Home > Macro/Monetary Theory > Support for Austrian Business Cycle Theory

Support for Austrian Business Cycle Theory

For those who aren’t familiar with ABCT, it can be most briefly explained with the parable of a home builder.  A man is given a stack of bricks of a certain size and decides to build a house out of them.  He designs the house based on the number of bricks he has and begins to build.  When he is half way done, he realizes that underneath the stack of bricks is a large mound of dirt which made the stack look larger than it really was.  He doesn’t have enough bricks to finish the house that he had designed and was half way done building.  He must build a smaller house but this means he has to tear down everything he had built and start over.  In this way the misconception about how many bricks he had to begin with is very destructive.

In a real economy, the bricks represent the real capital/savings available for investment.  The signal which tells investors how much capital is available is the interest rate.  If it were determined in the market, this would work fine but when the central bank sets the interest rate “too low” it signals that there is more capital available than there really is.  This causes investors to engage in more and longer term investment projects than they would if they were faced with a higher interest rate.  Eventually they realize that the savings necessary to support their investment are not available and the economy must restructure to adjust to the real environment in which it finds itself.  This adjustment takes the form of a recession.

Here is a passage from Wikipedia describing the process.

Though disputed, Austrian scholars assert that the boom then, 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.

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. 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.

Now compare that passage to the following excerpts from todays WSJ.

Some 1.5 million unfinished, unsold or unwanted residential units stand scattered across the country, products of a still-deflating housing bubble that threatens to undermine Spain’s broader economy for years to come. It is the hangover after an epic fiesta, a period Spaniards now refer to as “cuando pensábamos que éramos ricos”—”when we thought we were rich.”Once hailed as early proof of the success of the euro, Europe’s single currency, Spain’s low interest rates from the mid-1990s and its proximity to richer neighbors ushered in a decade-long period of prosperity.

…The decade through 2007 was a heady one for Spain. Flush with foreign investment and cheap credit that came with the arrival of the euro, it saw ambitious projects sprout everywhere. This was in stark contrast to the conservative approach to development that long held sway here.

…Problems started as early as 2006, when developers informed buyers that builders wouldn’t meet the initial deadline for completion, mostly because the construction boom had led to a shortage of labor and materials.

… Nowadays, scenic hillsides and beachfront vistas sit occupied by empty scaffolding, unfinished cinder-block frames and garbage heaps from work suspended months ago.

Anecdotal evidence?  Yes.  But striking is it not?  Now, lest I be labelled an Austrian economist, let me say that I think there are some shortcomings of ABCT and some questions left to be answered (as well as a bunch of long-standing methodological disputes that I won’t get into) but there is definitely some value in there.  It is amazing to me that mainstream economics can write this off entirely in favor of other theories with much more egregious philosophical flaws and a poor record of predicting economic fluctuations. 

Whether or not malinvestment is enough to explain a major recession is certainly open to debate but I can’t see how a reasonable person can look at the world and believe that it doesn’t exist or that it isn’t caused by low interest rates or that its effects are insignificant.  Sadly, the biggest problem with this theory seems to be the fact that its only policy implication is that we should rely on free markets rather than a semi-planned economy controlled by an interventionist central bank.  A conclusion which most policy makers and many economists seem determined to avoid if they can find any way possible.

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