Austrian business cycle theory
The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks.[1] The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in Economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.[2][3][4]
According to the theory, the business cycle unfolds in the following way: low interest rates tend to stimulate borrowing, which lead to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit-sourced boom results in widespread malinvestment. A correction or credit crunch, commonly called a "recession" or "bust", occurs when the credit creation has run its course. The money supply then contracts (or its growth slows), causing a curative recession and eventually allowing resources to be reallocated back towards their former uses.
The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists on both theoretical and empirical grounds.[5][6][7][8] Austrian School theorists have continued to contest these conclusions.[9]
Mechanism[edit]
Malinvestment and boom[edit]
According to ABCT, in a genuinely free market random bankruptcies and business failures will always occur at the margins of an economy, but should not "cluster" unless there is a widespread mispricing problem in the economy that triggers simultaneous and cascading business failures.[10] According to the theory a period of widespread and synchronized "malinvestment" is caused by mis-pricing of interest rates thereby causing a period of widespread and excessive business lending by banks, and this credit expansion is later followed by a sharp contraction and period of distressed asset sales (liquidation) which were purchased with overleveraged debt.[10][11] The initial expansion is believed to be caused by fractional reserve banking encouraging excessive lending and borrowing at interest rates below what full reserve banks would demand. Due to the availability of relatively inexpensive funds, entrepreneurs invest in capital goods for more roundabout, "longer process of production" technologies such as “high tech” industries. Borrowers take their newly acquired funds and purchase new capital goods, thereby causing an increase in the proportion of aggregate spending allocated to “high tech” capital goods rather than basic consumer goods such as food. However, such a shift is inevitably unsustainable over time due to mispricing caused by excessive credit creation by the banks and must reverse itself eventually as it is always unsustainable. The longer this distorting dislocation continues, the more violent and disruptive will be the necessary re-adjustment process.
Austrian School theorists argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment. "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. The artificial stimulus caused by bank lending causes a generalized speculative investment bubble which is not justified by the long-term factors of the market.[11]
Bust[edit]
The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.[12][13] 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.[12][13]
Continually expanding bank credit can keep the artificial credit-fueled boom alive (with the help of successively lower interest rates from the central bank). This postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices.[12][14]
The monetary boom ends when bank credit expansion finally stops, i.e. when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. 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.[12]
Government policy error[edit]
Austrian business cycle theory does not argue that fiscal restraint or "austerity" will necessarily increase economic growth or result in immediate recovery.[10] Rather, they argue that the alternatives (generally involving central government bailing out of banks and companies and individuals favoured by the government of the day) will make eventual recovery more difficult and unbalanced. All attempts by central governments to prop up asset prices, bail out insolvent banks, or "stimulate" the economy with deficit spending will only make the misallocations and malinvestments more acute and the economic distortions more pronounced, prolonging the depression and adjustment necessary to return to stable growth, especially if those stimulus measures substantially increase government debt and the long term debt load of the economy.[10] Austrians argue the policy error rests in the government's (and central bank's) weakness or negligence in allowing the "false" unsustainable credit-fueled boom to begin in the first place, not in having it end with fiscal and monetary "austerity". Debt liquidation and debt reduction is therefore the only solution to a debt-fueled problem. The opposite - getting even further into debt to spend the economy's way out of crisis - cannot logically be a solution to a crisis caused by too much debt.[15][16] More government or private debt solving a debt-related problem is logically impossible.[15][16]
According to Ludwig von Mises, "[t]here is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved".[12]
Empirical research[edit]
Empirical economic research findings are inconclusive, with different economic schools of thought arriving at different conclusions. In 1969, Nobel laureate Milton Friedman found the theory to be inconsistent with empirical evidence.[30] Twenty five years later in 1993, he reanalyzed the question using newer data, and reached the same conclusion.[31] However, in 2001, Austrian School economist James P. Keeler argued that the theory is consistent with empirical evidence.[32] Economists Francis Bismans and Christelle Mougeot arrived at the same conclusion in 2009.[33]
According to some economic historians, economies have experienced less severe boom-bust cycles after World War II, because governments have addressed the problem of economic recessions.[34][35][36][37] Many have argued that this has especially been true since the 1980s because central banks were granted more independence and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation.[38] However, Austrian economists argue the opposite, that boom-bust cycles following the creation of the Federal Reserve have been more frequent and more severe than those prior to 1913.[39]
Reactions of economists and policymakers[edit]
According to Nicholas Kaldor, Hayek's work on the Austrian business cycle theory had at first "fascinated the academic world of economists" but attempts to fill in the gaps in theory led to the gaps appearing "larger, instead of smaller" until ultimately "one was driven to the conclusion that the basic hypothesis of the theory, that scarcity of capital causes crises, must be wrong".[40]
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.[41]
The Nobel Prize Winner Maurice Allais was a proponent of Austrian business cycle theory and their perspective on the Great Depression and often quoted Ludwig Von Mises and Murray N. Rothbard.[42]
When, in 1937, the League of Nations examined the causes of and solutions to business cycles, the Austrian business cycle theory alongside the Keynesian and Marxian theory were the three main theories examined.[43]
Similar theories[edit]
The Austrian theory is considered one of the precursors to the modern credit cycle theory, which is emphasized by Post-Keynesian economists, economists at the Bank for International Settlements. 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.[44][45]
A different theory of credit cycles is the debt-deflation theory of Irving Fisher.
In 2003, Barry Eichengreen laid out a 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. However, inflation remains low 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.[44]
In 2006, William White argued that "financial liberalization has increased the likelihood of boom-bust cycles of the Austrian sort" and he has later argued the "near complete dominance of Keynesian economics in the post-world war II era" stifled further debate and research in this area.[46][47] 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.[47] 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.[4][47]
Related policy proposals[edit]
Economists Jeffrey Herbener,[48] Joseph Salerno,[49] Peter G. Klein[49] and John P. Cochran[50] have testified before Congressional Committee about the beneficial results of moving to either a free banking system or a free full-reserve banking system based on commodity money based on insights from Austrian business cycle theory.