Austrian Theory of the Business Cycle
Encyclopedia
The Austrian business cycle theory ("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 rate
s to remain too low for too long, resulting in excessive credit
creation, speculative economic bubble
s and lowered savings. 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. The Austrian theory of the business cycle is now rarely discussed by mainstream economists, but was more actively debated in the mid-20th century. More recently, mainstream economists Gordon Tullock
, Bryan Caplan
, and Nobel laureates Milton Friedman
and Paul Krugman
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. 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 malinvestment
s. 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.
'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
.
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. 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. Others who responded critically to Hayek's work on the business cycle included John Hicks
, Frank Knight
, and Gunnar Myrdal
. Hayek reformulated his theory in response to those objections.
Austrian economist Roger Garrison
explains the origins of the theory:
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
). Rothbard went into much greater detail in his book What Has Government Done to Our Money?
.
is generated by excessive and unsustainable credit expansion to businesses and individual borrowers by the bank
s. 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 preference
s, 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.
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.
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.
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 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.
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. 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.
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 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. Milton Friedman concluded that the Austrian claim contradicts empirical evidence, while Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with empirical evidence.
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.
, 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 entrepreneur
s 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 bank
s. 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.
) advocate either heavy regulation of the banking system (strictly enforcing a policy of full reserves on the bank
s) or, more often, free banking
, in order to prevent malinvestment. 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.
, 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." 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.
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. 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. 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.
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.
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
. 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.)
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.
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.
In 2006 William White
argued that "financial liberalization has increased the likelihood of boom-bust cycles of the Austrian sort". 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. 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.
Most mainstream economists argue that the Austrian business cycle theory requires bankers and investors to exhibit a kind of irrationality, because their theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates. 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.
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. 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.
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.
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. 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. 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.
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. 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
. 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. 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.
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." He analyzed the issue using newer data in 1993, and again reached the same conclusions. In 2001, Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with empirical evidence.
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
of economics. The theory views business cycles as the inevitable consequence of excessive growth in bank credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
, exacerbated by inherently damaging and ineffective central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
policies, which cause interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s to remain too low for too long, resulting in excessive credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
creation, speculative economic bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
s and lowered savings. The main proponents of the Austrian business cycle theory historically were Austrian School economists Ludwig von Mises
Ludwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...
and nobel laureate Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal
Gunnar Myrdal
Karl Gunnar Myrdal was a Swedish Nobel Laureate economist, sociologist, and politician. In 1974, he received the Nobel Memorial Prize in Economic Sciences with Friedrich Hayek for "their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the...
) in part for his work on this theory. The Austrian theory of the business cycle is now rarely discussed by mainstream economists, but was more actively debated in the mid-20th century. More recently, mainstream economists Gordon Tullock
Gordon Tullock
Gordon Tullock is an economist and retired Professor of Law and Economics at the George Mason University School of Law. He is best known for his work on public choice theory, the application of economic thinking to political issues...
, Bryan Caplan
Bryan Caplan
Bryan Caplan is an American economist, a Professor of Economics at George Mason University, Research Fellow at the Mercatus Center, adjunct scholar of the Cato Institute, and blogger for Econlog. He is best known for his work in public choice theory and for his libertarian ideology.-Personal...
, and Nobel laureates Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
and Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
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. 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
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, through the money creation
Money creation
In economics, money creation is the process by which the money supply of a country or a monetary region is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy by purchasing financial assets or lending money...
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 malinvestment
Malinvestment
Malinvestment is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.This concept is...
s. In the theory, a correction or "credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
" – commonly called a "recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...
" or "bust" – occurs when exponential
Exponential growth
Exponential growth occurs when the growth rate of a mathematical function is proportional to the function's current value...
credit creation cannot be sustained. Then the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
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
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
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.
Origin
A similar theory first appeared in the last few pages of Ludwig von MisesLudwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...
's The Theory of Money and Credit
The Theory of Money and Credit
The Theory of Money and Credit is an economics book written by Ludwig von Mises, originally published in German as Theorie des Geldes und der Umlaufsmittel in 1912...
(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
David Laidler
David Ernest William Laidler has been one of the foremost scholars of monetarism. He published major economics journal articles on the topic in the late 1960s and early 1970s...
has observed in a chapter on the theory that the origins lie in the ideas of Knut Wicksell
Knut Wicksell
Johan Gustaf Knut Wicksell was a leading Swedish economist of the Stockholm school. His economic contributions would influence both the Keynesian and Austrian schools of economic thought....
.
Nobel laureate Hayek's creation of the theory in the 1930s was harshly criticized by many economists, including John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
, Piero Sraffa
Piero Sraffa
Piero Sraffa was an influential Italian economist whose book Production of Commodities by Means of Commodities is taken as founding the Neo-Ricardian school of Economics.- Early life :...
and Nicholas Kaldor
Nicholas Kaldor
Nicholas Kaldor, Baron Kaldor was one of the foremost Cambridge economists in the post-war period...
, among others. In 1932, Piero Sraffa
Piero Sraffa
Piero Sraffa was an influential Italian economist whose book Production of Commodities by Means of Commodities is taken as founding the Neo-Ricardian school of Economics.- Early life :...
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. 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. Others who responded critically to Hayek's work on the business cycle included John Hicks
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...
, Frank Knight
Frank Knight
Frank Hyneman Knight was an American economist who spent most of his career at the University of Chicago, where he became one of the founders of the Chicago school. Nobel laureates James M. Buchanan, Milton Friedman and George Stigler were all students of Knight at Chicago. Knight supervised...
, and Gunnar Myrdal
Gunnar Myrdal
Karl Gunnar Myrdal was a Swedish Nobel Laureate economist, sociologist, and politician. In 1974, he received the Nobel Memorial Prize in Economic Sciences with Friedrich Hayek for "their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the...
. Hayek reformulated his theory in response to those objections.
Austrian economist Roger Garrison
Roger Garrison
Roger Garrison is a professor of economics at Auburn University, Alabama and adjunct scholar of the Ludwig von Mises Institute....
explains the origins of the theory:
Grounded in the economic theory set out in Carl MengerCarl MengerCarl Menger was the founder of the Austrian School of economics, famous for contributing to the development of the theory of marginal utility, which contested the cost-of-production theories of value, developed by the classical economists such as Adam Smith and David Ricardo.- Biography :Menger...
's Principles of EconomicsPrinciples of EconomicsPrinciples of Economics is a book by economist Carl Menger which is credited with the founding of the Austrian School of economics...
and built on the vision of a capital-using production process developed in Eugen von Böhm-BawerkEugen von Böhm-BawerkEugen Ritter von Böhm-Bawerk was an Austrian economist who made important contributions to the development of the Austrian School of economics.-Biography:...
's Capital and InterestCapital and InterestCapital and Interest is a three-volume work on finance published by Austrian economist Eugen von Böhm-Bawerk.The first two volumes were published in the 1880s when he was teaching at the University of Innsbruck....
, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Ludwig von MisesLudwig von MisesLudwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...
' 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 WicksellKnut WicksellJohan Gustaf Knut Wicksell was a leading Swedish economist of the Stockholm school. His economic contributions would influence both the Keynesian and Austrian schools of economic thought....
'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 capitalFinancial capitalFinancial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
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 SchoolBritish Currency SchoolThe British Currency School was a group of British economists, active in the 1840s and 1850s, who argued that the excessive issuing of banknotes was a major cause of price inflation, and believed that, in order to restrict circulation, issuers of new banknotes should be required to hold an...
, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specieCoinA coin is a piece of hard material that is standardized in weight, is produced in large quantities in order to facilitate trade, and primarily can be used as a legal tender token for commerce in the designated country, region, or territory....
flow.
A popularized version of the theory is presented in Murray Rothbard
Murray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
'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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
). Rothbard went into much greater detail in his book What Has Government Done to Our Money?
What Has Government Done to Our Money?
What Has Government Done to Our Money? is a book by Murray N. Rothbard that details the history of money, from early barter systems, to the gold standard, to present day systems of paper money.- How money developed :...
.
Questions
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:- Why is there a sudden general cluster of business errors?
- Why do capital goodCapital goodA capital good, or simply capital in economics, is a manufactured means of production. Capital goods are acquired by a society by saving wealth which can be invested in the means of production....
s 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 supplyMoney supplyIn economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
during the depression (or a sharp contraction in the growth of creditCredit (finance)Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
in a recession)?
Assertions
According to the theory, the boom-bust cycle of malinvestmentMalinvestment
Malinvestment is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.This concept is...
is generated by excessive and unsustainable credit expansion to businesses and individual borrowers by the bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s. This credit creation
Money creation
In economics, money creation is the process by which the money supply of a country or a monetary region is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy by purchasing financial assets or lending money...
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
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
is lowered. Borrowers, in short, are misled by the bank inflation
Monetary inflation
Monetary inflation is a sustained increase in the money supply of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services . Originally the term "inflation" was used to refer only to monetary inflation, whereas in present usage it...
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
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
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
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
to saving or investment is determined by people's time preference
Time preference
In economics, time preference pertains to how large a premium a consumer places on enjoyment nearer in time over more remote enjoyment....
s, 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.
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.
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.
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 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
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
and triggering an unsustainable injection of fiat money
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...
"funds" available for investment into the system, thereby tampering with the complex pricing mechanism of the free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...
. "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
Ludwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...
further suggests that a "crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
" (or "credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. 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.
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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
). 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 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. Milton Friedman concluded that the Austrian claim contradicts empirical evidence, while Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with empirical evidence.
There is also a notion of capital consumption contributing negatively to the readjustment period, which has been discussed in works such as Human Action
Human Action
Human Action: A Treatise on Economics is the magnum opus of the Austrian economist Ludwig von Mises. It presents a case for laissez-faire capitalism based on Mises' praxeology, or rational investigation of human decision-making. It rejects positivism within economics...
.
Ludwig von Mises
Ludwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...
and Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
warned of a major economic crisis before the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. 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 DepressionGreat Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
, 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 entrepreneur
Entrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...
s would not all make errors at the same time and would quickly take advantage of any temporary, isolated mispricing. In addition, in an open
Openness
Openness is the quality of being open. It sometimes refers to a very general philosophical position from which some individuals and organizations operate, often highlighted by a decision-making process recognizing communal management by distributed stakeholders rather than a centralized authority...
, 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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
. 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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
'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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
dominated free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...
).
Under the current fiat monetary
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...
system, a central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
creates new money when it lends to member banks, and this money is multiplied many times over through the money creation
Money creation
In economics, money creation is the process by which the money supply of a country or a monetary region is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy by purchasing financial assets or lending money...
process of the private bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s. 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
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
were stable.
Policy implications
Many proponents of the Austrian School business cycle theory (such as Murray RothbardMurray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
) advocate either heavy regulation of the banking system (strictly enforcing a policy of full reserves on the bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s) or, more often, free banking
Free banking
Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency...
, in order to prevent malinvestment. The main proponents of the Austrian business cycle theory historically were Ludwig von Mises
Ludwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...
and Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal
Gunnar Myrdal
Karl Gunnar Myrdal was a Swedish Nobel Laureate economist, sociologist, and politician. In 1974, he received the Nobel Memorial Prize in Economic Sciences with Friedrich Hayek for "their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the...
) in part for his work on this theory.
Influence
According to Nicholas KaldorNicholas Kaldor
Nicholas Kaldor, Baron Kaldor was one of the foremost Cambridge economists in the post-war period...
, 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." 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
Lionel Robbins
Lionel Charles Robbins, Baron Robbins, FBA was a British economist and head of the economics department at the London School of Economics...
, 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.
The late-2000s financial crisis
Late-2000s financial crisis
The late-2000s financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s...
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. 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. Austrian economics received media attention after Congressman and Presidential candidate Ron Paul
Ron Paul
Ronald Ernest "Ron" Paul is an American physician, author and United States Congressman who is seeking to be the Republican Party candidate in the 2012 presidential election. Paul represents Texas's 14th congressional district, which covers an area south and southwest of Houston that includes...
, 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.
Late-2000s financial crisis
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 leveragedLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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
The Use of Knowledge in Society
"The Use of Knowledge in Society" is a scholarly article written by economist Friedrich Hayek, first published in the September 1945 issue of The American Economic Review Written as a rebuttal to fellow economist Oskar R...
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.
Similar theories
The Austrian theory is considered one of the precursors to the modern credit cycleCredit cycle
The credit cycle is the expansion and contraction of access to credit over the course of the business cycle. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists, and some members of the Austrian school, regard credit cycles as the fundamental process...
theory, which is emphasized by Post-Keynesian economists
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...
, economists at the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
, and by a few mainstream academics such as Hyman Minsky
Hyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
and Charles P. Kindleberger
Charles P. Kindleberger
Charles Poor "Charlie" Kindleberger was a historical economist and author of over 30 books. His 1978 book Manias, Panics, and Crashes, about speculative stock market bubbles, was reprinted in 2000 after the dot-com bubble. He is well known for hegemonic stability theory.-Life:Kindleberger was born...
. These two emphasize asymmetric information and agency problems. (Henry George
Henry George
Henry George was an American writer, politician and political economist, who was the most influential proponent of the land value tax, also known as the "single tax" on land...
, 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.)
A different theory of credit cycles is the debt-deflation theory of Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
, 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
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
– 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.
In 2003 Barry Eichengreen
Barry Eichengreen
Barry Eichengreen is an American economist who holds the title of George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley, where he has taught since 1987...
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
Diminishing returns
In economics, diminishing returns is the decrease in the marginal output of a production process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay constant.The law of diminishing returns In economics, diminishing returns (also...
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.
In 2006 William White
William White (economist)
William R. White is a Canadian economist educated at the University of Windsor and the University of Manchester. In 1969, he began his career as an economist at the Bank of England. In 1972 he joined the Bank of Canada where he spent 22 year...
argued that "financial liberalization has increased the likelihood of boom-bust cycles of the Austrian sort". 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. 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.
Criticisms
According to most mainstream economists, the Austrian business cycle theory is incorrect.Most mainstream economists argue that the Austrian business cycle theory requires bankers and investors to exhibit a kind of irrationality, because their theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates. 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.
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. 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.
Austrian economist David Gordon
David Gordon (philosopher)
David Gordon is a libertarian philosopher and intellectual historian influenced by Rothbardian views of economics. He is a senior fellow at the Ludwig von Mises Institute and editor of "The Mises Review."...
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.
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. 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. 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
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. 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.
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. This has especially been true after central banks were granted independence in the 1980s, and started using monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
to stabilize the business cycle, an event known as The Great Moderation
The Great Moderation
In economics, the Great Moderation refers to a reduction in the volatility of business cycle fluctuations starting in the mid-1980s, believed to have been caused by institutional and structural changes in developed nations in the later part of the twentieth century...
. 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. 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
Thomas Woods
Thomas E. "Tom" Woods, Jr. is an American historian, economist, political analyst, and New York Times-bestselling author. He has written extensively on the subjects of American history, contemporary politics, and economic theory...
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.
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." He analyzed the issue using newer data in 1993, and again reached the same conclusions. In 2001, Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with empirical evidence.
See also
- America's Great DepressionAmerica's Great DepressionAmerica's Great Depression is a 1963 treatise on the 1930s Great Depression and its root causes, written by Austrian School economist and author Murray Rothbard. The fifth edition was released in 2000.-Brief summary:...
by Murray RothbardMurray RothbardMurray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the... - Human ActionHuman ActionHuman Action: A Treatise on Economics is the magnum opus of the Austrian economist Ludwig von Mises. It presents a case for laissez-faire capitalism based on Mises' praxeology, or rational investigation of human decision-making. It rejects positivism within economics...
by Ludwig von Mises - Hyman MinskyHyman MinskyHyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
's "Minsky Credit Cycle" and "Minsky momentMinsky momentA Minsky moment is when over-indebted investors are forced to sell good assets to pay back their loans, causing sharp declines in financial markets and jumps in demand for cash. In any credit cycle or business cycle it is the point when investors begin having cash flow problems due to the spiraling...
" - MeltdownMeltdown (book)Meltdown is a 2009 book on the global financial crisis of 2007–2010 by historian Thomas Woods, with a foreword by Rep. Ron Paul. Woods is a follower of the Austrian School of economics and believes in allowing the market to freely compete in currency, which he believes would lead to mostly...
by Thomas WoodsThomas WoodsThomas E. "Tom" Woods, Jr. is an American historian, economist, political analyst, and New York Times-bestselling author. He has written extensively on the subjects of American history, contemporary politics, and economic theory...