Reply To: Bubbles and Normal Market Flucutations

#17792
jmherbener
Participant

The proper distinction is between business fluctuations and business cycles.

Business fluctuations are caused by the normal changing of the pattern of consumer demands. The distinguishing characteristic of such fluctuations is that increases in demands for some goods must be counterbalanced by decreased demands for other goods. Changes in production that meet these changing demands earn profit and those that fail to meet them suffer losses. The additional resources needed to meet the increasing demands are balanced by resources being released where demands are falling. Entrepreneurial error can lead to mis-allocation of resources or mal-investments of capital funding, but these suffer losses and destroy equity and therefore, are not self re-enforcing. That is, other entrepreneurs do not make the same errors and those who have made mistakes correct them.

Business cycles are generated by monetary inflation and credit expansion. The additional money permits demands to increase for goods purchased with borrowed money without decreasing demand for goods bought without borrowed money. The distinguishing characteristic of business cycles is the clustering of entrepreneurial errors. Most auto companies mal-invest in their capital capacity during the boom. Most construction companies do the same. Because the changes in the pattern of demands are artificially induced by monetary inflation and credit expansion, they prove to be unsustainable. The proportion of their income that people prefer to save and invest is smaller than that made possible by credit expansion. But the build up of the capital structure during the boom is based on the greater apparent saving and investing made possible by credit expansion.

Asset price bubbles are a secondary feature of the boom and bust. Journalists focus on them because they are sensational and they can’t understand or think that their readers can’t understand the primary feature of the boom and bust. One problem of this focus is highlighted by your question: Can’t every instance of entrepreneurial mal-investment be interpreted, in retrospect, as an asset price bubble? If so, then the distinction between business fluctuations and business cycles is unnecessarily blurred.