Austrian business cycle theory

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.

See also:

• Thomas Robert Malthus

Examples of Austrian business cycle theory

• Credit Expansion: ABCT suggests that credit expansion is the primary cause of business cycles. When the money supply is increased, it causes interest rates to fall below the natural rate, leading to an artificial boom in the economy. This boom is unsustainable, and eventually leads to a bust.
• Malinvestments: ABCT also suggests that during an artificial boom, businesses are likely to make malinvestments, or investments that are not likely to pay off in the long run. These malinvestments lead to an unsustainable boom and eventual bust.
• Real-Money Supply: ABCT suggests that a real-money supply, such as gold or silver, is necessary for a stable economy. When the money supply is increased, it causes prices to rise and leads to an artificial boom in the economy. This boom is unsustainable, and eventually leads to a bust.

Advantages of Austrian business cycle theory

Austrian business cycle theory (ABCT) is an explanation of the business cycle proposed by prominent scholars of the Austrian school of economics. The primary advantages of ABCT include:

• It offers an explanation of the business cycle that does not rely on government intervention. ABCT emphasizes the role of monetary policy and its effects on the money supply, rather than government intervention, as the cause of business cycles.
• It is an effective tool for predicting business cycles. By analyzing the money supply and the structure of the economy, ABCT can be used to accurately predict when business cycles will occur.
• It provides a framework for the proper management of the economy. By emphasizing the importance of sound monetary policy, ABCT can be used to guide economic policy makers to ensure economic stability and long-term economic growth.

Limitations of Austrian business cycle theory

The Austrian Business Cycle Theory (ABCT) has several limitations including:

• It assumes that all economic actors are rational and respond in a predictable fashion to changes in interest rates. This ignores the reality that economic actors often have different preferences, risk tolerances and other individual factors that may cause them to act differently than expected.
• It relies heavily on the concept of fractional reserve banking, which is not always applicable in the real world. It does not account for more modern banking structures such as central banking, where the money supply is not determined by the actions of individual banks.
• It does not take into account the effect of government intervention on the economy, such as fiscal policy or quantitative easing. This can have a significant impact on the economy, which is not accounted for in ABCT.
• Finally, the theory does not take into account the possibility of irrational exuberance in markets, which can lead to unsustainable bubbles in asset prices. This can have a significant effect on the economy, and is not considered in the ABCT.

Other approaches related to Austrian business cycle theory

The Austrian Business Cycle Theory (ABCT) is an explanation of the business cycle proposed initially in 1912 by economist Ludwig von Mises. There are other approaches related to the ABCT, including:

• Monetary Disequilibrium Theory (MDT), which states that the business cycle is caused by an imbalance between the demand and supply of money.
• Time-Preference Theory, which suggests that the business cycle is rooted in people's preferences for present consumption over future consumption.
• Monetary Overinvestment Theory, which argues that the business cycle is caused by the misallocation of resources due to an increase in the money supply.
• Credit Expansion Theory, which suggests that the business cycle is caused by an expansion of credit that results in an artificial increase in investment.

All of these theories are related to the Austrian Business Cycle Theory in that they all suggest that changes in the money supply can have a significant impact on the business cycle. In summary, the Austrian Business Cycle Theory and its related approaches suggest that changes in the money supply can lead to economic fluctuations, such as recessions and booms.

Austrian business cycle theory — recommended articles

Austrian theory of money — Demand shock — David Ricardo — Monetarism — Global demand — Crowding out effect — Interventionism — Autonomous Investment — IS-LM model

References=

• Callahan, G., & Garrison, R. (2003). Does Austrian business cycle theory help explain the dot-com boom and bust?. The Quarterly Journal of Austrian Economics, 6(2), 67-98.
• Huerta de Soto, J., Money, Bank Credit and Economic Cycles, Ludwig von Mises Institute, Auburn, Alabama 2009
• Keeler, J. P. (2001). Empirical evidence on the Austrian business cycle theory. The Review of Austrian Economics, 14(4), 331-351.
• von Mises, L., Haberler, G., Rothbard, M., von Hayek, F., The Austrian Theory of the Trade Cycle and other essays, compiled by Richard M. Ebeling, Ludwig von Mises Institute, Auburn, Alabama 1996
• Mises Institute website.

Author: Bartosz Cioch