Austrian Business Cycle Theory - Assertions

Assertions

According to the theory, the boom-bust cycle of "malinvestment" is generated by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks. 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. 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, which, in the theory, stimulates a shift of investment from consumer goods to capital goods industries. Austrian economists further contend that such a shift is unsustainable and must reverse itself in due course. Proponents of the theory conclude that the longer the unsustainable shift in capital goods industries continues, the more violent and disruptive the necessary re-adjustment process. While agreeing with economist Tyler Cowen, Bryan Caplan has stated that he also denies "that the artificially stimulated investments have any tendency to become malinvestments".

The preference by entrepreneurs for longer term investments can be shown graphically by using any discounted cash flow model. 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. Therefore, investments that would not make sense with a 10% cost of funds become feasible with a prevailing interest rate of 5%.

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.

If the pricing signal triggering investment in the economy is artificially "fixed" too low 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) because the debasement of the means of exchange is universal. 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.

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. Austrians 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.

Austrians argue that 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. 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. This concept is dependent on notion of the "heterogeneity of capital", where Austrians emphasize that the mere macroeconomic "total" of investment does not adequately capture whether this investment is genuinely sustainable or productive, due to 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.

Austrians argue that a boom taking place under these circumstances 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 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.

Mises further argues that a "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. Mises conjectured that 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.

Austrians argue that 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). In the theory, this postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices. 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).

Austrians argue that 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. They further argue that 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.

Austrians do not claim that fiscal restraint or "austerity" will bring about economic growth. Rather, they argue that 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 worse, prolonging the depression and adjustment necessary to return to stable growth. 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 is therefore the only solution to a debt-fueled problem.

According to Ludwig von Mises:

There 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.

Read more about this topic:  Austrian Business Cycle Theory

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