The business cycle, speculation and crisis

The business cycle is the name given to the alternations between economic expansion and economic contraction in markets. It is called a cycle because it is expected that phases of expansion and contraction will continually recur. The business cycle isn't a claim that these expansions and contractions will necessarily occur with any particular frequency or regularity (that is, we can't predict the number of years between parts of the business cycle in advance). Instead, the business cycle is a review of the trend and general expectations of the market. It is difficult to know if we are at the peak of expansion or at the trough of contraction until the time has passed.

In the period of expansion there are generally new jobs, increased wealth, increased productivity, and lots of market transactions. In periods of contraction there are often job losses, business failures, increases in poverty, and reduced economic activity. Some of the periods of contraction are relatively gentle recessions, while others are more pronounced crises, such as Global Financial Crisis.

What causes the business cycle?

There are many different causes of the economic contractions that are part of the business cycle. Broadly, I think they can be placed into two categories: productive and epistemic. That is, the economic downturns are likely either a production problem or a knowledge problem.

Production problems are often very intuitive. For example, if a disease wipes out crops and causes a food shortage, a flood destroys infrastructure, or a war causes a loss of access to or labour to produce specific materials (especially things like oil and minerals). When these things occur it is no surprise that productivity goes down, because there are less resources (materials and labour energy) with which to produce goods.

Epistemic or knowledge problems are, on the other hand, not always visible or intuitive. An epistemic problem occurs when we have all the resources available to achieve a good quality of life, but make some mistake about how to allocate or use them. For example, we might over-allocate resources into certain types of housing, technology such as AI, or even tulips, and away from other more useful jobs.

But another type of epistemic problem is less about allocating resources incorrectly, but disrupting the system of allocation itself. For example, there is a difference between an issue with blackouts due to the power plants not producing enough power (a production problem), sending power to the wrong places like prioritising theme parks over hospitals and therefore not being able to save enough people's lives (an epistemic problem), and the powerlines themselves being faulty and not being able to convey the power that is produced to anywhere at all (a structural problem). For a power grid, this structural problem is not necessarily an epistemic problem, but for a market the system of allocating things is the exchange, which is not a physical system but a socially imagined one. This makes a disruption to the allocation system a type of epistemic problem, even as it is a structural one.

When a market system is disrupted, it means that even though there are material goods that would satisfy needs and people who have needs that are as yet unsatisfied, there is no way to get the goods to the needs. This is often considered a matter of liquidity, where there is not enough medium of exchange to facilitate the exchanges that people would otherwise want to happen. For example, if a lot of people lose their jobs, or if interest rates go up significantly, or if banks make it harder to loan money, then people are likely to spend less money. When people spend less money, businesses get less money, and they can't pay their employees as much money, which feeds into the same cycle. And this can happen even though there are lots of people who are capable of work, lots of resources to turn into goods, lots of goods ready to go, and lots of people who would like those goods. All the pieces of the puzzle are there, but they can't fit together.

What causes a system disruption?

One of the main causes of system disruption is what I call signal inversion, which is when the exchange-value of a good starts to exceed the use-value of a good. This often happens when people think something will be worth more in the future than it is now, and so they will hold onto the thing not because they want to use it (not for its use-value) but because they intend to sell it for as much as possible (for its exchange value). This can happen to physical assets, but also imaginary ones like stocks and derivatives.

As the exchange-value rises, it becomes more expensive to buy the good, and people often go into debt to make the purchase. Their assessment of the risk is that the debt is okay, because the good will increase in exchange-value and they can sell it for more than they bought it, enabling them to pay off the debt and bring in a profit. If banks believe the same thing, then they will be happy to give out the loan, because they will make money off the interest.

At some point, however, if the exchange-value of the good is above the use-value of the good, there will be a correction. People will decide that the good is not worth the exchange-value people are asking them to pay, and the exchange-value will head down until it is close to an equilibrium with the use-value. Another way of thinking about it is that people guessed the price others would be willing to pay for that good in the future was higher than today, but that at some point that guess is going to be wrong.

When the exchange-value corrects downwards, it does not change the amount of debt taken on to pay for the good initially. There will therefore be people who thought that they had more assets than debt, but are now in a position where they have more debt than assets. And sometimes those people will be the bank.

When this happens on a large enough scale, there will be a lot of people who will reduce their spending because they need to pay off their debt. And when it happens to banks, they will stop loaning out as money money until they have recovered or otherwise accounted for the outstanding loans. With less loans, people will be making less purchases, and economic activity will begin to slow.

When a lot of people have gone into debt for a good where the exchange-value is much higher than the use-value, and the signal reversion occurs and takes the exchange-value way back down very quickly, the result is a crisis. These overvaluation are called "bubbles" and the crisis occurs when the bubble "pops". At this point there is a lot of debt and less value to pay it with, and so the result is fiscal and then economic contraction (that is, people and banks first start spending less because of their finances, but this leads to consequences for the whole economy).

But a signal reversion can also be small, localised and happen slowly, leading to a more gentle recession.

Why does overvaluation cause more trouble than undervaluation?

Let's say someone buys a house for $1,000,000, and they take out a loan to pay for it. For simplicity's sake, we'll assume it is an interest free loan. A few years later they change jobs and need to move, and they sell the house. But now the sale price is $800,000. This person is now $200,000 in debt. If they can't pay the debt, the bank is now $200,000 down.

On the other hand, if a person buys a house for $1,000,000 and it later sells for $1,200,000, they - and the bank - are not in debt. The seller is $200,000 up, and the bank (or a bank, at least) probably loaned out the $200,000 that the new buyer needed.

So if people guess the value of something and they guess under the "real" value, and the price later corrects up, the impact is generally not too problematic. The goods can still be exchanged and move around the market, and it doesn't disrupt the future ability for them to do so. But if people guess too high and the price later corrects down, there is now a legacy of debt that needs to be paid off. And if enough debt accrues over time, it will eventually hamper economic activity.

It is potentially for this reason that historic societies had debt jubilees where, after a certain number of years, or during the change of monarchs, or when the economy was facing difficult times, debts would be forgiven and cancelled. This process takes the weight out of the economy that drags it down into a recession or a depression.

Exchange-value is the issue

The core of this issue is the concept of exchange-value itself. The use-value for something is often quite intuitive (though we are always finding new ways to use existing things), but not necessarily quantifiable. Apples are useful for eating, and I want one when I am hungry, but how do I put a number on the utility of an apple? Even if I am comparing it to an orange, and even when I know I prefer apples over oranges, do it makes sense to say that I prefer apples 1.3x that of oranges?

But exchanges require that we place exchange-value on things, and that value needs to be quantifiable. So if I like apples more than oranges, I might be willing to pay more for apples than for oranges, and, by surveying the prices for each, I might be able to come up with a guess at how much I like one more than the other. But it will always be a guess, because there is never an objectively right answer.

And for more speculative purchases, and for investments in the future, the guess is about how the aggregate of people will value it, and that guess isn't going to be easy. But the nature of that system - of exchange-value and of trying to guess what the "right" answer is - means that speculation is a common element of markets and can grind markets to a halt when all the bad guesses pile up (and they will inevitably pile up).