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
IVAN AND THE BRICKYARD Five houses could have been built had the master-builder 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.
IVAN AND THE BRICKYARD 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.