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.



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