austrian business cycle theory - how government manipulation of interest rates causes booms, busts,...

Austrian Business Cycle Theory

Austrian Business Cycle Theoryby Graham Wright

(http://managainstthestate.blogspot.com/)

http://managainstthestate.blogspot.com/




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


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


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


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


The structure of production is rearranged to increase production


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


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



Agenda


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.


AUSTRIANS AND KEYNESIANS

( http://www.youtube.com/watch?v=d0nERTFo-Sk )

“Fear The Boom and Bust” - A Hayek vs. Keynes Rap Anthem

http://www.youtube.com/watch?v=d0nERTFo-Sk



Agenda


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


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


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



Agenda


In a recession, Keynesians recommend that even more money is printed; politicians are happy to take this advice

BOOM-BUST CYCLE


• 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!


• 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


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



Agenda

“The curious task of economics is to demonstrate to men how little they

really know about what they imagine they can design.”


For free education, visitThe Ludwig von Mises Institute,

the intellectual home of the Austrian School,at

mises.org

http://www.mises.org/

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