No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 292 for other jobs. Their pain will be compounded by a slow overall job market during the general depression of the bust. The process of labor readjustment will also require a change in relative prices to make the unemployed workers competitive. Their wages were bid up during the boom, and they will have to fall during the bust—likely below their initial starting point. Likewise, capital equipment will have to be reallocated, and capital will be seen to be very heterogeneous (i.e., specific to a particular use). Owners of a steel factory, for example, might be able to sell the factory for only 20% of what they invested, if the next best use after steel production (say, a furniture showroom) didn’t require the extensive machinery, and therefore the machinery was recycled. Eighty percent of the capital would therefore be revealed as squandered (or mal-invested) during the boom. As painful as the readjustment process is for workers, human capital is typically the easiest to reallocate to other uses; physical capital such as plants and machinery is very specific to a particular purpose and may only bring scrap value when the inflation ends. There are a few important observations regarding the boom/bust cycle. First, the size of the bust is proportional to the amount of false stimulus and mal-investment that occurs during the boom. In short, the bigger the false boom, the bigger the bust. This is because the larger the boom, the more capital is mal-invested. Capital prices do not reflect underlying consumer preferences, and discovering those true preferences (as well as the price structure of capital assets that supports them) takes time. The important implication is that if we want to minimize the harm, it’s better to deal with the problem sooner rather than later—delay only increases the pain. Second, there is a tendency to lament the bust—as if the bust were the problem. So there are continuing political efforts to prevent the bust, but that only increases the amount of pain that the economy has to go through (as capital continues to be misallocated). Instead, the bust is the recovery to true economic fundamentals. The false boom is the period to lament; the bust is the necessary pain to recover. The commonly used analogy—and one that is certainly apropos—is that of a drunken binge. The boom feels good; everybody is making money and liquidity is everywhere, just like on Friday night when the drinks flow freely at the party. But eventually Saturday morning comes, with a very nasty hangover. Everyone laments the hangover, but the hangover isn’t the problem…it was the excess on Friday night that was the problem. The hangover is the unfortunate necessary condition to get to recovery. Aside from any moral connotations on drinking, or a credit binge, the aftermath is simply a necessity to resume normalcy. Attempts to lessen the pain of the bust with additional credit are no different than giving additional liquor to the person with a hangover on Saturday morning; you are really not doing him a favor, only making the overall pain worse. Heterogeneous capital: Capital is usually very specific to its intended use, and it is not equally applied elsewhere (i.e., it is not homogenous). The size of the bust is proportional to the amount of false stimulus and mal- investment that occurs during the boom. In short, the bigger the false boom, the bigger the bust.