By the end of this you can brag to your buddies at the parent’s meetings that you are an expert in Austrian Business Cycle Theory. How cool is that?!
Here’s Rothbard’s summary of the Austrian Business Cycle Theory (ABCT):
“In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption-investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful. Businessmen were led to this error by the credit expansion and its tampering with the free-market rate of interest.”
I thought this paragraph was a good summary of the ABCT, and hopefully its meaning will be more complete to you by the time you finish this paper. When you get to the end of it, I want you to read that paragraph again—I guarantee it will make perfect sense.
So, before I start explaining what I’ve learned about ABCT, I just want to issue one caveat: the theory seems so absolutely simple and persuading that you may think to yourself that there is no point in reading about it. Why bother with the effort to learn something when it is already obvious? If only it were obvious! When you’re reading about ABCT I want you to think in the context of modern economic thinking (the Great Depression was caused by greedy capitalists; printing money stimulates the economy; government spending is needed to keep an economy out of depression; interest rates can be manipulated by a group of central planners for the good of the economy; interest rates should be 0%; spending is good for the economy, not saving; etc.). Basically, when you consider the lack of thinking on economic subjects in our day, ABCT won’t seem so obvious.
(Of course, I say it’s simple and obvious, but I was reading it from a writer of much better ability, Murray Rothbard. If you do find it confusing, I take responsibility for not expressing it in the same fashion as Rothbard. And obviously with any theoretical work you will need to think your way through it, and that’s not always easy. I just meant that when I finally understood it, I was like, “No shit!!! This is common sense!”)
Alright, I’m going to lie some of the framework for the theory before I actually get into it. This should make it easier to understand the theory.
Here’s some boring technical stuff that will help you understand the theory more completely:
Higher order goods and Lower order goods- This is also called stages of production. If you remember Peter Schiff’s children’s book!! the fish were consumers goods and the net was a capital good. Higher and lower order just means goods used in the initial stages of production of the consumers goods. For example: suppose one of the characters in that book created a machine that increased the production of nets, so that the character didn’t have to build them by hand. This would mean that the process of production had three stages, in order from higher order goods to lower order goods: machine—net—fish. The production process would be expanded as the character creates even more capital goods. A real life example could be when I worked at the factory. The higher order goods (also called capital goods because they are used to produce lower order goods) would have been the machines and the ingredients used to produce parts, a lower order good would have been the actual parts we produced, and finally the whole purpose of this process is to deliver the consumers good, which would be a car.
Capeesh? Again, not too difficult. High order goods produce lower order goods which produce consumer’s goods.
Alright, so the second technical category is what Rothbard calls Time Preferences. This is easy to understand too. Basically, time preferences are the degree to which people prefer present to future satisfaction. Another way to think of it is the proportion of savings to consumption. A high time preference means people want to consume now (a lower proportion of savings to consumption), and a low time preference means people would rather consume less now and more at some point in the future (a greater proportion of savings to consumption). This is where I thought it got interesting: time preferences determine what interest rates are. If people have high time preferences, meaning they want to spend their money now, then the supply of savings is low, meaning interest rates will rise; conversely, if people have low time preferences, meaning they want to save their money for future satisfaction, then the supply of savings is higher and interest rates will decrease. So, if you think about it, interest rates are set by the supply of and demand for money. When the supply of money (savings) available for loans is high and the demand for money is also high (meaning people want to hold on to money) then time preferences are low and interest rates are low; conversely when the supply of money available for loans is low and demand for money is low interest rates are high.
So, at this point, all you really need to understand is that the process of production goes from higher order goods to lower order goods (or from capital to consumer); and that low time preferences are reflected in low interest rates and high time preferences are reflected in high interest rates. (Also remember that time preferences are a proportion of savings to consumption.)
Now, let’s see what happens when time preferences are low. As I said, interest rates will be low. This sends a signal to businesses that they need to invest in longer term projects, since demand for consumption in the present is low. Thus, demand for resources is taken from the lower stages of production and shifted to the higher stages of production. These new investments will allow businesses to produce more goods in the future when time preferences rise (when people wish to consume more relative to saving).
What about when time preferences are high? Interest rates will be high since people want to spend more in the present, which means the supply of savings goes down. This will shift demand back from higher order goods to lower order goods since businesses must concentrate on satisfying present demand, rather than invest in long-term capital projects.
Just a brief refresher here: the production process consists of higher order goods producing lower order goods which ultimately go on to produce the consumer’s goods. Interest rates (on a free market) are determined by people’s time preferences, or proportion of savings to consumption; a high time preference is reflected in high interest rates, and a low time preference is reflected in low interest rates and more investment in long term capital goods.
The final thing to understand before I go into the actual theory is the difference between a specific business fluctuation and a general business cycle.
Fluctuations may be expected all the time since we live in a society of perpetual change. Since people’s desires change, business data and markets are always subject to the chances of profits and losses.
However, fluctuations do not involve similar changes across the board. One industry may experience a time of losses while another experiences a time of profits.
On the other hand, a general business cycle features similar changes across the board. Many industries prosper and then fall at the same time.
Nothing complex there. Basic stuff!
But it raises the question as to why an economy should experience a general downturn or upswing all at once. Rothbard said that the first question for any cycle theory is: “Why is there a sudden general cluster of business errors?” Most businesses go along nicely making profits, so why all of a sudden do most businessmen make mistakes and suddenly experience losses? This is the question that ABCT seeks to answer.
Alright, enough of that technical information. Let’s use Rothbard to find the answer to that question.
Here’s the theory:
In the economy, there is a given stock of money at any given time. Some of it is spent on consumption, the rest is saved and invested for production. The proportion of saving to consumption is determined by people’s time preferences.
Now let’s suppose that banks print new money and loan it to businesses. This artificial bank credit expansion, argue the Austrians, is the igniter of boom and bust cycle. Rothbard said that the Mises theory is “the economic analysis of the necessary consequences of intervention in the free market by bank credit expansion.”
So, let’s see what the consequences are.
In the first place, the new money that was printed and loaned to businesses pours into the loan market and reduces the loan interest rates. When this happens, businessmen are under the false impression that the supply of savings has increased, making them believe people’s time preferences have fallen. “Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is,” said Rothbard.
So, if you remember from some of the above information, when interest rates drop, businessmen think people’s time preferences have fallen, or that they desire to consume less in the present. Therefore, businesses invest less in lower order goods and more in higher order goods. Demand is literally altered because of this credit expansion. You may hear it said that these booms are unsustainable. Rothbard explains why: “If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion.” That means that no circumstances changed regarding consumer demand or time preferences, only that interest rates were distorted by artificial credit expansion.
So after this bank credit expansion we have a shift in demand to capital goods industries, but we know that there won’t be a sufficient demand for what this industry supplies, since unnatural factors created the initial demand in the first place.
As this credit expansion creates a boom, people rush to spend their money, but when they do, they are spending at the same high time preferences as before, while businesses are still under the impression that a new lower time preference exists. From the businesses perspective, this is a rapid shift in time preferences (from low to high) which means they will have to suddenly end their investments in higher order goods to focus on satisfying current consumer demand. Basically, since people never expressed their desires to save more, businesses will find that they run out of resources when the supply of savings suddenly does not match their expectations.
At this moment, businesses will find that their investments in higher order goods have been in error, for no real demand exists for those goods at the present time. This malinvestment must be liquidated.
The crisis is not brought about for lack of consumer demand. Instead, it is a result of a lack of demand in the capital goods industries, because products were made that cannot be used. Who would want to buy them? Thus, Rothbard says that it is capital goods industries, and not consumers goods industries, that really suffer in a depression.
Now, go back up to the top of this paper and read Rothbard’s quote. It should make more sense now…
So that’s the gist of the ABCT:
- Banks expand credit by printing new money and loan it to businesses
- Interest rates fall
- Businesses, under a false impression, invest in higher order goods to satisfy future demand
- People continue spending more and not saving (the opposite of the impression created by the bank credit expansion)
- Since people are not saving more the supply of savings will not be sufficient for businesses to carry out these investment projects
- The sudden shift of time preferences from the apparently low to high causes businesses to shift demand back from higher order to lower order goods
- Demand for those capital goods does not exist, so business malinvestments must be liquidated
- The economy goes into a crisis
ABCT in a nutshell. That at least explains why economies seem to experience a period of prosperity, only to suddenly fall into depression. I’ll write a separate piece on the Austrian view of the proper way of handling a depression, which is basically the opposite of what governments do today!
Please, any questions or points you would like to refute let me know. It’s all about understanding!!