Austrian business cycle theory

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Austrian Business Cycle Theory (ABCT) is an explanation of the business cycle proposed initially in 1912 by Ludwig von Mises - economist representing "second wave" of the Austrian school, and later developed by other prominent scholars of the school: Friedrich von Hayek, Murray Rothbard and others.

General assumption of Austrian Business Cycle Theory

The theory assumes that business cycles develop as a result of bank credit expansion, which is not accompanied by an increase of savings in the society.

Regular free market

Under regular market conditions with a non-fiat monetary system (such as a gold standard which existed when ABCT was first formulated) any increase of bank lending must be preceded by at least similar increase of savings, since at any given moment in time there is only a limited supply of money on the market. Higher savings rate causes market interest rates to drop (since there is an increased supply of capital available to be lent). Lower interest rates stimulate investments, especially in long-term capital goods production projects, so called "higher order goods".

Increased savings equals lower consumption, which means that more resources (capital, labour)are available for investment purposes. In addition, reduction in consumption causes price structure on the market to change- relative prices of consumer goods drop compared to investment goods. This is an additional incentive for entrepreneurs to locate resources (capital, labour) in higher- yielding sectors- capital goods production. When new investment projects are complete, they produce higher total output of goods, which equals higher standard of living for the society (increased real wages).

Business cycle theory

Business cycle develops, when bank credit expansion is not accompanied by increased savings. Under gold standard this can happen when banks create credit using clients' demand deposits (which in theory should be backed by 100% gold reserves), or simply issue banknotes (which circulate valued equally to physical gold currency) which are not backed by any gold deposits.

In the fiat monetary system with a legal fractional-reserve banking (which functions in the present time), business cycle develops when banks create credit at a higher rate than normally, which is almost always a result of lower interest rates of the central bank.

Both cases produce the same result: more "capital" is available to the entrepreneurs, interest rates drop as if there was a larger pool of savings. Entrepreneurs start new investment projects which require additional resources, prices of investment goods rise. Low interest rates cause investment projects to be valued higher (by standard DCF, NPV measures). Some sectors may experience very rapid price increases, which are often described as "bubbles", depending on the level of additional money creation. Capital goods sectors flourish, with both higher company earnings and higher wages.

However, in this situation there was no reduction of society's consumption. Consumer preferences remain unchanged, savings rate had not risen. Higher wages earned by employees of capital goods sectors are spent at an unchanged rate. Additionally, in the modern financial system, consumer credit is available, witch also benefits from artificially lowered interest rates and further reduces propensity to save.

At some point both entrepreneurs and lenders realize that current credit- driven boom is unsustainable. In the gold standard, busts often started with runs on banks (when depositors realized that banknotes that they have are not backed by hard currency), which results in credit contraction. In the fiat- money systems busts often start when central bank raises interest rates (which changes investment projects and capital goods valuations and hampers both consumers' an entrepreneurs' ability to repay loans), which also means that credit expansion cannot be continued.

Bust as described in Austrian Business Cycle Theory

During "bust" period, one can observe higher unemployment and falling prices of capital goods. This is a period of liquidating bad investments and reallocating resources away from capital goods production ("higher order goods") to sectors which could make a better use of them.

If there was no interference to this process, it would happen rapidly and soon economic order would be restored. However, governments usually tend to "ease the pain" by imposing laws and regulations which prevent bad investments from being liquidated, which according to Austrian school, prolongs the process of recovery.

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Author: Bartosz Cioch