Can someone explain the "unchanged resource pool" thing?

[Knightskye]

I'm watching Tom Woods' speech about the depression of 1920, and he was talking about the Fed setting interest rates and screwing up the coordinating function.

But then he said there's increased demand from an "unchanged resource pool." So, I was wondering what he meant by that.

I understand the point that lowering the interest rate makes borrowing a lot of money a better deal. I just don't understand the whole "brick-layer doesn't know he's out of bricks until he almost finishes building the house" example.

 

[Stary Hickory]

You posted a very good question. It is something I have been researching too. Almost every time an Austrian economist describes the bust he fails to elaborate satisfactory exactly in what way the bust triggers. This is always vague. every time I hear an Austrian describe the bust phase I listen very carefully but alas I have never seen it explained in an adequate fashion.

However in every instance the bust really comes from a raising of interest rates. Like in housing, without cheap and unlimited fiat money coming in, there was no way to continue rolling over houses for higher and higher values. This led to a real drop in the real estate price. Most of that money was bubbled up in housing, so those existing outside the bubble had no way to raise the money needed to buy the houses since the money spicket had been turned off.

The resource pool thing is correct, in fact serious inflation signals that the resource pool is too small for amount of dollars in the system. The FED tries to prevent this from happening though by raising the interest rates before the economy over heats. Deflation of a bubble is just like inflation in the general economy. It only differs in who is getting screwed. The way to look at it is when the FED prints tons of money or credit it goes into a bubble normally and some of it drifts into the general market via government spending or bubble related activities that employ labor and resources from the general market.

But for the most part you have people who believe that they all own 1 million dollar houses...so they look around them at consumer prices and say I can have 1 million dollars worth of stuff at todays prices. Keep in mind the prices they are looking at are isolated from the bubble. There is no way that these people could all claim 1 million dollars worth of goods and services without there being serious shortages. The general market has not adjusted yet for the huge influx of new money, it has been bubbled up. This is where you can notice an insufficient resource pool appearing.

Without an ever expanding supply of credit to lend to new buyers of homes to continue rolling over the houses at higher and higher prices, the sellers of homes will reach a point where no one can buy from them at the price they want. This triggers a panic, as more people try to unload houses, and there is simply not enough money to be found in the general economy to continue the boom. This is when we get a bust as more people simultaneously try to sell and get out of the market.

The credit was fictitious, it was not backed by real savings and a curtailment of consumption. There is no way to support the housing market without more and more fake money. However, as we can see the FED in fact printed money and BOUGHT these houses for us. And now what is happening, is that we risk getting serious inflation because we are being forced to make good on this fictitious money expansion.

So in the end we will probably get inflation to cover the expansion. The deflation of the bubble isolated the fraud to the people who benefited from it. When the FED bailed out the banks everyone in America now gets defrauded while the banks got to benefit all along.

 

[Knightskye]

I'm still confused. A person sees interest rates at 1% and takes out a loan. How can he use that money if it doesn't exist?

How can the brick-layer build a house if his bricks don't exist?

 

[Stary Hickory]

I'm still confused. A person sees interest rates at 1% and takes out a loan. How can he use that money if it doesn't exist?

How can the brick-layer build a house if his bricks don't exist?

Well the money is created by the FED. This money is then used to acquire resources for constructing new houses and it bids up labor. This part of process actually adds to rising consumer prices more directly. So we are experiencing a form of fraud as our resource pool is constant and the money supply grows in the general economy.

But what makes a bubble so different is that inflation isolates itself in one area and feeds itself, as people continually buy into the credit expansion. This can continue until interest rates rise as the FED turns off or slows down the money supply. In order to feed a boom you need ever increasing quantities of money. So that everyone is able to roll over constantly the assets inside the bubble at a profit. It's a ponzi scheme of sorts, and to keep the prices rising you need more and more money coming in.

If the money supply keeps accelerating at an ever increasing pace there will be a huge bust and serious inflation and currency issues. The brick layer scenario is correct, because not only can you buy houses but you can also borrow for constructing factories or other long term investments. What is profitable at 1% will not be so at 5 or 6%. And this negatively impacts people investing in long term projects as well. Interest rates in the natural state are an indication of the willingness of consumers to abstain from direct consumption and to invest in capital production.

With a expansion of the money supply that does not immediately affect the general price levels you have a tug of war going on. Consumption remains high, and yet capital investment takes place too. The reason this seems hard to grasp at first, and why consumption and increased investment can happen at all is because there are people who hold investments. What I mean is there are people who are not spending the value of their investments but hold it. This almost acts like a buffer of sorts, allowing the tug o war to continue as long as those people holding investments don't try to cash them in and assimilate them into the real market economy.

We could all be given 20 million dollars a piece and as long as we never tried to spend it we would all have 20 million dollars and inflation would not rise( though it can be argued this would seriously affect the demand for money). However when money is locked into investments its not the same thing as cash on hand. But anyways, if we all had 20 million more and then we all tried to spend it, we would see HUGE shortages and serious inflation. This would show that people were not nearly as wealthy has they had supposed. They calculated the purchasing power of their 20 million based on the price levels of the general economy. Think the bricklayer here...

That is why a bubble is so deadly. The people who owned these houses all experienced this same scenario. The credit expansion merely artificially inflated the prices inside the bubble. People calculated the value of their houses based on consumer prices in the general economy. However without more and more credit expansion there was no way to roll the house onto another sucker borrowing money or getting credit. And that is when the first problems arose trying to find a buyer when the easy credit dried up.

Remember this, that the housing boom totally bypassed the checks and balances of the free market. The money was given to it straight from the FED, it did not pass through the matrix of consumer demand, which is an ellaborate consensus that is reached only after millions and millions of people make informed choices and input their desires on how production of goods and services should proceed. This is why it was never possible for those houses to be redeemed at their inflated values in the real market. The market had not accounted for all of that new money. It was isolated in a bubble.

It easier to think of the new money as simply fraud. Like a hot potato. People are always trying to toss it to someone else. Who gets defrauded? The holders of mortgage assets? Well that is deflation of the bubble, and those people who hold those assets feel the sting of fraud. Or maybe the government bails out the bankers and buys these assets with newly printed money? Well this means that the money can now escape into the economy freely from the banks and we get inflation. This is when WE, all of us existing outside the bubble get defrauded. So in a sense deflation and inflation are the same thing, they are two sides of one coin called "fraud" tails the bankers win and heads the average American loses.

You can see that the government and the FED have chosen to toss the hot potato right into our laps. Even though the aholes who actually benefited from the fraud are the bankers and those who made money in the bubble economy. This is why it is so evil. Keep the earnings and socialize the losses. And all they did was push fraud to get rich. Not to mention the serious distortions they caused in the production structure of our economy.

 

[pdavis]

I'm watching Tom Woods' speech about the depression of 1920, and he was talking about the Fed setting interest rates and screwing up the coordinating function.

But then he said there's increased demand from an "unchanged resource pool." So, I was wondering what he meant by that.

I understand the point that lowering the interest rate makes borrowing a lot of money a better deal. I just don't understand the whole "brick-layer doesn't know he's out of bricks until he almost finishes building the house" example.

Interest rates, in a free market, would reflect time preferences of savers. Lower interest rates in the economy would reflect a low time preference (people are foregoing consumption into the future) and higher interest rates would reflect a higher time preference (people are consuming, low savings), coordinating how entrepreneurs invest. When the FED lowers interest rates (increasing the money supply) below consumers' time preference (consumers are still consuming, low savings) they are creating a dueling capital structure. On one end, entrepreneurs are taking the newly created money and purchasing more resources for production for the future; on the other end, consumers are still consuming at a higher rate, pulling resources for the remote future. This dueling structure of production over time can cause a dwindling of capital.

 

[Stary Hickory]

Interest rates, in a free market, would reflect time preferences of savers. Lower interest rates in the economy would reflect a low time preference (people are foregoing consumption into the future) and higher interest rates would reflect a higher time preference (people are consuming, low savings), coordinating how entrepreneurs invest. When the FED lowers interest rates (increasing the money supply) below consumers' time preference (consumers are still consuming, low savings) they are creating a dueling capital structure. On one end, entrepreneurs are taking the newly created money and purchasing more resources for production for the future; on the other end, consumers are still consuming at a higher rate, pulling resources for the remote future. This dueling structure of production over time can cause a dwindling of capital.

Capital consumption is a consequence of inflationary policies. But as far as the bust is concerned, the growing imbalance between the general market and the bubble economy is what causes it, and the lowering of interest rates to prevent inflation. The capital misallocations are a part of this overall process and the distortions. I never could give much credence to capital consumption being a cause of the bust, but a consequence of the misallocations for sure.

As long as the boom continues resources are misused. Labor and material go towards the development of the bubble economy and we lose the capital structure that supported the old "equilibrium" of sorts. Domestic production shifts overseas as we produce paper dollars instead of goods. But this foolery goes on just as long as people are willing to hold dollars and not try to cash them in. The FEDs idea has always been to try and raise interest rates before it becomes quite obvious to all that there is no way to redeem all of the dollar denominated assets without a currency collapse. Fraud never works if people are wise to your game.

That is why all these economic hacks always talk about market confidence. In other words has the public bought into the fraud again?

 

[SelfTaught]

Interest rates, in a free market, would reflect time preferences of savers. Lower interest rates in the economy would reflect a low time preference (people are foregoing consumption into the future) and higher interest rates would reflect a higher time preference (people are consuming, low savings), coordinating how entrepreneurs invest. When the FED lowers interest rates (increasing the money supply) below consumers' time preference (consumers are still consuming, low savings) they are creating a dueling capital structure. On one end, entrepreneurs are taking the newly created money and purchasing more resources for production for the future; on the other end, consumers are still consuming at a higher rate, pulling resources for the remote future. This dueling structure of production over time can cause a dwindling of capital.

I was about to post this type of explanation, which I think is the best explanation for the OP's question.

As for the OP, look up Peter Schiff's example of the circus coming to town in his book Crash Proof. I think it's an easier example to understand.

 

[Stary Hickory]

I was about to post this type of explanation, which I think is the best explanation for the OP's question.

As for the OP, look up Peter Schiff's example of the circus coming to town in his book Crash Proof. I think it's an easier example to understand.

Well I said this same thing already,only in detail. If you are looking for an explanation, you can't use textbook jargon. It's obvious by the OPs question he has read this already presented in just such a fashion. Just spouting off the same thing he has probably read and not understood helps nothing.

His specific question was understanding how the bust comes about. It's one I understand because I went through the same process, not just wanting to hear a glossy explanation but understand it in on a very deep level. The bust scenario is never well explained. Schiff probably does it better than most. However the capital consumption theory is not adequate to describe the bust. It is a consequence of inflationary policies that fits in with misallocation of resources. The movement of resources and labor into the bubble is fully encompassed by rising inflation in the general economy.

 

[NightOwl]

This article on the Depression of 1920 explains what is meant by the "unchanged resource base":

Ludwig von Mises and F.A. Hayek both pointed to artificial credit expansion, normally at the hands of a government-established central bank, as the nonmarket culprit. (Hayek won the Nobel Prize in 1974 for his work on what is known as Austrian business-cycle theory.) When the central bank expands the money supply — for instance, when it buys government securities — it creates the money to do so out of thin air.

This money either goes directly to commercial banks or, if the securities were purchased from an investment bank, very quickly makes its way to the commercial banks when the investment banks deposit the Fed's checks. In the same way that the price of any good tends to decline with an increase in supply, the influx of new money leads to lower interest rates, since the banks have experienced an increase in loanable funds.

The lower interest rates stimulate investment in long-term projects, which are more interest-rate sensitive than shorter-term ones. (Compare the monthly interest paid on a thirty-year mortgage with the interest paid on a two-year mortgage — a tiny drop in interest rates will have a substantial impact on the former but a negligible impact on the latter.) Additional investment in, say, research and development (R&D), which can take many years to bear fruit, will suddenly seem profitable, whereas it would not have been profitable without the lower financing costs brought about by the lower interest rates.

We describe R&D as belonging to a "higher-order" stage of production than a retail establishment selling hats, for example, since the hats are immediately available to consumers while the commercial results of R&D will not be available for a relatively long time. The closer a stage of production is to the finished consumer good to which it contributes, the lower a stage we describe it as occupying.

On the free market, interest rates coordinate production across time. They ensure that the production structure is configured in a way that conforms to consumer preferences. If consumers want more of existing goods right now, the lower-order stages of production expand. If, on the other hand, they are willing to postpone consumption in the present, interest rates encourage entrepreneurs to use this opportunity to devote factors of production to projects not geared toward satisfying immediate consumer wants, but which, once they come to fruition, will yield a greater supply of consumer goods in the future.

Had the lower interest rates in our example been the result of voluntary saving by the public instead of central-bank intervention, the relative decrease in consumption spending that is a correlate of such saving would have released resources for use in the higher-order stages of production. In other words, in the case of genuine saving, demand for consumer goods undergoes a relative decline; people are saving more and spending less than they used to.

Consumer-goods industries, in turn, undergo a relative contraction in response to the decrease in demand for consumer goods. Factors of production that these industries once used — trucking services, for instance — are now released for use in more remote stages of the structure of production. Likewise for labor, steel, and other nonspecific inputs.

When the market's freely established structure of interest rates is tampered with, this coordinating function is disrupted. Increased investment in higher-order stages of production is undertaken at a time when demand for consumer goods has not slackened. The time structure of production is distorted such that it no longer corresponds to the time pattern of consumer demand. Consumers are demanding goods in the present at a time when investment in future production is being disproportionately undertaken.

Thus, when lower interest rates are the result of central bank policy rather than genuine saving, no letup in consumer demand has taken place. (If anything, the lower rates make people even more likely to spend than before.) In this case, resources have not been released for use in the higher-order stages. The economy instead finds itself in a tug-of-war over resources between the higher- and lower-order stages of production.

With resources unexpectedly scarce, the resulting rise in costs threatens the profitability of the higher-order projects. The central bank can artificially expand credit still further in order to bolster the higher-order stages' position in the tug of war, but it merely postpones the inevitable.

If the public's freely expressed pattern of saving and consumption will not support the diversion of resources to the higher-order stages, but, in fact, pulls those resources back to those firms dealing directly in finished consumer goods, then the central bank is in a war against reality. It will eventually have to decide whether, in order to validate all the higher-order expansion, it is prepared to expand credit at a galloping rate and risk destroying the currency altogether, or whether instead it must slow or abandon its expansion and let the economy adjust itself to real conditions.

The "tug-of-war" discussion is the key point.

 

[Knightskye]

Interest rates, in a free market, would reflect time preferences of savers. Lower interest rates in the economy would reflect a low time preference (people are foregoing consumption into the future) and higher interest rates would reflect a higher time preference (people are consuming, low savings), coordinating how entrepreneurs invest. When the FED lowers interest rates (increasing the money supply) below consumers' time preference (consumers are still consuming, low savings) they are creating a dueling capital structure. On one end, entrepreneurs are taking the newly created money and purchasing more resources for production for the future; on the other end, consumers are still consuming at a higher rate, pulling resources for the remote future. This dueling structure of production over time can cause a dwindling of capital.

Okay, so when the future comes and the long-term projects are nearing completion or are done, people don't have enough money to consume the fruit of those projects?