In his attempt at explaining what business cycles are all about, Milton Friedman held that the economy’s output is bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. He attributed this contraction to various shocks.
He was of the view that economic contractions involve declines in the economy’s output below its full potential ceiling or maximum level.
Friedman held that similarly to a guitar string the harder the economy is plucked down the stronger it should come back.
In the Friedman’s plucking model, a large contraction in output follows by a large business expansion. A mild contraction, by a mild expansion.
Following the plucking model Friedman had also concluded that there appears to be no systematic connection between the magnitude of an economic expansion and the extent of the following economic contraction.
Various studies seem to have vindicated Friedman’s plucking model. On November 4, 2019, a Bloomberg article by Noah Smith titled “Milton Friedman Got Another Big Idea Right” referred to a study by Tara Sinclair that employed advanced mathematical techniques that appeared to confirm Friedman’s hypothesis that in the US large recessions are followed by strong recoveries – but not the other way around. According to Bloomberg, some other researchers obtained similar results for other countries.
On this way of thinking, views such as those presented by Ludwig von Mises and Murray Rothbard that the extent of an economic bust is related to the magnitude of the previous boom is false.
The main problem with the Friedman’s framework of thinking, however, is that it lacks the fundamental definition of what boom-bust cycles are all about. Note that a fundamental definition identifies the essence of the subject of analysis.
Boom-Bust Cycles and the Central Bank
To establish the fundamental definition of the boom-bust cycle phenomenon we must trace it back as to how this phenomenon had emerged.
According to Murray Rothbard,
Before the Industrial Revolution in approximately the late 18th century, there were no regularly recurring booms and depressions. There would be a sudden economic crisis whenever some king made war or confiscated the property of his subjects; but there was no sign of the peculiarly modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions.
The boom-bust cycle phenomena is somehow linked to the modern world. However, what is the link? The source of the recurrent boom-bust cycle turns out to be the alleged "protector" of the economy — the central bank itself.
The central bank's ongoing policies that are aimed at fixing the unintended consequences that arise from its earlier attempts at stabilizing the so-called economy are key factors behind the recurrent boom-bust cycles.
Fed policy makers regard themselves as being the responsible entity authorized to bring the so-called economy onto the path of stable economic growth and stable prices. (Policy makers decide what the “right” stable growth path should be).
Consequently, any deviation from the stable growth path sets the Fed’s response in terms of either a tighter or a looser stance.
These responses to the effects of previous policies on economic data give rise to the fluctuations in the growth rate of the money supply out of “thin air” and in turn to the recurrent boom-bust cycles. (Note that money out of “thin air” is the result of the central bank loose monetary policy).
Observe that loose central bank monetary policy, which results in an expansion of money supply out of “thin air” sets in motion an exchange of nothing for something, which amounts to a diversion of wealth from wealth-generating activities to non-wealth-generating activities.
In the process, this diversion weakens wealth generators, and this in turn weakens their ability to grow the overall pool of wealth.
The emergence of activities on the back of a loose monetary policy is what an economic "boom" is all about. Observe that these activities cannot stand on their “own feet”. These activities are also labelled as bubble activities.
Also note that once the central bank's pace of monetary expansion strengthens the pace of the diversion of wealth towards bubble activities also strengthens.
Once however, the central bank tightens its monetary stance, this slows down the diversion of wealth from wealth producers to bubble activities.
Bubble activities that sprang up on the back of the previous loose monetary policy are now getting less support; they fall into trouble — an economic bust emerges.
Strength of the Boom Determines the Strength of the Slump
Both Mises and Rothbard had shown that the economic boom dictates the strength of the following economic slump. Note that it is not possible to have an economic bust without the previous boom.
Observe that during the economic slump the liquidation of bubble activities that emerged during the previous boom is taking place. Note again that bubble activities emerged on the back of increases in the money supply out of “thin air”.
Hence, the more of such activities that were generated during the economic boom, the greater the cleansing of such activities is required in order to revitalize the economy – consequently the greater the economic recession is going to be.
So how then we are to respond to various sophisticated studies, which support Friedman’s plucking theory, that large recessions are following by stronger economic booms – but not the other way around?
Now, according to Friedman, definitions that are linked to the facts of reality are not the key for the acceptance of a model. What is required is the model’s ability to make accurate predictions.
Friedman wrote that,
The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
The reason for Friedman’s reliance on mathematical and statistical methods is to validate his model by means of these methods.
In short, Friedman’s method relies on “curve fitting” to prove his hypothesis that was derived from a guitar string analogy.
Note that without ascertaining the essence of the subject of investigation one could come up with all sorts of models, which could be “validated” by means of statistical and mathematical methods. This however, proves nothing. (By means of data torturing one can prove anything).
Observe again without ascertaining the essence of boom-bust cycles any so-called validation is of a questionable nature. Again, for Friedman anything goes as long as the model can make accurate predictions.
Given that Friedman did not define the essence of boom-bust cycles, it is questionable that his framework can establish the causes behind these cycles.
Consequently, Friedman’s conclusion that strong recessions precede strong booms and not the other way around is questionable.
Conclusions
Various studies that employed advance mathematical techniques have supposedly confirmed Milton Friedman’s hypothesis that strong economic recessions follow by strong economic booms. However, strong economic booms do not precede strong economic busts.
On this way of thinking, views such as those presented by Ludwig von Mises and Murray Rothbard that the extent of an economic bust is related to the magnitude of the previous boom is false.
Given that Friedman did not define the essence of boom-bust cycle phenomena his framework does not explain the causes of boom-bust cycles. The Friedman’s framework is about a “curve fitting” exercise in order to validate his hypothesis that was designed from a guitar string analogy. Consequently, Friedman’s conclusion that strong recessions precede strong booms and not the other way around is questionable.
We have shown that the economic boom is about the formation of bubble activities on account of loose monetary stance of the central bank. Whilst the economic bust, is the demise of bubble activities in response to the tighter monetary policies of the central bank. On this way of thinking the longer the boom is, the more severe the bust is going to be, since a larger number of bubble activities would have to be liquidated.
The central bank's ongoing policies that are aimed at fixing the unintended consequences that arise from its earlier attempts at stabilizing the so-called economy are key factors behind the recurrent boom-bust cycles.
