Tuesday, 23 August 2016

The "Austrian" Theory of the Business Cycle

I'm in the process of completing a book addressing some of the economic problems associated with an elastic money supply (a currency with the ability to increase in volume based on demand), including how an ever-changing money supply affects the stock market. As part of this, I've attempted to synthesize the older and original writings on the Austrian Theory of the Business Cycle into one comprehensible document. An excerpt from this document is published below. I hope you enjoy it, and that it might help tie up any "loose ends" should you have any concerning this theory. Any comments you might have would be greatly appreciated.

A frequently misunderstood theory: 
The Austrian Theory of the Business Cycle puts economic concepts and relations together to not only explain how artificial booms are ignited and how they can continue for some time, but also to demonstrate how they necessarily must eventually end with a very real bust. The theory is however frequently misquoted and misunderstood as it is often applied to all situations involving an expansion of the money supply. This is not however what Mises and later Hayek had in mind when they developed the theory. Specifically, at the core of their theory was that an increase in money supply is brought about by an increase in bank credit where producers are the initial recipients of the newly created money. These producers would then use the newly created money they receive to invest in, and lengthen, the respective production processes. In its essence, the theory explains the economic consequences of a lengthening of the structure of production made possible only through an increase in credit and money. 

The roots of the Austrian theory of the business cycle can be traced back centuries. Our focus here will however be the theory as initially put forth by Ludwig von Mises and further developed by Friedrich Hayek and others.

Over the years, this theory has been referred to by many names. In his 1912 book The Theory of Money and Credit, Mises coined it the “trade-cycle theory,” a doctrine he stated “is called the monetary or circulation credit theory, sometimes also the Austrian theory.” [1] In this book we refer to this theory as the Austrian Theory of the Business Cycle or Austrian Business Cycle Theory as this is what the theory is commonly referred to these days. The latter name also readily allows us to shorten it to ABCT, an easy to remember acronym.

As explicit in its name, the ABCT seeks to identify and explain the underlying fundamental causes of what is commonly referred to as the business cycle, i.e. broad-based expansions and contractions of economic activities in an economy. Instead of merely identifying and explaining symptoms of the business cycle as have become not only common place, but often the only way these days in my opinion, any sound economic theory traces the problem all the way back to its root causes. As Greaves once explained: “…science trace cause and effect by going back and back and back until one cannot go back any further.” [2] And that is exactly what the ABCT does: it goes all the way back to the very reason overconsumption and malinvestments can take place at all in the first place and continue for some time. Most importantly, the theory also explains why both must one day come to an end.

The Austrian theory of the business cycle was developed at a time when banks lent money into existence mainly to businesses. Specifically, though Mises recognised that the lower interest rates caused by credit expansion attracted all producers who could use the borrowed funds, [3] the ABCT focuses on what happens when business use these funds to lengthen the production period. [4] At the core of the theory lies the idea that artificial booms and very real busts are brought about by a misdirection in production, i.e. malinvestments. Hayek explained that this can only occur “…when the pricing process is itself disturbed….” [5] The theory therefore seeks to get to the bottom of what factors can possibly disturb the “pricing process” and how these disturbances then create the business cycle. As we’ve already seen, the creation of new money is normally undertaken by banks by way of creating new deposits (money) through lending. As, especially at the time when the theory was developed, bank lending was usually done in the form of lending to businesses as mentioned above, the theory focuses on what happens when businesses lengthen the production processes with the newly created purchasing power they receive from the banks. In many ways, the theory has already been explained in the foregoing chapters. What remains now is to tie it all together in a comprehensible manner.

The elasticity of the money supply lies at the very heart of the Austrian Theory of the Business Cycle for one simple reason; there would be no broad based and large scale business cycles without it. Consequently, if the money supply was largely inelastic there simply would be no need for a theory of the business cycle at all as there would be no cycle to explain. Unfortunately, the reality is that we have lived with an elastic money supply to varying degrees for a very long time and most unfortunately we will likely have to live with it for the foreseeable future. The people, organisations, corporations and structures that have been built by design on, and which depend on, sapping purchasing power from others against their will and knowledge for their very existence are not easily untangled as history has shown. [6] That’s why a sound theory of the business cycle was an asset for anyone in its possession during the last century just as it will be for the foreseeable future.

It would be of no economic significance if changes in the money supply affected all prices equally and at the same time. [7] As prices in the real world are never affected equally and at the same time whenever the money supply changes, a theory of the business cycle hence needs to incorporate this fact in its analysis. Where and how the new money enters the market are therefore of importance when it comes to understanding how money supply changes affect the economy. Under existing monetary systems, someone will always receive the new money first and be in a position to spend it before others because, as Hayek puts it, “The influx of the additional money into the system always takes place at some particular point.” [8] Who this someone is largely depends on by what process the monetary inflation takes place at that particular time, e.g. banks issuing business- or consumer loans or banks and the central bank financing government deficit. The reality is of course that additional money is constantly being injected into the economy through many avenues. For example, mortgage lending is the dominant way banks extend credit to individuals in many countries as this is encouraged, and often financially supported, by governments. Real estate prices, and goods and services associated with real estate are therefore prime beneficiaries of an increased money supply.

In general, on what the new money is first spent, how the recipients of the money from the first receivers spend or invest their money and so forth in addition to the size and speed of the new money influx determine how prices and the economy are affected. But these different processes have one thing in common, independent on how the new money filters through the economy, and that is “…that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of the others and the whole structure of relative prices therefore very different from what the pure theorist describes as an equilibrium position.” [9] Prices are therefore never affected to the same extent and at the same time whenever the supply of money brings about changes in the structure of prices. [10] Changes in relative prices brought about by inflation are important for the Austrian theory of the business cycle as such changes will alter the distribution of productive resources, at least for a while. As individual prices and their interrelationships, rather than the general level of prices as such, act as signals for market participants, more will produced of those goods and services whose prices are now relatively higher (as the prospects of profits increase) and less will be produced of those goods and services that now fetch a relatively lower price (prospects of profits decrease). That is to say, changes in relative prices prompt changes in the structure of production. Furthermore, as the general level of prices may continue growing at a rate deemed “stable” even if relative prices are changing significantly, [11] it follows that changes in relative prices are more important than the rate of change in the general level of prices. [12]

The Austrian theory of the business cycle deals with the particular situation where banks grant credit to businesses via the loan market [13] and in this way inflates the money supply. According to Garrison, the Austrian theory of the business cycle, [14]

…emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not.

The essence of the Austrian theory of the business cycle can be described as follows. When banks expand credit, and with it new money, market interest rates are pushed below the level they would have been absent an expansion of credit and money. This lowering of the interest rate increases economic activity as credit is now more plentiful than before and as it can be attained at a lower cost. Entrepreneurs act accordingly as if actual savings has increased though it has not. That is, entrepreneurs invest more than savings have provided for and they do so in a lengthening of the production structure. [15] This increase in investments pushes the prices of producer goods up and an artificial boom ensues reflecting the extent of the credit expansion and the additional investments such credit expansion brings forth. Many ventures that previously would have been unprofitable are now found profitable given the cheaper and more readily available credit offered by banks. [16] More projects are as a result started than otherwise would have been the case, including more projects with expected payoffs longer into the future. The prices of consumer goods will increase as well, albeit at a slower pace than for producer goods, as both salaries and the number of people working in the producer goods industries increase. At least a part of this increase in total salaries will be spent on consumer goods. But the supply of consumer goods has however not yet increased as it takes time for the longer production processes that were started to finally start producing consumer goods. [17] It is this mismatch between the supply and demand for consumer goods that push consumer goods prices up. 

If the credit expansion was ended quickly, the economic distortions would be smaller. However, once started, credit expansion tends to continue as banks are able to create credit in excess of any limit set by their own assets and customer deposits. The price premium component of the market interest rate will rise, but it does not rise sufficiently to end the credit expansion as it will lag the rate of increase in new credit granted. Furthermore, the upward movement of the bank credit cycle sets in with full force as fractional reserve banking allows banks to create credit and with it new money based on customer deposits received which were originally created out of thin air by other banks. As the credit expansion process continues, the stock of consumer goods available is gradually depleted as the supply is yet to increase or yet to increase sufficiently to offset the higher demand brought about by the higher total salaries in the producer goods sector. When this process continues, prices of consumer goods will eventually rise faster than prices for producer goods as the economy was not sufficiently rich in the first place to undertake both a lengthening of the production process and an increase in the production of consumer goods. The purchasing power granted to the producers whom lengthened the production process was as a result simply diverted from other sectors of the economy. Moreover, this diversion of resources, set in motion by an increase in the money supply, was done against the will of the market. [18] A shortage of consumer goods manifests itself in the economy and the now relatively higher price- and profit increases for consumer goods brings about pressure toward a reduction or outright abandonment of investments in many of the new projects that were undertaken. This pressure can be postponed through yet higher doses of credit granted to the producer goods industries.

But the credit expansion cannot continue indefinitely. Once people come to expect continued price increases, panic will set in jeopardising the whole monetary system as the value of the currency rapidly declines. Mises refers to this as the “crack-up boom” as everybody becomes “...anxious to swap his money against “real” goods, no matter he needs them or not, no matter how much money he has to pay for them.” [19] Banks, and especially central banks, will however usually put in place measures to end or greatly reduce credit expansion before the onset of such a general panic. A bust in the producer goods industries dependent on further cheap credit, but which now face higher costs of borrowing, sets in and resources move away from producer goods to consumer goods in an effort to re-establish the preferred consumption-savings ratio of market participants. Interest rates rise as people’s degree of preference for the present over the future has increased (time-preference increases). The many who gained from the cheap credit and investment boom will now suffer; the unemployment rate in the affected industries will rise and a portion of the investments will be lost as it becomes apparent they were in fact malinvestments. During the process, resources were squandered and the economy as a whole is worse off a result. 

The economy now needs to be “repaired” and adapt to the new situation brought about by the wasting of resources (losses) the credit expansion orchestrated, a course which requires decreased consumption and increased savings. No further injection of credit and money can repair the damages done to the economy; all it can ever accomplish is to postpone the adjustment process and make the inevitable downturn even worse. This is the case as further credit injections only serve to further disturb the preferred consumption-savings ratio which has already been pushed out of balance, i.e. what is needed is an increased rate of saving instead of yet more consumption and depletion of resources. The savings that were depleted during the artificial boom phase now need to be replenished to allow the economy to prosper in a sustainable fashion going forward. The faster this is allowed to happen the shorter the downturn will be.


[1] (Mises, The Theory of Money & Credit, 1953, p. 423).
[2] (Understanding the Dollar Crisis, 1973, p. 76).
[3] See the introduction by Percy L. Greaves, Jr to The Causes of the Economic Crisis (Mises, The Causes of the Economic Crisis And Other Essays Before and After the Great Depression, 2006).
[4] See The Theory of Money and Credit, pp. 360-361 (Mises, The Theory of Money & Credit, 1953).
[5] (Hayek F. A., Monetary Theory and The Trade Cycle, 1933, pp. 84-85).
[6] Many of these structures could not survive or have grown to their current sizes based on voluntary taxes alone as tax payers would simply refuse to pay all of their income in taxes in order to finance them, e.g. government spending and the encompassing bureaucratisation, international organisations such as the IMF, World Bank and the OECD.
[7] E.g. see (Hayek F. A., Prices and Production, 2nd ed., 1935, p. 5).
[8] (The Austrian Theory of the Trade Cycle and other essays, 1996, p. 97).
[9] (Ebeling, Hayek, Mises, Rothbard, Haberler, & Garrison, 1996, pp. 97-98).
[10] See (Mises, Human Action, A Treatise on Economics, 2008, p. 409).
[11] Any change in the quantity of money must always, according to Hayek, influence relative prices whether or not it actually influences the level of prices (Hayek F. A., Prices and Production, 2nd ed., 1935, p. 28).
[12] Hayek explains that “…general price changes are no essential feature of a monetary theory of the Trade Cycle; they are not only unessential, but they would be completely irrelevant if only they were completely “general” – that is, if they affected all prices at the same time and in the same proportion” (Hayek F. A., Monetary Theory and The Trade Cycle, 1933, p. 123).
Hayek later explained that “There can also be no doubt that, in connection with these secondary monetary complication [“…the effects of the further monetary changes which may, and perhaps even probably will, but need not, be induced by this first change”], general price movements, apart from the changes in relative prices, will be of the greatest importance, and that anything which stops or reverses the general price movement may lead to induced monetary changes, the effect of which on the demand for consumers’ goods, and producers’ goods, may be stronger than the initial change in the quantity of money” (Hayek F. A., Prices and Production, 2nd ed., 1935, p. 158).
[13] In the chapter in Human Action laying out the theory of the business cycle, Mises explains: “In dealing with the consequences of credit expansion we assumed that the total amount of additional fiduciary media enters the market system via the loan market as advances to businesses. All that has been predicated with regard to the effects of credit expansion refers to this condition” (Mises, Human Action, A Treatise on Economics, 2008, p. 568).
[14] (Ebeling, Hayek, Mises, Rothbard, Haberler, & Garrison, 1996, p. 112).
[15] This happens as the shorter production methods are already exhausted as discussed earlier.
[16] Especially ventures with projected cash inflows long into the future will benefit as they are more sensitive to interest rate costs and discount rates.
[17] Remember, the ultimate purpose of all production is to produce consumer goods. Increased production of producer goods, which aim to increase the production of consumer goods in the future, therefore depends on increased demand for consumer goods when such increased supply finally makes it to the market.
[18] That is to say, the diversion of resources on a grand scale to the producer goods industry would not have happened if the money supply was inelastic as interest rates would rise sharply effectively putting an end to the boom in this industry.
[19] (Mises, Human Action, A Treatise on Economics, 2008, p. 425).

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