Apples and oranges

The Austrian school of economics place most of the blame on the boom and bust seemingly inherent in most countries on changes in the money supply – usually brought about by central banks, although there are other means.

Here I shall try to explain this through a crude example. Imagine two goods in an economy, says apples and oranges. Due to severe flooding in Florida and Spain, there is a worldwide orange shortage, and hence high prices. Big Apple, through their lobbyists, takes advantage and claims that apple prices are unfairly low and requests government stimulus to save the apple industry. The politicians, always keen to encourage economic growth, and well looked after with a lifetime supply of free apples, decide to stimulate the apple sector with some freshly printed money.

As was expected, with an increase in demand for apples but no corresponding increase in supply, apple prices rise. The apple sector hires more staff, investment piles in, and the politicians celebrate the stimulated economy with a few pints of cider. Land previously expected to grow other crops is bought up and new orchards planted. All seems well, and the money printing continues. The boom has begun.

A few years later, orange prices return to normal and politicians start to question the apple prices, which are now above those of oranges. Rising public anger at the situation leads the politicians to ignore the lobbyists and pull the plug on the printing presses. No longer supported with the extra cash, apple prices crash, workers get made redundant, and countless farmers go out of business. The bust has come. After 6 months, apple prices stabilize and are broadly the same as orange prices.

During the boom years, all the extra investment in the apple sector were malinvestments. All of the growth was unsustainable, it was an illusion. It was not backed by real consumer preferences. I said this was a crude example, and its unusual to see newly created money directed to one sector of the economy like this (although the US Fed is doing exactly this by purchasing billions of dollars of mortgage debt every month in its current QE program). But this process is nonetheless indicative if how boom and bust takes place. The new money entering the economy comes via central banks’ low interest rates, and the new money is not targeted to one sector, but it still has a destabilizing effect on the economy at large. New money nearly always comes through the banking sector, and so anything relying on loans and interest rates are more affected than others parts of the economy. Hence why real estate was such a major part of the recent boom.

Where most of he new money ends up each cycle varies – whether it be real estate, the stock market, government bonds, tulips or railways. This gives the appearance that each one is different, and there are certainly different factors at play each time. But all these bubbles were propped up with artificially created money that led to the economy no longer reflecting consumer preferences and the actual relationship between supply and demand.

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