Austrian Theory of the Business Cycle: A Basic Primer

I’m no expert in the Austrian School of Economics.  But I know enough to like what I see and what I read.  Austrian economics (also see here) views the economic world as fundamentally linked to human behavior.  Thus, equations and rigorous quantitative analysis are not all they’re cracked up to be, as economics operates based on human behavior, which is full of fundamentally irrational aspects.

The result is that to understand economics, certain axioms are asserted about how humans think and act.  The aggregate of these axioms, or their totality, constitutes the Austrian School of Economics.  Many are quite basic and intuitive; for instance, individuals like to economize limited resources.  They like to trade something of lesser value for something of greater value.  They want to minimize expenditures.  And they tend to trade only in instances where they think they will be benefited.  The Austrian theory is really quite fascinating.  Mises.org (named after Ludwig von Mises) has some great basic teachings and texts on the subject.  I highly recommend them.

One aspect of Austrian economics particularly pertinent to our condition is the theory of the business cycle.  For most mainstream economists nowadays, the business cycle is built into the laissez-faire economy.  Thus, intervention is needed to tame the excesses and maladies associated with the laissez-faire business cycle.

For the Austrian theory (which holds up very well to the scrutiny of economic history), the business cycle comes not from laissez-faire economic policies, but from economic interventionism.  The thinking goes something like this:

In a true free market, banks would lend out money at an interest rate based on the cash deposited into the bank.  (How else would banks be profitable?)  The more money is deposited, the more money is available for lending out (i.e. investment).  The less money is deposited, the less money is available for lending.  When money is scarce, then interest rates are high to limit investment.  When money is abundant at the bank, interest rates are low, thus encouraging would-be investors to invest.  But all investments, in a free market, are tied to the savings on hand (or some fractional reserve; but we’ll ignore this aspect for now to keep things basic).

Suppose a bank set the interest rates too low.  Investors would rush in and take out all sorts of loans.  The bank would run out of money.  Depositors wouldn’t be able to get their money back, as the bank has lent out too much money!  The bank would likely go under.

Suppose a bank set the interest rates too high.  Investors would choose to invest in another bank with comparatively lower interest rates.  And so competition tends to set the interest rate at some optimal market rate (which fluctuates, as the market does, with great frequency).  Thus, investments are balanced with deposits, in a free market.

People are encouraged to deposit their money, as investments are based off of savings.  No savings translates to no investments.  So individuals deposit their money, reaping the dividend (interest from the loans being paid back).

Suppose an interest rate is not market-based, nor set based on available savings.  Suppose it is lower than the market rate.  What would happen?

It’s obvious that investors would love to take advantage of this situation: easy loans means easy credit and more money-making opportunities.  (They may even be compelled to take advantage of this just to stay in business.)  So many loans are given out.  Entrepreneurs have a hay-day with the proliferation of money available.  The result is new jobs, new businesses, and high growth.  Very high.  This phase is called the “boom” or the “bubble.” 

It should be noted that investments are riskier and of lower quality than they would be if the interest rate was higher; lenders would be more particular about who they are lending their money to, and for what purpose.  People taking out loans would be more cautious if the required rate of return to pay their loan back was higher.

The result is a bunch of bad investments.  True, there are good ones as well, but there is a disproportionate amount of bad (that is, unsustainable) investments.  When the market tries to liquidate these unsustainable investments, businesses go under.  This is called the “bust” part of the cycle, or when the “bubble” bursts.

Thus, artificially set interest rates with the intent of spurring the economy result in an ill-advised credit spending spree.  When the piper must be paid, businesses start going under.  Lay-offs occur.  Money becomes tighter.  If the boom is big enough, then a recession may result.

Examples of booms are all around us: the “roaring 1920s” is a great example.  We recall this was followed by the Great Depression.  In more recent memory, the dot.com boom of the mid and late 1990s and the huge housing bubble in the early part of this century are examples.  Each is a result of low interest rates, which encourage a huge amount of investment in certain sectors.  In the short-term, many get wealthy and rich.  (How many got involved in sub-prime loans or home equity lines of credit, to name two examples?)  In the long-term, a “bust” or even a “recession” results.

Banks don’t like the roller-coaster ride.  If it were up to them, they would set interest rates at more sustainable levels: just enough to encourage constant economic growth with a minimum of malinvestment.  They don’t benefit from the high highs and the low lows.  They make money when people pay their loans back, not when they default.  They prefer an even keel.

Many well-meaning individuals (like Suze Orman, for instance) talk about how we are a credit-driven society.  She points out that we need to save rather than spend.  That is certainly true.  What she does not acknowledge is that the whole system is set up for easy credit, completely independent of savings.  There is little incentive to save, especially when the rate of return is so low (those artificially low interest rates again) that it’s almost impossible to keep up with inflation.  (Most don’t question this, viewing inflation as a given or a necessary evil.)

There’s much much more to this picture, but in summary, artificially low interest rates (set by the U.S. Central bank: the Federal Reserve) are responsible for the boom and bust cycles, and for much of the economic turmoil frequently associated with the free market.  There was a time when this was well-understood.  Now, it is all but ignored.

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Filed under Austrian Economics, fiscal policy, Libertarian

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