Valid Business Cycle Theory I

Dean Yeager: 'Doctor' Venkman. The purpose of science is to serve mankind. You seem to regard science as some kind of a dodge, or hustle. Your theories are the worst kind of popular tripe, your methods are sloppy, and your conclusions are highly questionable. You are a poor scientist, Doctor Venkman.
Dr Peter Venkman: I see.
--Ghostbusters

Not sure there is a more widely misunderstood phenomenon than the 'business cycle.' The sage Rothbard offers clarity in this regard.

First off, Rothbard observes that, in the 'old days,'  the standing term for all significant declines in economic activity was depression. With the onset of the Great Depression in the 1930s, policymakers and related economists resolved that such a situation should never happen again. Thus, they euphemized depressions out of existence, replacing them with watered down terms such as recessions, downturns, and soft patches.

Today, the popular view of the business cycle is the view made famous by Keynes (although, as Rothbard observes, Marx certainly influenced its popularity). Simply put, booms are the result of excessive consumer spending, and busts are the result of excessive consumer saving. Government is the great overseer, charged with tempering consumer spirits during uplegs, and stepping in to spend in place of austere consumers during downlegs.

Thus, and it is hard for me to type this with a straight face, government action serves to temper business cycle extremes.

Rothbard notes that this theory is problematic on a number of counts. One is that the general economy theory of which Keynesian cycle theory is a part espouses that supply and demand are in equilibrium in the market. Therefore, prices and factors of production are always moving toward equilibrium as well. How is it possible, then, that markets that are generally in equilibrium foster extremes that characterize booms and busts? Lacking a strong response to this question, mainstream economists have largely treated the equilibrium and business cycle theories as mutually exclusive--a primative ignorance reflective of poor science.

Today's economics also fails to explain the peculiar breakdown of the entrepreneurial function during times of depression. The function of the entrepreneur is to invest in productive methods after forecasting the potential payoff in light of the risks involved. The better the forecasting, the more successful the entrepreneur. Over time, entrepreneurs with poor forecasting abilities will be stripped of control of productive resources.

Markets, therefore, have a built-in natural selection mechanism for selecting talented entrepreneurs. Over the average period, we should not observe an inordinately large number of firms experiencing losses. How is it, then, that during economic declines that the business world suddenly experiences an enormous cluster of severe losses? According to mainstream economic theory, a point arrives where busiensspeople, previously adept at economic calculation, suddenly suffering large and unaccountable losses!?

A valid business cycle theory must account for this phenomenon of correlated losses--something that mainstream theory fails to do.

A third problem confronting mainstream business cycle theory is explaining why upstream capital goods industries experience early and more severe declines than downstream retail industries. Stated differently, why are booms and busts much more pronounced in capital goods sectors than in industries making consumer goods? If a decline in consumer goods is the cause of depression, then how is it that retail sectors are the last and the least to fall in economic downturns?

Keynesian business cycle theory is unable to adequately address these issues.

Fortunately, a valid theory of depressions and business cycles does exist although, as Rothbard observes, it remains largely neglected by present-day economists. In an upcoming installment, we will elaborate what is often referred to as Austrian Business Cycle Theory.