Austrian Business Cycle Theory

The business cycle describes regularly occurring booms and and busts observed in economic life and the Austrian Business Cycle Theory (sometimes 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.

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. 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.

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.

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.

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".

External links

• Austrian Business Cycle Theory on Wikipedia