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.

According to the theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "monetary boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

Mainstream economists rarely discuss the Austrian theory of the business cycle. It is regarded as incorrect by mainstream economists like Milton Friedman Gordon Tullock, Bryan Caplan, and Paul Krugman.

Origin

The trade cycle argument first appeared in the last few pages of Ludwig von 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.

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.

The canonical theory is expressed in Murray Rothbard's pamphlet Economic Depressions: Causes and Cures.

Questions

The theory of the business cycle attempts to answer the following questions about things which their theorists, notably Murray Rothbard, believe appear during the business cycle:

• Why is there a sudden general cluster of business errors?
• Why do capital goods industries and asset market prices fluctuate more widely than do the consumer goods industries and consumer prices?
• 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 (or a sharp contraction in the growth of credit in a recession)?

Assertions

The theory begins with the claim that in a market with 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".

The "boom-bust" cycle of generalised malinvestment is generated by monetary intervention in the market - specifically, by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks. 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).

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. Thus, 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 the entrepreneurial risk and purchasing power components.

Under fractional reserve banking, a central bank creates new money when it lends to member banks. This new money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.

This credit creation 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. In simple terms, investments that would not make sense with a 10% cost of funds become feasible with a prevailing interest rate of 5% (and may become compelling for many entrepreneurs with a prevailing interest rate of 2%).

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 entrepreneurs begin to borrow simply to avoid being "overrun" by other entrepreneurs 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.

This new money then percolates downward from the business borrowers to the factors of production: to the landowners and capital owners who sold assets to the newly indebted entrepreneurs, and then to the other factors of production in wages, rent, and 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 will have turned out to be wasteful, and the malinvestment must be liquidated.

The "boom," then, is actually a period of wasteful "malinvestment". It is the time when errors are made, when speculative borrowing has driven up prices for assets and capital to unsustainable levels, due to low interest rates "artificially" increasing the money supply and triggering an unsustainable injection of fiat money "funds" available for investment into the system, thereby tampering with the complex pricing mechanism of 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 generalised 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 takes very little time for the new money to filter down from the initial borrowers to the recipients of the borrowed funds (the various factors of production), why don't all booms come quickly to an end? 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). This postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices. It can also be temporarily put off by exogenous events such as the "cheap" or free acquisition of marketable resources by market participants and the banks funding the borrowing (such as the acquisition of land from local governments, or in extreme cases, the acquisition of foreign land through the waging of war).

The boom ends 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.

Empirical research

James P. Keeler states that the hypotheses of the theory are consistent with his preliminary empirical research.

Critiques of the theory

In 1969, Nobel Laureate Milton Friedman, after examining the history of business cycles in the US, 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 conclusions.

In 1988 Gordon Tullock explained his disagreement with the theory, engaging in a length discourse with Austrian economist Joseph T. Salerno. Salerno commented on the critique, with Tullock responding to Salerno's reply.

Mainstream economists argue that the theory requires bankers and investors to exhibit a kind of irrationality – that they be regularly fooled into making unprofitable investments by temporarily low interest rates. Carilli and Dempster have attempted to use a prisoner's dilemma framework to address this weakness in the theory.

Neo-Keynesian economist 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 theorists argue that this would follow from a general contraction of the money supply when the eventual "bust" chokes off demand for new borrowing, however they do not explain why the money supply should contract.

The Austrian school's theory claims that business cycles are caused by central banks' manipulation of the money supply. However, many economists believe that economies have experienced less severe boom-bust cycles after World War II, since central banks have started using monetary policy to stabilize economies.

See also

• America's Great Depression by Murray Rothbard
• Human Action by Ludwig von Mises
• 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)