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 "artificially" set 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 that 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. The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek, both of whom predicted the Great Depression.

Hayek's formulation of the theory was harshly criticised by John Maynard Keynes, Piero Sraffa and Nicholas Kaldor when he first advanced it in the 1930s. Mainstream economists like Milton Friedman, Gordon Tullock, Bryan Caplan, and Paul Krugman have stated that they regard the theory as incorrect. David Laidler views the theory as motivated to some extent 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 to some extent discredited because of its association with "nihilistic policy prescriptions" for the Great Depression. On the other hand, he did also state that its core insights were materially worthwhile, especially as they relate to the work of Dennis Robertson. In addition, William 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.

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: 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". In addition, in a non-centralized uninsured capital market, banks would shy away from speculative lending and uninsured depositors would carefully monitor the balance sheets of risky financial institutions.

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 borrowed money via the central bank's attempt to centralise control over interest rates and "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).

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. In other words, the particular types of investments made during the boom were inappropriate and "wrong" from the perspective of the long-term financial sustainability of the market because the price signals stimulating the investment were distorted by fractional reserve banking activities "corrupting" the pricing structure in various capital markets. These particular types of investments were never sustainable, and only temporary fiat money creation made them appear ephemerally attractive.

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", 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 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 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.

Similar theories

The effect of the expanding credit cycle on the business cycle is emphasized by some 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 articulated a similar theory, emphasizing the negative impact of speculative increases in the value of land, which places a heavy burden of mortgage payments on consumers and companies.

Barry Eichengreen lays 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.

Empirical research

Ludwig von Mises and Friedrich Hayek predicted 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.

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

Barry Eichengreen and Kris Mitchener empirically investigated the effect of the credit cycle on the Great Depression, and suggest that it may have had a greater effect than is generally acknowledged.

Critiques

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's reformulation was then criticised by Nicholas Kaldor in 1939 and again in 1942.

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. In 1989 Austrian economist Joseph T. Salerno commented on Tullock's critique, and Tullock responded to Salerno's reply. A year later a more detailed reply to Tullock was made by Austrian economist Martin Stefunko.

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. They predict that the money supply would contract because people are trying to pay down unsustainable debt rather than borrow more money, and banks are lending less money than their reserves would permit (thereby reducing the multiplier effect of fractional-reserve banking) due to greater concern about credit risk and fewer speculative opportunities existing in exhausted credit markets.

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)