• Milton Friedman Society

Complexity and Business Cycles

By Renato Lembe Agurto

The failure of mainstream economists to timely anticipate the Great Recession of 2008 motivated young economists to explore alternative approaches to business cycles. One of the most popular and successful of these revived attempts is the Austrian Business Cycle Theory (ABCT), whose cornerstone is the Austrian Capital Theory mainly developed by Eugen von Böhm-Bawerk[1]. Although it is arguable to regard ABCT as incomplete when it comes to understand why crises happens, it seems to be beyond dispute that the Austrian capital-based approach does explain why crises are more likely to happen nowadays, or do happen more frequently than in previous centuries. This article is aimed at investigating one material cause of business cycles, one condition that makes them not only possible, but easier to be trigged: complexity.

Let us imagine a small bakery: from 7 am onwards, daily customers order their breakfast with bread. To support the latter’s demand, the bakery owner must decide whether he: (i) hires skilled barkers, (ii) buys ready-made bread, or (iii) a bit of both. The first choice, in relation to the others, is the least productive of all in terms of volume: each baker can produce a limited quantity only of bread dough per morning. On the contrary, the supply of ready-made bread is practically indefinite in the owner’s point of view, allowing him to sell as much bread as his ovens are capable of baking. The determinants of his choice are, on the one hand, the cost of making each unit available and, on the other hand, the revenues each combination of ready-made bread and bakers generates.

If wages[2] are considerably low, hiring bakers only may be the profit-maximizing decision, as lower unitary costs compensate for smaller volumes for sale. On the opposite scenario, buying ready-made bread only, transferring margins to suppliers, reduces profit rates by a smaller extent than paying salaries would.

From the economist perspective, the bakery owner is actually choosing the intensity of the division of labor, either lower when managing all cooking stages on his own, or higher when solely purchasing pre-made goods. Since Adam Smith’s Wealth of Nations, the positive correlation between productivity and division of labor is common sense among economists and non-economists alike. The fact that the bakery owner chooses to foster productivity in response to growing wages should sound hardly strange: when the cost of labor increases, businessmen are more fiercely motivated to employ it as productive as possible.

It is not just productivity, however, that increases with the division of labor. When the baker owner chooses to rely solely on ready-made bread, addition risks emerge: (i) the quality is not directly assured, (ii) the pricing power of transformation industry to pass-through costs is generally greater than that of supermarkets selling ingredients, (iii) timely adjustments of supply in relation to shifts in demand become more challenging when production is somewhere else.

Furthermore, the factors of production of ready-made bread are not limited to those of indoors baking, as the former must be stored and transported with idiosyncratic equipment. In the case of ready-made bread, the bakery owner relies on a greater number of people, which comprehends, besides bakers, logistics operators and equipment providers (not to mention all their input suppliers, such as those of aluminium, plastic, and gas).

In sum, as division of labor becomes more intense, productivity increases as well as complexity in the sense that businessmen, by depending on more productive agents (many unknown), are subjected to increasing risk and uncertainty. The probability of negative events and the scope of their impact increase accordingly, allowing individual failures to rebound at a social level. As far as I am concerned, Wilhelm Röpke is the only economist that paid serious attention to this, in his Crises and Cycles.

Now, let us remember: division of labor – and, thus, complexity – is motivated by high wages. But what caused wages to increase in first place? In modern economies, they may increase due to minimum wage adjustments. It is worth mentioning that, besides causing unskilled labor unemployment, minimum wage adjustments favor complexity and systemic fragility to negative shocks – a fact trade unions hardly take into consideration.

In addition, wages also increase due to capital accumulation. As private savings aim at interest income, they fund credit operations and equity injection which, in turn, foster direct and/or indirect employment, causing wages to rise. Assuming that capital accumulation is a natural inclination of market economies, the tendency towards increasing productivity is accompanied by increasing susceptibility to business cycles. In this specific sense, market economies bear an internal tension – or an internal contradiction, to use the Marxist jargon: wages, standards of living, and systemic fragility walk hand-in-hands.

Most of bureaucrats and academics believe that fierce regulation is the answer to complexity. This position, however, is unsustainable in theory and in history. On the one hand, as argued F. A. Hayek in his Road to Serfdom, increasing complexity substantially reduces the ability of regulators to anticipate the consequences of their actions. Thus, regulation tends to be ineffective in relation to the aimed goal, but harmful when it comes to unintended consequences. On the other hand, as Niall Ferguson put in his Great Degeneration, inadequate regulation (and not deregulation) is to blame for the crisis of 2008: while publicly owned banks were expressly allowed to operate in high leverage, governments provided monetary and market incentives for increasing credit risk taking.

In the end, market economies, with their increasing complexity, are structurally susceptible to crises and shocks. All bureaucrats can do about it is to prevent their policies to become themselves an additional source of complexity, or worse, an actual shock capable of trigging the cycle.

[1] Knut Wicksell provided a systematic exposition of Bawerk’s theory in his Value, Capital, and Rent.

[2] Let us think on real terms only.

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