And Incredibly Simple Business Cycle Model

Recessions and depressions can be easily understood with the correct paradigm. You do not need to derive a complete model of human action from a few axioms. Neither do you need the Circular Flow Model, Aggregate Demand or the Paradox of Thrift espoused by the Keynesians. You don’t even need to understand how the banking and financial systems work. The fundamental mechanics of depressions and recessions are not about money. Nor are they about markets.

Indeed, we shall model an economic depression with something bordering on a command economy with no money. We shall explore the mechanics of economic depressions with a model consisting simply of…a single potato farm.

A Minimalist Economy

Consider a potato farm with a landlord and workers hired by the hour. The workers are paid in potatoes at the end of each week. That’s it. The remaining economic activity consists of do-it-yourself work and foraging in the surrounding forest. The potatoes are primarily for direct consumption.

The Circular Flow Model clearly does not apply here. The owner does not pay money provided by consumers, but from wealth directly produced on the farm.

Note also how time comes into the picture. For much of the year the weekly potato payouts come not from the results of the last week’s work; they come from the previous year’s harvest.

Now let us consider what happens should the stockpile of potatoes turn out to be less than assumed when the hourly wage was set. Maybe the landlord was drunk when he tallied the potatoes last fall. Maybe he and his sons played too many games of spudball during the winter months with what he thought were surplus potatoes. Maybe leprechauns robbed one of the cellars. It matter little. The salient point is that the potatoes needed to make payroll through the next harvest do not exist, and no policy can change this fact. This simplified economy can respond to this reality several different ways:

  1. The owner cuts the pay rate until the next harvest. The year up until harvest is unpleasant. The workers lose weight or they spend their spare time foraging in the forest to survive. But come the next harvest the economy is back on track.
  2. The workers demand full pay anyway. The owner recognizes he was at fault and gives in to worker demands. Work proceeds as before until the potatoes run out. The fields are abandoned. Weeds grow. The harvest (when pay can resume) is meager. The depression continues year after year, becoming Great.
  3. Pay rates are maintained but workers are laid off to make payroll. For those laid off, the year is hard indeed. The rest fare well. The fields are worked for the entire season, but with a partial workforce. The harvest is thus reduced (though not as badly as in Scenario 2), and so the depression continues the next year, becoming Great.
  4. Hourly wages are maintained but hours are cut. Everyone loses weight and/or spends more time foraging, but at least they have more time for foraging and leisure. Alas, because the workers work less the subsequent harvest is reduced. The depression continues, but at least it is not as unpleasant as the previous scenarios.

Do you see the parallels with the real-world economy? The first scenario models the panics in the days when the robber barons ruled the nation. Wages were cut. Union agitators were machine gunned when they got too uppity. But the economy recovered quickly. The second scenario models a populist revolution gone bad. When The People make demands which cannot be immediately met, bad things happen.

The Great Depression in the U.S. was a mix of the third and fourth scenarios. Herbert Hoover admonished industrialists to maintain wages. Roosevelt signed the Wagner Act, giving unions more power to demand good wages and working conditions. If you managed to keep an industrial job, the Great Depression was great: higher real wages and a shorter workweek. For those less fortunate, life was miserable indeed. At least there was an increase in government welfare to help keep body and soul together until the recovery.

How the Great Depression Ended

The Great Depression ended when we moved away from Scenarios 3 and 4 back to Scenario 1. When World War II broke out, the government inflated the currency thereby reducing real wages. Many men of working age were drafted into jobs with very poor working conditions: living in barracks or tents, subjected to strict discipline, and getting shot at. During the war the government rationed basic luxuries and set downward price controls on wages. (Our current system of employer-provided health insurance began with businesses trying to circumvent these price controls by giving out benefits instead of cash.)

A Call for Aristocracy?

Wow! This looks like a call for some serious reactionary measures. “Bring back the robber barons! Crack down on unions! Cut wages until everyone has a job!” And yes, we could use this paradigm to justify oligarchy and Right to Work legislation. But we would get limited votes. Many would turn to the Keynesian faith and read Krugman’s reassuring rants until the recession ends.

But there are populist applications of this paradigm as well! Recall the first explanation as to how depression started in the simple model above: the farm owner was drunk and miscounted the potatoes and played spudball with the surplus. Does this sound familiar? Replace spudball games with financial corporations handing out million dollar bonuses right before going bankrupt. Sounds like a call for some serious regulation. Or some other measures to ensure that those in financial power have Skin in the Game.

And note also that the word “worker” in the above model includes everyone getting paid for work in the real world, including top executives and CEOs. Wage cuts to get out of the crunch could be more at the top.

Finally, consider this final scenario:

  1. Hourly wages are maintained, but some of the payments are deferred until harvest time. Workers lose weight during the growing season but can fatten back up the following fall and winter. As long as the deferred payments come out of what would have been profits, vs. the next year’s payroll, the depression ends at harvest time (save for a lean year of spudball for the owner). If not, it may take several years of deferred payments and low owner profits to restore equilibrium.

This is how we got the post World War II economic boom. The government lowered real wages via inflation, but it also restricted consumption via rationing. Furthermore, patriotic workers bought war bonds which the government later honored. In effect during the war workers worked in part for future pay. Soldiers were paid in part through the G.I. Bill: money for college after the war ended.

Deferred pay is also how many computer programmers became millionaires despite lack of union representation. They accepted stock options in lieu of cash from the founders of various software and dot-com companies. Workers in the successful businesses got rich – after said companies succeeded.

To increase worker pay without inducing recessions, the working class needs to get some of their pay in deferred (and conditional) form.

A Limited Economic Model

The single potato farm model is admittedly crude. It does not model our complex financial system and why it acted like a drunk landowner miscounting his potato supply. Nor does it address job change friction, and how it causes unemployment when some sectors of the economy do worse than others. Nor does it address capital tied up in bankruptcy proceedings, wealth transfers between economic sectors, and some other important factors. For these more fidelity is required.

But this model is a good start, enormously better than the Circular Flow paradigm used by the Keynesians or the Supply Side models abused by many Republicans. Note how well it described the Great Depression.

It also describes our the more recent Great Recession. Note how our financial system acted like the drunk farm owner, handing out bonus checks for unrealized gains, and how our economy went on a binge of building homes we could not afford, while our factories rusted. See how our government acts like a leprechaun robbing the potato cellars, as it runs up gigantic deficits soaking up savings which could have gone into financing businesses to provide private sector jobs.

Further Reading

The simple potato farm model is inspired by a limited understanding of the Austrian School business cycle theory. This understanding comes mainly from Mark Skousen’s works, particularly The Structure of Production and Economics on Trial. However, these readings were done years ago, so there could be significant divergence beyond the intentional simplification. Read these works for a more detailed model.

Whether this model matches the Austrian School business cycle theory is left as an exercise for the more diligent readers.

You can comment on this chapter here.

(Link should open in a new window so you can see comments and text side by side.)