Austrian Business Cycle Theory

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The Austrian business cycle theory (ABCT) is the Austrian School's explanation of the phenomenon of business cycles. Austrian economists assert that central banks create the business cycle by inflating the supply of money in a fiat monetary system. The resultant lower interest rates (the price of borrowing) lead to a "boom" during which malinvestments cause capital resources to be misallocated. A correction—commonly called a "recession" or "bust"—occurs when resources are reallocated towards more efficient uses.

1 Origins
2 Questions
3 Theory
4 See also
5 References

[edit] Origins

Austrian economist Roger Garrison explains the origins of the theory thusly:

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.

[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. Austrian economists 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.

When banks create new money, whether by printing bank notes or entering 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 Austrian economists, 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. 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. 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. 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 Austrian economists. 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 "recession" or "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? Austrian economists 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.