David Glasner, ed., Business Cycles and Depressions
New York: Garland Publishing Co., 1997, pp. 23-27
The Austrian Theory of the Business
Roger W. Garrison
in the economic theory set out in Carl Menger's
Principles of Economics
and built on the vision of a capital-using production process developed
in Eugen von Böhm-Bawerk's Capital and Interest, the Austrian
theory of the business cycle remains sufficiently distinct to justify its
national identification. But even in its earliest rendition in Ludwig von
Mises' Theory of Money and Credit and in subsequent exposition and
extension in F. A. Hayek's Prices and Production, the theory incorporated
important elements from Swedish and British economics. Knut Wicksell's
and Prices, which showed how prices respond to a discrepancy between
the bank rate and the real rate of interest, provided the basis for the
Austrian account of the misallocation of capital during the boom. The market
process that eventually reveals the intertemporal misallocation and turns
boom into bust resembles an analogous process described by the British
Currency School, in which international misallocations induced by credit
expansion are subsequently eliminated by changes in the terms of trade
and hence in specie flow.
theory of the business cycle emerges straightforwardly from a simple comparison
of a savings-induced boom, which is sustainable, with a credit-induced
boom, which is not. An increase in saving by households and a credit expansion
orchestrated by the central bank set into motion market processes whose
initial allocational effects on the economy's capital structure are similar
but whose ultimate consequences are sharply different.
thrust of the theory, though not the full argument, can be stated in terms
of the conventional macroeconomic aggregates of saving and investment.
The level of investment is determined by the supply of and demand for loanable
funds, as shown in Figures 1(a) and 1(b). Supply reflects the willingness
of households to save at various rates of interest; demand reflects the
willingness of businesses to borrow in order to finance investment projects.
Each figure represents a state of equilibrium in the loan market: the market-clearing
rate of interest is i, as shown on the vertical axis; the amount of income
saved and borrowed for investment purposes is A, as shown on the horizontal
in the supply of loanable funds, as shown in Figures 1(a) and 1(b) alike,
has obvious initial effects on the rate of interest and on the level of
investment borrowing. But the ultimate consequences differ importantly
depending upon whether the increased supply of loanable funds derives from
increased saving by households or from increased credit creation by the
1(a) shows the market's reaction to an increased thriftiness by households,
as represented by a shift of the supply curve from S to S'.
Households have become more future-oriented; they prefer to shift consumption
from the present to the future. As a result of the increased availability
of loanable funds, the rate of interest falls from i to i', enticing businesses
to undertake investment projects previously considered unprofitable. At
the new lower market-clearing rate of interest, both saving and investment
increase by the amount AB. This increase in the economy's productive capacity
constitutes genuine growth.
1(b) shows the effect of an increase in credit creation brought about by
the central bank, as represented by a shift of the supply curve from S
S+/\M. Households have
not become more thrifty or future-oriented;
the central bank has simply inflated the supply of loanable funds by injecting
new money into credit markets. As the market-clearing rate of interest
falls from i to i', businesses are enticed to increase investment by the
amount AB, while genuine saving actually falls by the amount AC. Padding
the supply of loanable funds with new money holds the interest rate artificially
low and drives a wedge between saving and investment. The low bank rate
of interest has stimulated temporary—rather than sustainable—growth. The
credit-induced artificial boom is inherently unsustainable and is followed
inevitably by a bust, as investment falls back into line with saving.
Even in this
simple loanable-funds framework, many aspects of the Austrian theory of
the business cycle are evident. The natural rate of interest is the rate
that equates saving and investment. The bank rate diverges from the natural
rate as a result of credit expansion. When new money is injected into credit
markets, the injection effects, which the Austrian theorists emphasize
over price-level effects, take the form of too much investment. And actual
investment in excess of desired saving, CB, constitutes what Austrian theorists
call forced saving.
significant aspects of the Austrian theory of the business cycle can be
identified only after the simple concept of investment reflected in Figures
1(a) and 1(b) is replaced by the Austrian vision of a multi-stage, time-consuming
production process. The rate of interest governs not only the level of
investment but also the allocation of resources within the investment sector.
The economy's intertemporal structure of production consists of investment
subaggregates, which are defined in terms of their temporal relationship
to the consumer goods they help to produce. Some stages of production,
such as research and development and resource extraction, are temporally
distant from the output of consumer goods. Other stages, such as wholesale
and retail operations, are temporally close to final goods in the hands
of consumers. As implied by standard calculations of discounted factor
values, interest-rate sensitivity increases with the temporal distance
of the investment subaggregate, or stage of production, from final consumption.
rate governs the intertemporal pattern of resource allocation. For an economy
to exhibit equilibrating tendencies over time, the intertemporal pattern
of resource allocation must adjust to changes in the intertemporal pattern
of consumption preferences. An increase in the rate of saving implies a
change in the preferred consumption pattern such that planned consumption
is shifted from the near future to the remote future. A savings-induced
decrease in the rate of interest favors investment over current consumption,
as shown in Figures 1(a) and 1(b). Further—and more significant in Austrian
theorizing—it favors investment in more durable over less durable capital
and in capital suited for temporally more remote rather than less remote
stages of production. These are the kinds of changes within the capital
structure that are necessary to shift output from the near future to the
more remote future in conformity with changing intertemporal consumption
of capital away from final output—and hence the shift of output towards
the more remote future—can also be induced by credit creation. However,
the credit-induced decrease in the rate of interest engenders a disconformity
between intertemporal resource usage and intertemporal consumption preferences.
Market mechanisms that allocate resources within the capital structure
are imperfect enough to permit substantial intertemporal disequilibria,
but the market process that shifts output away from the near future when
savings preferences have not changed is bound to be ill-fated. The spending
pattern of income earners clashes with the production decisions that generated
their income. The intertemporal mismatch between earning and spending patterns
eventually turns boom into bust. More specifically, the artificially low
rate of interest that triggered the boom eventually gives way to a high
real rate of interest as overcommitted investors bid against one another
for increasingly scarce resources. The bust, which is simply the market's
recognition of the unsustainability of the boom, is followed by liquidation
and capital restructuring through which production activities are brought
back into conformity with consumption preferences.
macroeconomics bypasses all issues involving intertemporal capital structure
by positing a simple inverse relationship between aggregate (net) investment
and the interest rate. The investment aggregate is typically taken to be
interest-inelastic in the context of short-run macroeconomic theory and
policy prescription and interest-elastic in the context of long-run growth.
Further, the very simplicity of this formulation suggests that expectations—which
are formulated in the light of current and anticipated policy prescriptions—can
make or break policy effectiveness. The Austrian theory recognizes that
whatever the interest elasticity of the conventionally defined investment
aggregate, the impact of interest-rate movements on the structure of capital
is crucial to the maintenance of intertemporal equilibrium. Changes within
the capital structure may be significant even when the change in net investment
is not. And those structural changes can be equilibrating or disequilibrating
depending on whether they are savings-induced or credit-induced, or—more
generally—depending on whether they are preference-induced or policy-induced.
Further, the very complexity of the interplay between preferences and policy
within a multi-stage intertemporal capital structure suggests that market
participants cannot fully sort out and hedge against the effects of policy
on product and factor prices.
theory, a change in the conventionally defined investment aggregate not
accommodated by an increase in saving, commonly identified as overinvestment
and represented as CB in Figure 1(b), is often downplayed on both theoretical
and empirical grounds. In Austrian theory, the possibility of overinvestment
is recognized, but the central concern is with the more complex and insidious
(not represented at all in Figure 1(b) which involves the intertemporal
misallocation of resources within the capital structure.
"reference cycles" are marked by changes in employment and in total output.
The Austrian theory suggests that the boom and bust are more meaningfully
identified with intertemporal misallocations of resources within the economy's
capital structure followed by liquidation and capital restructuring. Under
extreme assumptions about labor mobility, an economy could undergo a policy-induced
intertemporal distortion and its subsequent elimination with no change
in total employment. Actual market processes, however, involve adjustments
in both capital and labor markets that translate capital-market distortions
into labor-market fluctuations. During the artificial boom, when workers
are bid away from late stages of production into earlier stages, unemployment
is low; when the boom ends, workers are simply being released, and unemployment
theory distinguishes between broadly conceived structural unemployment
(a mismatch of job openings and job applicants) and cyclical unemployment
(a decrease in job openings). In the Austrian view, cyclical unemployment
is, at least initially, a particular kind of structural unemployment: the
credit-induced restructuring of capital has created too many jobs in the
early stages of production. A relatively high level of unemployment ushered
in by the bust involves workers whose subsequent employment prospects depend
on reversing the credit-induced capital restructuring.
theory allows for the possibility that while malinvested capital is being
liquidated and reabsorbed elsewhere in the economy's intertemporal capital
structure, unemployment can increase dramatically as reduced incomes and
reduced spending feed upon one another. The self-aggravating contraction
of economic activity was designated as a "secondary deflation" by the Austrians
to distinguish it from the structural maladjustment that, in their view,
is the primary problem. By contrast, mainstream theories, which ignore
the intertemporal capital structure, deal exclusively with the downward
of policy and institutional reform are answered differently by Austrian
and mainstream economists because of the difference in focus as between
intertemporal distortions and downward spirals. The Austrians, who see
the intertemporal distortions as the more fundamental problem, recommend
monetary reform aimed at avoiding credit-induced booms. Hard money and
decentralized banking are key elements of the Austrian reform agenda. Mainstream
macroeconomists take structural problems (intertemporal or otherwise) to
be completely separate from the general problem of demand deficiency and
the periodic problem of downward spirals of demand and income. Their policy
prescriptions, which include fiscal and monetary stimulants aimed at maintaining
economic expansion, are seen by the Austrians as the primary source of
intertemporal distortions of the capital structure.
the purging in the 1930s of capital theory from macroeconomics consigned
the Austrian theory of the business cycle to a minority view, a number
of economists working within the Austrian tradition continue the development
of capital-based macroeconomics.
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