Transcript Ivan and the Brickyard

IVAN AND THE BRICKYARD
The old Soviet-style brickyard knows no markets and
knows no prices. It serves only as a keeper of the bricks.
The housing czar asks the brick czar how many houses
can be built. The brick czar sends Ivan to the brickyard to
count the bricks.
Ivan’s count is overly optimistic: “Enough bricks to build
six houses.” (Five may be a more realistic number.)
The housing czar informs the master-builder, who then
sets his workers to the task: two rows of three houses
each.
IVAN AND THE BRICKYARD
The situation is summed up by Ludwig von Mises:
“[Consider] the position of a master-builder whose
task it is to erect a building out of a limited supply of
building materials.
“If this man overestimates the quantity of the available
supply, he drafts a plan [that cannot be carried to
completion because] the means at his disposal are not
sufficient.
IVAN AND THE BRICKYARD
“He oversizes the groundwork and the foundation and
only discovers later in the progress of the construction
that he lacks the materials needed for the completion
of the structure.
“It is obvious that our master-builder’s fault was not
overinvestment, but an inappropriate employment of
the means at his disposal.”
LUDWIG VON MISES, HUMAN ACTION, 3rd ed., p. 560
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Five houses could have been built had the masterbuilder set out to build just five. But in trying to build
six, he was forced into liquidating (dismantling
houses) owing to the lack of sufficient bricks.
Given the losses (broken bricks) that always
accompany liquidation, the master-builder, in the end,
could only complete four houses.
And so we have it: Boom, bust, liquidation, and
(partial) recovery.
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The supply of bricks is given. It is represented
by a vertical supply curve.
If the bricks were sold rather than allocated by
the housing czar, the demand for bricks would
determine the market price.
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If we allow for incentives to govern both sides
of the brick market, then the supply of bricks is
upward-sloping.
With supply and demand fully in play, the
market coordinates buying and selling and gives
us and equilibrium price and quantity.
IVAN AND THE BRICKYARD
We can generalize from bricks to investable resources
and let our supply and demand depict the financial
markets that mobilize those resources. The quantity
axis shows saving (supply) and investment (demand).
The “i” on the vertical axis stands for “Ivan”--a.k.a.
the interest rate.
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At the equilibrium rate of interest, saving equals
investment. Loanable funds supplied equals
loanable funds demanded. The amount of
investable resources supplied equals the amount
demanded.
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The supply of loanable funds reflects people’s
inclination to save. This inclination--i.e., their
savings preferences--can change. People may decide
to save more--possibly for retirement or to finance
their children’s education.
IVAN AND THE BRICKYARD
Saving more is depicted by a rightward shift in the
supply of loanable funds. With more funds available
at 5% than are demanded by the investment
community, the interest rate is bid down--to 2.3%
where, once again, saving equals investment. The
economy grows more rapidly than before.
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Without an increase in the supply of loanable funds,
the economy’s growth rate is set by the equilibrium
values of saving and investment: S = I = 800.
If monetary expansion pushs the economy to grow
faster, the increased growth rate is not sustainable.
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Pumping new money through credit markets has
some effects that, initially, are similar to the effects
of increased saving. The interest rate decreases.
Investment increases. But the increased investment is
accompanied by increased consumption. It is not
funded by genuine saving.
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Genuine saving actually decreases. Which is to say,
consumption increases. In the story of Ivan and the
Brickyard, it is as if we were dealing not with bricks,
but with gingerbread: At the same time builders are
trying to build more gingerbread houses, the would-be
future occupants are eating more gingerbread.
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The conflict between (high levels of) investment and
(low levels of) saving is, for a time, masked by credit
creation. The change in the money supply is precisely
I - S. Eventually, the boom is revealed to be artificial
and the economy, short on bricks and shorter on
gingerbread, experiences a bust.
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