“Austrian” Business Cycle Theory and the Rate of Interest

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In an earlier essay, the present author explained “Austrian” Business Cycle Theory (ABCT) as an analogy to basic price theory, namely the specific law that a price ceiling for a specific good will lead to a shortage of that good. Here we will build on this analogy with an elaboration of what is meant by “the interest rate” with an additional emphasis that stresses the mismatch between the rate of saving and the rate of investing.

The reason for this new elaboration is that ABCT typically concentrates on “the rate of interest”, explaining the business cycle as an effect of “the market rate” of interest falling below “the natural rate”. This has opened “Austrians” up for criticism because any adherence to the pure time preference theory of interest runs into the problem of there being many “natural” rates for different capital goods and so we never know precisely which rate it is that is being undercut by credit expansion1. Moreover we might as well also point out that different borrowers pay a multiplicity of interest rates and that is dependent upon their specific contract so there is no, single “uniform” rate paid by every borrower.

What will be demonstrated here is that, while ABCT’s emphasis on interest rates is valid and is necessary to explain why particularly lengthier, roundabout projects will be engaged in, the most important aspect is that credit expansion simply permits borrowers to access funds for durations that lenders are not willing to lend for and it is this lack of harmony – made clear by our analogy to the results of price fixing – that is the key to unlocking the business cycle.

Robinson Crusoe Economics

In the situation where we have a lone human being (who, for argument’s sake, we shall call John), the fact of scarcity results in the necessity for John to choose which ends he will pursue and which he will discard. There are costs and benefits related to everything he does – such are the logical implications of the action axiom – but exchange of these costs and benefits is unilateral. If John decides to pick apples instead of picking oranges, the benefit he derives from picking apples comes at the cost of picking oranges. He cannot pursue both ends – he therefore exchanges picking oranges for picking apples, albeit unilaterally and in his own mind. This is the nature of basic, simple choices between presently available goods and services.

If John wishes to increase his consumption by investing in capital goods he must also make an exchange, but an exchange of a different nature. At any one moment John will have an array of resources available to him. His basic choice over these resources is whether to consume them now or to invest them to yield consumer goods in the future. It is plainly clear that John cannot do both at the same time – he cannot consume resources and invest them. If he wishes to invest the resources in a capital project that will yield consumer goods in one year’s time then he must be prepared to abstain from the consumption of the resources that he will invest in that project for one year’s time. If the period of investment will be two years then he must be prepared to abstain from consumption for two years, and so on. The precise length of time for which he will abstain from consumption and engage in investment is determined by his relative weighting of the value of time against the value of the quantity of consumer goods yielded – if the quantity of future consumer goods is more valuable to him than the waiting time then he will invest, wait and then enjoy the larger quantity of consumer goods when the investment project reaches its completion; if time is more valuable to him than the additional quantity of future goods then he will not invest but consume the lower available quantity of goods now. The result of such a valuation is summarised simply by the term “time preference”.

Is it possible for John, in his lonely world, to experience the unilateral equivalent of boom and bust? Will he experience a sudden spurt of investment followed by a downturn in his investment activity? The answer is yes, he could, because his capacity to keep on investing is connected solely to his willingness to carry on with the abstinence from consumption of the resources that are required for the investment project to come to fruition. If, half way through his investment project, he changes his mind and his desire for consumption increases so that he must divert resources away from the investment project then he will experience something of a bust – the project must now be liquidated as it has been starved of resources for completion. The viability of the investment project is wholly dependent upon his willingness to abstain from consumption and invest those resources that he could have consumed. The investment therefore turns out to be a malinvestment, unconnected to his consumption/waiting preferences as they are now revealed to be.

Bilateral Exchange

In an economy of more than one person, exchange of a simple good is now bilateral rather than unilateral but it is still based upon the same principles. We make a choice of what to receive in exchange and what to give in exchange. Normally, of course, we give money in exchange rather than a concrete good but we can think of the real cost as being other goods that the money could have bought. If, for example, I only have enough money to buy an apple or an orange and I choose to buy the apple, the cost of me buying the apple is the orange which I could have bought had I not purchased the apple. We can say that I exchanged the orange for the apple, even though the actual physical exchange involved not the orange but, rather, the money that could have been used to purchase it. It is clear, moreover, that I cannot have both the apple and the orange at the same time – or both the apple and the money used to buy it at the same time. I must choose between them because of the eternal condition of scarcity. Only an increase in wealth can alleviate this so that a person is in a position to be able to afford both an apple and an orange.

The market price of a good is the price at which the quantity of the good demanded is equal to the quantity supplied – in other words, it is the price where the number of willing buyers is equal to the number of willing sellers, the level where those who wish to give up in exchange equals the number of those who wish to receive. There is, therefore, not only a harmony of interests at the market price but also the market price regulates the amount of consumption of a certain good that is sustainable by the current level of wealth. Attempts at price controls interfere drastically with this harmony. Artificially lowering the price of, say apples, may, on paper, make it appear as though one now has enough money to buy both an apple and an orange rather than just an apple. The problem, however, is that at the new, sub-market price for apples, the number of willing buyers exceeds the number of willing sellers; the shrunk supply will be bought rapidly by the swollen demand and, therefore, shortages will ensue and there will be no apples left anywhere. This much is standard economic theory. What we can note, however, is that price controls are solely an attempt to allow people to have their cake and eat it – that, whereas at the market price, they could only afford an apple or an orange, the fixed, low price attempts to give them the ability to afford both the apple and the orange at the same time but without any corresponding increase in wealth. On our Robinson Crusoe island we noted that John could not enjoy apples and oranges at the same time because his wealth was insufficient to do this. Any attempt to do so would be at variance with reality and he would end up having to choose between them anyway. Exactly the same law operates in bilateral exchange. Simply trying to forcibly change the prices that emerge in bilateral exchange cannot defy reality and the whole scheme collapses precisely because the objective of providing more and cheaper goods cannot be sustained – you cannot have more of something without increasing wealth. People will find that all of the apples are gone and all that will be left is oranges so they are in the same position as before with only one fruit being available to them, except now without a choice of one or the other. Sustainable trade cannot exist under terms where the suppliers are not willing to offer goods for sale to the demanders.

A further feature of general buying and selling that we might note for our comparison with lending and borrowing that we shall explore in a moment is that every buyer pays the same price as every other buyer and every seller sells for the same price as every other seller. One buyer’s dollars are as good as any other’s and one seller’s good is interchangeable with another’s. In other words, except in cases where there is favouritism or prejudice for the individual personalities, there is insufficient qualitative difference between the different buyers and sellers to make an impact upon price.

Bilateral Investment

On our Robinson Crusoe island we noted that if John wished to increase his consumption in the future he had to abstain from the consumption of resources today in order to use them in investment projects that will yield consumer goods in the future. John’s level of investment was precisely correlated with the amount that he refused to consume and channelled into his project.

In the complex economy, where the abstinence (or saving) on the one hand and the investment on the other is carried out by different people the transaction is effected through the market for lending and borrowing. The market for money loans is actually little different from the sale and purchase of ordinary goods, except that what is being traded and at which prices is a little more difficult to understand. Specifically, what is being traded is not a hard good such as an apple or an orange; rather, it is the purchasing power over resources. A lender, in making a loan to a borrower, transfers his purchasing power over resources today in exchange for the borrower transferring an (at least nominally) higher purchasing power over resources at a point in the future. The market price for these loans – that is, the rate of interest that the borrower pays – is the price at which all willing lenders would be able to lend to all willing borrowers.

There are several key aspects of this market that must be highlighted. First, all loans contracts are for a specific duration which, for argument’s sake, we will say is three years. The lender here must be prepared to sacrifice his purchasing power over resources for three years. During this time, the borrower will use the resources purchased for his investment and will arrange himself to be in a position to transfer back purchasing power in three years’ time. More specifically, what this means is that the lender gives up his power to consume the resources that his purchasing power would afford him and transfers them to a person who wishes to invest them for a three year period that will yield consumer goods at the end of that period, thus earning him an income and the wherewithal to transfer back the purchasing power to the lender. This is the fuel of sustainable growth because the lender relinquishes consumption for exactly the same period as the borrower engages in investment. The basic theory is therefore nothing different from John on the Robinson Crusoe island. Just as John had to abstain from consumption for the duration of his investment project, so too must the lender be prepared to do the same so that the borrower’s project can be completed.

One notable difference of this market when compared to the market for simple, present goods, is that the rate of interest paid by different borrowers will be different rather than uniform for all borrowers. This is because the business of lending money contains an entrepreneurial element. The borrower is making a business decision that his investment will accrue enough income to enable him to pay back the capital and the interest. The lender, wishing to maximise the chance that he will receive his money back, shares this entrepreneurial burden and hence adjusts the rate of interest he charges to different borrowers. The riskiest borrowers – those whose entrepreneurial efforts appear the least likely to succeed – will pay higher rates of interest than the less risky borrowers. There are two possible ways of analysing this. Either we can say that there exists a single market for money loans which, all else being equal, every borrower would pay the same “core” interest rate determined by supply and demand for loanable funds with the difference between the actual rates constituting an entrepreneurial profit and loss element for the lender. Or, we could suggest that the qualitative difference between borrowers creates distinct markets for different categories of lending that attract different rates. In the markets for lending that contain the least risky borrowers the supply of loanable funds will be relatively high so interest charges will be low; in the markets with the most risky borrowers, however, supply will be relatively lower to demand resulting in higher interest charges to these borrowers. We shall use both analyses below although we will conclude with a preference for the latter – that of distinct markets that attract different rates. However, the most important fact that we need to concentrate on is that, whichever analysis we use, all lenders are prepared to fund all borrowers’ enterprises for the duration of their projects under whatever interest rate is agreed and hence these projects can be fully funded to completion.

The fact that the exchange between borrowers and lenders is facilitated by an intermediary – usually a bank – makes little difference to this situation. The bank simply borrows from the lender (or “saver”) at a certain rate and lends to the borrower at a slightly higher rate, the difference between the rates compensating the bank for its efforts in channelling the savings of ordinary people into the profitable projects of borrowers. The key aspect, again, is that there are real funds that can fuel all projects through to their completion under the terms agreed.

Credit Expansion

In order to understand the effects of credit expansion, let us first of all posit the case where a direct lender creates a mismatch with a borrower. Let’s say that a lender is prepared to lend for three years whereas the borrower thinks (erroneously) that he is borrowing for five years. The borrower’s project takes five years to complete and he needs purchasing power over resources for five years as his project will not earn an income to transfer back that purchasing power before five years is up. If, after three years, the lender, wishing to take back his purchasing power for present consumption, calls in the loan the borrower will have a shock. His project is only 3/5ths complete. Only two options are possible. Either the lender must change his priorities and save for the full duration of the investment project; or the borrower must liquidate the investment in order to pay back the lender2. If the latter option is necessary then we have a mini boom-bust between these two individuals; the investment is revealed to be a malinvestment as the borrower was not willing to lend purchasing power over resources for a time sufficient to complete the investment project. In order to create a sustainable investment project the lender must be prepared to advance purchasing power to the borrower for the full duration of the project. If he is not then the project cannot continue.

Now let us examine what happens when an intermediary bank engages in credit expansion and brings about effectively the same thing. The borrower is now a depositor of the bank and the borrower borrows from the bank rather than directly from the lender. Above we cited two possible analyses of the loan market – either there is a “core” rate of interest governed by supply and demand for loanable funds with individual variations in loan contracts representing the entrepreneurial risk that the lender takes; or, there are distinct markets for different types of loan, each of which attracts a different rate. We will use both analyses here.

On the eve of the credit expansion all willing lenders will have lent, through the bank, to all willing borrowers at whatever terms in the individual contracts. The willing lenders will be prepared to lend the funds for exactly the duration of the loans of the willing borrowers. Let us call these fulfilled borrowers Group A. When the bank expands credit, however, it gives the impression to unfulfilled borrowers – let’s call them Group B – that the supply of loanable funds has expanded. Under the first analysis, if the supply of funds expands then the “core” interest rate will reduce as the fresh funds have to find new, willing borrowers as those who were prepared to pay the highest charges have already been loaned to. This brings down the total amount of interest (“core” interest +/- the entrepreneurial charge) that Group B borrowers pay. Before credit expansion a core interest charge of (for example) 10% plus an entrepreneurial element of 5% would have given a Group B borrower a total interest charge of 15%, which may have been too high for him to take out a loan. Now, however, if the effects of credit expansion reduce the “core” interest charge to 5% leaving the entrepreneurial element unchanged then the total rate payable will be 10%, at which rate he may become a willing borrower. Hence the number of willing borrowers begins to expand. Under the second analysis, where there are distinct markets for different loans to different categories of borrower, expanding the volume of credit will expand the number of markets to which funds can be lent. As all of the Group A markets are fully lent to the new funds must seek out new, unfulfilled markets in Group B. This has the effect of bringing down the individual interest rates in these markets. Before credit expansion, the interest rate in these markets was infinitely high as supply in these markets was zero. Now, credit expansion has created supply that moves into these markets and depresses the interest rate to a level at it may reach demand. Hence loans will start to be made in these new markets.

To the present author, the second analysis seems preferential for visualising clearly the reconciliation between ABCT with the multiplicity of interest rates that are paid by borrowers. Indeed, while separating out the “core” rate from the entrepreneurial rate may be easy to conceptualise to a degree3, the idea of lowering rates is less straightforward to perceive when we think of the market as a unified whole. Conceiving them as separate rates in distinct markets which are individually depressed by credit expansion removes this conceptual difficulty4.

Under both analyses however, we can see that increased credit expansion leads to loans at rates that are lower than those that would be paid on the unhampered market. It is important to realise, though, that the contracted interest rates paid by borrowers in Group B – the new borrowers – may actually be higher than the rates paid by Group A. What we may observe is new borrowers in Group B paying what appear to be increasingly higher rates rather than increasingly lower rates. But the crucial point for ABCT is that the rates paid by Group B are lower than those that they would pay on the unhampered market. Such rates do not have to be lower than Groups A’s and thus it is still true to say that, overall, credit expansion has lowered interest rates.

How is it, though, that Group B borrowers, if they may pay higher rates than Group A borrowers, channel these funds into longer, more roundabout investment projects? Wouldn’t the interest rates have to be lower than Group A’s in order to accomplish this? The comparison to Group A’s rate is not relevant, however. It is still the case that extending loans to Group B will cause an overall lengthening of the structure of production as funds that previously were earmarked for consumption will now be channelled into investment5.

However, whatever the duration of a loan and whatever terms on which is it advanced the cardinal fact remains as follows: lenders are not prepared to devote real resources towards the investment projects of the borrowers for the entirety of their duration. Just as in the same way as price controls in our example above tried to give people the ability to have their cake and eat it – afford both one apple and one orange at the same time even though the level of wealth could not sustain these purchases – and just as in the same way that John on the Robinson Crusoe island not consume his resources and invest them at the same time, so too is credit expansion a societal wide attempt to indulge in both consumption and investment simultaneously. The borrower thinks his new money allows him to purchase resources for investment whereas the lender, not having relinquished his purchasing power, thinks that he can still use his original money for consumption. What happens in practice, of course, is that the credit expansion forcibly transfers purchasing power from the lender to the borrower. The increased money supply causes an increase in the prices of capital goods and a relatively weaker increase in the prices of consumer goods. The lender still loses out, therefore, as he must now pay higher prices for the things that he wished to consume – in just the same way as he would lose out from price controls when he sees that the shelves are empty. As the cycle gets underway, higher doses of credit expansion are necessary to maintain purchasing power in the hands of the borrowers as prices rise sharply and inflation premiums begin to be written into loan contracts. Once the inflation gets out of control and the credit expansion is halted or reduced funds are cut off to the borrowers in Group B as they must now rely upon the genuine saving of lenders. But lenders are not prepared to lend real purchasing power under the terms that these borrowers are willing to pay. Thus, starved of resources to complete their projects, Group B borrowers must liquidate their half-finished investments which are now revealed, after the true consumption/saving preference of lenders becomes apparent, to be malinvestments. The bust phase of the cycle therefore sets in.

Conclusion

What we have seen from this analysis, therefore, is that while the “Austrian” claim that “credit” expansion lowers “the interest rate” leading to the business cycle can be elaborated and defended to account for multiple rates paid by multiple borrowers, the primary fact is that lenders are not prepared to lend purchasing power over resources to the borrowers for the duration of their investments. It is this lack of harmony in the use of resources which is the key to understanding the start of the boom and the eventual collapse and this should be the focus of anyone wishing to understand and expound “Austrian” Business Cycle Theory.

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1See, for example, the relatively well known Hayek-Sraffa debate. “Austrian” economist Robert P Murphy has stated that “Austrians”, or at least those who ascribe to the pure time preference theory of interest, are yet to provide a sufficient answer to Sraffa’s objections. Robert P Murphy, Multiple Interest Rates and Austrian Business Cycle Theory, unpublished.

2We are, of course, ignoring the real-world possibility of refinancing.

3Although the length of time may itself be an element that is accounted for in risk.

4It is also the case that, even if all else was equal, there would not be one “core” interest rate in the loan market anyway as different lending periods would also attract different rates. Again, the second analysis overcomes this problem as different time periods would constitute individual markets.

5From a simple cost account point of view, the longer a particular business enterprise takes to come to fruition the harder it becomes to fund interest charges on the borrowing that has funded it. An uncompounded interest charge of 10% on a loan of $1m for a project that will last one year will result in a total repayment of $1.1m, something that might be manageable. If the same loan at the same rate was made for ten years, however, the borrower will to pay twice the capital – $2m – back at the maturity date; a cripplingly high cost for even the most profitable of projects. If the interest rate is reduced to 2%, however, the ten-year borrower would only pay back a total of $1.2m, which would be more manageable.

Labourers, Capitalists and Entrepreneurs

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Libertarians are well aware of the Marxist myth that labourers or employees are “exploited” by the capitalists, the entrepreneurs, the employers and the bosses, the former producing all of the valuable output in society and only permitted to consume enough to keep them at bare subsistence while the latter cream off the fat and live a life of carefree opulence.

The details of the economic fallacies of this position we will not explore here. Rather, the issue we wish to concentrate on is the common misperception that is “easy” to be a capitalist-entrepreneur (whom, hereafter, we will refer to as a “businessman”) and back-breakingly “difficult” to be a labourer. Such an impression is hard to dispel when, after all, the majority of the population are labourers, only a slim minority are businessmen and the relationship between the two is nearly always at arm’s length. Don’t the businessmen have the luxury of dictating to us the terms of our employment, our wages, what time we have to be there in the morning, what time we can leave, when we can have lunch, how often we can go to the toilet? And don’t they then decide when they’ll let us in to the shops to buy the stuff we need, setting the prices we must pay to ensure themselves enough profit, and us having to choose from whatever they have decided we can buy? Aren’t we just lucky to have whatever scraps that they throw down to us from their table? Although there will always be a natural antagonism between boss and employee the latter should think twice before becoming too envious of those who offer him work by failing to realise the pitfalls of becoming a businessman and ignoring the advantages of remaining as a labourer. Let us explore some of these in detail.

First of all, as a labourer you have the advantage of receiving your income first and incurring your costs later. The businessman pays you immediately once your work is complete and then you have a definite amount of money in your hand right now that you know you can spend on whatever you like. Furthermore, you do not have to wait until the product that you are working on for the businessman is completed before receiving this income, which might be weeks, months or even years before it reaches the hands of the consumer. No, you get your money now, cash in hand, with no waiting. And once you go to the shops you know the prices that you will pay so you can estimate easily how much you can spend and how much you can save in order live sustainably. In short, living as a labourer has a high degree of certainty. Labourers do, of course, partly share in entrepreneurial burdens. Not only do they have to know which skills are the best to offer prospective employers but they also bear the risk of redundancy in the event that the employer is forced to cease trading, or if the entire industry in which they work should become obsolete. But his entrepreneurial risk is greatly diminished compared to that of the businessman. Moreover, as a labourer, there is normally a strict starting point to your day and a strict ending point. Yes, you have to turn up and work for those eight or so hours in the day between those times but the time outside of that is yours and work, except for the very highest salaried employees, does not have to interfere with your leisure time.

Let us contrast this with the position of the businessman. He does not have the benefit of receiving his income first and incurring his costs later. Rather, he must first of all save and then burden himself with costs (including your wages) on an operation without knowing precisely how much this operation will yield in income. Indeed, the whole operation might bring him a net loss. He doesn’t know precisely what the outcome will be and he is, indeed, taking an enormous risk by entering this venture. It is simply anticipation on his part. Yet you, even if you participate in his operation, have been insulated from this by being paid up front. The businessman doesn’t come back to you after the end of a loss-making year and demand some of your wages back. You get to keep everything whereas he may lose a significant portion of his wealth. Equally and oppositely, therefore nor should he be expected to give you some of his surplus at the end of a profitable year. Furthermore, while businessmen as a whole “set prices”, any one of them does not do so as he pleases. Rather, he has to compete with what other businessmen are willing to pay for their inputs on the one hand and sell their outputs for on the other. The prices he pays for goods, raw materials and your wages to produce the goods he will sell are set not by him but by the bids of all the other businessmen who wish to uses these resources in their competing operations. Our businessman must be prepared to pay at least as much as they are if he is to secure the inputs necessary to run his business. Indeed one of the great Marxist myths – that the capitalists drive down wages to the lowest possible – is made plainly untrue by this fact. It is the competition between businessmen that drives up the wages of labour as it increases the demand for it. What is likely to reduce wages, on the other hand, is the existence of other workers as each new labourer adds an additional supply of labour, especially in particular industries where certain skills are necessary for which there is a finite demand. Indeed one of the reasons why unionised labour has always supported the minimum wage is to make the lowest skilled workers unemployable and reduce the competition for their more highly skilled members, thus raising the wages of the latter at the expense of the former. So much, one might say, for the collective interests of each class. When it comes to the prices of the product to be sold, the businessman must similarly compete with all of the products offered by his competitors for the contents of the consumers’ wallets and purses. His prices will therefore be determined by all of the other asking prices of his competitors and he must be prepared to offer a low enough price to draw consumers away from these other businesses1. Once a product is produced it is normally in a businessman’s best interests to sell it as quickly as possible. He does not have the luxury of “un-producing” it, winding back the clock and choosing to do something else. Rather, he is stuck with it and the longer he holds onto it the more likely it is that perishable items will simply be wasted and more durable items will incur further costs of storage. The only option, barring the possibility of personal use (which is obviously impossible for any large scale business) will be to sell it. Very often, therefore, the supply curve for a businessman will be vertical, meaning that he is prepared to take whatever the consumers will pay for his wares. If this is not enough to cover his costs then he will go out of business. He only earns a profit if the consumers are prepared to pay more than the product cost to produce. Occasionally a business may hold onto goods in the anticipation that their prices will rise at a later date, but this is normally the function of speculators in commodities and raw materials which have a diverse range of potential uses and not the function of manufacturers and vendors of highly specific, consumer goods. While businesses as a whole set prices, therefore, any one business is highly restricted in the prices it pays for its inputs and the prices it receives for its outputs and it takes tremendous skill and foresight to ensure that the latter is higher than the former.

Furthermore, the profits that a businessman will earn if he is successful in this regard are in no way “deductions” from wages. Rather, properly considered, wages are deductions from profits. When an businessman brings his produced product to market on a certain day, it will sell for whatever people are prepared to pay for it that day and the businessman will consequently earn certain revenue. If, for the sake of argument, he had been able to bring that product to market without incurring a single cost then his profit would be his entire revenue. In the real world, however, he must incur costs and every single cost, including wages, that has brought him to the position of being able to sell that product is a deduction from that revenue and only the remainder is the resulting profit. If the deductions are too high then he makes a loss. Indeed, this is precisely how a company’s income statement is laid out – revenue at the top followed by costs deducted leading to the final figure which is the profit; hence the expression “the bottom line”. If another businessman brought the same type and quantity of products to market on the same day he would earn exactly the same revenue as our first businessman, but if this second businessman had done so while incurring fewer costs then his deductions would be lower and his profit would be higher. Every time a businessman considers hiring one more employee he has to estimate whether the additional revenue gained from doing so will be higher than the deduction from that revenue he must pay out in wages. In short, your help in his enterprise allows you to pinch from his pie upfront, and only at the very end, after you have vanished, does he know how big the pie is. If he is unsuccessful you, the labourer, might well have left nothing for him.

Another myth we need to tackle is that capitalist-entrepreneurs automatically become rich. For every successful entrepreneur there are a dozen or more failures because the ability to judge, in advance, which products and services consumers will want to and how much they are willing to pay is a rare skill; hence it is very highly rewarded when it is successful. In a genuine free market there would never be a “class” of capitalists or of entrepreneurs. Rather, everyone would be free to risk his money in a new business if he believed that he had identified a marketable good or service. What gives us the illusion of a capitalist class today is the government protection accorded to large, established businesses and their owners and managers. Indeed the cash-bloated financial sector has only swollen to its titanic size because of the largess that government lavishes on this industry, whereas in a genuine free market financial services would earn the ordinary rate of profit. Furthermore, government makes it extremely difficult to start a new business, crushing it with the cost of crippling regulatory requirements before the budding entrepreneurs can give thought to more relevant things such as their product, their customers and their genuine costs. All this serves to make the businessmen an impenetrable caste of permanent membership, hence increasing the resentment of their position. Furthermore, it is possible to mistake the volume of money sloshing around in a business for the wealth that business possesses. It might be awe-inspiring to see a company’s bank statement raking in millions of pounds a month whereas you, as a little labourer, might only earn a thousand pounds in the same period. But deep pockets are usually raided by fatter hands; just as the income is much greater than yours, so too are the outgoings. It matters not a whit if a company is seeing income of £1 million per month. What matters is the differential between the revenue and the costs. If, in order to earn £1 million pounds the business had to pay out £1.1 million pounds then it would be left with a net loss of £100K. Just because lots of money is coming in to the bank does not mean that a company has endless amounts of cash to play around with and this is compounded by the fact we mentioned earlier of businesses having to incur their costs before their revenue is received. At least as a labourer if you decide to spend a bit more on some luxury in a certain month you still have the ability to calculate precisely what you will have at the end of that month. Businesses do not have this ability and particularly where profit margins are slim only a very slight tipping of the balance into the red can cause money to evaporate very rapidly.

Related to this aspect of the volume of cash in a business is the so-called “inequality of bargaining power” – that businesses, being so big and wealthy are more “powerful” than the tiny labourer who has to come, cup in hand, for whatever he can get. There is, however, no such thing as “bargaining power”. Each party enters a contractual agreement because they each desire something that the other possesses. The value of one party gaining what is yours is in his mind and is not inherent in you. If you are able to negotiate terms that are very favourable to you it simply means that he values what you have more than you value what he has. You have no control over this aspect and all it would take is for someone else to come along and offer something that is better than what you have. Secondly, and, ironically, it is not the growing and profitable businesses – the ones who have “bargaining power” – that tend to be restrictive on how much they are willing to pay in costs. The enthusiasm of a new entrepreneurial venture coupled with the either the anticipation or the reality of large profits results in a lower degree of scrupulousness in controlling costs and the very opposite of a Scrooge-like approach to hiring workers. Indeed it has been estimated that entrepreneurs as a whole pay too much in advances for their inputs and make an overall loss, with even the big winners failing to cancel out the losses of the big winners2. The point at which businesses become tight-fisted is when there is strong competition in a saturated market, driving down profit margins resulting in the need to cut costs in order to stay ahead. In other words it is when profits are low – i.e. when a business’s bargaining power is restricted – that causes a business to demand less favourable terms for its employees. There is also the alternative possibility that a business can grow so large that it soaks up the entire supply of an input and hence is said to be insulated from competitive pressure in setting the prices it pays. This is the frequent allegation that is made against large supermarket chains such as Tesco in their dealings with small suppliers. Of this we can say three things. First, in a genuinely free market, if a business has grown that large then it has done so because it has met the needs of consumers better than anyone else. Secondly, such a behemoth contains the seeds of its own destruction as size and domination leads to complacency and stifling innovation, giving opportunity for more nimble and enthusiastic start-ups to enter the fray and draw away suppliers with more favourable terms. Indeed the evolution of the technology sector may, perhaps, illustrate this. Microsoft dominated the PC age; Google the internet age; and Facebook the social networking era. No one firm was able to retain its dominating influence as consumer focus shifted from one thing to the next. Indeed already we are perhaps seeing a waning of social networking with Facebook’s acquisition of WhatsApp specifically for the purpose of attracting a younger audience for whom instant communication through smartphone technology has proven to be more important than creating a profile on a website. Who will dominate this latter era, if it proves to be one, remains to be seen. Thirdly the large corporate monopoly as we have come to know it is most often sustained by government and not by its consumers. Regulatory privilege, artificial barriers of entry and direct government contracts insulate these firms from actual and potential competition, meaning that their “bargaining power” is bestowed by nothing more than government force and fiat. Clearly this would not be the case in a genuinely free market.

What we have seen therefore is that being a businessman is far from easy. Yes there may be the reward of large profits but the path to success, in a free market at least, is fraught with uncertainty and difficulty. Life as a labourer may be relatively low paid, dull, repetitive but at least it is relatively secure and certain. We should end by reinforcing the fact that throughout this essay we have been talking about businessmen who earn their profits through serving the needs of consumers – those who have successfully determined the needs of their customers and directed the scarce resources available accordingly. We have not been referring to the government-protected or what we might call the “political” entrepreneur who has won his riches through lobbying and government protection. These latter creatures should be reviled for what they are and by pressing ahead for the establishment of a genuine free market we can enjoy watching their ill-gotten fortunes evaporate into the hands of those businessmen who truly know how to serve our needs.

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1Contrary to another popular myth competition is not restricted to particular industries. If you are sell apples then it is in your interests to draw people away from spending their money on, say, cinema trips just as it is on other apple vendors. All businesses are competing for the finite contents of consumers’ bank balances.

2Virginia Postrel, Economic Scene; a Vital Economy is one that Suffers Lucky Fools Gladly, New York Times, September 6th 2001: “If the few big wins cancel out the many losses, starting a business would be a risky, but rational, bet — the sort of investment a “cautious businessman” might make. But Professor [John V C] Nye [economic historian] argued that the wins and the losses probably don’t cancel out. Even the biggest winners don’t make enough money personally to cover the losses of all the individuals who went into businesses that failed. The big winners are usually people who, based on rational calculations, shouldn’t have bet their time, money and ideas. They overestimated their chances of striking it rich. But they were lucky and beat the odds. Even more important, the lucky fools create huge spillover benefits for society: new sources of wealth, new jobs, new industries offering less-risky opportunities, new technologies that improve life. Entrepreneurship does generate net gains, but most of those gains don’t go to the risk-takers. The gains are spread out to the rest of us. Capitalism, in this view, works by exploiting the capitalists themselves.”