Seek ye therefore first the kingdom of God, and His justice, and all these things shall be added unto you. Matthew 6:33

Friday, April 1, 2011

An Easier Way to Think About Bubbles

If you're not interested in an intellectual preface of the basic logic of the Austrian theory of the business cycle, skip to the second paragraph.

As Austrians so forthrightly explain, the boom-bust business cycle occurs when artificially low interests rates indicate more capital is available than really exists. Entrepreneurs, totally dependent upon this incorrect market signal, adjust their behavior by taking on new and more round-about production processes (e.g., building a ton of houses). But because the new capital is in actuality mere fiat currency, un-backed as it were by actual resources (i.e., savings) eventually inflation or otherwise an adjustment in prices reveals that the boom is unsustainable. We must then readjust our behavior to a state that cause us to be less well-off than when we started because real savings (read effort) made in the meantime were diverted into unrealizable projects, and it is costly to properly rearrange or salvage it.

But there is a much more personal way to think about how a bubble works and the problems it causes. Let me use myself as an example. I recently obtained a new job. This job pays a significantly higher salary than my previous job. And I do not start until April 25th. I have known this since mid-March. During this intervening time period (from mid-March to April 25th) I have already adjusted my behavior in anticipation of my higher income.

Expenses that I have been putting off (e.g., making a superficial repair to my car) I have now made. I have shifted some of my savings into riskier assets like stocks because, no longer being unemployed, guaranteeing the level of my savings does not fluctuate wildly is less of a concern. I realize most people would not do such a thing, but I nonetheless have. And let me ask, when we apply this analogy to the wider economy, would not a billionaire investor do similarly?

And I have made a hundred dollar plus deposit in order to guarantee me an apartment I otherwise would not have rented. Now, let's assume April 25th arrives and the job is eliminated. Chalk it up to whatever you want:  the company went bankrupt, the hiring manager changed his mind, etc. What does this do to my mis-informed actions? I will lose the hundred-plus dollar deposit, as I no longer need the apartment and being unemployed, don't actually want to rent it. I may need to sell some of the stocks I bought sooner and at lower prices than I would have if I actually got the job. I dearly wish I would've retained the money spent on superficial car repair. This is the equivalent of a bust for me.

Notice, I did not actually have to receive my new salary for it to have an effect my actions, investments, and current standard of living. I am now poorer, at least by the amount of the deposit and the time wasted preparing for a job that does not exist. So too do lower interest rates caused by Federal Reserve "money printing" (or digit creation) lead entrepreneurs to make misinformed decisions which ultimately lead to everyone's impoverishment when it turns out they can't be carried all the way through.

NB: I made my decisions with at least a partial realization that I may never actually see my paycheck. Entrepreneurs, however, are entirely dependent upon the market interest rate and cannot determine whether the particular lot of money they receive is newly created or representative of actual savings-capital. Thus, if anything, the Fed's actions are to that extent even more impoverishing.

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