Business Cycles Aren’t All Bad

It's a matter of trust

Most economists today consider business cycles to be credit cycles. In other words, they have to do with public confidence, or trust, in our economic infrastructure. When confidence is high, credit flows and economic activity increases. Eventually, confidence reverts to the mean and below, before repeating the cycle. More deeply considered, all economic activity has to do with trust. The story of the development of that trust from personal to infrastructural is the focus of this article.

I. Pre-scientific economics: Cooperation

The Beginnings of Commercial Activity

A do-it-yourself approach to life is inefficient and unfulfilling for most people, so people group together for mutual protection, shared resources, and companionship. People who live near one another, and who have a social relationship involving at least a minimal level of trust, may trade valuables with one another, or trade labor for valuable items, such as food and clothing.

Precious Metals

Bartering for goods and services has limitations, however. Finding someone who has what you want and wants what you have is chancy. However, certain items, such as gold and silver, possessed common appeal, due to rarity, durability and beauty. They became useful as exchange media, and as measures of value.

Economic Necessities: Food

Token Accounting

In ancient Sumeria, grain was stored for farmers in shared facilities. Clay tokens representing fixed values were given to farmers to certify ownership of fixed amounts of grain. While these tokens possessed no intrinsic value, they became acceptable for exchange among various parties, in addition to redemption at the granary.

Owners of these tokens commonly held them in sealed envelopes, with identification of owner and value on the outside. Eventually, the envelopes themselves became tokens of value, which improved efficiency of trade. Coins were heavy and subject to debasement (shaving, sweating and melting). Paper money was inexpensive and replicable.

Crop Loans

During the middle ages, the Lombard plains of Italy produced vast amounts of grain, and provided marketplaces for grain trade. While Christians were forbidden to charge interest, Jews were forbidden to own land. As a result, Jewish immigrants were willing and able to lend seed money to farmers, with the assurance of sharing the revenue from grain sales after harvest. Additionally, these merchant bankers were able to provide crop insurance to the farmers, as well as alternate grain supplies to wholesalers after a crop failure.
Eventually, this trade expanded to handling trades for others, as well as issuing bank notes for deposits. Today’s investment banks have extended their services to raising capital through public offerings of stocks and bonds.
Other monetary functions, such as money changing and pawn broking were left to less prestigious institutions.

Economic Necessities: Shelter

Value-added Goldsmithing

In 17th-century England, gold craftsmen had the safest storage facilities, since their materials were so valuable. As a result, their vaults came to be used for storage of precious metals. Goldsmiths issued notes to depositors, which they could redeem with the gold in their vaults, upon demand. These demand notes came to be accepted as a substitute for coins in everyday transactions. In the meantime, goldsmiths noticed that many deposits stayed in their vaults for a long time, and that not all deposits were withdrawn at the same time. They began to issue the demand notes to non-depositors as loans. The goldsmiths charged interest on the notes, which became profitable enough that the goldsmiths began to pay interest to attract more deposits.

Fractional Reserve Banking, with Land as Collateral

One of the important elements of these credit transactions, as instituted by John Law (the English goldsmith credited with popularization of fractional reserve banking), was the acceptance of the value of land as collateral, to expand lending far beyond that which was possible with only precious metals as collateral. The availability of home mortgages eventually made home ownership possible for members of the lower economic classes.

Military and Political Institutions need Money, too

The world’s first central bank is the Swedish Riksbank, which currently awards the annual Nobel Prize in Economics. The second central bank, and more relevant to this discussion, was the Bank of England. A group of wealthy bankers formed the Bank of England in 1694, in order to lend money to King William of Orange to fight a war with France. The Bank was allowed to accept private deposits and offer loans. It was also allowed to print money, and backed up the other English banks. The Bank of England was nationalized in 1946, and still acts as the nation’s central bank.

Among the central banks of today, the key role is to orchestrate national monetary policy with the purchase and sale of Treasury Securities (open market operations) and, to a lesser degree, affect the discount rate. Currency distribution (without the assistance of helicopters) and maintenance of international exchange rates are generally the responsibility of central banks. Central banks also set and enforce rules for commercial banks, having to do with capital, reserve and reporting requirements.

Economic Necessities: Clothing

Textile Manufacture and the Industrial Revolution

In economics, whenever you think you have discovered a seminal event, there is always a precursor. Some events are critical, nonetheless. Richard Arkwright started the Industrial Revolution in 1771 by building a water-powered spinning wheel in Cromford, England. Arkwright improved the production of one of the three basic human necessities, clothing, by a multiple of 10, then 100. The series of events which led to this achievement are interesting, as well.

In 1733, John Kay patented a flying shuttle, improving the production efficiency of weaving. Demand for fiber increased, so fiber spinners had to find a way to work faster. Thomas Highs had provided a critical mechanism for stretching fiber before spinning it, to enable mass production. However, Highs was undercapitalized.

Richard Arkwright, having obtained (for lack of a better word) Highs’ technology, moved forward with a remarkable combination of business, financial and mechanical ingenuity. Arkwright raised capital and hired Highs’ technical expert, also named John Kay. He adjusted the machine to run on water power when he saw that human and horse power were insufficient. He was even smart enough to realize that he needed warm water year-round to power the water wheel. As a result, he relocated to remote Cromford, a full day’s travel from Nottingham, to find warm underground springs. Like Bill Gates, his vision and ambition (really, I need better words) were far beyond those of his peers, as was his business acumen. He initiated the industrial revolution by implementing mass production, highly productive employment of unskilled labor and continuous production processes.

The Malthusian Catastrophe

None of the above could happen without reasonably patient capital. Saving labor costs on spinning, which is only one of 8 primary steps in producing cloth, is valuable only on a massive scale. Thankfully, the scale has been enormous. As we have seen over the last 200 years, technological improvements, enabled by capital, have outpaced population growth to an extent unimagined by Thomas Malthus. Malthus was Dr. Doom 200 years before Nouriel Roubini. Like Dr. Roubini, he predicted the demise of civilization as we know it. Malthus’ reasoning was that population would grow faster than the farmers’ meager ability to provide more food, given the technology of his day. Hence, economics became known as the Dismal Science. Malthus didn’t anticipate the productive explosion resultant from redeployment of capital from agrarian to industrial uses.

Now, in 2009, we expect (and, indeed we possess) food, clothing, shelter and much more. Transportation, education and health care are available to members of all economic classes, and have come to be expected as basic necessities.

II. Economic Science: Observation and Analysis

Capitalism is not an idea; it is a series of observations

Political Economy-Philosophical Inquiry

Many early English capitalists, like Adam Smith and John Stuart Mill, were moral philosophers rather than government or business activists. They intended to improve upon Physiocratic and Mercantilist economics, which failed to address the improvement of the common good. They noticed that the people doing the back-breaking work were poorly rewarded. Using John Locke’s conception of the Labor Theory of Value, they advocated liberation of the masses from economic subjugation. Whereas the Physiocrats and Mercantilists used government to protect the interests of the wealthy and nobility, laissez-faire Capitalism offered economic opportunity to workers, by reducing government interference.

Outtake: Socialism

Karl Marx  argued, like Malthus, that workers had little opportunity, because the supply of workers  generally exceeded demand for labor. He insisted that violent revolution was necessary in order to progress from capitalism to utopian socialism. Violence overcame oligarchy, and awakened each person to his authentic being (remember, we are still in the age of economic philosophy; empirical analysis is coming next).

Political Economy-Mathematical Analysis

Three economists (William Steven Jevons in England, Carl Menger in Austria and Leon Walras in Switzerland) revolutionized economics in the 1870’s. Each, in his own way, said that the commercial value of a product or service is its market price, rather than the sum of its production costs. This rejection of the Labor Theory of Value led to a change in focus to more empirical observation and mathematical analysis, except in the case of the Austrians. The next 60 years of economic inquiry were largely devoted to these pursuits.

Government Policy: Fiscal Intervention

During the Great Depression, John Maynard Keynes (a non-violent Fabian Socialist) proposed a solution to cyclical business downturns. He suggested that governments spend money when confidence was low, making up the difference when a strong economy yielded higher tax receipts.

Government Policy: Monetary Intervention

Milton Friedman was concerned that government action to smooth business cycles would cause too much long-term damage. Instead, he proposed that business cycles were manageable by consumers and producers as long as government intervention didn’t exacerbate cyclical volatility. He cited government action, specifically monetary contraction as the primary cause of the Great Depression. He believed that business cycles would be less volatile with a steady money supply (up to 3% inflation is OK, too, he said).

Recently, political economy debates have centered on the differences between the views of Keynes and Friedman. The finer points of their respective arguments are well-publicized and beyond the scope of this article. However, they agree on this: governments can help the real economy only marginally.

III. The Real Economy: Not an Ideal

The amount of money in circulation, multiplied by the frequency of its use, with certain adjustments, measures our mutual cooperation. U.S. GDP, a related measure, is over 3 times the amount of the next highest country (Japan), and makes up of 25% of world GDP, though we have only 4.5% of the world population. We are extraordinarily productive, and it is critical that we continue to produce the goods and services desired by consumers worldwide.

Our worker productivity is very high, compared with the rest of the world, for a variety of reasons. One of the most important advantages the U.S. has is plentiful capital to improve production and distribution efforts. This capital is less plentiful today than it was a year ago, due to the financial delevering of the last year. This brings out the importance of equity investment, as debt capital has become rarer.

Capitalism: Exploitation or Enhancement of Labor?

To paraphrase Richard Nixon, we are all Capitalists now (I’ve wanted to say that for 6 pages). You see, I love commerce. I am so excited about wealth creation. Capital, innovation, specialization and distribution have made our lives more comfortable, safe and enjoyable than those of our forebears.

Having witnessed Celine Dionne’s rendition of the theme song to “Titanic”, I thought of the honor it must be to deliver such inspirational artistry to appreciative audiences. In my own career as a financial planner, I am honored to share in the commercial accomplishments of Western culture, in the same manner in which she shares in the delivery of beautiful music.

You should feel the same way. You provide the strong, patient, reliable capital which our civilization needs to prevent a Malthusian catastrophe. You are the benefactor of laborers and consumers, and deserve to be paid well for your contribution. I am confident that you will be rewarded, as has been the case since the dawn of the Industrial Revolution.

We at Porter Kickham REALLY appreciate your interest in a subject so fascinating to us. We hope that this presentation complements your appreciation of economics, and that you are able to put it to good use in your private endeavors and arguments around the dinner table.

Michael J Kickham, CFP®     Registered Principal