Economic Boom And Bust Cycles

Today, I would like to introduce more of my economic theory. Today's posting concerns the destructive boom and bust cycles that plague the economy. When I landed in the U.S. as a child, there was a large open field nearby and one of the first things I did was to look around that field. I found several pieces of wood that were of similar length and attempted to construct a tepee like one of the ones that I had seen on television.

Now, I consider such a tepee as an ideal model of a modern ecomomy. This type of structure consists of several lengths of wood placed upright with one end on the ground so that they meet and can be tied together at the top, forming a cone-shaped structure. Cloth or animal skins can be placed around the outside of the structure for warmth and protection from the wind and rain. When it comes time to move, the structure can be easily dismantled and transported to a new location.

INDEPENDENT AND DEPENDENT SECTORS OF THE ECONOMY

Now think of the different sectors of the economy today. There are what I will call the "independent sectors" and the "dependent sectors". The independent sectors of the economy revolve around basic necessities that we cannot do without and will always require. These are primarily food, clothing and, housing.

There are, as I see it, many more dependent sectors. There are the ones that are not as absolutely necessary to life as the dependent sectors. These include computers, communications, transportation, the military, education, government, finance, entertainment and, sports.

The purpose of this posting is to convey my explanation of the economic "bubbles" that grow and cause financial havoc when they inevitably burst. This is one of the great drawbacks of capitalism, it's perpetual boom and bust cycles. This explanation involves the same type of logic that I presented in the posting "Recessions Made Really Simple" on this blog.

The danger begins when one sector of the economy begins growing at a much faster rate than the other sectors. This is not always a bad thing as long as it is caused by genuine progress. The truth, however, is that artificial booms are usually driven by a mad rush of investors to what they perceive as the latest hot new thing.

We must remember that one sector of the economy, as a proportion of the economy, can only grow at the expense of the other sectors. When investors put more money into one of the sectors than is justified by genuine technical or social progress, we get a distortion in the economy that we commonly call a "bubble". When this happens, sooner or later it tends to burst.

An economy is most stable when all of it's primary sectors grow together, at least in proportion to genuine progress. Investors, anxious to get in on a quick money maker, do not take this big picture into account, with eventually catastrophic results. There has been more than one real estate bust caused by the concept that property values will go on rising forever without stopping to realize that for this to happen, workers in the other sectors of the economy that are the ones buying the properties would have to have their earnings increasing that the same rate that the property values are increasing.

This means that for property values to go on increasing indefinitely, the other sectors of the economy must also be increasing at a similar rate. If this is not happening, the workers in these other sectors will not have enough money to keep driving up property values and sooner or later, those values must return to realistic levels.

I want to introduce the concept that, while these destructive bubbles can occur in either the independent or the dependent sectors of the economy, they do so for different reasons. There will always be the economic sectors that produce and market the basic necessites like food, clothing and, housing. The most important factor limiting the growth of these sectors is the income of people as a whole.

Put simply, all people require food, clothing and, shelter. But if someone were to suddenly increase their income by a factor of three, they probably will not buy three homes, instead of one, three times as much clothes and, three times as much food. Rather, they will tend to buy similar amounts of these goods but of higher quality.

Thus, growth of the independent sectors of the economy will focus on quality, more than quantity, and the limiting factor of this growth is the income of workers in the other sectors of the economy. The independent sectors must exist because they represent basic necessities but are constrained from growing faster than the dependent sectors.

FUNDAMENTAL IMPORTANCE

To describe the inherent limits on growth in the dependent sectors of the economy, I would like to introduce a concept that seems vital to me. To avoid destructive bursting of bubbles in the future we must remember that the dependent sectors of the economy, which produce and market goods and services that are not absolutely necessary to life, have a certain "Fundamental Importance" to the economy as a whole.

When investors rush to a certain dependent sector of the economy, they risk pushing the money in that sector beyond that amount which is proportional to the sector's fundamental importance. This will inevitably result in a boom and the inevitable bursting of the resulting bubble.

There is no better example of this than the Dot Com Bust in 2000. Windows 95 did wonders for the computer sector and investment poured in throughout the late 90s. The trouble was that it was not matched by that sector's fundamental importance to the economy. Of course computers are here to stay, but we tried to push too far, too fast and the result was the bust.

ECONOMIC RULES OF FUNDAMENTAL IMPORTANCE

Here are my rules of logic concerning the fundamental importance of the dependent sectors of the economy. Destructive bubbles in the economy result when investment pouring into one of these sectors is out of proportion to it's fundamental importance.

Computers can do wonders. But we must not forget that the purpose of computers is to manage information. Therefore, the subjects which the computers manage information about must necessarily be considered as more important than the computers themselves. It would not make sense to build a sector of the economy to manage information about other sectors unless those other sectors were more important than the sector that was constructed to manage information about them. Thus, an economy with computers as it's most important sector makes no sense.

The communications sector relays information. But the sector that relays information about the other sectors must necessarily be considered as of less fundamental importance than the sectors that it relays information about. It does not make sense to build a sector of the economy to relay information about other sectors of the economy unless those other sectors are considered as fundamentally more important than the sector that relays information about them. Thus, an economy with communications as it's most important sector makes no sense.

The purpose of the transportation sector of the economy is to get us from Point A to Point B. This must mean that the fundamental importance of this sector must be less than those sectors whose activities take place at Point A and Point B. Thus, an economy with transportation as it's most important sector makes no sense.

The purpose of the financial sector of the economy is to extend credit to the other sectors. This means that it must necessarily be considered as less important than those other sectors and an economy with finance as it's most important sector makes no sense.

The purpose of the educational sector of the economy is to provide the knowledge and training necessary to the other sectors of the economy. Therefore, it must be considered as inherently of less fundamental importance than those other sectors and an economy in which education is the most important sector makes no sense.

The purpose of the health sector of the economy is to keep people healthy so that they can work efficiently in the other sectors of the economy. The purpose of the military, law enforcement and judicial sectors of the economy are to protect the people working in the other sectors of the economy. The purpose of the government sector of the economy is to administer the other sectors so that they can operate at the best efficiency. The purpose of the entertainment and sports sectors of the economy is to entertain people who work in the other sectors during their free time. Therefore, an economy with any of these sectors being considered as it's most important makes no sense.

You can see how the different sectors of the economy very must resemble several lengths of wood places together to stand upright. The stability of the structure would be compromised if one of the pieces were to grow disproportionally to the others. As long as the sectors grow together, there are practically no limits to growth. By keeping this in mind, we can avoid the destructive boom and bust cycles that have plagued the idea of free enterprise.