Austrian Theory of the Business Cycle
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The Austrian business cycle theory (ABCT) is in many ways the quintessence of Austrian economics, as it integrates so many ideas that are unique to that school of thought, such as capital structure, monetary theory, economic calculation, and entrepreneurship.
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[edit] Origins
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.
[edit] Questions
The Austrian Theory of the Business Cycle attempts to answer the following questions about the business cycle:
- Why is there a sudden general cluster of business errors?
- Why do capital goods industries fluctuate more widely than do the consumer goods industries?
- 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?
[edit] Theory
Austrian economists claim that, in the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. Instead, they believe the "boom-bust" cycle is generated by monetary intervention in the market, specifically bank credit expansion to business.
In Austrian theory, 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. Austrians believe 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 entrepreneurial risk and purchasing power components.
What happens when banks print new money, whether as bank notes or bank deposits, and lend it to business? The new money pours forth on the loan market and lowers the loan rate of interest. According to Austrians, it looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. When saved funds increase, businessmen invest in "longer process of production," i.e., the capital structure is lengthened, especially in the "higher orders", most remote from the consumer. Businessmen 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 [[1]]. 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 fooled into believing the income they will receive in the future is sufficient to cover their near term investment costs.
Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rent, interest. Austrians 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. 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 have turned out to be wasteful, and the malinvestment must be liquidated.
The "boom," then, is actually a period of wasteful misinvestment, according to Austrians. It is the time when errors are made, due to bank credit's tampering with the free market. The "crisis" arrives when the consumers come to reestablish their desired proportions. The "depression" is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires.
Since it clearly takes very little time for the new money to filter down from business to factors of production, why don't all booms come quickly to an end? Austrians say that continually expanded bank credit can keep the borrowers one step ahead of consumer retribution. The boom will end when bank credit expansion finally stops. Evidently, the longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment.
