The Science of Economics, by Fred Foldvary
1. The nature of the business cycle
A cycle is a pattern that repeats either exactly or
approximately over time. Market economies have experienced what
are called "business" or "trade" cycles. Business conditions,
including total output, employment, and profits, experience booms,
times of growth and prosperity, and busts, times of decline and
depressed conditions. When charted over time, the variables
resemble a sine wave, the top half of a circle followed by the
There are various names for the phases of the cycle. The
bottom is called a depression or trough. It is followed by an
upswing, called an expansion. The first part of the upswing is a
recovery, and the second part, if it is steeply rising, is called
a boom. The top is called a peak. If the following decline is
very steep, it is a crash (the economy crashes). The downswing is
called a recession (to recede means to go back or down).
Since this cycle resembles a sine wave, going up and then
down, with a curved top and bottom, it has some interesting
mathematical properties. Wait a minute! Don't roll your eyes! I
will try to make the math as simple as possible. Math, after all,
is just logic written in a different language. As a logical
person, you can follow the math if it is presented gradually and
If you draw a straight line on paper, it has a slope. Suppose
it is a line drawn diagonally to the right, starting at the lower
left and going to the upper right. The slope tells us how steeply
the line is rising. It is calculated by making two points on the
line and then drawing a horizontal line from the bottom point
towards the right and from the top line down until it meets the
horizontal line. (If this is new to you, try it with paper and
pencil.) Now measure the length of the vertical line and the
horizontal line (from their meeting point to the diagonal line).
Then divide the vertical line by the horizontal line. This number
is the slope. If it equals one, the line has a 45 degree angle.
If the slope is bigger than one, the diagonal line is steep; if
less than one, the line has a low slope.
If a line is not straight, then the slope changes along the
line. The slope can be seen by drawing a straight line at a point
which is tangent to it, which means that if you come to the line
from the perpendicular to it, you are also coming perpendicularly
to the line, perpendicular meaning at right angles.
Now here is the punch line of this little mathematical
excursion. Lets start at a depression. The slope of the cycle is
zero - in the small neighborhood of the bottom, it is nearly a
horizontal line. That's because the economy is no longer declining
but also not yet arisen. When the economy recovers, the cycle is
headed diagonally upward, and the slope becomes positive. As the
cycle line continues upward, the slope becomes steeper and steeper
as the recover gets faster and faster.
But somewhere along the expansion, the line stops getting
steeper and becomes less steep. It still slopes up, but the
tangent line, the slope, becomes shallower and shallower until at
the peak, it is horizontal again, growth having slowed to a halt.
That point where the slope changed from increasing in steepness to
decreasing in steepness is called the "inflection point."
Which is a very important point! Because even though during
the recovery, all variables are headed up - output, employment,
profits, are still increasing vigorously - the change in the slope
means that from now on, the rate of increase will slow down. The
steepness will decrease. The expansion is already doomed just when
things look best! As Henry George (1879, p. 542) stated, in a
different context, "When the sun passes the meridian, it can be
told only by the way the short shadows fall; for the heat of the
day yet increases."
Do you see the importance of the slope? The puzzling thing
about business cycles is why an economy that is doing so great
comes to a screeching halt and then declines. But if the slope has
started to decrease already during the boom, we can see that the
reason the economy peaked out is that the change in slope turned
negative already during the boom at the point of inflection.
Now we need to answer the question: why did the slope change?
Why can't the economy just keep going up and up and up, or at least
stay at a peak, forever?
2. Theories of business cycles.
Economists, puzzled by depressions, have come up with many
different "theories" or explanations for them. They can be divided
into two types: real and financial. A real theory means that real
factors such as changes in supply or demand are the causes.
Financial factors mean that the cause is a change in the amount of
money or prices. It is generally agreed that most of these
"theories" or hypotheses have not explained cycles very well.
We will not delve into all these hypotheses, but concentrate
on two which fit the facts better than the others. One is
financial and the other emphasizes real factors. When we put the
two together, we get a full explanation of business cycles and how
to stop them.
The real-factor theory was first discovered by Henry George,
who recognized the key role played by real estate in bringing a
boom to a halt.1
George (1879) noted that depressions were preceded by booms
accompanied by land speculation, "followed by symptoms of checked
production" (p. 268). The major barrier to production becomes the
high cost of land and rent, in effect "a lockout of labor and
capital by landowners" (p. 270). Speculative land costs demand a
part of future output in the present. George's theory attempted to
resolve the paradox of idle labor and capital in the depths of a
depression. The reason the market was not clearing was that labor
and capital were cut off from the necessary natural opportunities
offered by land.
Writing after the depression of the 1870s, George pointed to
the example of the railroads, the construction of which had been
accompanied by widespread speculation that "ran up land values in
every direction... Lots on the outskirts of San Francisco rose
hundreds and thousands per cent, and farming land was taken up and
held for high prices" (p. 276). As the transcontinental railroad
approached completion, instead of bringing prosperity, a depression
began. The rapid construction of railroads itself was a result of
land grants by the federal government to spur on a national rail
network. The train of events that contributed to the depression of
the 1870s was therefore not a pure market process but induced to a
great extent by the shock of infrastructure subsidies by
government, capitalized into land values which then increased via
speculation to heights which choked off enterprise.
To examine George's theory, let's start at the depression or
trough. Due to low demand and high vacancies due to bankruptcies
and cutbacks, commercial rent and land prices are at rock bottom.
The downward spiral has ended, as most fragile and badly-invested
ventures have already gone bankrupt. Now the stronger enterprises
start expanding again, helped by low prices of labor, real estate,
and interest rates. While demand rises (demand curves shift to the
right), prices during the recovery are usually steady, since there
is a large supply of idle resources.
As the expansion progresses, an upward spiral is set in
motion, since greater employment implies greater spending,
stimulating more enterprise. Now vacancies in real estate become
low, and prices and rents start rising. A boom in the construction
of buildings begins, stimulating the demand for land. The recovery
becomes a boom. The rate of increase, or slope, of the upswing is
at its maximum. Speculators now enter the market, since they
anticipate higher future prices for real estate. They drive the
price of land even higher. Much of the real estate construction is
also speculative, as builders expect their land value to rise and
contribute to profits.
But now enterprises find that the price of real estate is
higher than that warranted for present-day use, since it reflects
future expectations. "The invisible barrier but for which
buildings would rise and the city would spread, is the high price
of land, a price that increases the more certainly it is seen that
a growing population needs the land" (George, 1883, p. 126). Adam
Smith's invisible hand is blocked by George's invisible barrier.
There are of course other increasing costs, such as interest rates,
raw materials, and labor, but speculation is an especially powerful
price-increasing force for land.
Enterprises slow down their expanding. We have reached the
inflection point. Even though enterprises are still expanding
rapidly, the rate of expansion has slowed down due to the too-high
price of real estate. Contributing to the slow-down are higher
prices for labor and other inputs as well, but these have not
increased nearly as much, because only with land does an increase
in demand fall fully on an increase in price - because the supply
of land in a given area cannot be expanded, unlike other inputs!
The slowdown in real-estate construction spreads to other
industries, as, for example, less furniture is ordered and less
steel and lumber is demanded. Industries producing such capital
goods, which expanded rapidly, now contract. Workers laid off or
working fewer hours spend less. The rate of increase in the
economy slows even more, until the slope becomes horizontal -
growth has halted. The economy is at its peak, but is now headed
for a fall! Because the growth rate has been decreasing, and now
When investors realize growth has stopped, many will want to
unload stocks, and a crash in the stock market often heralds the
coming depression. But that's only the beginning, and only a
symptom of the problem, not the originating cause, although the
loss of stock value contributes to the decline, since those who
have lost their financial wealth will no longer spend money on
The recession feeds on itself, as lower output leads to lower
income and to lower spending, which reduces output even more. Real
estate prices have remained at a plateau even though vacancies have
increased, because the owners don't wish to sell below peak prices.
This phenomenon repeats itself each cycle! But eventually,
increasing bankruptcies result in lower rentals for landlords, and
some of those with negative cash flows must sell. Prices now start
tumbling down. Many landlords go broke, not being able to pay
their mortgages. In many cases, the debts of real-estate owners
are greater than the value of their properties. Loans are not
being repaid, and banks are losing great amounts of money. Many
After the crash, bankruptcies and cutbacks slow down, and the
rate of decrease becomes less steep. This is the second inflection
point, where the economy is still shrinking, but the change in the
rate of growth has become positive - the decreases become less
steep. The economy is receding, headed towards a trough. In the
depression, many resources, especially labor and real estate, are
idle, and prices are low. But the decrease has ended - growth is
flat again, and the change in the rate is positive as old and new
businesses take advantage of low prices to expand again.
But this is only half the story. We need to go further into
the second half, involving the financial sector. As stated by
Friedrich Hayek (1933, p. 90), "Although there is no doubt that all
nonmonetary Trade Cycle theories tacitly assume that the production
of capital goods has been made possible by the creation of new
credit, ... no one has yet proved that this circumstance should
form the exclusive basis of the explanation." The real estate that
was bought by enterprises and speculators during the boom was
gotten using borrowed money. We need to see what was happening
with the banking system.
One scenario described by the Austrian school of economics,
especially by Friedrich Hayek (1933), starts with the injection of
money into the economy by the banking system, especially nowadays
by a central bank. During a depression, it is common for central
banks such as the U.S. Federal Reserve System to increase the money
supply to stimulate growth and bring about a quicker recovery. The
money supply might also be increased to accommodate a real-estate
boom. Whatever the cause, the extra money has the same temporary
effect as extra savings. With more loanable funds, interest rates
drop, or they do not rise as much as they normally would during a
Enterprises producing higher-order capital goods, used by
other industries, are especially sensitive to interest rates, since
their investments need to be very long term. These firms borrow
money to expand. But this is a phony expansion, since the low
interest rate is artificial and temporary. As prices rise due to
the expanded money, either the money supply must stop its
artificial increase, or else the inflation will accelerate as
people anticipate ever higher prices and react by increasing prices
and wages even more. The decrease in money expansion creates
"tight" credit, and interest rates increase, bringing to a halt the
expansion of interest-senstitive firms, including especially
Without the money injection, interest rates would rise anyway
due to increased demand for loans for real-estate speculation. So
the monetary factor and rise in interest rates work together with
the rise in land prices to increase the costs of new investments
and lower their returns. Both these cause bring about the
inflection point during the boom, when the rate of increase slows.
Thus it is that during the height of the boom, the economy is
already doomed. The cause of the bust is the previous boom.
3. Eliminating the business cycle
Business cycles are economically wasteful and cause misery to
those thrown out of work. Millions of lives are disrupted.
Moreover, during a phony boom, resources are diverted to projects
that turn out to be wasted - such as shopping centers that stand
half vacant for years. It is recognized by governments at least
that recessions are unpopular, but they attempt to treat only the
symptoms and effects of the cycle, such as "stimulating" the
economy, a stimulus that can be ill timed and only offer temporary
artificial relieve, often hurting the economy later.
If indeed the major causes of the cycles are the real-estate
speculative booms and the artificial increases in the money supply,
the remedy is to stop both events. The artificial increase in
money supply can be halted permanently by implementing free
banking. Without a central bank and a national currency imposed on
the economy, inflation of the money supply beyond the growth of the
economy is no longer feasible, since there is no longer a monopoly
of the money supply, as discussed in Chapter 11.
This leaves us with the real-estate boom. But land gets its
value from future rents, speculators anticipating increased rent.
When most or all this rent is collected by the government or by
communities, it knocks the legs out of land speculation, because
all the future gain is collected away. Real estate prices and
rents then only reflect current use, not expected future uses. The
absence of land speculation also reduces the demand for loans, so
interest rates are not so high. With both interest rates and real
estate prices determined by current enterprise, the expansion does
not develop into an unsustainable boom.
The remedy, then, for business cycles consists of CCR - the
community collection of rent - and free banking. Free banking will
dampen the cycles somewhat, but both together will eliminate the
major cycles. Shorter minor cycles can still arise, but they will
not produce the massive unemployment and bankruptcies that have
plagued the U.S. and Europe since 1800. In a pure market economy,
growth can still be uneven as technology develops new products in
spurts, but the world-wide massive cycles will become history.
Eliminate the cause, and the effect will vanish.
1. The following on George's theory of business cycles is derived from Foldvary (1991).