Hi there,
I've been aware of the Austrian Business Cycle Theory for a while now, although I haven't read nearly enough about it. From what I can tell, one of the major problems is that resources are misdirected into capital goods industries and away from consumer goods because:
a) entrepreneurs are tricked into thinking that consumption is being deferred to be consumed in the future, presumably when their investments begin to yield a greater capacity.
b) the lower interest rates have the direct effect of making unsustainable projects look more profitable than they really are.
However, I do not understand how resources for this are reallocated from consumer goods industries. After all, the lower interest rates cause not only greater borrowing for investment, but also for consumption. Individuals save less, and consume more. Often they consume even more than they produce.
Clearly the demand for consumer goods such as cars, TVs, computers, etc., is also on the rise when interest rates are artificially lowered. So given that entrepreneurs see the rise in demand for consumer goods, why would they redirect resources away from these industries?
And if in reality both consumer and capital goods industries boom together (as I think they do), then I'm wondering where all of these investments come from. Are we "eating" into the capital stock? The capital stock is a very abstract term though. If anyone can make this clearer for me, it would be a great help. I'm writing a short essay trying to summarise the ABCT, but I can't seem to make this part clear enough.
Thanks,
Fred
Fred Furash:So the part about reallocation is just false... I wonder where I got it from. I swear it's linked to Rothbard somehow...maybe in his Great Depression book.
It's a common misunderstanding, but I seriously doubt that you got it from Rothbard.
Fred Furash:But these unsustainable (in the long run) investments are nevertheless maintained for the period of the boom. So what I'm wondering is where do the resources come from in order to maintain them in the short run?
The boom is a result of inflation. Precisely because not enough resources are freed from consumption in order to meet the new demand in capital goods, the boom is experienced as an increase in prices. What sustains the boom in the short run is the inflation. As long as money can be injected into the system at an accelerating rate, the boom can be maintained
Fred Furash: Is it some sort of pool of savings or capital that is being consumed at a rate faster than it is being produced?
Yes, you can say that. The affect of credit expansion is that it distorts the price structure of the economy. Certainly, the rising prices will fuel speculative behavior further exacerbating the problem.
Because the low interest rates make investments in the stages furthest from consumption appear to be more profitable, resources will be withdrawn from more urgent needs to where prices are now signaling the highest rate of returns in terms of profits. This is where the malivestment part of the theory enters. But the total amount of resources allocated to higher order stages has not changed.
Fred Furash:However, I do not understand how resources for this are reallocated from consumer goods industries.
There is a good reason as to why you don't understand this. It's not true.
Resources are not necessarily reallocated from consumption to higher order goods, at least not in any pattern that is consistent with the amount of investment. This is precisely why the investments are unsustainable and are later proven to be nonprofitable.
Fred Furash:After all, the lower interest rates cause not only greater borrowing for investment, but also for consumption.
And it also encourages consumption due to lower interest rates. So yes, consumers don't cut down on consumption. The investments in higher order goods are therefore, not financed by real savings. When this is revealed, the boom turns into a bust.
So the part about reallocation is just false... I wonder where I got it from. I swear it's linked to Rothbard somehow...maybe in his Great Depression book.
DD5: And it also encourages consumption due to lower interest rates. So yes, consumers don't cut down on consumption. The investments in higher order goods are therefore, not financed by real savings. When this is revealed, the boom turns into a bust.
This I understand. But the way the explanation goes is: incentives are created for unsustainable consumption and investment. When it is revealed they are unsustainable, they must be liquidated, and this process is the bust.
But these unsustainable (in the long run) investments are nevertheless maintained for the period of the boom. So what I'm wondering is where do the resources come from in order to maintain them in the short run? Is it some sort of pool of savings or capital that is being consumed at a rate faster than it is being produced? If anyone knows of a more detailed explanation of that part it would help a lot.
DD5:It's a common misunderstanding, but I seriously doubt that you got it from Rothbard.
You're right, I couldn't find any such references after skimming his Great Depression.
DD5:The boom is a result of inflation. Precisely because not enough resources are freed from consumption in order to meet the new demand in capital goods, the boom is experienced as an increase in prices. What sustains the boom in the short run is the inflation. As long as money can be injected into the system at an accelerating rate, the boom can be maintained
I think I got it now, it's the fact that markets take time to adjust to the new money, since they cannot easily distinguish old money from new, real savings from fake credit expansion. The "pool" or whatnot that I was looking for, is merely the time interval it takes for prices to adjust to the monetary inflation, and for unsustainable investments to be revealed as such. During this time, the money can chase after investments with diminishing returns.
Thanks, you helped me think through this problem :)