Austrian business cycle theory
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The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics concerning how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit, due to an artificially low market rate of interest. The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.
Proponents believe that a sustained period of low interest rates and excessive credit creation result in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. It is argued that this leads to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit-sourced boom results in widespread malinvestment. In the theory, a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when the credit creation has run its course. Then the money supply contracts, causing resources to be reallocated back towards their former uses.
Austrian business cycle theory states that distortions in the availability of credit are the cause of business cycles. A modern presentation of this theory can be found in the book "Time and Money" by Roger Garrison, which presents a graphical framework for capital-based macroeconomics and offers a critique of Keynesian graphical analysis.
The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists.
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According to the theory, the boom-bust cycle of "malinvestment" is generated by unsustainable credit expansion to businesses by the banks. Interest rates are lowered, and as a result entrepreneurs invest in more roundabout, "longer process of production". Borrowers take their newly acquired funds and purchase new capital goods, thereby causing a shift of investment from consumer goods to capital goods industries. Austrian economists further contend that such a shift is unsustainable and must reverse itself in due course. Proponents of the theory conclude that the longer the unsustainable shift in capital goods industries continues, the more violent and disruptive the necessary re-adjustment process. While agreeing with economist Tyler Cowen, Bryan Caplan has stated that he also denies "that the artificially stimulated investments have any tendency to become malinvestments".
Austrians argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. According to Mises's work, the artificial stimulus caused by bank lending causes a generalized speculative investment bubble which is not justified by the long-term factors of the market.[not specific enough to verify]
Mises wrote that a "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. Mises conjectured that the "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires.[not specific enough to verify]
Austrians argue that continually expanding bank credit can keep the borrowers one step ahead of consumer retribution (with the help of successively lower interest rates from the central bank). In the theory, this postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices.
Austrians argue that the monetary boom ends when bank credit expansion finally stops – when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. They further argue that the longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures, and depression readjustment.[not specific enough to verify]
Austrian business cycle theory does not argue that fiscal restraint or "austerity" will necessarily affect economic growth. Rather, they argue that all attempts by central governments to prop up asset prices, bail out insolvent banks, or "stimulate" the economy with deficit spending will only make the misallocations and malinvestments worse, prolonging the depression and adjustment necessary to return to stable growth. Austrians argue the policy error rests in the government's (and central bank's) weakness or negligence in allowing the "false" unsustainable credit-fueled boom to begin in the first place, not in having it end with fiscal and monetary "austerity". Debt liquidation is therefore the only solution to a debt-fueled problem.
According to Ludwig von Mises:
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
The role of central banks
Austrians generally argue that inherently damaging and ineffective central bank policies, including unsustainable expansion of bank credit through fractional reserve banking, are the predominant cause of most business cycles, as they tend to set artificial interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles", and artificially low savings. Under fiat monetary systems, a central bank creates new money when it lends to member banks, and this money is multiplied many times over through the money creation process of the private banks. This new bank-created money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.
A similar theory appeared in the last few pages of Mises's The Theory of Money and Credit (1912). This early development of Austrian business cycle theory was a direct manifestation of Mises's rejection of the concept of neutral money and emerged as an almost incidental by-product of his exploration of the theory of banking. David Laidler has observed in a chapter on the theory that the origins lie in the ideas of Knut Wicksell.
Nobel laureate Hayek's presentation of the theory in the 1930s was criticized by many economists, including John Maynard Keynes, Piero Sraffa, and Nicholas Kaldor. In 1932, Piero Sraffa argued that Hayek's theory did not explain why "forced savings" induced by inflation would generate investments in capital that were inherently less sustainable than those induced by voluntary savings. Sraffa also argued that Hayek's theory failed to define a single "natural" rate of interest that might prevent a period of growth from leading to a crisis. Others who responded critically to Hayek's work on the business cycle included John Hicks, Frank Knight, and Gunnar Myrdal. Hayek reformulated his theory in response to those objections.
Austrian economist Roger Garrison explains the origins of the theory:
Grounded in the economic theory set out in Carl Menger's Principles of Economics and built on the vision of a capital-using production process developed in Eugen von Böhm-Bawerk's Capital and Interest, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Mises's Theory of Money and Credit and in subsequent exposition and extension in F. A. Hayek's Prices and Production, the theory incorporated important elements from Swedish and British economics. Knut Wicksell's Interest and Prices, which showed how prices respond to a discrepancy between the bank rate and the real rate of interest, provided the basis for the Austrian account of the misallocation of capital during the boom. The market process that eventually reveals the intertemporal misallocation and turns boom into bust resembles an analogous process described by the British Currency School, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specie flow.
Ludwig von Mises and Friedrich Hayek were two of the few economists who gave warning of a major economic crisis before the great crash of 1929. In February 1929, Hayek warned that a coming financial crisis was an unavoidable consequence of reckless monetary expansion.
Austrian School economist Peter J. Boettke argues that the Federal Reserve is presently making a mistake of not allowing consumer prices to fall. According to him, Fed's policy of reducing interest rates to below-market-level when there was a chance of deflation in the early 2000s together with government policy of subsidizing homeownership resulted in unwanted asset inflation. Financial institutions leveraged up to increase their returns in the environment of below market interest rates. Boettke further argues that government regulation through credit rating agencies enabled financial institutions to act irresponsibly and invest in securities that would perform only if the prices in the housing market continued to rise. However, once the interest rates went back up to the market level, prices in the housing market began to fall and soon afterwards financial crisis ensued. Boettke attributes failure to policy makers who assumed that they had the necessary knowledge to make positive interventions in the economy. The Austrian School view is that government attempts to influence markets prolong the process of needed adjustment and reallocation of resources to more productive uses. In this view bailouts serve only to distribute wealth to the well-connected, while long-term costs are borne out by the majority of the ill-informed public.
Economist Steve H. Hanke identifies the 2007–2010 Global Financial Crises as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by the Austrian business cycle theory. Some analysts such as Jerry Tempelman have also argued that the predictive and explanatory power of ABCT in relation to the Global Financial Crisis has reaffirmed its status and perhaps cast into question the utility of mainstream theories and critiques.
Empirical research by economists regarding the accuracy of the Austrian business cycle theory has generated disparate conclusions, though most research within mainstream economics regarding the theory concludes that the theory is inconsistent with empirical evidence. In 1969, Friedman argued that the theory is not consistent with empirical evidence and using newer data in 1993 reached the same conclusion. However, in 2001, Austrian economist James P. Keeler argued that the theory is consistent with empirical evidence In a 1998 interview, Friedman summarized his view of the Austrian Business Cycle Theory:
- "I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm."
According to most economic historians, economies have experienced less severe boom-bust cycles after World War II, because governments have addressed the problem of economic recessions. Many argued, prior to the events of 2008, that this has especially been true since the 1980s because central banks were granted more independence and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation.
Reactions of economists and policymakers
According to Nicholas Kaldor, Hayek's work on the Austrian business cycle theory had at first "fascinated the academic world of economists," but attempts to fill in the gaps in theory led to the gaps appearing "larger, instead of smaller," until ultimately "one was driven to the conclusion that the basic hypothesis of the theory, that scarcity of capital causes crises, must be wrong."
Lionel Robbins, who had embraced the Austrian theory of the business cycle in The Great Depression (1934), later regretted having written that book and accepted many of the Keynesian counterarguments.
When, in 1937, the League of Nations examined the causes of and solutions to business cycles, the Austrian business cycle theory alongside the Keynesian and Marxian theory were the three main theories examined.
The Austrian theory is considered one of the precursors to the modern credit cycle theory, which is emphasized by Post-Keynesian economists, economists at the Bank for International Settlements. These two emphasize asymmetric information and agency problems. Henry George, another precursor, emphasized the negative impact of speculative increases in the value of land, which places a heavy burden of mortgage payments on consumers and companies.
In 2003 Barry Eichengreen laid out a credit boom theory as a cycle in which loans increase as the economy expands, particularly where regulation is weak, and through these loans money supply increases. Inflation remains low, however, because of either a pegged exchange rate or a supply shock, and thus the central bank does not tighten credit and money. Increasingly speculative loans are made as diminishing returns lead to reduced yields. Eventually inflation begins or the economy slows, and when asset prices decline, a bubble is pricked which encourages a macroeconomic bust.
In 2006 William White argued that "financial liberalization has increased the likelihood of boom-bust cycles of the Austrian sort" and he has later argued the "near complete dominance of Keynesian economics in the post-world war II era". While White conceded that the status quo policy had been successful in reducing the impacts of busts, he commented that the view on inflation should perhaps be longer term and that the excesses of the time seemed dangerous. In addition, White believes that the Austrian explanation of the business cycle might be relevant once again in an environment of excessively low interest rates. According to the theory, a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.
Related policy proposals
Economists Jeffrey Herbener, Joseph Salerno, Peter G. Klein and John P. Cochran  have testified before Congressional Committee about the beneficial results of moving to either a free banking system or a free Full-reserve banking system based on commodity money based on insights from Austrian business cycle theory.
According to John Quiggin, most economists believe that the Austrian business cycle theory is incorrect because of its incompleteness and other problems.[further explanation needed] Economists such as Gottfried von Haberler, Milton Friedman, Gordon Tullock, Bryan Caplan, and Paul Krugman have argued that the theory is incorrect.
Some economists argue that the Austrian business cycle theory requires bankers and investors to exhibit a kind of irrationality, because their theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates. In response, historian Thomas Woods argues that few bankers and investors are familiar enough with the Austrian business cycle theory to consistently make sound investment decisions. Austrian economists Anthony Carilli and Gregory Dempster argue that a banker or firm loses market share if it does not borrow or loan at a magnitude consistent with current interest rates, regardless of whether rates are below their natural levels. Thus businesses are forced to operate as though rates were set appropriately, because the consequence of a single entity deviating would be a loss of business. Austrian economist Robert Murphy argues that it is difficult for bankers and investors to make sound business choices because they cannot know what the interest rate would be if it were set by the market. Austrian economist Sean Rosenthal argues that widespread knowledge of the Austrian business cycle theory increases the amount of malinvestment during periods of artificially low interest rates.
Economist Paul Krugman has argued that the theory cannot explain changes in unemployment over the business cycle. Austrian business cycle theory postulates that business cycles are caused by the misallocation of resources from consumption to investment during "booms", and out of investment during "busts". Krugman argues that because total spending is equal to total income in an economy, the theory implies that the reallocation of resources during "busts" would increase employment in consumption industries, whereas in reality, spending declines in all sectors of an economy during recessions. He also argues that according to the theory the initial "booms" would also cause resource reallocation, which implies an increase in unemployment during booms as well. In response, Austrian economist David Gordon argues that Krugman's argument is dependent on a misrepresentation of the theory. He furthermore argues that prices on consumption goods may go up as a result of the investment bust, which could mean that the amount spent on consumption could increase even though the quantity of goods consumed has not. Furthermore, Roger Garrison argues that a false boom caused by artificially low interest rates would cause a boom in consumption goods as well as investment goods (with a decrease in "middle goods"), thus explaining the jump in unemployment at the end of a boom. Many Austrians also argue that capital allocated to investment goods cannot be quickly augmented to create consumption goods.
Economist Jeffery Hummel is critical of Hayek's explanation of labor asymmetry in booms and busts. He argues that Hayek makes peculiar assumptions about demand curves for labor in his explanation of how a decrease in investment spending creates unemployment. He also argues that the labor asymmetry can be explained in terms of a change in real wages, but this explanation fails to explain the business cycle in terms of resource allocation.
Hummel argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he notes that investment spending remained positive in all recessions where there are data, except for the Great Depression. He argues that this casts doubt on the notion that recessions are caused by a reallocation of resources from industrial production to consumption, since he argues that the Austrian business cycle theory implies that net investment should be below zero during recessions. In response, Austrian economist Walter Block argues that the misallocation during booms does not preclude the possibility of demand increasing overall.
In 1969, economist Milton Friedman, after examining the history of business cycles in the U.S., concluded that "The Hayek–Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false." He analyzed the issue using newer data in 1993, and again reached the same conclusion. Economist Jesus Huerta de Soto claims that Friedman has not proven his conclusion because he focuses on the contraction of GDP being as high as the previous contraction, but that the theory "establishes a correlation between credit expansion, microeconomic malinvestment and recession, not between economic expansion and recession, both of which are measured by an aggregate (GDP)" and that the empirical record shows strong correlation.
Referring to Friedman's discussion of the business cycle, Austrian economist Roger Garrison stated, "Friedman's empirical findings are broadly consistent with both Monetarist and Austrian views," and goes on to argue that although Friedman's model "describes the economy's performance at the highest level of aggregation; Austrian theory offers an insightful account of the market process that might underlie those aggregates."
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