February 16, 2012

An entrepreneur's business cycle theory

Over the last five years or so I've become increasingly interested in macroeconomics and monetary theory. At the center of this subject is the age-old question of what causes the business cycle, and especially the more pronounced "booms and busts". All the schools of monetary theory have their explanations. The Keynesians see the market economy as fundamentally unstable and in need of constant intervention [1], the Modern Monetary Theorists seem to think a bust is an unavoidable consequence of a prolonged imbalance of payments between the private and the public sector [2] and the Austrians have a complex hypothesis about artificially low interest rates fooling entrepreneurs to "malinvest" in stages of production that are too far removed from the consumer [3].

If you don't believe me that the Austrian explanation is rather complex and contrived watch this interview with Lawrence H. White, Professor of Economics at George Mason University. Let's just say he's not exactly crystal clear on what really causes that "cluster of (entrepreneurial) errors".

(Some more background is provided in Brian Caplan's explanation of why he's not an Austrian [4], Paul Krugman's refutation of what he calls the hangover theory [5] and Brian J. Stanley's defense of the same [6] if you're interested.)

Now the interesting part: I think I can formulate a clear, logical and plausible explanation for how loose monetary policy causes a boom and bust cycle. I know, that sounds pretentious, but please bear with me. :)

My theory of the business cycle takes Hayek as its starting point but goes like this: Entrepreneurs are not fooled by artificially low interest rates. Entrepreneurs are fooled by a phony market response, the market in turn is "fooled" by credit expansion and credit expansion is caused by artificially low interest rates. Now let me try to briefly explain what I mean by that.

What is in a price

It's easy to ascribe more importance to money than is really warranted. Money is just the medium of exchange. What people really want are the things that money can buy [7].

Likewise, we put a price on things in the monetary unit, but it's not that we want to keep the money that stops us from buying something expensive, it's that we will then not be able to afford other things, or we will have to work hard to make more money. 

If you really think about it a "price" is whatever a customer forfeits in order to buy a product or service, a sort of opportunity cost. That's unique for every customer (even if the monetary price is the same) and largely depends on how accessible money is to them, and what alternative use they have for it. Anyone who has run a business knows this intuitively, that's why "market skimming" is so popular.

Credit expansion and price stability

When economists talk about the effect of credit expansion on price stability they usually mean the tendency for monetary prices to (sooner or later) rise, causing what we call inflation. But monetary prices are "sticky". The much more immediate effect is that credit expansion lowers the opportunity cost of many things for many people, because money becomes easier to come by.

Suddenly you have to forfeit less to be able to afford a certain product or service. For example, who do you think would pay a hundred dollars for a pedicure for their dog if they had to take an extra job to (first) earn that money? How about if they had to forfeit a tiny portion of their $500k+ home equity, a few hours worth of "the appreciation you get in a normal market" [8]? :)

You may say that's just inflation, and you would perhaps in some sense of the word be right. It spreads like rings on the water across the economy in much the same way as inflation does. But it's a stealthy sort of inflation. It doesn't show up in the statistics and central banks pay no attention to it (and if they do they call it the "wealth effect" and regard it as something positive).

Why entrepreneurs are fooled

Predicting the market's response to a new product or service is incredibly difficult. So difficult in fact that most experts on the subject have accepted that it's often stupid to even try and better to continuously measure market response and iterate on your offering. In startup lingo it's called "customer development" or "finding product/market fit" [9][10] but it's basically the same idea that entrepreneurs have employed for centuries (knowingly or subconsciously); you feel your way to profitable business by continuously probing the market, testing your hypotheses, trying new things.

But credit expansion distorts the market response. Entrepreneurs find what they think is new profitable business, because customers are willing to pay more for the product or service than what it costs to produce, but they are only willing to do so as long as money is "artificially" easy to come by (and have no more important alternative use). When credit stops expanding and starts to contract customers are gone with the wind, leaving fooled entrepreneurs with a failing businesses behind.

In order to avoid that fate entrepreneurs not only have to understand that interest rates are being held too low and that credit is expanding too quickly, they also have to guess in exactly what way the market response for their particular product or service is distorted. The market for a new product or service is incredibly difficult to predict, but more or less impossible to second guess. That's why entrepreneurs are fooled. That's why they "malinvest" in a correlated fashion, forming a "cluster of errors".


[1] Wikipedia: Keynesian economics; http://en.wikipedia.org/wiki/Keynesian_economics.

[2] New Economic Perspectives blog, Modern Money Primer; http://www.neweconomicperspectives.org/p/modern-money-primer.html.

[3] Wikipedia: Austrian Business Cycle Theory; http://en.wikipedia.org/wiki/Austrian_business_cycle_theory.

[4] Bryan Caplan, Why I Am Not an Austrian Economist; http://econfaculty.gmu.edu/bcaplan/whyaust.htm.

[6] Brian J. Stanley, Why Don't Entrepreneurs Outsmart the Business Cycle?; http://mises.org/daily/2673.

[7] Paul Graham, How to Make Wealth; http://paulgraham.com/wealth.html.

[8] YouTube: Peter Schiff Was Right 2006 - 2007 (2nd Edition); http://www.youtube.com/watch?v=2I0QN-FYkpw.

[9] Steve Blank, The Four Steps to the Epiphany: Successful Strategies for Products that Win; http://www.amazon.com/Four-Steps-Epiphany-Successful-Strategies/dp/0976470705.

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