Austrian Business Cycle Theory
Austrian Business Cycle Theoryby Graham Wright
(http://managainstthestate.blogspot.com/)
Austrian Business Cycle Theory
Ludwig Von Mises (1881-1973)
F.A. Hayek(1899-1992)
The Austrian Business Cycle Theory (ABCT) was developed by Ludwig Von Mises and his student F.A. Hayek in the 1920’s and 1930’s.
INTRODUCTION
Austrian Business Cycle Theory
1. “How Things Go Right”: Prices and Production2. Austrians and Keynesians on Business Cycles3. Austrian Theory of the Boom and the Bust4. In a recession, what can government do to help?
“Before we can meaningfully ask what might go wrong, we should first understand
how things could ever go right.”
Agenda
Austrian Business Cycle Theory
In a free market, production is coordinated to make best use of resources, in terms of consumer desires and values.
• On a free market, prices are formed by supply and demand.• Production is coordinated by entrepreneurs seeking profits and
responding to profit and loss signals. There is no need for a ‘central planner’.
• The profit-loss mechanism of the market ensures that:– Entrepreneurs best satisfying consumer demands (using resources efficiently)
are rewarded and survive, and – Entrepreneurs failing to satisfying consumer demands (wasting resources) are
punished with losses and bankruptcy.• When the price of a product is manipulated by governments… the market
becomes uncoordinated and resources are wasted / misallocated / malinvested from the consumers’ point of view.
PRICES AND PRODUCTION
Austrian Business Cycle Theory
The market process is entrepreneurs and investors responding to profit and loss signals. (1)
Demand >
Supply
Prices Increase
Profits Increase
Production Increases
Entrepreneurs increase prices to try to maximise profits
Existing firms increase production of that product, and new firms enter the market.
More production needed
PRICES AND PRODUCTION
The structure of production is rearranged to increase production
Austrian Business Cycle Theory
The market process is entrepreneurs and investors responding to profit and loss signals. (2)
Supply >
Demand
Prices Decrease
Profits Decrease
Production Decreases
Less production needed; resources are needed elsewhere
PRICES AND PRODUCTION
The structure of production is rearranged to decrease production
Existing firms decrease production of that product, and some firms go bankrupt.
Competition impels entrepreneurs to decrease prices to try to maximise profits
Austrian Business Cycle Theory
1. “How Things Go Right”: Prices and Production2. Austrians and Keynesians on Business Cycles3. Austrian Theory of the Boom and the Bust4. In a recession, what can government do to help?
Agenda
Austrian Business Cycle Theory
So why are economies plagued by recurrent business cycles?AUSTRIANS AND KEYNESIANS
Keynesians
The business cycle is a fundamental feature of a market economy, caused ultimately by human ‘animal spirits’.
Governments can lessen the effect of the business cycle through fiscal/monetary policy.
Austrians
The business cycle is caused by governments artificially lowering interest rates.
Governments interventions worsen recessions. With a free market interest rate, the business cycle simply
would not occur.
Austrian Business Cycle Theory
AUSTRIANS AND KEYNESIANS
( http://www.youtube.com/watch?v=d0nERTFo-Sk )
“Fear The Boom and Bust” - A Hayek vs. Keynes Rap Anthem
Austrian Business Cycle Theory
1. “How Things Go Right”: Prices and Production2. Austrians and Keynesians on Business Cycles3. Austrian Theory of the Boom and the Bust4. In a recession, what can government do to help?
Agenda
Austrian Business Cycle Theory
The interest rate is a reflection of time-preferences
• The interest rate is the price of borrowing money.• Like all prices, in a free market, the interest rate is determined by supply
and demand. The supply of money to be loaned (savings) and the demand for loans.
• The free market interest rate is therefore a reflection of the time-preferences of the individuals in society; that is, how highly people value current consumption over saving that will allow them future consumption.
• Interest rates coordinate the time-structure of production. That is, the profitability of short-term versus long-term production projects.
BOOM-BUST CYCLE
High time-preferences High interest ratesHigh spending, low saving
Low time-preferences Low interest ratesLow spending, high saving
Austrian Business Cycle Theory
Government manipulation of the interest necessarily results in a malinvestment boom
• When a central bank inflates the money supply the interest rate price signal is distorted. This causes the time-structure of production to become distorted.
• With an interest rate lower than the free market rate due to government manipulation, the amount of savings appears to be higher than it really is.
• It appears as though people are saving for the future, when in fact they want to consume now.
• Entrepreneurs are misled into starting more and different, especially long-term production projects, believing they will be profitable.
• There is an “artificial” boom, especially in capital goods industries: housing, construction, mining, manufacturing, etc. This boom is a result of malinvestments of resources in unsustainable projects.
• While the boom continues, the malinvestments are unseen; they appear to be profitable businesses. The bigger and longer the boom, the more malinvestments occur.
BOOM-BUST CYCLE
Austrian Business Cycle Theory
Resources are scarce, so inevitably, there will be a bust, at which time the malinvestments become apparent: bursting price bubbles, job cuts, foreclosures and bankruptcies.
BOOM-BUST CYCLE
Austrian Business Cycle Theory
1. “How Things Go Right”: Prices and Production2. Austrians and Keynesians on Business Cycles3. Austrian Theory of the Boom and the Bust4. In a recession, what can government do to help?
Agenda
Austrian Business Cycle Theory
In a recession, Keynesians recommend that even more money is printed; politicians are happy to take this advice
BOOM-BUST CYCLE
Austrian Business Cycle Theory
• The inevitable recession is the market process of adjusting the structure of production back to satisfying consumers’ real time-preferences.
• Bankruptcies, defaults and unemployment increase as the malinvestments are liquidated. This frees up the land, labor and capital to be put to use satisfying real consumer demand.
• The recession-recovery can only be slowed down and made more severe by government interference, since the market process requires free market prices.
BOOM-BUST CYCLE The recession is the recovery period; the “hangover”
following the binge of the artificial boom
BailoutsStimulus PackagesNationalizations
More RegulationsLow Interest Rates
Lower TaxesLess Regulation
Eliminate Price ControlsStop Inflating!
Austrian Business Cycle Theory
• Further money creation – attempting to keep interest rates low – may delay the bust, but it will only create even more malinvestments, which will cause a bigger bust in the future.
• Hyperinflation is when the money supply is increased so much (in an attempt to delay a bust) that the value of the money rapidly decreases, until it is almost worthless.
BOOM-BUST CYCLE Money creation cannot go on forever; a “permanent boom” is
impossible
Austrian Business Cycle Theory
Government actions following the bust of 1929 caused the Great Depression
The Forgotten Depression, 1920-21
•From 1913 to 1920, the newly-founded central bank of the United States increased the money supply by 100%.•This created a large artificial boom,
resulting in an inevitable bust in 1920.•Government Interventions to “Help
The Economy”: Almost none
•The recession was severe, but short. Within 18 months, the economy had recovered.
The Great Depression, 1929-1946
•From 1921 to 1929, the central bank increased the money supply by 63%.•This created a large artificial boom, resulting in an inevitable bust in 1929.•Government Interventions to “Help The Economy”:
BailoutsStimulus packages
Deposit “insurance”Bank nationalisations
High government taxation/spendingPublic works
High deficits/debtsPrice controls
Further money creationMass confiscation of gold
The end of the classical “gold-standard” dollar
•The result was very severe, and long; the Great Depression; the economy did not recover for 17 years.
BOOM-BUST CYCLE
Austrian Business Cycle Theory
1. “How Things Go Right”: Prices and Production2. Austrians and Keynesians on Business Cycles3. Austrian Theory of the Boom and the Bust4. In a recession, what can government do to help?
Agenda
“The curious task of economics is to demonstrate to men how little they
really know about what they imagine they can design.”
Austrian Business Cycle Theory
For free education, visitThe Ludwig von Mises Institute,
the intellectual home of the Austrian School,at
mises.org