jmherbenerIt’s important to emphasize that the Fed generated monetary inflation and credit expansion lengthens out the capital structure beyond what is sustainable given people’s time preferences. This mis-match between the capital structure and time preferences is what reverses the boom. So, the steps might be listed out as below:
1. Fed buys assets from banks increasing the banks’ reserves.
2. Banks create credit by issuing fiduciary media on their new reserves.
3. The greater supply of credit pushes down interest rates and funds riskier investment projects.
4. Demand for higher-order capital goods increases relative to lower-order capital goods because more timber must be cut and milled before more houses can be produced and more iron must be mined and milled into steel before more cars can be produced.
5. Resources shift toward higher-stages and away from lower-stages, but this shift is not supported by a lowering of people’s time preferences.
6. People reestablish their time preferences by spending and saving their incomes, which are larger with the greater stock of money, according to their time preferences. This restores interest rates to their higher levels, which collapsed asset prices.
7. Asset prices also decline because investors perceive the greater risk of investing further in the boom lines of production.
8. Lower asset prices reveal the mal-investments of the boom.
9. The collapse of asset prices makes banks insolvent since their assets are financial claims on the assets whose prices are falling, e.g., mortgages on houses.
10. Profits exist in reallocating resources to shorten the capital structure in a way that satisfies time preferences.
11. Entrepreneurs liquidate the mal-investments and reallocate resources. Once the capital structure is reconfigured, economic normalcy returns.
Take a look at Rothbard’s summary of business cycle theory in chapter 1 of America’s Great Depression:
http://library.mises.org/books/Murray%20N%20Rothbard/Americas%20Great%20Depression.pdf