Austrian business cycle theory

The Austrian business cycle theory is the Austrian School's explanation of the phenomenon of business cycles (or "credit cycles"). Austrian economists assert that inherently damaging and ineffective central bank policies 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.

Low interest rates tend to stimulate borrowing from the banking system, which creates money via fractional reserve banking techniques. This expansion of credit causes inflation and expansion of the supply of money in a fiat monetary system. This in turn leads to an unsustainable "monetary boom" during which the "artificially" stimulated borrowing seeks out diminishing investment opportunities, resulting in widespread malinvestments, in turn causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable.

A correction – commonly called a "recession" or "bust" or "credit crunch"– occurs when credit creation cannot be sustained and markets "clear", allowing resources to be reallocated towards more efficient uses.

Origins

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 Ludwig von Mises' 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.

Questions

The Austrian theory of the business cycle attempts to answer the following questions about the business cycle:

• Why is there a sudden general cluster of business errors?
• Why do capital goods industries and asset markets fluctuate more widely than do the consumer goods industries?
• Why is there a general increase in the quantity of money in the economy during every boom, and why is there generally, though not universally, a fall in the money supply during the depression?

Theory

Austrian economists claim that, in the purely free and unhampered market where there was no central bank, there would be no sustained cluster of malinvestments or entrepreneurial errors, since astute entrepreneurs would not all make errors at the same time and would quickly take advantage of any temporary, isolated "mispricing" in a truly free marketplace.

Instead, they believe the "boom-bust" cycle of generalized malinvestment is generated by monetary intervention in the market - specifically, by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks.. They further believe that this "over-encouragement" to borrow and lend is caused by the mispricing of money via the central bank's attempt to centralise control over interest rates (which Austrian economists believe are often set too low when compared to the rates that would prevail in a genuine non-central bank dominated free market).

In Austrian theory, the proportion of consumption to saving or investment is determined by people's time preferences, which is the degree to which they prefer present to future satisfactions. Austrian economists believe the pure interest rate is determined by the time preferences of the individuals in society, and the final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components.

When banks create new money by inducing borrowers to borrow (thereby expanding bank deposits), and lend to businesses to invest, the new money pours forth on the loan market and lowers the rate of interest, compared to the interest rate which would prevail if the money supply was stable.

According to Austrian economists, this credit creation (using fractional reserve banking techniques) makes it appear as if the supply of "saved funds" for investment has increased, for the effect is the same: the supply of funds for investment purposes increases, and the interest rate is lowered. Borrowers, in short, are misled by the bank inflation into believing that the supply of saved funds (the pool of "deferred" funds ready to be invested) is greater than it really is. When the pool of "saved funds" increases, entrepreneurs invest in "longer process of production," i.e., the capital structure is lengthened, especially in the "higher orders", most remote from the consumer. Borrowers take their newly acquired funds and bid up the prices of capital and other producers' goods, stimulating a shift of investment from consumer goods to capital goods industries. The preference by entrepreneurs for longer term investments can be shown graphically by using any discounted cash flow model. Essentially lower interest rates increase the relative value of cash flows that come in the future. When modeling an investment opportunity, if interest rates are artificially low, entrepreneurs are led to believe the income they will receive in the future is sufficient to cover their near term investment costs. Because the debasement of the means of exchange is universal, many entrepreneurs can make the same mistake at the same time (i.e. many believe investment funds are really available for long term projects when in fact the pool of available funds has come from credit creation - not "real" savings out of the existing money supply). As they are all competing for the same pool of capital and market share, some entrepeneurs begin to borrow simply to avoid being "overrun" by other entrepeneurs who may take advantage of the lower interest rates to invest in more up-to-date capital infrastructure. A tendency towards over-investment and speculative borrowing in this "artificial" low interest rate environment is therefore almost inevitable.

Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rent, interest. Austrian economists conclude that, since time preferences have not changed, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. In other words, depositors will tend to remove cash from the banking system and spend it (not save it), banks will then ask their borrowers for payment and interest rates and credit conditions will deteriorate.

Capital goods industries will find that their investments have been in error; that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.

The "boom," then, is actually a period of wasteful "misinvestment", according to Austrian economists. It is the time when errors are made, due to the artificial increase in the money supply and the supply of "funds" available for investment tampering with the free market. "Real" savings would have required higher interest rates to encourage depositors to save their money to invest in longer term projects under a stable money supply. The artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.

The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.

The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of sustainable consumer desires.

Since it clearly takes very little time for the new money to filter down from business to factors of production, why don't all booms come quickly to an end? Austrian economists say that continually expanded bank credit can keep the borrowers one step ahead of consumer retribution (with the help of successively lower interest rates from the central bank, they can try to put off the "day of reckoning" and defer the collapse of unsustainably inflated asset prices).

The boom will end when bank credit expansion finally stops - when no further speculative investments can be found which provide adequate returns at prevailing interest rates. Evidently, the longer the boom goes on, the more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary depression readjustment.

Criticisms

Critics of the theory argue that it requires that investors exhibit a kind of irrationality – that they be regularly fooled into making unprofitable investments by temporarily low interest rates.

Mainstream economists also argue that the Austrian school's theory cannot explain many of the observed empirical regularities in business cycles. For instance, MIT professor Paul Krugman has argued the theory implies that consumption would increase during downturns and cannot explain the empirical observation that spending in all sectors of the economy fall during a recession. Austrian theory states that this would follow from a general contraction of the money supply when the eventual "bust" chokes off demand for new borrowing. Others point out that economies have experienced less severe boom-bust cycles since central banks have tried to stabilize economies, rather than the more severe cycles predicted by the theory.

See also

• America's Great Depression by Murray Rothbard
• Hyman Minsky's "Minsky Credit Cycle" and "Minsky moment"

External links

• Austrian Business Cycle Theory: A Brief Explanation
• America’s Great Depression
• Explaining Japan's Recession
• Fall of the Dot Coms
• ABCT lecture (audio)
• Garrison, Roger (1997), "The Austrian Theory of the Business Cycle", Business Cycles and Depressions, Garland Publishing Co.,{{citation}}: CS1 maint: extra punctuation (link)