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Austrian business cycle
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The Austrian business cycle theory (or ABCT) attempts to explain business cycles through a set of ideas held by the heterodox Austrian School of economics. The theory views business cycles as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.[1] The main proponents of the Austrian business cycle theory historically were Austrian School economists Ludwig von Mises and nobel laureate Friedrich Hayek. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.[2][3] The Austrian theory of the business cycle is now rarely discussed by mainstream economists, but was more actively debated in the mid-20th century.[4] More recently, mainstream economists Gordon Tullock,[5] Bryan Caplan,[6] and Nobel laureates Milton Friedman[7][8] and Paul Krugman[9] have stated that they regard the theory as incorrect.
Proponents believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.[10] 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. It is asserted that this leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. Proponents hold that a credit-sourced boom results in widespread malinvestments. In the theory, a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when exponential 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 Austrian explanation of the business cycle varies significantly from the mainstream understanding of business cycles, and is generally rejected by mainstream economists. The Austrian school's methods of deriving theories have been criticized by mainstream economists as a priori "non-empirical" analysis and differing from the practices of scientific theorizing, as widely conducted in economics.[11][12][13][14]
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A similar theory 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.[15]:27
Nobel laureate Hayek's creation of the theory in the 1930s was harshly criticized by many economists, including John Maynard Keynes, Piero Sraffa and Nicholas Kaldor, among others. In 1932, Piero Sraffa argued that Hayek's theory did not explain why "forced savings" induced by inflation would generate investments in capital that were inherently less sustainable than those induced by voluntary savings.[16] Sraffa also argued that Hayek's theory failed to define a single "natural" rate of interest that might prevent a period of growth from leading to a crisis.[16] Others who responded critically to Hayek's work on the business cycle included John Hicks, Frank Knight, and Gunnar Myrdal.[17] Hayek reformulated his theory in response to those objections.
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.[18]
A popularized version of the theory is presented in Murray Rothbard's pamphlet Economic Depressions: Their Cause and Cure, which endeavors to explain the business cycle by focusing on excessive bank-sourced credit expansion and centralized government intervention (through the actions of a central bank).[19] Rothbard went into much greater detail in his book What Has Government Done to Our Money?.
According to Murray Rothbard, the Austrian business cycle theory attempts to answer the following questions about things which Austrian theorists believe appear over the course of a business cycle:[20]
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.[21] 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.[22] 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,[8] 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."[6]
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. 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.[23]
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.[21]
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.[21]
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.[24] 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 a boom taking place under these circumstances 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.[21]
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.[24][25] Mises conjectured that 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.[24][25]
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.[24][26] It can also be temporarily put off by 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).[27]
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.[24]
There is also a notion of capital consumption contributing negatively to the readjustment period, which has been discussed in works such as Human Action.[24]
Ludwig von Mises[28] and Friedrich Hayek[29] 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.[30]
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.[31] 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."[6]
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).[21][25]
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.[21][22]
Many proponents of the Austrian School business cycle theory (such as Murray Rothbard) advocate either heavy regulation of the banking system (strictly enforcing a policy of full reserves on the banks) or, more often, free banking, in order to prevent malinvestment.[32] The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.[33][34]
According to Nicholas Kaldor, Hayek's work on the Austrian business cycle theory had at first "fascinated the academic world of economists," but attempts to fill in the gaps in theory led to the gaps appearing "larger, instead of smaller," until ultimately "one was driven to the conclusion that the basic hypothesis of the theory, that scarcity of capital causes crises, must be wrong."[35] After 1941, Hayek abandoned his research in macroeconomics altogether, focusing instead on issues of the economics of information, political philosophy, and the theory of law. Lionel Robbins, who had embraced the Austrian theory of the business cycle in The Great Depression (1934), later regretted having written that book and accepted many of the Keynesian counterarguments.[36]
The late-2000s financial crisis has resulted in a revival of interest in the Austrian business cycle theory, but has also resulted in a revival of interest of theories more critical of Austrian theory, such as those promoted by Keynesian economics.[37] According to Austrian school supporters, over 25 Austrian school economists are publicly on record as having accurately predicted a housing bubble prior to new home prices reaching their peak in March 2007.[38] Austrian economics received media attention after Congressman and Presidential candidate Ron Paul, was praised by MSNBC's Joe Scarborough for predicting the housing bubble and financial crisis and Paul subsequently appeared on Scarborough's 'Morning Joe' show and credited his understanding of Austrian economics for predicting the financial crisis.[39]
Peter J. Boettke argues that the Fed is making a mistake by not letting consumer prices fall. According to him, Fed's policy of reducing interest rates to below-market-level when there was a chance of deflation in the early 2000s together with government policy of subsidizing homeownership resulted in unwanted asset inflation. Financial institutions leveraged up to increase their returns in the environment of below market interest rates. Boettke further argues that government regulation through credit rating agencies enabled financial institutions to act irresponsibly and invest in securities that would perform only if the prices in the housing market continued to rise. However, once the interest rates went back up to the market level prices in the housing market began to fall and soon afterwards financial crisis ensued. Boettke attributes failure to policy makers who assumed that they had the necessary knowledge to make positive interventions in the economy. The Austrian School view is that government attempts to influence markets prolong the process of needed adjustment and reallocation of resources to more productive uses. In this view bailouts serve only to distribute wealth to the well-connected, while long-term costs are borne out by the majority of the ill-informed public.[40][41]
The Austrian theory is considered one of the precursors to the modern credit cycle theory, which is emphasized by Post-Keynesian economists, economists at the Bank for International Settlements, and by a few mainstream academics such as Hyman Minsky and Charles P. Kindleberger.[42] These two emphasize asymmetric information and agency problems. Henry George, another precursor, emphasized the negative impact of speculative increases in the value of land, which places a heavy burden of mortgage payments on consumers and companies.[42][42][43]
A different theory of credit cycles is the debt-deflation theory of Irving Fisher, which is today placed in the Post-Keynesian tradition. The difference between these may be stated as debt-deflation being a demand-side theory, which emphasizes the period after the peak – the end of a credit bubble and contraction of debt causing a fall in aggregate demand – while the Austrian theory is a supply-side theory, which emphasizes the period before the peak – the growth of debt during the growth phase causing malinvestment. The theories may thus be seen as complementary, addressing different aspects of the issue, and are so-considered by some economists.[44][45]
In 2003 Barry Eichengreen laid 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.[42]
In 2006 William White argued that "financial liberalization has increased the likelihood of boom-bust cycles of the Austrian sort".[46] While White conceded that the status quo policy had been successful in reducing the impacts of busts, he commented that the view on inflation should perhaps be longer term and that the excesses of the time seemed dangerous.[46] In addition, 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.[10][46]
According to most mainstream economists, the Austrian business cycle theory is incorrect.[47]
Most mainstream economists argue that the Austrian business cycle theory requires bankers and investors to exhibit a kind of irrationality, because the theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates.[12][5][48] In response, Austrian economists Anthony Carilli and Gregory Dempster have argued that a banker or firm loses market share if it does not borrow or loan at a magnitude consistent with current interest rates, regardless of whether rates are below their natural levels. Thus businesses are forced to operate as though rates were set appropriately, because the consequence of a single entity deviating would be a loss of business. Austrian economist Robert Murphy has also argued that it is difficult for bankers and investors to make sound business choices because they cannot know what the interest rate would be if it were set by the market.[49]
Paul Krugman dubs the theory the "hangover theory", and has written that it cannot explain changes in unemployment over the business cycle. Austrian business cycle theory postulates that business cycles are caused by the misallocation of resources from consumption to investment during 'booms', and out of investment during 'busts'. Krugman argues that because total spending is equal to total income in an economy, the theory implies that the reallocation of resources during 'busts' would increase employment in consumption industries, whereas in reality, spending declines in all sectors of an economy during recessions. He also argues that according to the theory the initial 'booms' would also cause resource reallocation, which implies an increase in unemployment during booms as well.[9] Krugman also argues that Austrian economists often explain the boom in terms of changes in demand, but then fail to accept the implications of that position during the bust.[50]
Austrian economist David Gordon has argued that prices on consumption goods may go up as a result of the investment bust, which could mean that the amount spent on consumption could increase even though the quantity of goods consumed has not.[51]
Economist Jeffery Hummel is critical of Hayek's explanation of labor asymmetry in booms and busts. He argues that Hayek makes peculiar assumptions about demand curves for labor in his explanation of how a decrease in investment spending creates unemployment.[52] He also argues that the labor asymmetry can be explained in terms of a change in real wages, but this explanation fails to explain the business cycle in terms of resource allocation. In response, Austrian economist Walter Block argues that the misallocation during booms is only relative, and that there is an absolute increase in demand.[53] In addition, Hummel argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he points out that investment spending remained positive in all recessions where there are data, except for the Great Depression. He argues that this casts doubt on the notion that recessions are caused by a reallocation of resources from industrial production to consumption, since the Austrian business cycle theory implies that net investment should be below zero during recessions.[52]
According to most economic historians, economies have experienced less severe boom-bust cycles after World War II, because governments have addressed the problem of economic recessions.[47][54][55][56] This has especially been true after central banks were granted independence in the 1980s, and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation.[57] Critics have also argued that, as the Austrian business cycle theory points to the actions of fractional-reserve banks and central banks to explain the business cycles, it fails to explain the severity of business cycles before the establishment of the Federal Reserve in 1913.[47] Supporters of the Austrian business cycle theory respond that the theory applies to the expansion of the money supply, not necessarily an expansion done by a central bank. Historian Thomas Woods argues that the crashes were caused by various privately-owned banks with state charters that issued paper money, supposedly convertible to gold, in amounts greatly exceeding their gold reserves.[58]
In 1969, Milton Friedman, after examining the history of business cycles in the U.S., concluded that "The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false."[7] He analyzed the issue using newer data in 1993, and again reached the same conclusion.[8] Austrian economist James P. Keeler argued that the theory is consistent with empirical evidence.[59]