Argumentation:ABCT

This highly experimental page is devoted to the attempt to create an argumentation chain for the Austrian Business Cycle Theory (ABCT). It is not intended to cover every possible angle, merely to build up one (or more) ways to explain ABCT. People may pick up any part in their own argumentation.

General assumptions

Money is not wealth

In everyday life money is a good indicator for wealth and is sometimes seen as the same thing. For an extreme example of why it isn't the case, check the hyperinflation in Zimbabwe or Weimar Germany.

The value of money is subjective, it is what people can expect to exchange it for. Having more money does not necessarily mean you will be able to buy more for it.

See also: Money

Business cycle as a historical fact

Entrepreneurs try to predict the future state of the market (consumer demand, prices of their inputs, etc.) and plan accordingly. Of course, sometimes they fail - that is only human and predicting the future is always hard.

What is known as the bust - a part of the business cycle - is not simply failure. It is a large number of failures, coming apart at the same time, coupled with a general downturn in economic activity. The bust is preceded by a boom - an increase in economic activity, often later perceived as unhealthy or speculative in nature. The regularly occurring booms and and busts were observed from approximately late eighteenth century.

See also: Business cycle

See also: Entrepreneurship

Economic growth and the interest rate

Lowering of interest rate with increased savings

Interest rates coordinate investment and consumption across time. When interest rates come down naturally it is because people are saving more. Banks become flush with cash which causes them to lower rates to stimulate loans.

Entrepreneurs are receiving two signals from the market when this happens:

1. That new resources are available to make new investments.
2. That demand exists that is not currently being satisfied (people are forgoing purchases for the future).

When investment is made in this environment, there is, as always, the possibility of failure, but the investment is backed by actual saved resources and there is pent up consumer demand that can make it profitable upon completion.

The lower interest rate is also signal for consumers that there are more funds they can borrow and enjoy (providing they repay them, of course).

See also: Interest rate

See also: Saving

Monetary policy

Perfect creation of new money

Many economists claim, that by creating new money out of nowhere can be created economic wealth.

Let's consider first an unrealistic scenario. An angel listens to the pleas of many people for more money and with magic doubles the amount of money everyone has (the Angel Gabriel model by David Hume). What would happen?

While everybody would be happy to have twice the money as before, society wouldn't be better off - there would be no increase in capital, productivity or goods. The only effect would be the (approximate) doubling of prices and the currency would lose half of its purchasing power.

See also: Money

Creation of new money in reality

What if interest rates are brought down artificially, but not so obviously, for example by a central bank like the Federal Reserve? Entrepreneurs still receive and act upon the same economic signals, but no new investable resources exist to complete the new projects, and no pent up demand exists to justify their undertaking.

But the situation is much worse than that. The lower rates encourage people to take out what savings they have and spend it now. (And more consumers are encouraged to borrow and enjoy consumption.) As a result, actual demand will be even lower when the completed projects are ready to enter the market.

This is what is meant by malinvestment and overconsumption from changing interest rates. It creates an artificial boom in economic activity followed by a bust when the economy realizes the errors it made.

There is no free lunch. All of those rate cuts have to eventually be increased, at which point all of the stimulative forces reverse and the bad investments reveal themselves. The alternative to rate increases is continued inflation, which can only end in a collapse of the currency.

See also: Inflation

Consequences

The creation of new money out of thin air really creates what appears to be growth. Signaling, that more resources are available, businessmen invest, start new projects, employment rises, consumers enjoy more consumption, analytics rejoice.

This fake prosperity - also known as a boom - ends in a very real crisis - the bust. The wrong investments reveal, that many resources have been wasted on nonviable projects and produced goods the customers didn't want. Many projects cannot be completed at all. Unemployment will rise and the economy will suffer a crisis.

The repeating of the boom-and-bust is the familiar business cycle.

See also: Malinvestment

See also: Business cycle

See also: Austrian Business Cycle Theory

Counterarguments and Questions

But there were crises before the Fed!

The ABCT does not depend on the presence of a central bank. Money can be created "out of thin air" by other institutions (see e.g. the role of the Treasury in the Panic of 1907).

Fractional reserve banking also expands the money supply. Banks engaging in this practice keep only a fraction of their reserves on hand and lend the rest.

See also: Argumentation:Fractional Reserve Banking

Does ABCT explain everything?

The Austrian Business Cycle Theory does not claim to explain every single economic crisis. There are still wars and catastrophes, and there are particularly destructive government interventions, all of which can create a crisis.

The ABCT explains and describes a particular type of crisis, which seems to be unfortunately rather prevalent.

See also: Financial crises

Can ABCT predict a crisis?

ABCT can help with the recognition of an unsustainable boom. It does not predict when exactly the bust will happen.

Austrian economists are in general very careful with the unpredictable nature of human action. However, they are on record with numerous successful predictions, not least for the current crisis.