Roofer with a Mortgage

The last basic topic of Economics that I want to cover is this idea of “business cycles.” That’s the term economists use for when the “boom” times (periods of prosperity and rapid economic growth) are followed by the “bust” times (recessions/depressions). I need hardly point out that we’re experiencing the “bust” part of one of these cycles right now, though some economists are hopeful that we’re at the tail end, or even that we may be finally recovering.

A large part of why I decided to write this Econ 101 series was to be able to explain and discuss business cycles. You really have to understand all of the concepts covered so far before you can make sense of what happened, how to recover, and how to prevent it from happening again. And so, without further ado, here’s my attempt to put it all together:

Generally, the scenario runs as follows. The central bank starts increasing the amount of money in circulation, which has the effect of lowering interest rates to a point below the rate that would occur on the free market. These low rates lead to an increased use of credit, particularly in any industries that are being incentivized by the government. In the late 1990s, this took the form of investment in tech startups; in the early and mid 2000s, it took the forms of investment in housing through construction loans but also through greatly relaxed lending standards for homebuyers. The lower lending standards had the effect of increasing the demand for housing, driving up prices quickly and far beyond what the market would have set without all this excess credit. To get back to the general case, as the increased use of credit spreads throughout the economy, demand for the goods and services of the incentivized industries creates more jobs in those industries and causes wages in those industries to increase. People perceive that they are more prosperous, even though another result of the increased supply of money will have been an increase in prices, first in the favored industries, then in related fields, and so on until the increase becomes general throughout the economy. But who cares if prices go up a bit? Everybody’s working, everybody’s making more money, everybody’s better off, right?

At some point in this process, reality is restored. This happens when the money-issuing governmental authority (i.e., central bank) determines that it has been inflating the money supply too quickly and begins to scale back. It does not have to decrease the money supply nor even to halt expansion. All that is required is that the expansion of credit slows, which spooks investors into thinking that projects they’ve taken on with the expectation of freely available credit may not be able to be completed. Investors will cease to invest, lest they lose even more money on projects that cannot be completed, and just like that, the boom ends and the bust begins.

Projects taken on during the boom are now seen to be untenable, and the producers’ perception of a growing demand in their industry is now shown to have been an illusion based on easy credit, without which the demand is greatly reduced. These companies, which had hired workers and increased wages (to attract or retain workers for those projects), begin laying off those workers in large numbers. Prices stagnate or decline as the producers try to recoup whatever money they can with increasing desperation. Many simply go out of business. This trend continues until the resources in the economy can be reallocated to more productive uses in companies or industries for which there is an actual, non-credit-based, demand.

And that’s the business cycle. The only thing I’ve left out at this point is what the central banks or the government should be doing to help us get out of the bust period. The answer is: nothing. As you may have guessed if you have read the posts on Government Interventions and on Central Banking, any steps that the authorities take will, in the words of Sir Topham Hatt, “cause confusion and delay” in getting the economy back on track.

For our discussion of central banking, I want to give some brief background and then describe for you the mechanism by which America’s central bank, the Federal Reserve System (hereafter called “the Fed”), creates money out of nothing. An understanding of this process is crucial to the understanding of business cycles (the “boom” and “bust” times for the economy) to be covered in the next (and final) article.

National central banks are established for a variety of reasons both public and private. Publicly, central banks are said to be “lenders of last resort,” meaning that if local banks get low on funds and can’t (or won’t) raise cash by other means, they can get loans from the central bank in order to stay in operation. The central banks are also usually charged with setting the rate of inflation, and, in the case of the Fed, maintaining full employment for the nation as a whole.

Central banks are usually seen to be a part of the national government, and in most cases they are. In the U.S., however, the Federal Reserve System is a hybrid, in that it is privately owned, but it was created by an Act of Congress and its Board of Governors is appointed by the President of the United States. The Fed is, in fact, a cartel of several large banks which have been given authority over the control of the nation’s money supply and rate of inflation. Established by the Federal Reserve Act of 1913, it was publicly touted as a way to keep banks from failing and from over-inflating. What it has done in reality has been to prop up big banks when they’ve made bad decisions, to continually inflate (and therefore devalue) the dollar over the past 100 years so that it’s lost (arguably) 95-98% of its purchasing power, to allow the U.S. government to finance large-scale operations that could never have been funded by tax dollars (e.g., long wars), and to wreak havoc on the free market system. This sounds a bit over the top on re-reading, but it’s absolutely true. Here’s how the system works:

When the Fed sets out to lower interest rates, it does so by infusing banks with new money. The expectation is that the banks, now having a larger supply of money, will lend it out at lower interest rates in an effort to entice potential borrowers. This goes back to our discussion of supply and demand, where – all else being equal – an increase in the supply of a good or service will tend to decrease its price. The Fed gets the new money by creating it out of nothing. The money-creation process goes like this:

1)  The Fed’s Open Market Committee (FOMC) buys something by writing a check for that thing. The item purchased could be anything, but is most commonly a large bulk of United States Treasuries (bonds). At this point the new money does not yet exist.

2)  The recipient of the Fed’s check takes it to his bank to be deposited in his/her account. At this point the new money still does not yet exist.

3)  The recipient’s bank takes the check to the Fed and redeems it by depositing it in their account with the Fed. Here is where the money actually comes into being. But it doesn’t stop there.

4)  The bank’s account with the Fed is their “reserve” account. The Fed has a table regulating how much must be kept on reserve based on a bank’s existing capital, but for convenience, let’s just use 10%, since that’s the highest amount in the table at present. By depositing a check from the Fed into their account with the Fed, the bank is authorizing itself to lend out 9 times the amount of the deposit.

That’s the deal. The Fed buys something with a check, the check gets deposited at the Fed in the account of a member bank, and a total of 10 times the amount written on the check gets created out of thin air. This, of course, leads to the inflation previously discussed, which is bad enough by itself, and indeed is a “hidden tax” that steals from every dollar-holding person on the planet for the benefit of a very few recipients of the new money. Beyond that, it also sets up the “boom-bust” business cycle that causes such misery across the whole economy. And that will be the topic of the final article in this series.

*Note: I’m just going to pretend it hasn’t been over 9 months since the previous post and continue on as if it were the next day. You may want to re-read it as a refresher, however.*

We’ve now seen how money goes from being an item with both use-value and exchange-value (e.g. gold, silver) to an item with only exchange value (e.g. warehouse receipts for gold or silver). We need to know a bit more about banking’s history if we want to understand some of the implications of this.

Over time, banks begin to notice that people rarely withdraw all of their money – gold, in our example – at once, and that a large amount of gold is just sitting around the warehouse all the time. Since anyone’s gold is identical to the same amount of anyone else’s gold (a necessary property of money, after all), people also rarely demand their specific gold deposit. The bank begins to see the gold in their warehouse as an asset that can be loaned out for additional revenue, rather than as someone else’s property that is being kept in safe storage. As long as there’s enough gold left in the warehouse to meet the demands of the depositors, what harm would there be? The bank may then establish some fraction of the total gold to be reserved for depositors and loan out the rest. This system is called Fractional-Reserve Banking.

The great problem with Fractional-Reserve Banking should be immediately obvious. As soon as the depositors demand more of their money than the bank has kept in reserve, the bank is shown to be insolvent and has to close. It has defrauded its customers by claiming to keep their deposits safe while actually taking those deposits for itself and selling them off in the form of loans. Fractional-Reserve Banking could still conceivably be workable in this instance, as long as the bank was able to call in its loans and restore the depositors’ gold more or less on demand. It would still be fraud, but of a type that could be easily rectified. However, for one thing, calling in loans is never instant, and the full amount can never be instantly repaid; if it could, there would be no reason to take out a loan in the first place. Furthermore, once warehouse receipts are being traded as money, then the bank need not even lend out the actual gold; it can simply print receipts for gold that doesn’t exist and lend those out. Again, as long as there is enough gold to meet depositors’ demands, who would know? The problems multiply here, however.

Since fewer people are demanding actual gold, the bank is free to become more liberal with its lending. It creates more receipts and lends them out, effectively creating more money. This process of money-creation was originally called inflation because it inflates the total supply of money. All of this extra money out in the world now begins to dilute the spending power of the money. The amount of goods and services in the world hasn’t changed, but with more money available to purchase those same things, prices begin to rise. This rise in prices has come to be known as inflation because that’s the most noticeable aspect for the public-at-large, but originally inflation simply referred to the supply of money getting larger.

With prices rising, people can’t buy as much stuff for the same amount of money and so are more likely to continue drawing down their bank account to have access to more and more money. As mentioned above, this will eventually cut into the bank’s reserves. When a customer of a bank sees other bank customers withdrawing more and more money, that person gets concerned that the bank may run out of money before he can get his out, and so he’ll join in the draw-down. This is a reasonable concern since, if you recall, more receipts exist than actual money to cover them. This rapid and accelerating withdrawal of money from a bank is called a “run” on the bank, and in a run, the point will eventually be reached when the bank is shown to be bankrupt and will be forced to close.

There have been two major institutions established to guard against bank failures due to being legally obligated to give out more money than they can get their hands on: deposit insurance companies and a national central bank. In the United States, deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC), and the national central bank is actually a group of banks called the Federal Reserve System. I won’t dwell on the FDIC except to say that, by insuring a depositor’s account up to a certain amount, and being backed by “the full faith and credit of the United States” – a euphemism meaning “tax dollars” – it simply encourages the banks to be more careless in their loans and in how much they hold in reserve. The Federal Reserve System, however, warrants more discussion, but again I’ve run out of space. So, seriously this time, the next post will deal only with Central Banking and the Federal Reserve System. I’ll try to keep it short.

In the article about Interest Rates and Credit, I mentioned that I would attempt to explain in a later article how the Federal Reserve Bank raises or lowers interest rates. That article is coming, but I believe the explanation requires a bit of background first. I’ll start with money.

Money is defined in part as a “medium of exchange,” which is a fancy way of saying “the thing you swap with folks to get the things you want.” The process of a thing becoming money goes like this: You’ve got something I want, say a bucket of fried chicken, but I don’t have anything of comparable value that you want. Maybe you’re willing to trade the chicken bucket for my car, but this seems excessive to me, even though I do want to get rid of the car. You also like shiny things, however, such as gold. I know a guy who will give me enough gold in exchange for my car to make me feel like I’ve gotten a good deal, say 100 pieces, so I make that trade with my guy. I now have 100 pieces of gold to carry around. You’d be happy to get 2 pieces of gold for your chicken bucket, so we make that trade, and now I’ve got my chicken (plus 98 pieces of gold) and you’ve got your shiny things. The gold in this example is the “medium of exchange.” My guy gave some gold to me to get the car, and I gave some to you to get the crispy golden-brown goodness in its convenient storage vessel. All this seems really obvious because we’re so used to it, but if I hadn’t known my guy would trade in gold and that you would also trade in gold, I’d have had to remain chickenless.

As an object becomes more and more accepted for use, not for its “use value” but for its “exchange value,” that object becomes the money. As money becomes more abundant and widely used, people begin to want to store it someplace safe, and gold (or silver or whatever) warehouses spring up to meet that demand for safe storage. These warehouses take account of how much money each customer is storing with them and issue those customers receipts. Now if I want to trade some amount of money for a chicken bucket, I have to go to the warehouse, show them my receipt, and withdraw the money while they make a note on my account. I then go to the chicken bucket supplier and give them the money.

To save time and inconvenience, I might just give the receipt to the bucketeer in the first place, and let him go to the warehouse to get the money. This is easier to do if the warehouse issues multiple receipts or something like tickets for certain amounts of money, so that my total “receipt” is really just a collection of tickets in various amounts whose total matches the total of my account at the warehouse. That way, I only have to hand the chicken provider a few of those tickets, rather than marking through my receipt to show the amount for which I’m authorizing withdrawal. Over time, these tickets begin to be seen as being “as good as” the real money, at which point people just trade the tickets since they act as a claim on the real thing in a real warehouse somewhere. People know they could get the real money out if they wanted or needed to, but as long as sellers will accept the claim on the money, there’s no need to carry around the real thing.

This is, conceptually anyway, the origin of money and banking, with a bit of the evolution of money thrown in. In the next post, I’ll discuss a bit about how banking has evolved, including the promised Federal Reserve discussion and the evolution of the concept of inflation. I’ll try not to write that one while I’m hungry.

Our second example issue is labor unions and their effects on the economy. I wrote a few different drafts of this, and I almost didn’t post it at all because my conclusion has basically been touched on in earlier posts. This is another one that tends to be politically-charged, so again I do my best to stick to the economic effects without passing judgment on the goodness or badness of unionization as such.

A labor union is “an organization of workers formed for the purpose of advancing its members’ interests in respect to wages, benefits, and working conditions,” according to Webster’s dictionary. The way that a union advances its members’ interests is by negotiating with the members’ employers for an employment contract. Their primary bargaining chips are the threat of bad publicity or a general work stoppage (a strike).

Economically then, we find that labor unions act as a cartel of labor service suppliers, setting the price of labor services above what it would be if each individual supplier of labor services had to reach his or her own price agreement with the buyer of those services, the employer. As we’ve seen with the minimum wage, a higher-than-market price for labor will necessarily lead to less labor being employed and fewer of the products of the employing company or industry being produced. If the union negotiates a contract for a higher wage, for example, any current employees subject to that contract will enjoy increased earnings. At the same time, fewer new workers will be hired, and any workers not subject to the contract may see a reduction in wages, a reduction in hours, or termination of employment.

The net result, then, of having a cartel of labor service suppliers in a company or industry is that fewer workers will be hired, less output will be produced, and prices will be higher than would be if the employees and the employers had to agree individually on the price of their labor services. Whether these seemingly negative effects outweigh the benefits gained for the workers is not a question for a discussion of the economics involved.