Can We Eliminate the Boom/Bust Cycle?

Land value tax is the one tax to which the Laffer Curve does not apply. Arthur Laffer?

(Note: we've been unable to find any documentation
for this remark that has been attributed to Arthur Laffer.
Wish we could, though, because it is a good and true one! L.D.)

Up to now we have had a whole Economics course without a single supply-and-demand chart. Alas, for those of your who've found that refreshing! We'll eschew them no longer. In this section we analyze the boom/bust cycle by means of the squirming-about of lines on that icon of Neoclassical economics, the Aggregate Supply and Demand Chart.

A supply-and-demand chart is merely a picture of basic relationships. We observe that

  1. When things are costing less, buyers tend to want more of them.
  2. When things are selling for more, sellers try to bring more of them to market.
  3. Markets tend to move toward an equilibrium point, at which buyers want to buy just as many things as sellers want to sell.
  4. When buyers suddenly want a lot more things, existing resources get used to capacity, and past that point, it costs a lot more to produce them.

The supply-and-demand chart depicts the dynamic interaction of those four forces. This is true of the microeconomic chart, which tracks the market behavior of a single good as well as the macroeconomic, or aggregate supply-and-demand chart, which looks at prices and output for the whole economy. [Click here for more on Micro vs. Macro charts]

Why are the curves shaped this way?

The aggregate demand curve is easy: it goes down (AD for always down). Why? The axes of the graph are labeled Q for Quantity and P for Price. The Demand curve shows the quantity demanded at any given price. For example, when the price is relatively high, a smaller quantity is demanded so the demand curve slopes smoothly downward. It is smooth because we are exercising the economist's prerogative of "all else being equal". We're simply showing the relationship of quantity demanded to price. For the Aggregate Demand Curve, "all other variables" get averaged out into a smooth curve depicting overall demand for goods and services (at a given point in time).

The Supply curve shows the quantity supplied at any given price level. For a time, it slopes upward. Although prices are rising across the board, prices for commodities are often more elastic than the costs of producing them (nominal wages, for example, will probably be sticky and take some time to follow the general inflationary trend). That means that for a time, as prices rise, producers will want to supply more goods. Its shape, however, is not smooth; it has a kink. Why? Up to a certain point, increased demand will be met with very small increases in price; this is because producers are not yet operating at full capacity, and it doesn't cost much more to simply crank out more things. But, when the cost of the factors of production rises to the same level as the price of goods, then producers cannot produce more without raising prices more rapidly. At that point, the AS curve turns sharply upward.

In this exercise in which the charts depict the whole economy the P axis of the graph is the general price level, as measured by an index such as the Consumer Price Index (CPI), and the Q axis is the overall output of goods and services, on a measure of total output such as the Gross Domestic Product (GDP). Aggregate supply and demand curves can shift due to various forces that affect the overall economy everything from oil price shocks to new consumer fads to rumors of war. The way in which these curves shift can help us to understand what is happening or might happen in the economy.

Now, let's look at some ways in which events can shift the curves around, and what those shifting lines signify in the real world.

Scenario 1: Good Times

Choose: (1), (2), (original)
People have jobs; they're making good money. Houses are being built and parents are buying their kids lots of Christmas presents. People want more stuff, and they're willing to pay for it, so the Demand curve
shifts upward. Note the new point of equilibrium: prices have increased, but modestly; output has increased by a greater proportion.

Scenario 2: Good Times Start to Overheat

Demand continues to be strong, shifting the Demand curve past that kink in the Aggregate Supply curve! In other words, the eqilibrium point has shifted past that point that economsts call potential output. When they try to meet this higher level of demand, producers' costs increase sharply. Now, prices are increasing more rapidly than output. We may be heading into an inflationary spiral, one of the type known as demand-pull inflation.

Choose: (3), (original)

Scenario 3: The Supply Shock

Here, a relatively sudden increase in the cost of some widely-need material or resource causes an increase in overall production costs. This time, the Supply curve shifts upward things cost more to produce at any level of demand. Look what has happened to the equilibrium point! Prices have risen even as output has fallen. This is the condition commonly called stagflation and the associated inflation is termed cost-push inflation. (The high oil prices associated with the Arab oil embargo of the early 70s is the classic example of this phenomenon. But, any factor could produce this effect. For example, a sudden doubling of the Federal minimum wage all else being equal could cause a supply shock!)

Choose:(4), (5), (original)

Scenarios 4 & 5: Are there Good Supply Shocks?!

It is worth mentioning that now and then things can come along that shift the Aggregate Supply curve in beneficial ways. We would experience a positive supply shock if some widely-needed resource suddenly got less expensive if we were to find a huge new deposit of easily recoverable oil, for example, or if high-temperature superconductors were to make electricity drastically cheaper. That would shift the AS curve downward, lowering production costs at every level of demand.

There could also be a widespread increase in productivity, allowing us to increase output by getting more production out of existing resources. Such a productivity increase like that caused by the explosion of information technology in the 1990s could shift the AS curve to the right. Here, output can rise much more than before, without surging past the potential output point and triggering inflation.

Scenarios 6 & 7: Gloom and Doom

Choose: (6), (7), (original)
But: if the (bad) supply shock comes at a time when Boom Times are already pushing prices too far up the curve, price levels
increase precipitously with little or no increase in output.

It is also possible for there to be a decline in productivity, shifting the AS curve to the left and making matters even worse. What would cause such a thing? A mis-use of existing resources. Perhaps the labor force turns out to be educationally unsuited to making productive use of new technology. Or, perhaps social strife, caused by racial or class conflict, wastes the productive energy of workers.

This is not a picture that macro-economic planners would want to see. Neither alternative inflation or recession has much to recommend it. At this point, output cannot increase without prices going up much faster and, production would have to fall quite a lot before we would achieve much of a reduction in price levels. [What macroeconomic tools are used in the attempt to stave off this dreadful state of affairs?]

Inflation and Unemployment

The economy depicted above is headed either for galloping inflation, or much more likely in a modern industrial economy a recession. Demand declines, output declines, causing further lowering of demand, causing less output... Much of the pain of this process is illustrated on our chart for we note that output will have to decline quite a lot before prices ease back significantly. It would certainly be nice wouldn't it? if some sort of benevolent supply shock would step in and help things along...

The point at which the AS curve starts to ascend steeply is termed the potential output of the economy. That term is slightly misleading, however because the economy is quite capable of producing more goods and services than that. If it does so, however, it will have to contend with higher prices. Potential output, then, is not "the most we can produce" but rather the highest level of output at which there is not an unacceptably rapid increase in prices. Another similarly misleading term for this is full employment: the highest level of unemployment that can be sustained without too high a rate of inflation. The rate of unemployed workers designated as "full employment" is revised periodically by government beancounters, usually upward. It is a difficult figure to quantify, for there are various conceptions of which workers are or are not part of the labor force, but in a period of "full employment", at least three to five per cent of the labor force is unemployed. This was the case right through the booming 1990s.

We might wonder why everyone can't find a job at a time when demand is robust and inflation is low. Clearly, all the desires of all the consumers have not been satisfied; there are still things that people could be hired to do. Yet, if that last four or five per cent got work, we'd run into that kink in the AS curve and prices would rocket upward! But why? In the 1990s, for example, we haven't seen any precipitous increase in wages that would create a suppply shock and technological improvements, along with international trade, have lowered production costs so what is it that would make costs go up? Something must be soaking up those increases in output and retarding productivity growth. Something must be going up in price a lot faster than the overall rate of inflation.

Enter Henry George's theory of the business cycle which, though it has never been refuted, is resolutely ignored in most of today's discussions of the subject. George observed that one of the factors that is absolutely necessary for all production land has an inherent tendency to rise in price, faster and faster, as the economy grows. When we think about what land is, the reason for this becomes clear. The quantity of land (the stock of locations and natural resources) is fixed. Its supply cannot increase. Therefore, when demand for land increases, its price must go up. Investors see this tendency, and they buy land, withholding it from use in order to take advantage of its increased value in the future. In every booming economy we see the prices of land, housing and rents increase far more rapidly than the overall rate of inflation.

In effect, land speculation creates a built-in supply shock, that kicks in as economic output increases! This is a systemic retardation of the economy. It operates as long as there is land speculation, creating an underlying tendency toward inflation or recession. So is land speculation always the cause of economic downturns? By George, it is! There are any number of contributing causes; things like oil price shocks, consumer confidence crises, international trade fluctuations, natural disasters but none of these things creates the underlying weakness. They may be likened to a straw that breaks the camel's back! [Here's how Henry George put it.]

Land speculation retards the economy in two ways. It increases production costs by making land in general more expensive (shifting the AS curve upward) as well as decreasing productivity by denying access to the best locations, shifting the AS curve to the left and lowering "potential output". (In the same process, it also exacerbates sprawl, pollution, and waste of all sorts.) In short, the "gloom & doom" tendencies of scenario #5 do not represent some sort of rare calamity of history. They are the normal state of affairs.

Eliminating Land Speculation

The Georgist remedy, which came to be known as the "Single Tax", aims to remove the underlying problem that causes the boom/bust cycle. It would collect for public revenue the rental value of all land and natural opportunities, and simultaneously abolish all taxes on labor, production and commerce. The reform would have profound benefits:

Move your mouse over the chart

Henry George's analysis of poltical economy shows that the dual burdens of land speculation and taxes on production are not necessary, but rather are impositions on civilization that benefit privileged interests at the expense of the general good. Removing these huge weights from our economy would eliminate our having to settle for a dismal trade between inflation and unemployment.

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