The Austrian Business Cycle Theory

Economics has often been called a "dismal science". Looking at the current discourse on the economic crisis it is probably the only conclusion that any normal person could draw. Real intellectual thought is indeed near extinction in the economics profession. After all that algebra, all those graphs and all those fancy econometric models they were taught in college, economists these days are completely lost(well they're okayish in microeconomics, but macro is horrible).

If you ask a non-economist about the causes of the economic crisis, the answer will probably be as insightful as if you asked an economist. They'll say it's "inherent in capitalism", a result of "deregulation" or maybe they'll confess and simply say that they don't know. The reasons are many, but the solutions are the same without fail: more state intervention in the economy.

"Economics is not a dry subject. It is not a dismal subject. It is not about statistics. It is about human life. It is about the ideas that motivate human beings. It is about how men act from birth to death. It is about the most important and interesting drama of all — human action." ~Leonard P. Liggio

Economics has drifted far from the causal-realist analysis that it is supposed to be. When talking about economic policy, some already use "happiness economics" as a scientific justification for further intervention, when what they are talking about isn't economics or even science really. Or to be more precise; studying how happy people feel they are might be science, but many of the conclusions drawn from the results are normally worthy of no serious attention.

Then we of course have the idea of Rational Expectations that "...assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random."

The father of the Efficient Market Hypothesis Eugene Fama on the other hand says:
"I don't even know what a bubble means. These words have become popular. I don't think they have any meaning. ... They [bubbles] have to be predictable phenomena. I don't think any of this was particularly predictable."

Keynesians have aggregates and magical multipliers that confuse people with the skim milk fallacy. To quote Michael Levin:
"According to this paradigm [the skim milk fallacy], science always shows that things are the reverse of how they seem. Deep scrutiny of virtually any phenomenon will reveal that everyday convictions about it are wrong. In fact, taking things at face value betrays naiveté, while readiness to debunk is the mark of the sophisticate."
A household spends less if they are facing financial difficulties. According to Keynes the state should do the exact opposite. Creating new pieces of paper(new money) does not create additional wealth. But during a recession it does?

If none of this seems to fit well with reality, that's because it doesn't. Deviations from perfect foresight can be systematic, bubbles are bubbles even if they aren't predictable and the Keynesian stuff is just nonsense.

The Austrian School of Economics is simply the only school of thought that makes any sense. I will now try to briefly explain the Austrian theory of the business cycle.

"Before we can meaningfully ask what might go wrong, we should first understand how things could ever go right." ~F. A. Hayek

In a market economy the most successful entrepreneurs make profits and can thus expand their business. Bad players are automatically weeded out through the profit-and-loss mechanism. Even good entrepreneurs make mistakes, but when almost everyone makes mistakes(often the same kind of mistakes to boot) at the same time, shouldn't there be an explanation for this? Isn't this a question worth asking?

I am not quite satisfied with the usual suspects, whether it be greed, irrational exuberance or just the good old animal spirits. If collective insanity was really the explanation, why does it take so long for the mistakes to be revealed? Why is the economy so completely out of whack when the bust hits? How could there suddenly be such a lack of capital?

A castaway is on an island by himself. To sustain himself he decides to catch fish. He doesn't have any capital(any equipment other than his own body) so he does it with his bare hands and is able to catch only 3 fish each day. After a week or so he decides to make a net, but he knows he'll need a whole day to complete it. But he also needs to eat, so what does he do?

He'll need to eat only 2 fish per day(he'll need to underconsume) for three days to save 3 fish for the day on which he constructs the net. He saves because he thinks those savings will enable greater enjoyment later(remember time preference?). Those savings are his subsistence fund, the net will be his new capital equipment and this way of production is called a more roundabout method of production. It takes a longer time to construct the net and use it than to just keep catching fish with your bare hands, but it is also a more productive method and if it wasn't then there would be no point in doing it. If two methods of production are equally productive, then the one that takes longer will always be rejected.

As we underconsume we release resources into the economy to be used by others. Banks then allocate these funds in various ways and everyone is happy. Savers are paid interest for their sacrifice and borrowers use these savings to fund different activities. As we've already seen, a fall in time preference(less present, more future consumption) lowers the rate of interest. But when the rate of interest falls, what kinds of effect does that have on the structure of production?

Long-term debt is interest rate sensitive. When comparing to short-term debt, the demand for long-term debt changes much more with changes in the rate of interest. This is not surprising, as we always try to use the shortest and most productive processes of production. If there is more to invest and the shorter (less roundabout) processes are already in use, how else could the savings be allocated than to fund more roundabout production processes?

By saving we've indicated that we want to consume less in the present. This obviously lowers the demand for the production of lower-order goods(close to the consumer: warehousing, retailing etc) and releases these resources to be used in the production of higher-order goods(far away from the consumer: research and development, mining etc).

Everything is still in perfect harmony. We save more, we release resources to be used for a lenghtened structure of production and we wish to consume more in the future(this greater consumption in the future is enabled precisely by the lenghtened structure of production).

"The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions." ~Ludwig von Mises

Central banks create new money all the time. By doing so they push the rate of interest down. New money is also created through fractional-reserve banking. Now if banks have more to lend, they'll obviously charge a lower rate of interest for it. So everything goes as I described, except that there's one big difference: there are no additional savings. There is certainly additional credit, because the banks create it out of nothing, but no one has underconsumed and the society's subsistence fund hasn't changed.

Entrepreneurs will react to a change in the rate of interest and start more roundabout methods of production. They will start bidding resources away from the rest of the economy. But as these funds trickle back to people through wages, interest, rents and dividends, people will go and spend this money according to their old consumption/saving patterns(maybe they'll save even less; the rate of interest is lower after all). The lower-order stages of production see this demand and a tug o' war with higher-order stages begins, as both sides try to outbid each other. This leads to a rise in the price of capital and the rate of interest is pushed higher.

A modern society has a subsistence fund that isn't composed of just current savings, but also of past savings that have already been "used" to fund projects. The increasing costs of capital may for example lead to a decision that a machine isn't replaced with a new one even though it was supposed to be. In this way the machine(funded by past savings) is acting as a buffer to deal with the diminishing subsistence fund. This is one of the reasons why the boom can go on for so long.

As the price of higher-order goods rises much faster(they also collapse much more severely during the bust) during the boom, illusory profits appear. This creates an illusion of greater wealth while capital is being actually consumed. This perception of wealth can lead to a change in people's consumption/saving patterns, as they will feel richer. This is why the boom can(does not always happen) spread from higher-order goods to consumption.

The central bank can try to fight the rise in the rate of interest by injecting more credit into the economy, but this can only postpone the day of reckoning. At some point the choice will be between hyperinflation or letting the rate of interest rise.

As the rate of interest rises, the mistakes reveal themselves. Profitable ventures become unprofitable and the lack of real savings becomes apparent. There were no additional savings to begin with, but on top of that a lot of the existing savings were mishandled during the boom. The whole thing was unsustainable from the beginning.

Ludwig von Mises, in his book Human Action uses the example of a master builder who is building a house. This master builder thinks that he has 20% more bricks than he actually has at his disposal. If he thinks he has more bricks then he'll obviously build a completely different or at least a larger house than if he knew the real amount of bricks.

While the master builder is contructing the house everything is going well: people are employed, capital is being used, wages are paid and the house is being built. But would it be better for the master builder to realize his error sooner or later? When someone says that we need to inject more credit into the economy, he's basically suggesting that we get the master builder completely drunk, so maybe he won't notice the dwindling supply of bricks. This doesn't change the fact that the master builder is building a house that cannot be completed and he is wasting his time and resources.

The sooner the boom comes to an end, the better. The boom is the problem; it's during the boom that all the mistakes are made. Of course the best policy would be to never start the artificial boom to begin with, but this would require the abolition of central banks and fractional-reserve banking(JFYI: I'd like to abolish them).

The rate of interest should be left alone.