The booms creators (central bank, commercial banks, entrepreneurs) pay with
these new money their employees; the later meet/compete on the market
with those that did not change their consumption vs. savings proportion
If the boom is sustained (through additional and repeated expansion of credit)
the prices increase and PPM decrease (revealing the false/artificially low
interest rate) => entrepreneurial projects become expensive/unprofitable=>
entrepreneurial error is revealed, especially those projects unbacked by real
savings; the error has a systematic character (mass error), and not a simple
error; bankruptcy becomes current business (the first phase of the crisis,
boom)
In practice, the crisis has started when entrepreneurial projects/investments
began although they did not have a correspondence in real savings; more than
would have been possible to complete

The Expansion of Credit (1)


The new money/credit progressively enters the economy through business
loans
The loans are apparently attractive since they come with a lower rate of
interest (which accompanies the artificially expanded money supply);
lowering the rate of interest creates the illusion that a greater number of
entrepreneurs satisfy the conditions of a loan; in fact, the market rate of
interest (counterfactual, un-manipulated) would not have permitted many
of them to take loans

The illusion of profitability given by lowering the rate of interest determines


entrepreneurs (more or less vocational) to invest money in various projects,
thus lengthening the structure of production to a level which does not
correspond with market interest rate (those who save/invest)
discussion: economic calculus is distorted together with incentives

Entrepreneurs buy various factors of production which increase their


prices, hire more people and pay larger wages which at their turn increase
consumer goods prices

Addenda
Mainstream popular explanations of the crisis
The under consumption thesis
The crisis is caused by the small degrees of consumption in
economy => an infusion of money in the economy can give
it a boost
The degrees of optimality in consumption is given by
consumer/individuals preferences (consumers do not under
consume or over consume, they just consume)
Implausible, for the problem is not in the consumption goods
sphere but in the capital goods; consumers do not spend money in
the capital goods because they did not change their time
preferences
It fails to regard the real problem: the artificially expanded capital
goods sector or not connected with the proportion of consumers
savings
Assuming that would be the case, how come entrepreneurs
cannot forecast this period of under consumption?

Bank Credit Expansion: Economic


Consequences (2)
The Inflationary Boom

Distortions in the Rate of Interest and the


Structure of Production

The inflationary boom (2)


Inflation = an increase in the quantity of money (1)/a
general increase in prices (2)
Inflation can also appear in private regime of money
production, when are issued non-backed warehouse receipts
discussion: disadvantage => the counterfeiter is rapidly discovered
(competition between the producers), and consumers become more
attentive; mass entrepreneurial error/cluster of errors is absent

In a regime with monopoly on the production of money


(the present regime) literally any expansion of money
supply is inflationist
The non-neutrality of money (Cantillon effect: the
expansion determines a redistribution phenomenon of
wealth/welfare; the first possessors of the new money
who are they? buy more goods than the latter possessors
who are they? who get a considerable eroded PPM)

The Inflationary Boom (2)


Moderate phase
The increase in the quantity of money through fractional
reserve banking system enters the economy through loans
and produce a general increase in prices/lowering of the
PPM
Entrepreneurs pay higher wages to employees which in turn
spend these money in consumption (according to their
counterfactual time preference)
Inflation distorts economic calculation and incentives:
calculation chaos : those who do not discover the origin of the
new money engage their own savings in various projects => capital
consumption
Apparently, in the inflationary boom all the entrepreneurs are
successful; the efficient ones are penalized if they dont
forecast/anticipate the expansion, and those inefficient are
encouraged to take risks and to enter in the machinery which
distributes new money

The Inflationist Boom (2)

Moderate phase

The accounting problem: inflation tends to overestimate business


profits (the capital consumption is not noticed by accounting)

Inflation lowers the quality of goods and labor (the systematic decrease
of PPM determines qualitative adjustments in the production of goods;
population becomes more interested in illusionary games such as Get
rich fast!, The Wheel of Luck, Lotteries, having a disrespect for
serious effort)

Inflation leads to an increasing indebtedness (the progressive decrease


in PPM penalizes the population efforts to save; it becomes profitable
to make debts and pay as latter as possible)

Disequilibria in the balance of payments (BOP): since it erodes the PPM


and increase prices of goods, this will lead to increased imports (the
competitiveness of domestic products falls relative to foreign ones) and
a deficit in the BOP

The Inflationist Boom (2)


Hyper-inflation phase
It appears when the expansion of credit cannot keep up
with the inflationist expectations; people do not trust
anymore that authorities can stop the inflation
phenomenon so they spend all the money in various
economic goods which have a more stable value (gold,
painture, food etc.)
With every expenditure that they make, people contribute
to the hyper-inflationist phenomenon (lowering the PPM)
If the expansionist trend is not stopped it can reach the
economic limit: extreme poverty and civilizational regress
Historical instances: the German hyper-inflation of 1923
and the Austrian (Vienna) hyper-inflation of 1917-1918

Distortions in the Rate of Interest and the


Structure of Production (2)
The expansion of credit determines entrepreneurs to invest
in higher-order goods sector thus lengthening the structure
of production to unsustainable limits
paradox: although people prefer to spend more on consumption
goods, entrepreneurs (receiving wrong signals) invest in capital
goods (it is like Cosmin wants an apple for consumption and
Clin who is entrepreneur wants the same apple for making
some comfiture); society is both in the position of consumption
and of expanding production

Why higher-order/capital goods sector is more attractive?


The present value for short-term project is less sensitive
(relatively) than for long-term projects
Lower interest rates increase the (relative) bargaining power of
those entrepreneurs who invest in long-term projects

The Depression (3)


The occurrence of crisis

Mal-Investments

The Recovery: Deflationary Credit Contraction

The Occurrence of Crisis (3)


The occurrence stems from the obvious incapacity of
entrepreneurs to end the projects started in the boom; the
crisis is the natural consequence of not having matching
consumer wants (higher time preference and rate of
interest)
The depression/crisis is essentially a process of recovery
and readjustment of the productive activity to the old
proportions (before bank credit expansion) of consumption
vs. savings
The crisis sheds light on those sectors which artificially
expanded in the boom/mal-investments/wasteful projects;
normally the market should partially or totally liquidate
them
Partially because some rest of them can be used/adjustable to
the reinstalled conditions imposed by consumers time
preference; totally because some must be abandoned
But the reality speaks against. What does this prove?

The Occurrence of Crisis (3)

This recovery phase is accompanied by changes in the structure of


production, prices and labor:

Given by readjusting to the old price differentials between capital goods and
consumer goods
Capital goods prices decrease in relation to consumer goods prices; the
later bid away resources from the former
Unemployment occurs in capital goods sphere

The possibility of delaying the crisis

Can become truth if:

Banks continue expanding credit (the greater the credit expansion and the longer it
lasts the longer will the boom last, M. Rothbard, Americas Great Depression; this does
not allow entrepreneurs to adjust
The monetary authority of the government (the central bank) bailouts bankrupt banks
and/or financial companies
Both of the aforementioned are plausible if an electoral process is in progress or if it is
on the way

Economically, the horizon of delaying is limited by the quantity of saved


capital; a business cycle is necessarily a phenomenon of unsustainable
capital consumption therefore it must logically end when the entire quantity
of capital is wasted; at this point social division of labor collapses and the
society is at an extreme level of poverty

Mal-Investments (3)
Any investment which is not connected with the demand
side/consumers is a wasteful investment/mal-investment; on the
free market successful entrepreneurs get profits while those
unsuccessful get losses (incentives: effort-reward)
The necessity of mal-investments stems from:
The bad quality of the banking system (fractional-reserve banking
backed by the central bank) which allows banks to take risks by
creating circulation credit/fiat money and loan more than it owns in
reserves
Note that the banking system is connected with different savings and loan
associations and life insurance companies; they all participate in distributing
the fiat money

The fact that entrepreneurs are misled in their actions; they invest in
projects which on the free market would have corresponded with a
lower rate of interest; since consumers do not change their time
preferences and thus rate of interest is still higher the bad turn is clear

The Recovery: Deflationary Credit


Contraction (3)
Deflation = a decrease of the money supply (1)/ a general decrease
in prices (2); almost always a general fall in prices can be seen but
not necessary a decrease of the money supply
A phenomenon of credit contraction is installed. It can be the result
of:
Entrepreneurs along with the banks and financial companies
skepticism concerning their situation (falling prices, unemployment)
The fear of bank runs, since people become suspicious toward the
banks financial stability

In a depression an increase in the demand for money (for liquidities)


is seen:

The falling prices determines people to demand money for hoarding,


to be spent in the future
Banks also invite their borrowers to pay their debts
An increase in the demand for money while the supply of money
remaining constant leads to a general decrease in prices (deflation)

The Recovery: Deflationary Credit


Contraction (3)
Deflation is essentially a process of recovery,
not an aggravating factor
Falling prices generates a more powerful PPM
which on the market translates into a better
economic position
What is important to entrepreneurs/businesses is
not the level of prices but the price differentials
(costs vs. profits; natural interest rate)
The accounting problem: deflation tends to
overstates business losses or the effectiveness of
the recovery process

Addenda (3)
The hostility towards hoarding: it blocks money
penetration into productive sphere (money should
circulate) and thus depress economic activity => the more
people tend to save or hoard the more depressed will be
the economic activity
The productive sphere can only be fulfilled with saved money; if
no one saves (abstinence of consumption) no further
investments can be made, since no one reserved any capital for
them
Any given amount of money is composed of:
Saved money
Money in consumption (the degree of consumption is an indicator for
the degree of production)

An ultimate implication of this would be that no savings leads


to the greatest expansion of productive activity; if one does not
reason with this it is forced to look in vain for arbitrarious
criteria of optimum degree of savings and spending

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