Basic Economic Definitions

Brad Matthews economics category

The purpose of this post is to test my knowledge by explaining a few fairly basic economic terms. Some that I understand already, others I had to read up on. Yes, this is pretty dry — hopefully my most bland post for the next 30 days at least.

I’ll skip the super easy stuff like broken window fallacy, effects of minimum wage etc. I’m not aiming for perfection here, just short and accurate without excessive detail.

Boom-Bust Cycle:

The boom-bust or business cycle refers to the repetitive economic pattern we experience consisting of a period of growth followed by a (roughly) equivalent downturn. This downturn is followed by another period of growth and the cycle continues, usually with (somewhat) consistent periods in between. There are many different schools of thought about what cause the business cycle, but all acknowledge that descriptively, there is a period of ‘growth and prosperity’. This period of prosperity is followed by a recession — where growth stops. The recession becomes a downturn or depression, where much of the prosperity achieved during the growth period is undone. By undone I mean businesses become insolvent or bankrupt, unemployment rises and living standards tend to plateau or fall.

Austrian Business Cycle Theory:

The Austrians argue that the business cycle is a result of government intervention in the economy. Government moves interest rates below the ‘market rate’ — the rate people would voluntarily borrow and lend at if it weren’t set by diktat. This makes borrowing more attractive compared to the higher market rate, which might have been prohibitively high. If it remained high the borrower wouldn’t have thought the risk worthwhile. With their risks minimised by the intervention, banks engage in risky lending they otherwise would not. Which is to say, people engage in borrowing they otherwise would not.

Now we have a situation where banks are lending to people they otherwise wouldn’t, and people are borrowing to start businesses or expand when they otherwise wouldn’t. They pour this borrowed money into resources for these projects and everything seems gravy.

But it really isn’t.

Banks cannot continue to hand out cheap and easy money to anyone and everyone. It’s unsustainable.

Some of these projects result in goods or services people don’t actually want. Spurred on by the low cost of borrowing money, business owners took a risk they would have deemed inappropriate at the market rate of interest. Often they don’t realise this until they’ve blown through the money and used up a large chunk of resources. Resources that otherwise would have been spent on things people actually wanted.

This is why Austrians describe the boom not as prosperous, but as sowing the seeds of destruction. The growth is an artificial one, people are actually malinvesting their money and resources. The bust is the correction. Granted it is bad for living standards, those who malinvested and society who lose resources to wasteful projects. But economically it signals a return to where things would be absent intervention (or a close approximation). People come to terms with the incorrect decisions and projects are abandoned or sold at below-cost prices.

It’s worth noting that the longer the boom is prolonged by intervention (be it by further lowering interest rates, printing money and regulatory pressures on banks to lend), the more wasteful borrowing occurs. Thus, when the bust occurs, it is more destructive than if the government had not taken measures to prevent it.

Time Preference:

Time preference refers to the value of a good now compared to its value in the future. If that good is money, it’s valued more in the present because it can satisfy immediate wants — I can use it to buy stuff. I can’t use future money to buy stuff because I don’t have it. I can borrow though. Since money is worth more now, and because government continually prints more and diminishes its value, I have to pay a premium to borrow.

As an extension of this, the further into the future one expects to receive a good, the less they value it. $50 in two days time will be worth more than in 2 months. It will be worth less still in two years. Given the importance of innovation and staying on top of the competition, entrepreneurs usually want to start building now rather than wait.

Say’s Law:

“Supply creates it’s own demand”.

Great. What does it mean?

It means that it’s impossible to produce too much stuff. There might be overproduction in particular businesses or industries, but not economy wide.

Another way of thinking about it is, while there are particular individuals who favour minimalism and having few possessions, this is not true for the majority of society — (most) people always want more stuff. People prefer to have things than to not have things, depending on price and whether they have a use for a particular good.

John Stuart Mill better put Say’s Law as something along the lines of: there’s no such thing as a general glut. Whatever might cause a recession, it would never be a deficiency of demand. People’s desire to buy will always exceed production. As a result, trying to fix a recession by stimulating public spending is a poor and ineffective policy (at best).

Cantillon Effect:

Named after Richard Cantillon, early contemporary to Adam Smith and probably the first to use the term ‘entrepreneur’. Almost certainly the first to understand the role of the entrepreneur in economics. But that has nothing to do with the Cantillon Effect.

The Cantillon Effect refers to how new (government created) money decreases in value as it spreads through an economy. When they print new money, it does not immediately affect the value of money already in circulation. The value of existing money does not depreciate by virtue of the fat stacks of cash created.

As that money enters the economy, the first to get hold of it (typically the banks and those they lend to), can make purchases at current prices. At this stage, nobody is aware of the increased amount of paper in circulation. As this money flows into different industries and filters throughout the wider economy however, the economy begins to adjust to the increased amount of paper money. Prices gradually rise as the money flows through the economy until it reaches an equilibrium. This devalues the money for everyone — there’s more available now so it is worth less.

Everybody loses at the expense of those who had access to the new money early on, at the beginning of the decline in value.

Those with income not linked to inflation lose out. Anyone saving money loses out. They still earn the same amount of dollars, but now thanks to the money printing — those dollars are worth less. As a result, they can no longer buy the same amount of goods with the same amount of dollars.

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