December 5, 2022

Dark Hole or Shock Absorber: How Does a Free-Market Economy React to Crises?

Because the inevitable economic downturn becomes a lot more evident, the Fed will certainly attempt to stop deflation

Mainstream economists view the economy as fickle, unstable, and always in danger of utter collapse.

They view the outlook as very hopeless if not for the enormous current superstructure of government treatment, including constant stimulus of “ aggregate demand. ” In their minds, this essential stabilization would also include the present intricate arrangement of legislation and restriction, the military of technocratic bureaucrats overlording every market, and the rollout of massive interventions plus macro stabilization schemes, anytime necessary.

This bureaucratic view is predicated on the assumption of the superiority of technocratic ability, “ scientific” knowledge, and centralized resources. It is a view which is only plausible when combined with the supposed inability of individual actors to foresee this kind of events or to respond to events, especially those deemed further than their control. In addition to disregarding government intervention as the reason for crises, this top-down see is incorrect and is directly at odds with actuality. 1

In contrast, Austrian economists see the free market as highly stable and fast to adapt to changing circumstances, including huge macro destabilizing events such as hurricanes, battles, famines, and pandemics. Here, the crisis is the unavoidable result of government intervention, although natural disasters are not ignored.

This bottom-up view is based on an understanding from the interests and ability of entrepreneurs to respond to occasions, minor and major, to enhance their situation and indirectly to “ stabilize” the particular economy. Individuals can respond to even dramatic changes in supply and demand problems. They respond to crises since consumers, laborers, managers, plus entrepreneurs, as well as communities, chapels, civic groups, family members, close friends, and neighbors, but just about all can be paralyzed or disabled by the top-down policy approach.

Without explaining the process of how the free-market system works and without the benefit of any kind of real-world experience, the decision associated with what approach to choose is a coin toss. In a planet in which education, the mass media, and the government all side with the top-down government strategy, it will win the public opinion coin toss by default— after all,   something   must be done! The purpose of this article is to explain how the anarchy of individual actions works to buffer the economy like a shock absorber.

The Black Hole of Economics

It is hard to explain and understand how mainstream economists think about economic crises, because they have written so little about how the economics of the crisis works, per se. Their bogeyman is deflation. They see deflation, in the form of falling prices, to be like a black hole. If the economy gets near deflation, it will be sucked into the black opening and never be able to emerge once again. I have coined the term  apoplithorismosphobia   to describe their psychological issue and  my post   on the same issue should be sufficient to describe the particular manifestations of the phobia and it is tragic results. Ben  Bernanke   has deflation-phobia and so does Paul  Krugman   so it is safe to suppose the fear is widely spread.

Their credibility is unmasked by the proven fact that the biggest direct losers through deflation are the wealthy political elites and crony capitalists. Everyone will get some kind of “ haircut” during the process, but the large losers are mostly the same people who benefitted from the corrupt system that caused the crisis in the first place!

The enormous unmentioned benefit of this particular deflationary/crisis process is that we would be able to break free from document fiat-money inflation, the “ regulated” fractional reserve financial system, exploding government financial debt, and the Fed itself! Obviously, the rank-and-file citizen might benefit from the completion of this process.

Free-Market Shock Absorbers

The traditional vehicle suspension system contains many mechanical components with the most famous being the shock absorber. It is designed to absorb much of the energy that results from the change in the road surface. It dissipates a lot of the absorbed energy from bumps in the road to smooth out the ride designed for motorists. Indeed, much of the auto involves absorbing shocks, from the tires to the padded seats and steering wheel, making vehicle transport more desirable than otherwise.

The economic analogy to micro and macroeconomic shocks also involves a similar set of “ parts” including prices, marketplaces, warehousing, transportation, etc . That can reduce (minimization subject to cost) shocks. Most of these parts functionality to economize on the organic uncertainty of change to get entrepreneurs that result from unexpected changes in prices, the conventional imperfections of the road, as they say. This process is governed or even regulated by the natural program of  profit and loss .

These same parts also functionality in irregular occurrences of macroeconomic shocks, as once the brakes, tires, steering, shocks, etc . Are engaged prior to an accident. The market economy also offers analogs to the car’s bumpers, air bags, and other emergency features. These secondary parts consist of untapped resources, such as financial savings, land, mines, unused industrial facilities, facilities, and residences, as well as a multitude of unemployed labor with “ full employment. ” In addition , there is always untapped technologies, or “ advanced” technology that is unprofitable prior to a surprise. The tertiary level of shock absorption are global, financial, and sophisticated institutions that are effective at absorbing macroeconomic shocks, such as multinational corporations and financial institutions, hedge funds, and sovereign funds, although this is not always their primary purpose.

The primary component in most these shock absorbing parts is definitely entrepreneurship. The free marketplace provides the widest possible latitude for individuals to seek their the majority of rewarding course of action and to achieve their goals. This is true, not just for entrepreneur/business owners, but also for capitalists, property owners, and labor, all of whom are constrained by self-interest, if not by direct profit and loss.

We can view the free market as a shock absorber for all events huge and small. The smallest buy creates an immediate reaction concerning inventory information that moves backward through the structure of production from retail in order to wholesale to production facilities to input suppliers and labor markets, and all the way in which back to raw materials and source extraction. This system has a pre-installed, profit driven, feedback mechanism of signals regarding changes in supply or requirement, and thus signals to business owners to either cutback, redouble, or redirect their initiatives.

The failsafe mechanism, beyond adjustments intended for profit and loss, is related to the legal system. Whole firms can shut down production, downsize, or go out of business. This frees up the industry’s resources for alternative utilizes in other companies. Weak companies can combine with stronger companies through mergers and purchases to take advantage of cost savings plus economies of scale. Next to this is the process of bankruptcy meant for insolvent companies, where distressed companies can be reconfigured to keep operating. All these processes generate efficiency and frees upward resources for alternative uses. So , the basic legal and judicial systems play an important role in this economic process.

Nuts and Bolts

What happens in an economic crisis is based on the knowledge of how the market works. As a result explains how the market softens the blow from the problems. Furthermore, the process is self-contained and self-regulated. It does not require acts of government intervention. This failure to understand the marketplace process is why mainstream economists believe in black hole economics.

The most salient feature of a crisis is a sharp fall in the value of most capital assets. The most apparent aspect of this feature is a strong decline in share markets. In general, the value of stocks is estimated by the market with the discounted value of the estimated revenues over time which value is “ shocked” by the revelation of a turmoil, whether its war, company cycle, or something else. For instance , the NASDAQ Composite stock catalog, which is heavily weighted to technology and capital expenditure, fell by roughly two-thirds in the tech bust from the early 2000s, by one-half after the housing bubble, and it has already fallen by about one-third its value in the current problems.

Secondarily, the values of raw materials also tend to collapse. For example , the price of wood declined significantly after the Technology Bubble, the Housing Bubble, and the Lockdown Bubble. Being a master ingredient in production and consumption, the price of oil ebbs and flows with the Boom Bust cycle too. The graph below displays the price of oil since the mid-1980s with the National Bureau of Economic Research recessions shaded in gray.


A third noteworthy impact of an financial crisis is its negative impact on labor markets. Unemployment within the capital goods related industrial sectors is significant and the impact is pervasive on employment, new hirings, and wage rates. We have recently experienced a significant decline in the labor force participation rate, a record number of job openings (60 % higher than the prelockdown information! ), and a very large quantity of new hirings in the aftermath of government lockdowns, yet average real wages have previously declined by 10 percent since the recent peak.

Economic crises also negatively impact the price of consumer products. With the capital-intensive sectors broke and fewer job opportunities and lower real wages for workers, it is not amazing that the prices of customer goods weaken. However , consumers adjust to crises by reducing investments, luxury goods, consumer durable purchases, such as houses, cars, clothes, and devices, and focus on primary goods such as food and energy. This particular typically means that the prices of such goods do not decrease nearly as much as capital plus labor.

This particular all sounds bad because everything is in decline, yet alert individuals realize this situation is pivotal for making income. If capital and natural material prices have crashed and wage rates have collapsed, but consumer good prices have not, then entrepreneurs will certainly sense and investigate revenue opportunities.

These types of opportunities cluster around the low prices of capital goods (e. g., office space, real estate, technology, and production facilities), recycleables, and labor (skilled plus technology workers and current college graduates, especially), combined with the relatively elevated prices associated with final consumer goods. Entrepreneurs exploit these profit possibilities by reorganizing unemployed funds, labor, and materials to market consumer goods as well as brand new products. This also applies to formerly advanced technologies, a gold lining to the otherwise regrettable boom-bust process.

For example , imagine a large financial crisis where major airlines proceed bankrupt, flights are cancelled en masse, planes, pilots, and flight attendants are unemployed, airports are nearly empty, and the price of aircraft fuel drops considerably. May airline entrepreneurs not enter the market and offer cheap plane tickets at a profit? Or may former Boeing engineers not really develop and test the prototype pilotless plane within their spare time?

This deflationary process is a primary aspect of the free market’s role as an automatic shock absorber. The best discussion of this is still probably Rothbard’s (1963)  America’s Great Depression   chapter to the theory of the business period and his discussion on the “ general economic ‘ return to normal, ‘” although the last few pages of  Murphy’s text   is also good. This process is generally not taught in economics courses and is not portrayed in textbooks, which are generally limited to the topics from the government’s “ automatic stabilizers” and fiscal and monetary stabilization policies. William Anderson  summarizes Rothbard’s view on deflation , as well.

Not surprisingly, the people producing decisions concerning an economic crisis— politicians, bureaucrats, and Given officials— have no skills to help make the right decisions. As a result, these are likely to panic and to act in the  passions of the political elites . This means the  incorrect solution of more financial inflation   and other interventions to protect those interests.

In contrast, the best political solutions are straightforward from a proper understanding of just how markets work. I will present them in a future article but in general the idea is to keep and expand the free-market economy and reduce and limit government intervention from the economy.

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