Sunday, August 26, 2007

The Business Cycle: a simple introduction

In view of the recent problems in the housing market and with the mortgage companies, you might be wondering why we have these periodic panics. If the economy is growing over the long term, why can't it grow consistently over the short term? Why do we have bubbles? Why recessions? Why can't things be nice and stable?

I'd like to explain the business cycle -- the cycle of booms and busts -- with a simple example. Let's imagine a town that has ten restaurants. The town has grown a little lately and people have been going out to eat more often, so all the restaurants are doing well. On Friday and Saturday nights, you have to wait a long time to get a table. The restaurant business is so good that a rational observer who looked at the trends would conclude that the town can actually support 12 restaurants.

What happens? It depends on the economic system.

In a Communist system the government would have to open those two new restaurants. There's a restaurant commissar whose paycheck won't increase at all if there are two more restaurants. He'll have more headaches, and in fact his income might go down. As things stand now, people are willing to bribe him to make sure they get a table on Friday or Saturday night. If he opens enough restaurants to serve everybody quickly, that income stream will dry up. Ten restaurants is plenty.

In a system with a privately owned restaurant monopoly, the monopolist also thinks long lines are good. His reaction will be: "I can raise my prices." Or maybe he'll open one new restaurant and raise prices too.

But now imagine that the ten restaurants are owned by ten different people and financed by ten different bankers. They'll all look at their crowded restaurants and say, "I could open a second restaurant on the other side of town." Their bankers will look at their business plans and agree. Five of the new restaurants open at more-or-less the same time.

Suddenly a town that can support 12 restaurants has 15. They compete not just for customers but for staff as well. Wages go up, business goes down. The plans for the other five new restaurants get canceled. All the restaurants -- not just the new ones -- start losing money. Some of them -- some new, some old -- eventually go under. The town might wind up with the 12 restaurants it can support. Or 11. Or 13.

That's if the general economy behaves itself and the previous trends continue. But now imagine that something unexpected happens just as those five new restaurants open. Maybe a local factory gets moved to China. Maybe there's a natural disaster or the market for the local farm crop goes down. Rational people expected that the town would be able to support 12 restaurants. They had ten. The restaurant owners opened 15. Actually the town can support eight. What happens?

Now the 15 restaurants start losing money hand-over-fist, and the bankers get scared. The restaurant business is a bad business. You don't want anything to do with the restaurant business. Any time a restaurant loan comes due, you take what you can get and get out. The more restaurants go bankrupt, the clearer it becomes that it's a bad business. The 15 become 12, then 9. Then 8, 6, 4.

Somehow the four restaurants hang on. Eventually things stabilize. Now there are four restaurants in a market than can support eight. Business is good. Maybe we should expand.

It all starts over.

What's the lesson here? The business cycle is rooted in the nature of the capitalist system and in the human responses of greed and fear. The government can do a few things to lessen the severity of panics (like the FDIC making sure depositors don't start a run on the bank when news of the bad restaurant loans hits the media), but constant stable growth is a mirage. Businesses are going to compete for new markets or growing markets, and sometimes they will compete based on over-optimistic projections. So there will be overbuilding, and some businesses will go under. Trying to cushion that blow can backfire. If they thought the government would bail them out in case of trouble, the restaurant owners might have opened 20 new restaurants.

What you can do to protect yourself personally is to learn how to recognize greed and fear in yourself and in the people around you. Don't be afraid to be left out when everyone around you thinks they're going to get rich. And when everyone is panicking, try to hang on.


Blogger Myrafly said...

That's very simplistic example. In the last three bubbles (sub-prime, energy, and dot-com) there was a lot of greed and dirty dealings too. In sub-prime there was selling imaginary loans to banks, in energy there was selling imaginary companies and in Dot com imaginary companies again. It's dissapointing that Sarbanes Oxley did nothing to stop the sub-primes from making imaginary deals. The reaction that you describe however where they pull back way too far is what will happen to sub-prime. The reaction is way over much. When a mortgage forcloses you end up with the property and you then (admitedly after much time) can in fact sell it. You will only loose the imaginary part of the deal. The amount that the property is really worth will be returned to you. It may be that there are some real smart investors out there buying at a steep discount some pretty good deals for themselves. I'm sure someone is doing that. The time for panic was last year when we started hearing about loans where you didn't have to prove your income. That should have lit up the regulators warning light, but it sure didn't.

I guess what I am saying is that your example is true except that you have to somehow add in the scoundral effect. Because normal cycles don't hurt as bad as the ones with scoundrals involved.


12:48 PM  
Blogger Doug Muder said...

Scoundrels are a fairly normal part of the cycle, though I admit they don't show up in my example.

What's normal is that there's an optimistic part of the cycle in which nobody thinks the market can ever go down. Everybody is focused totally on greed and not at all on fear. In that state, a person is prey to every kind of con man. Naturally, the con men notice and take advantage.

9:20 AM  

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