The notion of a business cycle appears quite strange to me. Investors are able to accurately judge the market and make profits en masse, but in a few years they all make mistakes and incur losses at the same time. There is a catastrophic cluster of errors.

During recessions, mistakes of the past are realized and capital loses value. For instance, the capital invested in the housing boom or stock market boom were not reflective of consumers wishes and now must lose value. However, this is not the product of capitalism.

Since interest rates are a reflection of consumer demands and the relative amount of future goods desired, the interest rate set by the Federal Reserve will almost never match the market demand for the ratio of current to future goods. If the Federal Reserve sets interest rates too low, entrepreneurs acting in the market will believe that consumers desire more future goods and will invest in ways to bring future goods about.

The foundations of future good production are high order capital goods such as real estate, stocks, and high order industrial production (mining, logging. etc). This is because any future expansion will require a larger base to produce consumer goods. The artificially low interest rates will result in a rise in prices in those areas, and this will result in a boom with heavy investment in those areas. This boom will not represent consumer demands and the investments will be unsound. This will cause a displacement of capital towards higher order areas and away from lower order (furniture stores, restaurants, picture frame shops) areas. When the mistakes realized the capital rapidly loses value. This is the cause of all asset bubbles and all recessions since the foundation of the Federal Reserve in 1913. This misallocation of capital will necessarily result in a needed depression in which those investments are liquidated.

How would the market respond to a sudden drop in the value and amount of capital? The natural response is a rise in interest rates to attract new capital. As capital is accumulated again, less profitable investments are liquidated and the interest rate will fall. This will eventually allow for the interest rate to return to a level that reflects consumer’s desires.

However, this will signal a recession and a temporary frictional lowering of the standard of living. In a Democracy, this is unpopular, so “solutions” are implemented to cause the assets to gain value. First and foremost, the Federal Reserve lowers interest rates to “provide liquidity”, but in all reality, they simply raise the prices in the higher order goods. There will also be political moves to keep assets values high. This can be seen in the current “bailout bill” wherein the Treasury artificially overvalues the price of the assets.

What these new distortions will do is cause a slower adjustment to new prices. The prices need to fall in the higher order goods in order for capital to be sent into lower order goods. Without this adjustment, inflation and recession are required. The recession is inevitable, and positively a good thing, because it allows for bad investments to be liquidated and adjustment to occur. More on this later this week.