Austrian business cycle theory

Proposed economic waves

Cycle/wave name	Period (years)
Kitchin cycle (inventory, e.g. pork cycle)	3–5
Juglar cycle (fixed investment)	7–11
Kuznets swing (infrastructural investment)	15–25
Kondratiev wave (technological basis)	45–60

The Austrian business cycle theory ("ABCT") is an explanation of business cycles held by the heterodox Austrian School of economics. The theory views business cycles (or, as some Austrians prefer, "credit cycles") as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.

Austrians believe that a sustained period of low interest rates and excessive credit creation results 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. 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 credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when exponential 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.

Given these perceived damaging and disruptive effects caused by what Austrian scholars believe to be volatile and unsustainable growth in credit-sourced money, many proponents (such as Murray Rothbard) advocate either heavy regulation of the banking system (strictly enforcing a policy of full reserves on the banks) or, more often, free banking. The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.

The Austrian explanation of the business cycle varies significantly from the mainstream understanding of business cycles, and is generally rejected by mainstream economists. Economists such as Milton Friedman, Gordon Tullock, Bryan Caplan, and Paul Krugman have said that they regard the theory as incorrect. Further, the Austrian school's methods of deriving theories have been criticized by mainstream economists as a priori "non-empirical" analysis and differing from the practices of scientific theorizing, as widely conducted in economics.

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. David Laidler has observed in a chapter on the theory that the origins lie in the ideas of Knut Wicksell.

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.

A popularized version of the theory is presented in Murray Rothbard's pamphlet Economic Depressions: Their Cause and Cure, which endeavors to explain the business cycle by focusing on excessive bank-sourced credit expansion and centralized government intervention (through the actions of a central bank). Rothbard went into much greater detail in his book What Has Government Done to Our Money?.

Questions

The Austrian business cycle theory attempts to answer the following questions about things which Austrian 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

According to the theory, the boom-bust cycle of malinvestment is generated by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks. This credit creation makes it appear as if the supply of "saved funds" ready 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, which, in the theory, stimulates a shift of investment from consumer goods to capital goods industries. Austrians 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 towards capital goods industries continues, the more violent and disruptive the necessary re-adjustment process.

The preference by entrepreneurs for longer term investments in a low interest rate environment 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%).

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. In a stable money environment the interest rate is the price signal reflecting the balance of consumption and saving. If the goods and services presently on offer encourage people to spend, interest rates will be higher, reflecting people's short-term time preferences. If the goods and services presently on offer do not encourage people to spend, interest rates will be lower, reflecting people's desire to save their money (and spend their money on goods and services in the future). Thus, the pure interest rate in a stable money environment 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.

In an environment where the money supply is continually expanding through the issuance of credit, interest rates no longer reflect people's time preferences, as interest rates are set by the central bank. Because the debasement of the means of exchange in a low interest rate environment 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. Mises conjectures that 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, Austrians contend that interest rates and credit conditions will deteriorate.

Entrepeneurs in 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.

This concept is captured by the term "heterogeneity of capital", where Austrian economists emphasize that the mere macroeconomic "total" of investment does not adequately capture whether this investment is genuinely sustainable or productive, due the inability of the raw numbers to reveal the particular investment activities being undertaken and the inherent inability of the numbers to reveal whether these particular investment activities were appropriate and economically sustainable given people's real preferences.

The boom, then, is actually a period of wasteful malinvestment, a "false boom" where the particular kinds of investments undertaken during the period of fiat money expansion are revealed to lead nowhere but to insolvency and unsustainability. 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 in term deposits 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.

A "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 monetary boom, and reestablishes efficient service of sustainable consumer desires.

Since it takes very little time for the new credit-sourced 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 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. It is asserted 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. There is also a notion of capital consumption contributing negatively to the readjustment period, which has been discussed in works such as Human Action.

Ludwig von Mises and Friedrich Hayek warned of a major economic crisis before the Great Depression. Hayek made his prediction of a coming business crisis in February 1929. He warned that a financial crisis was an unavoidable consequence of reckless monetary expansion.

The role of central banks

All Austrian theorists consider the unsustainable expansion of bank credit through fractional reserve banking as the driving feature of most business cycles. However, Murray Rothbard paid particular attention to the role of central banks in creating an environment of loose credit prior to the onset of the Great Depression, and the subsequent ineffectiveness of central bank policies, which simply delayed necessary price adjustments and prolonged market dysfunction. Rothbard begins with the claim that in a market with no centralized monetary authority, there would be no simultaneous 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 addition, in an open, non-centralized (uninsured) capital market, astute bankers would shy away from speculative lending and uninsured depositors would carefully monitor the balance sheets of risky financial institutions, tempering any speculative excesses that arose sporadically in the finance markets. In Rothbard's view, the cycle of generalized malinvestment is greatly exacerbated by centralized monetary intervention in the money markets by the central bank. Such propositions from Rothbard prompted criticism from Bryan Caplan, who questions "Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation... Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot."

However, Rothbard asserts that an over-encouragement to borrow and lend is initiated by the mispricing of credit via the central bank's centralized control over interest rates and its need to protect banks from periodic bank runs (which Austrian economists believe then causes interest rates to be set too low for too long when compared to the rates that would prevail in a genuine non-central bank dominated free market).

Under the current fiat monetary system, 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.

Financial crisis of 2007–2010

Economist Tyler Cowen in 2005 said that Austrian business cycle theory should be refocused to result in a viable synthesis of Keynesian and Hayekian theories. In 2005 Cowen also said that if he believed in Austrian business cycle theory he would say that U.S. economy is overinvested in housing and a massive shock (sectoral shift toward exports) will result. After the United States housing bubble began its decline in 2006, Peter Schiff, a supporter of the Austrian school, made some predictions regarding a housing crash in the US, though (as of early 2009) Schiff's investment firm had not been able to profit from strategies based on his predictions.

The financial crisis of 2007-2010 has resulted in a revival of interest in the Austrian business cycle theory , but has also resulted in a revival of interest of theories more critical of Austrian theory, such as Keynesianism and Post-Keynesian economics.

Similar theories

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, and by a few mainstream academics such as Hyman Minsky and Charles P. Kindleberger. 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.)

A different theory of credit cycles is the debt-deflation theory of Irving Fisher, which is today placed in the Post-Keynesian tradition. The difference between these may be stated as debt-deflation being a demand-side theory, which emphasizes the period after the peak – the end of a credit bubble and contraction of debt causing a fall in aggregate demand – while the Austrian theory is a supply-side theory, which emphasizes the period before the peak – the growth of debt during the growth phase causing malinvestment. The theories may thus be seen as complementary, addressing different aspects of the issue, and are so-considered by some economists.

In 2003 Barry Eichengreen laid out modern 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". 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.

Empirical research

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 2001, Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with his preliminary empirical research.

Critiques

The Austrian theory of the business cycle is now rarely discussed by mainstream economists, but was more actively debated in the mid-20th century. Nobel laureate Hayek's formulation of the theory in the 1930s was harshly criticized by John Maynard Keynes, Piero Sraffa and Nicholas Kaldor. In 1932, Piero Sraffa argued that Hayek's formulation of the business cycle required a kind of money that was entirely neutral, and was in effect a simple commodity, unable to act as a store of value or be loaned at interest. Hayek reformulated his theory in response to those objections, but his reformulation was then criticised by Nicholas Kaldor in 1939 and again in 1942.

More recently, mainstream economists like Nobel laureate Milton Friedman, Gordon Tullock, Bryan Caplan, and Paul Krugman have stated that they regard the theory as incorrect. Bryan Caplan has stated that he denies "that the artificially stimulated investments have any tendency to become malinvestments." David Laidler views the theory as motivated by the political leanings of its major proponents, as Austrian economists are known for their strong opposition to government involvement in the economy, and argues that the theory was discredited because of its association with "nihilistic policy prescriptions" for the Great Depression. On the other hand, Laidler also stated that its core insights were materially worthwhile, especially as related to the work of Dennis Robertson.

In 1988 Gordon Tullock explained his disagreement with the theory. His main point is that "if the process that Rothbard describes did occur, there would be many corporate bankruptcies and business people jumping out of the windows of office buildings, but there would be only minor transitional unemployment. In fact, measured GNP would be higher as a result." This is because the Austrian theory implies fluctuations in investment, but not in the production decisions of firms. Nobel laureate Paul Krugman also made a similar argument when he stated that the theory implies that consumption would increase during downturns and cannot explain the empirical observation that spending in all sectors of the economy falls during a recession,.

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.

Critics have also argued that, as the theory points to the actions of fractional-reserve banks and central banks to explain business cycles, it fails to explain the existence of business cycles before the establishment of Federal Reserve in 1913. For example, the Panic of 1873 would initiate the Long Depression in US and much of Europe. Additionally, there were also severe market crashes in the United States of the magnitude of the 1929 crash in 1869, 1882, 1884, 1896, 1901, and 1907; there was no central bank or national monetary policy in the US during these crises. In fact, the movement to establish central banking in the United States was in part a response to the business cycle, particularly the Panic of 1907.

Mainstream 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 especially The Great Moderation.

Notable Responses

With regards to the criticism which concludes that the Austrian Business Cycle theory requires widespread irrationality about the future of interest rates, Austrian thinkers Carilli and Dempster have offered a response. They have argued that a prisoner's dilemma framework can explain the apparent failure of investors to learn from previous experience.

In response to several severe economic crashes that occurred without a central bank, historian Thomas Woods argues in his book Meltdown that the crashes were caused by various privately-owned banks (with state charters) which issued paper money, supposedly convertible to gold, in amounts greatly exceeding their gold reserves.

See also

• America's Great Depression by Murray Rothbard
• Human Action by Ludwig von Mises
• Hyman Minsky's "Minsky Credit Cycle" and "Minsky moment"
• Meltdown by Thomas Woods

External links

• EconStories (Keynes vs Hayek Rap on ABCT)
• Austrian Business Cycle Theory: A Brief Explanation, Dan Mahoney
• Correcting Quiggin on ABCT, Robert Murphy
• ABCT lecture (audio)
• America’s Great Depression
• Explaining Japan's Recession
• Fall of the Dot Coms
• Garrison, Roger (1997). "The Austrian Theory of the Business Cycle". Business Cycles and Depressions. Garland Publishing Co.