Austrian Business Cycle Theory

The business cycle describes regularly occurring booms and busts observed in economic life and the Austrian Business Cycle Theory (sometimes called the "hangover theory" or even shortened to ABCT) is an explanation of this phenomenon. Originally developed by Ludwig von Mises in the 1912 Theory of Money and Credit it was elaborated on by Hayek and others. In one classical rendition:

Banks expand credit well beyond their own assets and by the funds of their clients. This additional credit lowers the interest rate, and stimulates economic activity. Projects which would not have been started before, seem now profitable, creating malinvestment. They increase demand for production materials and for labor and their prices rise, which, in turn, leads to an increase in prices of consumption goods. If the banks would stop the extension of credit, the boom would be rapidly over. To prevent the sudden halt of this boom (and the resulting collapse of prices), the banks must create more and more credit, and the prices will rise even more.

But this expansion of credit cannot continue forever. There is no additional capital or labor; there is only more money. The means of production and labor which have been diverted to the new enterprises have to be taken away from others. Society is not sufficiently rich to permit the creation of new enterprises without taking away from others. As long as the expansion of credit is continued this will not be noticed, but it can't be pushed indefinitely. The inflation and the boom can last only as long as the public thinks that the prices will stop rising in the near future. When the public becomes aware, that there the inflation will not end, and that prices will continue to rise, panic sets in. Eventually, people will give up the currency.

History

The regularly occurring booms and and busts were observed from approximately late eighteenth century, along with the start of the Industrial Revolution. Sudden economic crisis, when some king made war or confiscated the property of his subject were known; but there was no sign of the modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions.

The Austrian cycle theory began with the eighteenth century Scottish philosopher and economist David Hume, and with the eminent early nineteenth century English classical economist David Ricardo. These theorists observed another crucial institution developing in the mid-eighteenth century, alongside the industrial system. It was the institution of banking, with its capacity to expand credit and the money supply (first, in the form of paper money, or bank notes, and later in the form of demand deposits, or checking accounts, that are instantly redeemable in cash at the banks). It was the operations of these commercial banks which held the key to the mysterious recurrent cycles of expansion and contraction, of boom and bust, that had puzzled observers since the mid-eighteenth century.

The English "Currency School" has tried to explain the boom by the extension of credit resulting from the issue of banknotes without metallic backing. But the school did not see that current accounts which could be drawn upon at any time via checks, play exactly the same role in the extension of credit as bank notes. Because of the legislation inspired by the Currency School (like the Peel's Bank Act of 1844 and similar laws in other countries), to prevent other economic crises, the issue of banknotes without metallic backing was restricted, but the expansion of credit through current accounts was unregulated. From this it was wrongly concluded that the English School's attempt to explain the trade cycle in monetary terms had been refuted by the facts.

The Currency School has also restricted its analysis to the case where credit is expanded in only one country while the banking policy of all the others remains conservative. The internal rise in prices would encourage imports and paralyse exports. Metallic money would drain away to foreign countries. As a result the banks would face increased demands for repayment of the instruments they have put into circulation (such as unbacked notes and current accounts), until they have to restrict credit. Ultimately the outflow of specie checks the rise in prices. The Currency School analyzed only this particular case; it did not consider credit expansion on an international scale by all the capitalist countries simultaneously. In the second half of the 19th century, this theory of the trade cycle fell into discredit, and the notion that the trade cycle had nothing to do with money and credit gained acceptance. The attempt of Wicksell (1898) to rehabilitate the Currency School was short-lived.

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. Despite mainstream findings of evidence to the contrary, proponents of the theory conclude that the longer the unsustainable shift in capital goods industries continues, the more violent and disruptive the necessary re-adjustment process. While agreeing with economist Tyler Cowen, Bryan Caplan has stated that he also denies "that the artificially stimulated investments have any tendency to become malinvestments."

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 modelling 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, interest rates in a stable money environment are determined by the time preferences of depositors.

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 suggests 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 spend money on consumption items, capital investors will find their projects are unsustainable, banks will then ask their borrowers for payment and interest rates and credit conditions will deteriorate.

Austrian economists theorize that 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 monetary 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's recursive lending "ballooning" the pricing structure in various capital markets.

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 to 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.

Austrian scholars assert that 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. According to von Mises's work, the artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.

Ludwig von Mises further suggests that 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? Austrians assert that 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). In the theory, this postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices. It can also be temporarily put off by price deflation or 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).

Austrian scholars theorize that 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., though Milton Friedman concluded that the Austrian claim contradicts the evidence examined in his studies.

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.

Other theories

Since the cycles appeared on the scene at about the same time as modern industry, Marx concluded that business cycles were an inherent feature of the capitalist market economy. Many current schools of economic thought, regardless of other differences and the different causes that they attribute to the cycle, agree on this vital point: That the business cycle originates somewhere deep within the free-market economy, and it can be only solved by some form of massive government intervention.

Innovations

It is sometimes held, that innovations cause the ups and downs of the business cycle. The most prominent defender of that view was probably Joseph Schumpeter. He stated that booms are due to technological or other innovations whose implementations at first seem to promise high profits. After a while, more and more entrepreneurs copy the strategy of the pioneer firms until competitive behavior forces profits to go down again and a depression begins, in which the market is cleaned of unprofitable firms. This is a brief description of the well-known process of "creative destruction" — a term made famous by Schumpeter himself. The new state of equilibrium is only maintained until a new innovation creates the foundation for another boom.

The industrial revolution, the appearance of railway tracks, or the rise of cheap automobiles can be interpreted as examples. Furthermore, the dotcom bubble at the end of the last decade could have been due to innovations like the internet. Even the current crisis can be regarded as the result of financial innovations.

However, it is not technological innovation that generates the boom, but the general boom that makes it possible for more and more firms to implement their innovative ideas. In every moment there exist many ideas for possible innovations and improvements. The latest innovation has not yet been implemented in every business. If there are always many ideas whose only problem is to get enough funds, then it is not technology, but savings that limit development. To implement them, the companies need capital. Society has to save first and then grant credit.

There is, of course, nothing wrong with using credit for an innovative project. The problem only appears when these credits are created out of thin air, thus inducing malinvestments. In an environment of monetary expansion, many innovative projects can be started that are in fact not sustainable. The clusters of innovative activities that seem to be the cause of inevitable depressions are in fact a symptom of the distortion of the market process that is introduced by fractional-reserve banks.

From a policy point of view, using political means to push forward new innovations (like "renewable energy sources") will not suffice to get the economy out of the slump. Moreover, it can be highly dangerous for the aid for such innovations to be flanked by expansive monetary policy.A recent study suggests that this was the case in Spain where a "green" bubble went boom and bust — with all its destructive side effects, including unemployment.

Criticisms

These are some of the more frequent or known criticisms of the theory.

Central banking

Some critics point out, that the theory blames the business cycle on central banks, but the cycle has been well known throughout 19th century, well before central banking in the modern sense and the 20th century growth of the state. One particular example are the United States and its wide range of monetary and banking systems.

Many casual expositions of ABCT say things like, "The business cycle is not a feature of the free market, but instead is caused by the manipulations of the central bank." But it is far more accurate to say that ABCT blames the boom-bust cycle on fractional reserve banking. Specifically, when banks are allowed to issue paper money (or increase customers' electronic bank deposits) without an actual act of saving by somebody in the economy, then the resulting drop in interest rates is artificial. The false interest rate sets in motion an unsustainable boom period, which leads people to erroneously consume capital and which creates the inevitable bust.

Government intervention is still very much involved here. Were it not for legal privileges granted to banks, the practice of fractional-reserve banking would be "regulated" by market competition. Even if banks were legally allowed to extend more loans than they had cash (or gold) in the vaults, they would be very cautious with their overissue so long as a bank run would spell ruin. Yet time and again, even before the establishment of central banks, governments would allow the banks to "suspend specie payment" during panics. This practice of absolving privileged bankers of their legal obligations was simply institutionalized (in the United States) with the creation of the Federal Reserve. It is no coincidence that the worst boom-bust in US history occurred sixteen years after the formation of the modern American central bank.

See also: History of money and banking in the US

Rational Expectations

"If investors correctly anticipate that a decline in interest rates will be temporary, they won't evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make "bad" investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there's no reason to think that market outcomes will be optimal in general."

First off, free individuals often make mistakes — even systematic mistakes. But even perfectly rational entrepreneurs who know a boom is underway cannot prevent their more reckless competitors from taking cheap (or now free) government loans and bidding away scarce resources. Workers don't care whether their paychecks come from genuine saving or from the printing press, and every few years there is always a fresh crop of naïve employers willing to borrow money and start new projects.

Second, Austrians emphasize that interest rates communicate information to entrepreneurs. In some critiques it seems that "everybody knows" that the true interest rate ought to be 5 percent, and so the central bank's efforts to push it down to 3 percent should be easily corrected. Yet nobody knows what the truly free-market interest rate is. That's why market prices are important in the first place, and why government distortions of these prices lead to real imbalances in the economy.

Entrepreneurs don't need to speculate about a change in consumers’ "rate of time preference", or about the "supply of capital goods". An individual entrepreneur is concerned only with a very small set of market prices, namely, the prices of the inputs she will need for her projects, and the prices for which these products will sell. That’s the whole point of relying on the market rates of interest and other prices — it eliminates the need for individuals to speculate about aggregates that are far too complex for any single mind to comprehend.

Also, some expositions of ABCT assume an initial free market state, and then analyze the impact of a one-shot intervention. But in reality the government of each major country intervene permanently in the credit market by the creation of a central bank (or a centralized system of banks). Actors in these economies have no idea what the free market rate of interest would be in the absence of such interference; even if the rates were raised, the new rate could still be below the "natural rate".

Investment vs. Consumption

If booms are driven by mistaken beliefs that investments have become more profitable, and labor and other resources are channeled into projects not compatible with the overall level of real savings, then consumption should go down, say some critics. But booms are characterized by high, not low, consumption. If the government can't make the economy more productive by pushing down interest rates, how could businesses possibly produce more investment and consumption goods during the boom?

The answer is in the Austrian approach to capital theory. The low interest rates of the boom period mislead entrepreneurs into borrowing too much, but they also mislead consumers into borrowing too much and saving too little. This is physically possible because resources that otherwise would have gone into replenishing the capital structure are instead devoted to new projects or additional consumption goods. This "eating of the seed corn" can take a while to manifest in a complex, modern economy.

Unemployment in the boom

In a similar vein, it is pointed out that there is generally no period of high unemployment when resources are transferred out of consumption-producing sectors into investment goods-producing sectors. There is no necessity that the transfer of resources out of investment goods-producing sectors be accompanied by high unemployment.

Suppose we start in an original equilibrium position, where unemployment is at the "natural" rate, reflecting the normal turnover of workers as some businesses fail, etc. Then a $100 billion in crisp new bills is printed, and handed out to bankers. The banks lend the new money to employers, who enter the labor market with the fresh wads of cash in their pockets. Armed with the money that was just created out of thin air, the employers bid up wage rates. Seeing the higher pay, many workers quit their current jobs and take new positions in the expanding sectors. Also, some previously unemployed workers end their job search and take positions with the employers who got their hands on the new $100 billion. There is no reason for unemployment to go up in the scenario just described.

But when the the influx of new money is cut off, the underlying economic fundamentals will reassert themselves. The workers who had been drawn into the expanding sectors by new money weren't supposed to move to those sectors. The employers in the boom sectors will lose their advantage over their competitors in other sectors. Without being propped up artificially by cheap money, the bloated boom sectors will realize their unprofitability. They will cut back on operations and lay off workers.

And why don't the laid-off workers move seamlessly back into the original niches from which they came? Why does a massive reservoir of unemployed workers build up after the bust, when no such reservoir built up during the boom? The answer is pretty simple: Workers are more eager to quit and take a better job than to be laid off and take a worse job. During the boom, workers are drawn into the expanding sectors by the promise of higher wages. They aren't forced into the expanding sectors by getting let go from their original position; instead they voluntarily leave. No less important is the capital consumption during the boom period. Society "eats the seed corn" through malinvestment.

There was no inflation

Some critics point out, that if prices did not rise (the CPI did not rise excessively) there was really no inflation. There was no wave of rising consumer price inflation in the 2000s.

Expansionary monetary policy makes prices higher than they otherwise would have been. For example, the extraordinary interventions in late 2008 — in which the M1 measure of the monetary stock rose 12 percent over a three-month period — went hand-in-hand with falling prices. Prices should have fallen in response to the bursting bubble. Prices would have fallen more, were it not for a floor under them with an aggressive influx of new money. At the same time, house prices rose at unusual rates during the boom years.

External links

• Austrian Business Cycle Theory on Wikipedia
• Austrian Business Cycle Theory: A Brief Explanation by Dan Mahoney, May 2001
• Why Don't Entrepreneurs Outsmart the Business Cycle? by Brian J. Stanley, August 2007
• Are the Austrians Too Harsh? by John P. Cochran, October 2010
• Putting Austrian Business-Cycle Theory to the Test by Robert P. Murphy, October 2010