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A great many theories have been presented over the years. Here are the major categories of proposed causes for our recurring economic difficulties:
- overproduction -- Businesses have cranked out too many goods, more than consumers want. So they don't need to produce any more for a while, and they must lay off workers.
- underconsumption -- Consumers just don't buy enough; they are putting away too much wealth for a rainy day. Goods go unpurchased and demand drops.
- monetary theories -- If the money supply is prematurely expanded, it could lead to overproduction (because it would lower the rate of interest, making loans easier to get). Reversing this process, by lowering interest rates, could cause a slump.
- psychological theories -- Consumers shy away from making purchases, producers shy away from expanding production, out of concern that things will turn bad. This implies that economic downturns are self-fulfilling prophecies.
You may notice that none of these theories really address why the market fails to correct these imbalances. If, for example, too many cars have been produced for the current market, we should expect that slack demand would lead to lower prices, until consumers started taking advantages of bargain prices for cars, and balance would be restored without disaster. If households save too much, then there will be an oversupply of capital, and interest rates should decrease until they stop the extra saving. Similarly, monetary theorists don't explain why the money supply needs to be over-expanded in the first place. And psychological theorists conveniently forget that while people have all kinds of things to be afraid of, they really only tend to stop spending their money when they start losing their jobs.
In fact, the logic of all these "explanations" for the business cycle leads to the conclusion that we're just stuck with it -- that the boom/bust cycle is inextricably linked with modern capitalism. That was, in a nutshell, the revolutionary insight of John Maynard Keynes, which led to the rise of "Keynesian economics". Keynes held that the business cycle is an inextricable part of modern economies, and that government must use its power to even out the boom/bust cycle. The alternative is to face cataclysmic depression. Keynes's theory offered no long-run solutions to this problem; in fact, Lord Keynes famously quipped, "In the long run, we are all dead."
The tools used in this balancing act are the supply of money, and government borrowing and spending. When inflation heats up, the money supply is tightened by a lowering of interest rates (and an increase of required bank reserves). When we get into a recession, they lower interest rates, and perhaps even "prime the economy's pump" by having the Federal government borrow money to spend in the economy. Using these tools, we seek to soften the wild boom/bust swings and keep unemployment right around that "full employment" point (which is just where we came in).
One phenomenon that has played a big role in economic slumps is the "speculative bubble". People will invest in some asset whose value is rapidly rising; this will lead to more investment and further inflated values, on and on until... "Pop!" The bubble bursts and a tremendous amount of "paper wealth" is lost. The infamous stock-market crash of 1929, for example, was one of the major economic stresses that led to the great depression. By tempting more and more people to invest their earnings in a nebulous promise of future windfalls (and not in actual productive capital), speculative bubbles can do great damage to the economy.
The American economist Henry George, in his classic book Progress and Poverty, observed that not only are speculative bubbles harmful, but there is one kind of speculative bubble, furthermore, that is a fundamental part of our economy. George observed that the market for land, by its very nature, is a speculative bubble. Although we are accustomed to paying land "owners" for access to land, land is not produced by human labor. So, buying title to a piece of land is really completely different from buying an article of wealth, a labor product. The land title is really only a legal right to use something that was already there. Furthermore, because land is needed for all production, any time overall production is increasing, land's value is increasing. Seeing this, land owners typically do not sell their land for a price based on its current value, because they can confidently expect the land to be worth more in the future! To make a long story short, the market for land is, by its very nature, a speculative bubble.
When the speculative price of land rises beyond the ability of a large number of producers to afford it, then they will stop producing, and the economy will slump. Thus, Henry George explained why the boom/bust cycle seems to be a permanent part of the modern economy: because its root cause is the way in which we deal with the ownership of land, an essential factor of production.
George's theory does not, by the way, discount all those other contributing factors, such as shifting fashions and fads, overseas unrest and strife, money-supply finagling and consumer unconfidence. Indeed, the "last straw that breaks the camel's back" is never the thing that puts such a great stress on that poor camel! Nevertheless, George's theory shows that as long as landowners can make money by holding land out of use, waiting for future profits, then that "full employment point" of 6% unemployment will be just about the best we can do.
Background Questions
- Describe three proposed explanations for the business cycle.
- Why do economists believe that business cycles cannot be eliminated?
- What is a speculative bubble? Give an example.
- What is the difference between land speculation and other kinds of speculative bubbles?
- Why did Henry George identify land speculation as the root cause of business cycles?
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