[jmherbener]

Not exactly. The argument is that banks create credit out of thin air by issuing fiduciary media. If all the created credit went to mortgages, it would push mortgage interest rates down while other interest rates would stay the same. But then banks would earn more profit from additional fiduciary media issue by lending it into other loans types of loans. So banks arbitrage the create credit across all types of loans according to people preferences (and state interventions).

If all the created credit went into mortgages, then the capital structure would not be built up. Instead it would be expanded in those parts that support housing and would be shrunk in those parts that support other consumer goods.

The primary distortion of the business cycle called “lengthening the capital structure” comes about through producer loans and present money lent directly into the capital structure. The secondary distortion of the business cycle occurs in shifting production toward certain consumer goods bought on credit and away from other consumer goods. These two distortions are intertwined during the business cycle.

Because the effects in these consumer goods industries are secondary, the government’s efforts to boost their demand to boom time levels, even if it could be done, will not restore the economy to normalcy.

[jmherbener]

Consider the operation of the time market in the unhampered market economy. People with higher time preferences borrow from people with lower time preferences. The level of the rate of interest clears the market so that the quantity demanded and quantity supplied of present money are the same. The present money is allocated across the time market into consumer loans, producer loans, and the capital structure so that no further arbitrage profit arises. Only that portion of present money lent into production goes to capital projects across the capital structure. Consumer loans do not build up the capital structure, but merely transfer consumption from lower time preference people to higher time preference people. For example, let’s say that the people making consumer loans reduce their demands for clothing while people who borrow increase their demands for cell phones. Then the capital structure supporting the production of clothing (spinning cloth, growing cotton, etc.) will shrink while the capital structure supporting the production of cell phones (producing chips, touch screens, etc.) will grow. The overall capital structure will not be built up. Capital production will merely shift from areas with smaller demands to areas will greater demands.

The business cycle is inter-temporal mal-investment. Central bank monetary inflation and credit expansion increase the supply of credit beyond what people’s time preferences dictate. The increase supply of credit is arbitraged into the different areas of the time market so that no additional profit in shifting it is possible. That portion of the new credit going into producer loans and the capital structure allows entrepreneurs to lengthen the capital structure by building up capital goods in the higher and intermediate stages of production. The build-up of the overall capital structure proves to be unsustainable because it fails to satisfy people’s time preferences. The build up of the capital structure supporting the areas of production stimulated by consumer loans (housing, autos, etc.) is part and parcel of the overall lengthening of the capital structure.

[jmherbener]

The investor borrows by issuing overnight repos which he renews each day. He pays 10 basis points to borrow overnight money because the Fed has pushed the Fed Funds Rate to that level. He then invests the funds in T-bonds paying 200 basis points and earns 190 spread. If the bond price begins to fall (i.e., its interest rate begins to rise), he loses capital on his investment. So, he sells and then pays off his repos instead of renewing them.

Stockman calls this “carry trade” because the investor is aiming to earn the spread between interest rates but faces the possibility of losses from adverse movements in bond prices just as the carry trade in foreign exchange seeks to earn an interest rate spread but can suffer losses from adverse movements in exchange rates.

[jmherbener]

He explains the division of payments a few pages after the quote you give. On page 268, he shows that if there are five workers each to be paid at the end of five years when the steam engine is sold for $5,500 and the rate of interest if 0.05, then the payments would be.

1st worker who waits four years to be paid: $1,200
2nd worker who waits three years to be paid: $1,150
3rd worker who waits two years to be paid: $1,100
4th worker who waits one year to be paid: $1,050
5th worker who gets paid immediately: $1,000

This division is necessary to make the total $5,500 with the rate of interest 0.05.

The present value of the 1st worker’s effort four years before completion of the steam engine is $1,000. That is $1,000(1.05)(1.05)(1.05)(1.05) = $1,215

The PV of the 2nd worker’s effort is $1,000(1.05)(1.05)1.05) = $1,157

For the 3rd worker $1,000(1.05)(1.05) = $1,102

The 4th $1,000(1.05) = $1050

The 5th $1,000

As B-B says, his figures do not compound the interest.

[jmherbener]

If a Fed generated monetary inflation and credit expansion had its effects only domestically, it would lower the dollar’s purchasing power in the U.S. and extend credit to less profitable investment projects in the U.S. Because dollar-denominated credit markets are worldwide, arbitrage opportunities would then arise. Investors could profit by extending credit to investment projects overseas that are still earning the higher pre-inflation rate of return. Because Fed monetary inflation has made the purchasing power of the dollar higher overseas, people can gain by spending dollars there and foreigners will hold the additional dollars until it purchasing power is the same in the U.S. as in foreign countries.

[jmherbener]

The question seems to rest on a false assumption, namely, that market prices must always favor the buyer. In other words, it presupposes that if this scenario happens, then there is a market failure. The market, however, is concerted effort. It’s the attempt of people to arrange a division of labor to economize production.

As to the scenario itself, an entrepreneur maximizes his revenue by asking the price at the mid-point of his demand curve (where demand is unit elastic). Any other price, either higher or lower, reduces his revenue. If entrepreneurs act together, this principle is true of their overall demand. With a given demand for the product, entrepreneurs would lose revenue when they restrict supply and begin to sell at the higher price.

Take a look at the lecture on Competition and Monopoly.

Of course, it could be the case that the unit elastic point of the joint demand for the entrepreneurs’ product is at a higher price than the unit elastic point of any of the entrepreneur’s demand when they do not act together. But in that case, they must sell less at the higher price to earn more revenue. In other words, they must not dump their supply on the market, but continue to restrict it to maintain the higher prices and larger revenue.

Take a look at Murray Rothbard on cartels in Man, Economy, and State.

http://library.mises.org/books/Murray%20N%20Rothbard/Man,%20Economy,%20and%20State,%20with%20Power%20and%20Market.pdf

[jmherbener]

Intermediate capital goods become part of the output that is sold to the next stage of production. So, the entrepreneur does not retain possession of intermediate capital goods. When he sells his output, they go with it. But he retains ownership of his plant, equipment, improved land, and other assets. Even though some portion of them are used up in production (and he depreciates his asset values to account for that), he retains possession of them when he sells his output.

[jmherbener]

Investment counts only if it’s for assets held by the entrepreneur and used by him in production. If an auto company builds a new factory or buys new equipment, it’s included. But the tires, paint, steel, and all other intermediate capital goods the company buys are not included. Intermediate capital goods are not held by the company as final user, but pass to the next stage of production.

[jmherbener]

There is no such thing as stability of prices. The very concept is a chimera. As long as we change as human persons and change the world through our actions, prices will change.

Moreover, neither rising nor falling prices in general make it more or less difficult for entrepreneurs to estimate the prices relevant to their own production. If prices in general rose 2 percent per year or fell 2 percent per year, it would add no difficultly to entrepreneurial prediction.

Finally, money production in the market is regulated by profit, which is itself subject to entrepreneurial speculation. Prices in general, then, have as little volatility as possible. With the state inflating fiat paper money, waves of price changes are constantly rippling through the entire market. And if the monetary inflation is done through credit expansion, it generates the volatility called the boom-bust cycle.

[jmherbener]

GDP = C + I + G + (X-M)

Gross Domestic Product is equal to the sum of Consumption Expenditures, Investment Expenditures, Government Expenditures and Net Exports. The Final Goods included in GDP, then, are goods in the hands of final users: Consumer Goods bought by consumers, Capital Goods bought by entrepreneurs and held by them as assets, Government Goods bought by government officials and Net Exports.

There are two omissions to note. First, GDP does not include the production of intermediate capital goods. So to produce automobiles, which would be included in GDP, iron must be mined, steel must be made, fenders must be formed, and so on. None of the production of these intermediate capital goods is included in GDP. Second, government transfer payments are not included. So, fiscal expenditures for F-18s are included in GDP while social security payments are not.

Yes, G adds dollar for dollar to GDP. So, when the federal government increased its annual fiscal expenditures from $2.9 trillion to $4.0 trillion in 2009, GDP was $1.1 trillion larger than otherwise.

The argument about including G in GDP is that since G are financed by coercive extractions, the prices paid for government goods do not, and cannot, reflect the value people place on them. So adding G to C and I is like adding apples and oranges. Even though they are both denominated in money, government expenditures and private expenditures do not have a common meaning.

[jmherbener]

Tell the critic to stop talking in metaphors, The market is not a beast and the government doesn’t tame it.

The theory of how people act in concert within a division of labor to accumulate capital and generate economic progress in markets has been around without refutation since Adam Smith. Explain it to the critic and then ask him how exactly the coercive power of the state, aside from defending person and property, can improve the economizing of of production decisions made by entrepreneurs in the market..

[jmherbener]

Ask your friend what Americans would do with Chinese Renminbi they acquired by selling goods to the Chinese? They would spend them in China or trade them for dollars to someone who then spent them in China.

Even if the Chinese kept dollars, let’s say to make expenditures in the underground economy, it would have no effect on production in America. It would merely make the purchasing power of the dollar higher than otherwise in America. That is, the prices of everything would be lower than otherwise in America. Most people don’t realize that nearly 2/3 of all dollar currency is held overseas. And foreign holding of dollars increased dramatically in the prosperous 1990s.

[jmherbener]

Economic theory doesn’t tell us the particular reason for the lack of complete arbitrage or competition, just that they are incomplete is such cases. My example only discussed competition, i.e., buyers deserting high-priced sellers and patronizing low-priced sellers. Of course, the average gasoline buyer is not going to arbitrage, i.e., buy at a low price and resell at a high price. But, suppliers of gasoline to the gas stations might be able to arbitrage it. You would have to investigate the particulars of the case to find out whether they do or do not.

[jmherbener]

Here is a article by Max Wirth from the Journal of Political Economy (Mar. 1893) on the Crisis of 1890. He chronicles the credit expansion fueled boom in businesses at the end of the 1880s, especially in Europe and then the collapse in 1890-91.

http://www.jstor.org/stable/pdfplus/1817769.pdf?acceptTC=true

Here is an article by David Whitten that traces the consequent boom and bust in America with an eye toward the European situation. Table 3 documents some of the capital build up and collapse.

http://eh.net/encyclopedia/article/whitten.panic.1893

Murray Rothbard writes about this episode in his book A History of Money and Banking in the United States.

http://library.mises.org/books/Murray%20N%20Rothbard/History%20of%20Money%20and%20Banking%20in%20the%20United%20States%20The%20Colonial%20Era%20to%20World%20War%20II.pdf

As Rothbard points out the agitation in the U.S. for free silver led to passage of the free silver act of 1890 which doubled the Treasury’s production of silver and signaled a return to bimetallism. Foreigners speculated about more monetary inflation began to redeem gold at the Treasury. In June 1892, the Treasury put on the monetary brakes and the money supply fell precipitating the downturn of 1893.

The monetary inflation of the early 1890s led to malinvestments which were then liquidated in the depression. The severity of the downturn was caused, in part, by rising labor union activity. On that point, take a look at Robert Higg’s book, Crisis and Leviathan.

In short, this episode can be explained by the Austrian theory of the boom-bust cycle. Take a look at Tom Woods’ book, Meltdown, for an explanation of the theory.

[jmherbener]

Obviously, there must a reason why participants in this particular situation do not seek to exploit this difference by arbitrage or competition. Usually the reason is a particular preference people have. Buyers may perceive one station as having a superior product or buying experience. This kind of thing is common and often related to the personality of the seller or the personalities of the other customers. So trendy restaurants can sell meals at higher prices than the competition. Some Americans are loyal toward American car companies and so, their prices are higher than otherwise and, perhaps, even above technically superior foreign cars that are sold in the same market.

To apply this reasoning to big differences in gas prices in the same town, but not at stations across the street from each other, some buyers may view the location of some station as dangerous and therefore, not compete away a large price difference while the customers at the high price station don’t drive to the lower price stations out of loyalty to their neighborhood. Suppliers of gasoline don’t try to supply more at the dangerous stations because they really are dangerous and therefore, their costs are higher.

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