Robinson Crusoe: Depression, Recession, and Bubbles

Introduction

Robinson Crusoe, Daniel Defoe's shipwrecked adventurer, aids economists in analyzing a person's economic actions and consequences in the most simplistic situation. Hypothetical situations pit Robinson Crusoe against death. He must use his only available capital (knowledge and labor) to transform nature's scarce resources into food, shelter, clothing, and leisure. 

Keynesians, Chicagoans, and other schools of economic thought sometimes scoff at "Crusoe Economics" deriding it as too simplistic. Crusoe Economics are not intended to perfectly describe and analyze an economy the size of the united States by drawing conclusions from a single actor. Rather, it subscribes to the idea that "before we can analyze an economy composed of billions of interacting people, we should start with just one person and make sure we understand what makes him tick." (Murphy, Lessons for a Young Economist)

In this blog, I'll attempt to use Crusoe Economics to explain why we suffer from economic depressions, recessions, and bubbles. Wish me luck!

Crusoe Saves and Invests

When Things Go Right

Imagine Robinson Crusoe freshly shipwrecked on his desert island. He spots a bush and decides to pick its berries for food. Crusoe can pick enough berries in one day only to satiate his hunger. He would be happier if he could eat more or had leisure time. But, to accomplish this he needs to increase his ability to produce berries. If Crusoe could fashion some sort of basket to place under the bush he could shake the branches and have the berries fall into his basket increasing his production. 

In order to create a basket, Crusoe calculates he must take three days' time away from berry picking to gather supplies and create his new tool. Thus, Crusoe lives "below his means" for a few days, eats less, and stockpiles 20% of his daily berries. In fifteen days, Crusoe has enough berries saved to forgo picking, collect palm leaves, and weave a basket without starving. Using the saved fruits (literally) of his labor, Crusoe completes his three day project, collects berries more efficiently, and has more time each day for leisure.

Crusoe's story draws an important conclusion in economic theory: Adequate savings (berries) are necessary for investment (a basket).

When Things Go Wrong

Quite a few scenarios could occur that make Crusoe's saving and investment venture go wrong. I'll propose two. I acknowledge there's many more, but these are directly relevant to the point I'll make later.

First, what if Crusoe miscalculated the time it took him to make the basket? What if he planned and saved for a three day venture, but at the end of three days, his basket wasn't completed and he was out of saved berries? Crusoe must then abandon his incomplete basket and return to full-time berry picking. Using economic terms, there were not adequate savings (berries) to support the investment (basket).

Secondly, what if Crusoe could not find the resources necessary to create his basket? Imagine Crusoe is about halfway through weaving his basket, when he realizes he needs twice the amount of palm leaves and twine that he originally planned. He scours the island for suitable leaves, but can't find enough to finish his basket. In economic terms, there were not adequate resources (palm leaves) to complete his investment (again, basket).

Herein lies an important economic conclusion: inadequate savings and/or inadequate resources foil the investment process. This means resources were misallocated to an investment that - in the end - was not profitable or possible. Crusoe's savings of three days' rations were squandered and all the island's good palm leaves were expended and wasted on a half finished basket.

America Saves and Invests

When Things Go Right

When a modern economy saves and invests (and things go right) a direct analogy can be drawn back to Robinson Crusoe on his little island. Crusoe saves berries and invests in a basket. The modern economy saves money and invests in capital goods. Here's an example:

Company A saves money (or citizens save money to loan to Company A). Company A invests in a research project that will allow them to produce "widgets" more efficiently. Company A successfully completes the project and now produces ten times the widgets per week they formerly produced. The increase in the supply of widgets lowers the price of widgets (simple supply and demand) and now even the poorest family in America can go out and buy a widget of their very own.

This is how America's economy functioned during most of the 18th and 19th centuries. It was called the Industrial Revolution. The standards of living for the lower working classes increased drastically. The middle class grew to proportions never before seen in the history of the world. Goods and services became available to working class citizens that were formerly out of financial reach. For instance radios, lightbulbs, cars, cross-country travel, canned food, phonographs and the telegraph all became easily accessible to the American public at large through the process of saving and investment.

When things go right, when adequate savings fund sound investments, everyone benefits from increased production just like Crusoe.

When Things Go Terribly, Terribly, Terribly Wrong

Volumes upon volumes have been written about times when something happens in the economy causing things to go terribly wrong: the Great Depression, Stagflation of the 1970s and 1980s, the Dot-Com Bubble in the 1990s, the Housing Bubble of 2008 and many other periods of economic downturn. 

The conventional "wisdom" on why economies tank so hard often blames the capitalist system and the free market itself. The mainstream media and their economists sacrifice many different scapegoats: underconsumption, overproduction, greedy capitalists, unfair wages, etc., etc. 

Fortunately, there exists a different idea on why things go terribly wrong. It is called the Austrian Business Cycle Theory.

In Crusoe's story we identified two places investment errors could arise. One was not saving enough berries to feed himself while creating the basket; the other was misjudging the amount of available palm leaves. In the modern economy, the same two errors befall investors. 

In our economy - just as in Crusoe's - investment should come from real savings (money) being loaned to businesses for investment (as it did in the 18th and 19th century). However, the Federal Reserve controls the money supply, and herein lies the problem. The Fed and other central banks have the ability to create money (savings) out of thin air. The Fed then lets entrepreneurs access this "savings" to complete their investment projects when they misjudge the real savings available.

Now, I know you're asking: What's so bad about that? The project is completed and we benefit from increased capital, right?

Wrong. This "easy money" policy actually tricks entrepreneurs into engaging in long term investments where the resources are not necessarily available for them to complete the project. Think of Crusoe's second scenario where he ran out of palm leaves. Entrepreneurs need real physical goods available to complete investment projects just like Crusoe needed the palm leaves. By creating money out of thin air and driving down interest rates, the Federal Reserve incentivizes investors to engage in long term projects or investments. The illusion is created that sufficient savings are available to fund investments. As the project matures, the investors soon find out the real resources that needed to be saved (lumber, steel, bricks, oil, trucks, or what have you) are not actually available to complete their project. The drain on available resources and eventual abandonment of investment projects is what causes the economy to come to a grinding halt.

Conclusion

The Austrian Business Cycle Theory describes this whole process as a "boom and bust cycle." During the boom phase, "easy money" is printed by the Federal Reserve and interest rates drop. This signals to investors that enough money and resources have been saved by the economy as a whole to complete large, long-term projects. The bust comes when entrepreneurs realize their errors in judgment and withdraw from their investment projects. 

Real savings are destroyed just as Crusoe's berry stash was depleted. Available goods are misallocated just as Crusoe's palm branches were wasted on his half complete basket. And, most unfortunate of all, everyone is worse off afterwards. The antithesis of sound investment has occurred. All thanks be to the Federal Reserve and other Central Banks around the world. Since the early 20th century, things have gone terribly, terribly, terribly wrong.



**If you've enjoyed any of my posts, I'd love to meet you on Twitter.**
**If you enjoyed this post in particular, please consider sharing it on Facebook or Twitter below**

Picking Up Where I Left Off, 3.0

Here is the final installation of "Picking Up Where I Left Off." Using Kollin's emails has really helped me get back on track. I hope everyone enjoys this last one, and a special thanks to Kollin for always making me think about really tough questions.

Kollin:
http://mises.org/daily/6674/The-High-Price-of-Delaying-the-Default

Interested to see when you think this collapse might happen, in what physical way, and how it could be averted or at least prepared for by the individual. Might be over your head but thought you might have some ideas.

I think it's undeniable to say that at some point fiat currency will be worthless.

Brad:

I agree with you. It's undeniable that inflation (maybe German-style hyperinflation) will render fiat currencies worthless.

Timing wise, I believe the economy will have to suffer a few more bubbles bursting and a few more fed bailouts before we see any outrageous inflationary numbers. The reason being the US economy is so insulated against inflation because of our fore-fathers' great prudence and accumulation of hard capital assets. Any other country with less capital assets - practicing the Federal Reserve's printing levels - would surely have fallen long ago (think Greece, Crete, Italy, and other EU countries suffering from massive unemployment and inflation at the same time).

The manifestation of the Fed's current policy will be seen in more bubbles inflating and bursting, more tax-payer funded bailouts for "too-big-to-fail" companies, and a creeping erosion of our capital base and production abilities. The prices of oil, gold, and the Producer's Price Index will continue to climb and eventually skyrocket (all three are indicators of the coming inflation because the highest orders of production goods suffer from inflation first).

How can we prepare for it? Personally, I buy about $100 worth of silver every two to four weeks. If I had more money saved up I would keep about 1 year's worth of expenses in cash, invest about 10-20% of the remaining in gold, silver, platinum, and palladium, and diversify the rest into companies that own hard assets (mining companies that have both land and equipment being a good example). Avoid .coms like Facebook and Twitter like the plague. Peter Schiff did a great piece on the Tom Woods Show I'll link to below.

Here's some articles I've read in the past that helped me come up with my answers. I hope this helps!!! Thanks for the questions. I always enjoy our conversations.

http://mises.org/daily/6340/Where-Is-the-Inflation

http://mises.org/daily/6484/

http://mises.org/daily/6617/We-Will-Be-Told-Hyperinflation-is-Necessary-Proper-Patriotic-and-Ethical

http://www.schiffradio.com/pg/jsp/verticals/archive.jsp?dispid=310&pid=63826

Picking Up Where I Left Off, Vol. 2.1

Photo of the north bridge at Lake Brownwood, pre-draught conditions

In Vol. 2, Kollin and I discussed libertarian ideas on conservationism and environmentalism. A recent Mises Daily does a great job of explaining what I was glossing over: Government monopolies and mandates on natural resources actually deplete (not conserve) natural resources.

Private ownership of lakes, rivers, and streams is the only way to create true market prices for correct allocation of any good or service - especially a resource as precious as water.

Below I have compiled a reading list on libertarian conservationism. If you're interested in finding more, visit Mises.org or LewRockwell.com and search their archives.

On water allocation:

Chris Brown, "The Water Wizards of Oz"

Kathryn Muratore, "Government Water and Drought in California"

Murray Rothbard, "Water Shortage?"

Murray Rothbard, "Who Owns Water?"

William Anderson, "The Economics of Water in the West"

Ryan McMaken, "Water Shortages and Subsidies in the American West"

On deforestation:

William L. Anderson, "Fires of the Feds: How the Government Has Destroyed Forests"

Timothy D. Terrell, "What Evangelical Environmentalists Do Not Know About Economics"

Fernando Chiocca, "Who Owns the Amazon?"

A long read by Rothbard building a theoretical foundation for Austro-libertarian environmentalism

"Law, Property Rights, and Air Pollution"

My Take on Ukraine

Consider this: 100,000 political dissenters stormed Kiev, Ukraine in protest, burning buildings, looting private property, flipping cars, and causing total civil unrest. That's 100,000 people in a country of over 45 million!

After the riots started, the Russian government released an audio recording of a phone call between Victoria Nuland (U.S. Assistant Secretary of State) and Geoffrey Pyatt (U.S. Ambassador to Ukraine) confirming the U.S. government’s involvement in the insurrection and regime change in the Ukraine. Referencing the EU’s lack of urgency in facilitating the coup, Nuland said “F**k the EU.”

“Shortly after “Ukraine-gate” broke, Sergei Glazyev, advisor to Russian president Putin claimed that the US was spending $20 million per week on the Ukrainian opposition, including supplying opposition with training and weapons.” –Daniel McAdams, Ron Paul Institute, via LewRockwell.com

In the aftermath of this embarrassing episode in U.S. foreign folly, President Obama issued a statement that any use of force against the protestors in Kiev would be met with a U.S. military reaction similar to Lybia.

So, let’s review: The U.S. government is caught red-handed funding, facilitating, and cheering on 100,000 protestors (in a country of 45 million) attempting the coup of a democratically elected president in a country 4,864 miles away from Washington, D.C. If President Yanukovych does anything to defend Ukraine’s capital city from inevitable destruction, Obama promises retaliation including – but not limited to – U.S. missile strikes.

Now, let’s put this shoe on the other foot. 

Imagine 100,000 Republican protestors stormed the streets of Washington D.C. after Obama’s election in 2008. The Republican’s are heavily armed, well trained, and professionally organized because of funding from the Japanese government. The Japanese government informs Obama that if he attempts to quell the riots with military force, Japan will launch missiles at the "aggressing" U.S. military forces. Canada decides to throw their support behind the democratically elected Obama and also draws condemnation and threats of war from Japan.

Three obvious questions arise here: 

1. Why can’t President Obama protect the capital from the protestors? 
2. Why is Japan even involved in American domestic policy? They’re on the opposite side of the Earth! And,
3. Why is Canada’s involvement in it’s nearest neighbor and closest ally’s domestic affairs any business of Japan?

Now let’s pose the same questions using the real situation instead of the hypothetical: 

1. Why can’t President Yanukovych stop a handful of rebels from burning the Ukraine’s capital city to the ground? 
2. Why is America involved in Ukrainian domestic affairs? The U.S. is located 4,800 miles away! And,
3. Why is Russia’s involvement in it’s nearest neighbor and ally’s domestic affairs any business of the U.S. government?

To answer these two sets of questions with any consistency would challenge the average American's worldview a great deal. 

Why are the united States allowed to treat other countries differently than they would want to be treated?

My answer: They're not.

Picking Up Where I Left Off, Vol. 2

I just watched Tarantino's "Kill Bill" movies, so I decided to include a little homage to that in the title this week.

Here's another one of my email correspondences with Kollin. He asked me what I thought about eminent domain and capitalists exhausting resources. I replied with a few articles and my thoughts on the subject. Please take the time to read the Mises Daily on endangered species I hyperlinked in my reply. Its a really great read, especially if you're a self-described environmentalists or into conservation, ecology, or biology.

One of the most common arguments against libertarianism and capitalism is: "The greedy capitalists are going to pollute our drinking water and chop down all our forests if the government doesn't put into place some kind of regulations!!!" I'm here to tell you, that argument couldn't be more false.

Kollin:

Had a random thought...

Does the government have a right to interfere in the free market if people are exhausting resources? Such as parks and wildlife preservation. You could say that the free market would take care of it and private preservationist groups would do the work the government has done/does, but surely they wouldn't do it as effectively as a government mandate that says "do not kill this animal" or "do not chop down trees here."
Or is the government justified in their actions in these specific examples through the eminent domain concept?

Brad:

A couple thoughts come to mind here. First, private property rights almost always create responsibility for resources. If a land owner chops down all his trees for lumber sales without replanting or harvests all his deer in one season without allowing them to mate, then he loses all future profits from the scarce resources. For the landowner's land to remain profitable, he must refrain from exhausting all his natural resources. Most misuse of land and resources stem from a lack of private ownership of land, rivers, lakes, etc. (Rothbard on pollution)

Secondly, the government mandate stating "do not kill this animal" often incentivizes poaching by increasing the price paid for the animal on the black market (Endangered Species, Private Property, and the American Bison). Indirectly, the government mandate actually increases demand and "subsidizes" poachers.

Also, Murray Rothbard has a great chapter on this whole issue in "For A New Liberty." In chapter 13 - Conservation, Ecology, and Growth - he spells out much more succinctly than I ever could the benefit the free market and private property rights have on conservation. I think it'll probably answer all your questions and more.

Kollin:

Those are some good points I hadn't thought of. And I think you're probably right that private businesses would have their own best interest at hand to conserve resources. It seems sometimes, however, that industries simply want to keep up with demand until demand is exhausted (and so are the resources). I think of fur trappers or buffalo hunters in the 18th and 19th centuries. They trapped and trapped and trapped until the beavers (or buffalo) were near extinct. I could see oil companies doing the same thing if they were allowed to drill unregulated in parts of the continental U.S.


And unlike manufacturing (such as toys, clothes, etc.), you don't get "do-overs" once a natural resource is completely exhausted. Although on the same line of thinking, if a natural resource were exhausted, there would be a demand for innovation which would inevitably be met by someone on the free market, I suppose.

Postscript reply by me:

(I never replied to Kollin's last email, but I'll try here)
The fur trapper and buffalo question is answered very well in the aforementioned Mises Daily. Oil, however, is not a renewable resource, thus cannot be considered alongside beavers and buffalo. Drilling oil until the supply is exhausted would lower the price for the consumers. Then, new energy resources and drilling procedures (sugar-based ethanol, biofuels, and fracture drilling) would emerge on the market via free-market innovations. The government regulation limiting oil production benefits large oil companies by NOT flooding the market with an excess of oil. This only harms consumers and is exactly what stifles innovation in new fuels.


I hope everyone is enjoying my attempts at blogging. I've still yet to receive one comment on any of my blogs. I'd really like to hear y'all's take on anything I write, so please don't hesitate to comment. If any questions come to mind that aren't answered above then please ask them. I'd love to research the questions and try to find a good answer.