Money, Banking, and the Business Cycle

Volume II: Remedies and Alternative Theories

B. Simpson

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137336569
• Topic: Economics
• Subtopic: Economic Policy
• Index: Economics

The business cycle is a complex phenomenon. On the surface, it involves a multitude of mechanisms, such as oscillations in interest rates, prices, wages, unemployment, output, and spending. But a deeper understanding requires a unifying theory to make these various parts whole. Money, Banking, and the Business Cycle provides a comprehensive framework for analyzing these mechanisms, and offers a robust prescription for reducing financial instability over the long-term. Volume II refutes Keynesian and real business cycle theories and provides policy prescriptions to virtually eliminate the cycle. Simpson offers a detailed analysis of several historical monetary systems around the world and shows the causes and effects of fiat money and fractional-reserve banking, as well as a 100-percent reserve gold standard.

Part I

REFUTATION OF ALTERNATIVE EXPLANATIONS OF THE BUSINESS CYCLE

1

UNDERCONSUMPTION AND OVERPRODUCTION THEORIES OF THE BUSINESS CYCLE

INTRODUCTION

There are many theories of the business cycle. Some are better than others but all of them are deficient in some way except Austrian business cycle theory (ABCT). None of the alternative theories provide, as does ABCT, a comprehensive and logically consistent explanation of the business cycle based on the facts of reality. Some correctly identify some aspects of the cycle and may offer valid explanations of some aspects of the cycle, but none of them fully explain the causes of the cycle or the monetary and real changes occurring in the economy as a result of the cycle. I address the main attempts to explain the cycle in this and the following two chapters. I show logically and factually why they do not provide a valid explanation of the cycle. Once this has been done, and if one reads volume one of this work on the business cycle, one will have a complete understanding of the cycle. One will know logically what causes the cycle, will see and understand the causal factors at work in the facts of history, and will understand where alternative theories go wrong.

In the next few chapters, I discuss overproduction and underconsumption theories of the cycle, John Maynard Keynes’s theory of depressions and fluctuations (which is also underconsumptionist), so-called sticky price theory (which is also Keynesian), real business cycle theory, among a few other theories.

OVERPRODUCTION

The overproduction theory of the business cycle originated with socialist thinkers or those who leaned in that direction and was advocated by such individuals as Thomas Malthus, the nineteenth-century Swiss socialist J. C. L. de Sismondi, and Karl Marx.¹ This theory says recessions and depressions occur because capitalism is characterized by periods of too much production. During these periods of excess production, businesses begin to accumulate inventory, cannot sell the inventory at profitable prices, and must cut back on production. The cutback in production leads to workers being laid off, factories being shut down, and causes a general decline in business activity. Hence, recessions and depressions result from overproduction in the free market.

Employment and production increase only after the inventories of businesses have been depleted sufficiently to make production profitable once again. So the economy goes back and forth between these periods of overproduction and production, in an endless cycle.

The specific reasons why it is said capitalists periodically produce too much vary, but it is generally based on the belief that the need and desire for goods is limited and the rapidly expanding production in a capitalist society inherently leads to the supply of goods outstripping the limited need and desire. If the need and desire for goods is less than the supply, then of course the demand will also be insufficient to purchase all the goods produced. Hence, production is periodically reduced back down to the demand for goods in recurring recessions and depressions.

The first and most obvious point to make with regard to this theory of depressions is that there is an inherent contradiction in it. The claim is that recessions and depressions occur because too much has been produced. This implies they are periods of abundance or greater prosperity. If more has been produced than people have a need or desire for, then, in essence, people have grown so rich that they can cut back on production and enjoy the fruits of their labor. Obviously, this is false. Recessions and depressions are periods of greater poverty and hardship, not prosperity. This alone is enough to discredit this theory as a valid theory of the business cycle. However, there is another problem with the theory.

The other problem is with the idea that humans have a limited need and desire for wealth. This idea is false. Humans, in fact, have a limitless need and desire for wealth. This desire is based on the fact that human beings are rational beings—beings that possess the faculty of reason. Reason is the faculty that makes it possible for humans to think at the conceptual level (in terms of principles and ideas). The possession of reason makes it possible for humans to continuously expand the knowledge they possess. It makes it possible for them to progress forward through the continuous acquisition and application of knowledge. This progression is a part of how man improves his ability to survive and flourish; it is a part of man using reason—his basic tool of survival—to continuously improve his ability to further his life and happiness. As a result of the possession of reason and the progression it makes possible, man has a potentially limitless range of knowledge and awareness and thus the potential for a limitless range of actions and experiences based on this knowledge.

One can begin to see the limitless need and desire for wealth in the advance of knowledge and production since the beginning of the Industrial Revolution. One need merely think of the myriad products available today that were not even dreamed of in the mid-eighteenth century: from cellular phones, automobiles, and space travel to air conditioning, life-saving drugs, electronic computers, all sorts of other electronic devices, and many more. The production of and desire for these products represent an enormous increase in the need and desire for wealth. There is no limit to progress as long as man is able to use reason to acquire knowledge and apply it to production.

Even satisfying one of man’s basic needs, such as his need for shelter, implies a limitless need and desire for wealth. Man does not satisfy this need by living in a cave that he happens to stumble upon, like the lower animals might do. Man must grow trees for lumber, build lumber mills, build hardware stores, and produce all the products that these stores sell. He must mine ores and build steel mills to produce steel. He must produce transportation systems to carry building materials to where they are needed. He must produce aluminum siding and stucco, windows, heating and air conditioning systems, appliances, and plumbing systems (including pipes, pumping stations, water purification systems, etc.). The list could go on and on, and this is just with regard to producing shelter to meet his needs and desires.

Even as we grow richer, our need and desire for wealth remains limitless. As beings that possess reason, we have a continuous desire to progress forward economically. For example, if a man owns a car, then perhaps he would like to own a better car. If he has one of the best cars, perhaps he would like several vehicles to fulfill his transportation needs and desires (an exotic sports car, a family car, an off-road vehicle, a truck for hauling items, etc.). If he owns a home, then perhaps he would like a better home. If he has the house of his dreams, perhaps he would like a second home in a beautiful vacation spot. Perhaps he would also like to be able to afford more and better vacations, to be able to spend more time with his family and engage in more and better leisure activities, retire at an earlier age than he can presently afford, provide a better education for his children, and so on. To afford all of these things, a greater productive capability and higher standard of living are required; that is, more wealth is needed. Satisfying our needs and desires requires an ever expanding ability to produce wealth.

Man’s possession of reason vastly increases the scope of his needs and desires. In addition, by enabling him to increase his capacity to produce wealth, it makes it possible for him to constantly improve his ability to satisfy his needs and desires. This is something that is impossible for beings that do not possess reason to do, such as dogs, cats, cows, zebras, chimpanzees, and all the other lower animals. They go through their lives, generation after generation and century after century, performing the exact same tasks in the exact same manner as each previous generation. All they do is eat, sleep, eliminate, and mate over and over again until they die. There is no forward movement with the lower animals. There is no progression of knowledge. Later generations do not build upon the knowledge gained by previous ones. There is no ability or desire to constantly improve upon the satisfaction of their needs.²

The above implies that, in a general sense, there can never be too much production. There is always some use to which man can put greater sums of wealth, if not to improve upon the satisfaction of an already existing need or desire, then to satisfy a different need or desire that has arisen due to the discovery of new knowledge.

The only sense in which there can be an overproduction of goods is in a partial or relative sense: there can be an overproduction of some goods in the economy; however, this implies a corresponding underproduction of other goods. Such a situation implies that the areas of the economy that are experiencing the overproduction will be depressed: prices and profits will be low, workers will be laid off, factories will shut down, and businesses will go bankrupt. However, this implies at the same time that the areas of the economy that are experiencing the underproduction will be booming: prices and profits will be high, workers will be hired, new factories will be built, existing businesses will expand, and new businesses will open. This is not a general, economy-wide business cycle. It is not the boom and bust that is the focus of business cycle theory. It is a boom and bust only within certain industries and will not lead to an overall rise and fall of production in the economy but to a shifting of production from some areas of the economy to others.

To illustrate that there can be no economy-wide overproduction, imagine that production magically doubles overnight in the economy. Imagine that there are twice as many automobiles, computers, cellular phones, homes, clothes, toothpicks, swimming pools, thimbles, and so on produced overnight. Surely it appears that there is an economy-wide overproduction. However, even here there is not. Although it might be true that people do not want twice as many of all products, there are some products of which people want more than twice as many. For instance, most people do not want twice as much table salt, twice as many toothpicks, or twice as much low quality food (such as low quality types of meat). But most people do want twice as many cars, homes, vacations, restaurant meals, et cetera, and if they do not want twice as many of these things, most people certainly want the equivalent of twice as much in improved quality. That is, they might not want two Toyota Corollas but they would like to own a Lexus instead of a Corolla. Further, some of the increase in production could be devoted to the invention and development of new products, unheard of and impossible to produce with the previously lower productive capability. In general, people do not want twice as many staple and low quality goods, but they do want more than twice as many luxury and high quality goods, the equivalent of more than twice as much in improved quality, and the equivalent of more than twice as much in the form of the invention and development of new products.

What this means is, if a uniform doubling in the productive capability occurs throughout the economy, productive resources must be transferred from some areas of the economy to others. Capital and labor must be transferred from the areas in which too much is produced to those in which too little is produced. As stated by the economist George Reisman, “The problem in such a case is not any actually excessive ability to produce, but merely the misapplication of an increased ability to produce in an undue concentration on the production of a particular good. The solution is thus simply a better balance in the production of additional goods.”³

So the overproduction theory is not a valid theory of the business cycle. It implies prosperity in the midst of poverty. Further, humans have an unlimited need and desire for wealth and therefore economy-wide overproduction is impossible. The overproduction theory is based on the fallacy of composition. Since one industry can be unprofitable due to its overproduction, people think that when virtually all industries are unprofitable it must be from all of them overproducing. What people forget is that when one industry is experiencing lower profits or losses due to its overproduction, other industries are correspondingly more profitable due to their underproduction. This is because the industries are competing with each other. However, at the level of the economy as a whole, there is no competition. Competition only takes place within an economy. Changes in profitability at the level of the economy as a whole, as well as recessions and depressions, occur due to changes in the supply of money and spending.⁴

UNDERCONSUMPTION

Closely related to the overproduction theory of the business cycle is the underconsumption theory of the cycle. This theory has been put forward by Sismondi, Keynes, and others.⁵ Although the details may vary among supporters of this theory, the main claim is that when there is not enough consumptive spending in the economy, goods go unsold, workers are laid off, and businesses shut their doors. In other words, a depression occurs. One reason given why there is not enough consumptive spending is that capitalists might shift their spending from hiring workers to purchasing capital goods (i.e., substitute capital for labor). This means workers will be paid less and thus will allegedly not have enough money with which to consume all the goods produced. Whatever the reason given for the lack of consumption, the result is the same according to supporters of underconsumption theory: economic crisis and depression.

The situation is made worse, according to advocates of underconsumption theory, to the extent that greater savings accompany the lack of consumption because this leads to a greater supply of capital goods and thus a greater supply of goods produced. What this means, according to proponents of this theory, is that the supply of goods increases at the same time that spending for goods decreases and thus the underconsumption depression is exacerbated. As an example of underconsumption theory that focuses on too much saving, here is a quotation from the economist J. A. Hobson and his coauthor A. F. Mummery in John Maynard Keynes’s The General Theory of Employment, Interest, and Money, whom Keynes quotes favorably:

The object of production is to provide “utilities and conveniences” for consumers, and the process is a continuous one from the first handling of the raw material to the moment when it is finally consumed as a utility or a convenience. The only use of Capital being to aid the production of these utilities and conveniences, the total used will necessarily vary with the total of utilities and conveniences daily or weekly consumed. Now saving, while it increases the existing aggregate of Capital, simultaneously reduces the quantity of utilities and conveniences consumed; any undue exercise of this habit must, therefore, cause an accumulation of Capital in excess of that which is required for use.⁶

Because it is generally claimed that reduced spending and a depression result from too much saving, this theory can also be referred to as the over-saving doctrine. To ensure there is no doubt what too much saving (or too little consumption) leads to, a further quotation from Hobson and Mummery in Keynes’s The General ...

Table of contents

• Cover
• Title
• Introduction
• Part I   Refutation of Alternative Explanations of the Business Cycle
• Part II   To Cure the Business Cycle
• Epilogue
• Notes
• Selected Bibliography
• Index