22 January 2009

Austrian economic theory on the business cycle

The only cogent explanation for our current ills to which we would add dollar hegemony, which gave an irresponsible central bank, the FED, international reach and the practice of fractional reserve banking, to which we must add the shadow banking system. So this credit bubble is like none before.

From Wikipedia.

"According to Austrian economist Joseph Salerno, what most distinctly sets the Austrian school apart from neoclassical economics is the Austrian Business Cycle Theory: [2]“ The Austrian theory embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. And it tells a compelling story about an area of history neoclassicals think of as their turf. The model of applying this theory remains Rothbard's America's Great Depression. ”


Austrian economists focus on the amplifying, "wave-like" effects of the credit cycle as the primary cause of most business cycles. Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.[44]

According to the Austrian business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "monetary boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. The global economic crisis of 2008 represents, according to some pundits, an example of the Austrian business cycle theory's dependability.[45]

Austrian economists argue that a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when credit creation cannot be sustained. They claim that the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back toward more efficient uses."

Here is more detail...
The theory begins with the claim that in a market with no central bank, there would be no sustained cluster of malinvestments or entrepreneurial errors, since astute entrepreneurs would not all make errors at the same time and would quickly take advantage of any temporary, isolated "mispricing".[14] In addition, in an open, non-centralised (uninsured) capital market, astute bankers would shy away from speculative lending and uninsured depositors would carefully monitor the balance sheets of risky financial institutions.

The "boom-bust" cycle of generalised malinvestment is generated by centralised monetary intervention in the market - specifically, by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks.[15] This "over-encouragement" to borrow and lend is caused by the mispricing of borrowed money via the central bank's attempt to centralise control over interest rates and "protect" banks from periodic bank runs (which Austrian economists believe then causes interest rates to be set too low for too long when compared to the rates that would prevail in a genuine non-central bank dominated free market).[16][14]

The proportion of consumption to saving or investment is determined by people's time preferences, which is the degree to which they prefer present to future satisfactions. Thus, the pure interest rate is determined by the time preferences of the individuals in society, and the final market rates of interest reflect the pure interest rate plus or minus the entrepreneurial risk and purchasing power components.[17]

Under the current fiat monetary system, a central bank creates new money when it lends to member banks, and this money is multipled many times over through the money creation process of the private banks. This new bank-created money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.[18][14]

This credit creation makes it appear as if the supply of "saved funds" ready for investment has increased, for the effect is the same: the supply of funds for investment purposes increases, and the interest rate is lowered.[18][14] Borrowers, in short, are misled by the bank inflation into believing that the supply of saved funds (the pool of "deferred" funds ready to be invested) is greater than it really is. When the pool of "saved funds" increases, entrepreneurs invest in "longer process of production," i.e., the capital structure is lengthened, especially in the "higher orders", most remote from the consumer. Borrowers take their newly acquired funds and bid up the prices of capital and other producers' goods, stimulating a shift of investment from consumer goods to capital goods industries. The preference by entrepreneurs for longer term investments can be shown graphically by using any discounted cash flow model. Essentially lower interest rates increase the relative value of cash flows that come in the future. When modelling an investment opportunity, if interest rates are artificially low, entrepreneurs are led to believe the income they will receive in the future is sufficient to cover their near term investment costs. In simple terms, investments that would not make sense with a 10% cost of funds become feasible with a prevailing interest rate of 5% (and may become compelling for many entrepreneurs with a prevailing interest rate of 2%).

Because the debasement of the means of exchange is universal, many entrepreneurs can make the same mistake at the same time (i.e. many believe investment funds are really available for long term projects when in fact the pool of available funds has come from credit creation - not "real" savings out of the existing money supply). As they are all competing for the same pool of capital and market share, some entrepreneurs begin to borrow simply to avoid being "overrun" by other entrepreneurs who may take advantage of the lower interest rates to invest in more up-to-date capital infrastructure. A tendency towards over-investment and speculative borrowing in this "artificial" low interest rate environment is therefore almost inevitable.[14]

This new money then percolates downward from the business borrowers to the factors of production: to the landowners and capital owners who sold assets to the newly indebted entrepreneurs, and then to the other factors of production in wages, rent, and interest. Austrian economists conclude that, since time preferences have not changed, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. In other words, depositors will tend to remove cash from the banking system and spend it (not save it), banks will then ask their borrowers for payment and interest rates and credit conditions will deteriorate.[14]

Capital goods industries will find that their investments have been in error; that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production will have turned out to be wasteful, and the malinvestment must be liquidated.[19] In other words, the particular types of investments made during the monetary boom were inappropriate and "wrong" from the perspective of the long-term financial sustainability of the market because the price signals stimulating the investment were distorted by fractional reserve banking's recursive lending "ballooning" the pricing structure in various capital markets. These particular types of investments were never sustainable, and only temporary fiat money creation made them appear ephemerally attractive.

This concept is captured by the term "heterogeneity of capital", where Austrian economists emphasise that the mere macroeconomic "total" of investment does not adequately capture whether this investment is genuinely sustainable or productive, due the inability of the raw numbers to reveal the particular investment activities being undertaken and the inherent inability of the numbers to reveal whether these particular investment activities were appropriate and economically sustainable given people's real preferences.

The "monetary 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. The artificial stimulus caused by bank-created credit causes a generalised speculative investment bubble, not justified by the long-term structure of the market.[14]

The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.[16][19] 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.[16][19]

Since it takes very little time for the new money to filter down from the initial borrowers to the recipients of the borrowed funds (the various factors of production), why don't all booms come quickly to an end? Continually expanding bank credit can keep the borrowers one step ahead of consumer retribution (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.[20][19] It can also be temporarily put off by exogenous events such as the "cheap" or free acquisition of marketable resources by market participants and the banks funding the borrowing (such as the acquisition of land from local governments, or in extreme cases, the acquisition of foreign land through the waging of war).[21]

The monetary boom ends when bank credit expansion finally stops - when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. Evidently, 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.[20][19]

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Similar theories

The effect of the expanding credit cycle on the business cycle is emphasised by some economists at the Bank for International Settlements, and by a few mainstream academics such as Hyman Minsky and Charles P. Kindleberger. These two emphasize asymmetric information and agency problems. Henry George articulated a similar theory, emphasising the negative impact of speculative increases in the value of land, which places a heavy burden of mortgage payments on consumers and companies.[22] [23]

Barry Eichengreen lays out modern 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. Inflation remains low, however, 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.[22]

There you go...

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