Please, could someone check that the following is an accurate description of Austrian Business Cycle Theory? It is extracted from a review I am writing of Chris Leithner's new book.
How does central banking (or more accurately, FRB) bring about economic crises? To answer this question Leithner turns to Austrian Business Cycle Theory (ABCT). ABCT suggests that economic downturns are the price paid for prior credit expansion, especially when that prior expansion was brought about artificially by the central bank. The rationale is as follows. When central banks lower the market rate of interest below the natural rate this leads to distortions in the structure of production, excessive borrowing and speculation. Specifically, the central bank’s loose money policy misleads investors into starting projects that appear profitable, but are in reality not. Projects inspired by the easy supply of credit cannot end up being profitable because when interest rates rise in the future (as they inevitably must) the stark reality is revealed. The credit-induced boom cannot last forever because of a fundamental mismatch between savings and investment. Consumers do not have the money to buy the fruits of investors’ labour since they did not save enough in the first place. Interest rates were low because of the central banks’ interventions, not because there is a large pool of savings available to finance future consumption.
How does central banking (or more accurately, FRB) bring about economic crises?
To answer this question Leithner turns to Austrian Business Cycle Theory (ABCT). ABCT suggests that economic downturns are the price paid for prior credit expansion, especially when that prior expansion was brought about artificially by the central bank. The rationale is as follows. When central banks lower the market rate of interest below the natural rate this leads to distortions in the structure of production, excessive borrowing and speculation. Specifically, the central bank’s loose money policy misleads investors into starting projects that appear profitable, but are in reality not. Projects inspired by the easy supply of credit cannot end up being profitable because when interest rates rise in the future (as they inevitably must) the stark reality is revealed. The credit-induced boom cannot last forever because of a fundamental mismatch between savings and investment. Consumers do not have the money to buy the fruits of investors’ labour since they did not save enough in the first place. Interest rates were low because of the central banks’ interventions, not because there is a large pool of savings available to finance future consumption.
That's a pretty decent explanation but after I've read your post, I'm left wondering "why?" Why are investors mislead into starting unprofitable projects? Why do unprofitable projects appear profitable? Why must interest rates rise and why do booms/busts happen even if interest rates remain stable? Why is a mismatch between savings and investment bad and why does this mismatch mean that a boom cannot last forever? etc.
First of all, mention something about the rate of return. If "the interest rate" is 5%, then it is profitable to invest in any project which has a return greater than 5%. If "the interest rate" is 1%, then it is profitable to invest in any project which has a return greater than 1%. Investors, businessmen, entrepreneurs don't care about how much people save. They care about the interest rate at which they can borrow, the interest rate at which they can lend, and the rate of return they think their investment projects will earn them.
Secondly, you're just plain wrong about how interest rates "inevitably must" rise in the future. Frequently, busts occur when there are little to no changes in the interest rate, compared to the boom period. How do you explain this? And how do you counterargue someone who wants the same real rate of interest at all times (say, a real rate of interest at 0.5%)?
Thirdly, why cannot the "credit-induced" boom last forever due to a "fundamental mismatch" between savings and investment? What do you mean consumers cannot buy the fruits of the investors' labor? After all, if interest rates remain low, they can simply borrow to buy them.
What you're missing here is the fundamental lesson of scarcity.
In a normal economy (meaning an economy in which prices aren't distorted by booms and busts), if the savings rate increases, then the demand for loanable funds decreases while the supply of loanable funds increases. An increase in the savings rate necessitates a decrease in consumption and this decrease in consumption necessitates that scarce resources (meaning labor, capital, and natural resources) used by producers close to consumption will be released back into the market. Basically, a decrease in consumption means that the rate of return decreases for those projects close to the consumer, which means those projects will have to disinvest themselves, to a degree, from the market.
The lower real interest rates and the lower prices for factors of production make investment projects further from the consumer more profitable. The rate of return for these projects rises, thereby incentivizing investment in these projects and disinvestment in projects with lower rates of return. These projects can then use the scarce resources/factors of production/inputs released into the market by other projects in order to operate profitably.
In an unstable economy, if credit is created unbacked by savings, then it has similar effects to an increase in savings. The supply of loanable funds will increase, thus, the interest rate will fall. However, the demand for loanable funds, if anything, will increase, and, more importantly, there will be no decrease in consumption. It is more likely that consumption will increase (think: consumer credit). Because consumption will increase or remain the same, and because the interest rate will fall, the rate of return on these projects will increase, not decrease. Thus, it will be profitable for these projects to buy up more scarce resources, more factors of production.
Before I get ahead of myself, let me mention what will happen to those projects further away from the consumer. They too will experience a lower interest rate. Thus, it will be profitable to invest in these lower rate of return projects further from the consumer. Moreover, they too will probably experience an increase in demand (e.g. businesses using the lower interest rate to buy more higher order goods). Thus, the rate of return for these projects will increase. Therefore, investment in these projects will increase.
There are two problems that will manifest themselves in this economy: first of all, the credit created unbacked by savings is itself a scarce resource, and as such it will eventually run out and interest rates will begin to rise; secondly, the factors of production are a scarce resource and as demand for them rises from both the "lower order" and the "higher order" sectors of the economy, their price will increase, and as such investment projects which initially appeared to have a high rate of return now will be revealed to have a low rate of return. These two problems act synergistically to end the boom; as soon as the interest rate rises and meets the falling rate of return for projects, the projects become unprofitable.
Okay, so there are two problems here, but one of these can be solved by government: what if a central bank or monetary authority has a target interest rate, and it will continue injecting credit into the system in order to keep the interest rate at that target? In other words, what if a government institution eliminates the first problem of interest rates rising due to a scarcity of unbacked credit?
Well, then the boom will be accentuated, it will last longer as scarcity of credit will no longer be a limiting factor. But the factors of production are still a scarce resource, and they will still act as a limiting factor to the boom. Due to the lower interest rate, and the perceived higher rate of return across the board, various investment projects, old and new, lower order and higher order, will continue to compete among each other for these factors of production. These investment projects will continue to bid up the price of these scarce factors of production. Remember, any increase in the price of these factors is necessarily a decrease in the rate of return for projects, since the factors of production are a major cost that investment projects have to pay. So, eventually, these factors of production will be bid up so high that certain projects become unprofitable because their rate of return will shrink and fall below the interest rate. This will set into motion the bust, where certain projects are liquidated and the factors of production are released into the market in order to find more profitable uses. Remember that one of the factors of production is labor, and that each laborer is also a consumer. The reduction in income/increase in unemployment will necessarily cause a decrease in consumption, which will in turn have a negative impact on the lower order industries.
There are other factors which I could have added into here, but assuming a basic knowledge of economics, I think every reader here should be able to make the connections on his own.
Political Atheists Blog
1. Seems fine, but for one quibble. You write, "Consumers do not have the money to buy the fruits of investors’ labour since they did not save enough in the first place. Interest rates were low because of the central banks’ interventions, not because there is a large pool of savings available to finance future consumption."
The way I understood it, the problem with a lack of savings is not that consumers cannot buy the new goodies, but a step way before that. When the factory is half finished, there is no pool of savings [= dollars, but which represent raw resources in the concrete non money world] to pay for having the factory completed.
2. I like to think that the dot.com bubble, while not a counterexample to ABCT, shows it needs to be expanded a bit. The key line in your post I refer to is "...loose money policy misleads investors into starting projects that appear profitable". Because to anyone with a brain, those dot.com companies were doomed to fail from day one. But this is my pet theory, so I won't expand on it here.
My humble blog
It's easy to refute an argument if you first misrepresent it. William Keizer
Dave hit the biggest part on the head...
Put more simply, it's not that consumers don't have money to buy all these "extra products" because they have no savings...think deeper than that. Savings represent extra resources..resources that are available due to underconsumption (that's what saving is). So when entrepreneurs undertake projects because interest rates are lower, the implication is that there is a pool of resources available to actually use in their ventures. The problem is those resources don't exist. It's an illustion.
So again, it's not that people don't have money to buy products later on...it's that the products don't even get made...because the factories don't even get finished. Mises used the analogy of starting construction on a house without having enough bricks to finish it. The amount of the house that you actually do build is representative of the amount of malinvestment that has taken place...the farther along you get, the more time and actual resources you've wasted in a project that physically cannot be finished.
And in fact this is exactly what we saw in markets like Las Vegas...where large scale casino projects still sit unfinished. Tom Woods covers this quite well in his book Meltdown.
The only other thing you might change is the part about how it's "the price paid for prior credit expansion." While that's technically true, it's generally better to stay away from that language, as it is often spun into a morality argument...the idea that you believe that the market misbehaved so now there are consequences. Like some sort of economic karma. Obviously that's not at all the argument, but whether it's spun into that on purpose, or that's how it is genuinely interpreted, it's best to just stay away from that kind of language.
If you need any more insight, these will certainly help:
ABCT in a few minutes
Austrian Business Cycle Theory learning materials
To expand on the point made by John James vis a vi "price paid" wording, I'd also flush out the readjustment period a bit. Having been mislead and malinvested byt the false market signals, entrepreneurs must then look at the existing state of affairs - resources, labor, plant and equipment - and rediscover how to allocate them to best meet consumer demand. And prices must fall during this period to facilitate this process. This helps explain the aftermath not as some moral punishment a la Krugman's explanations of ABCT, but as the necessary readjustment period which brings the structure of production back in line with what demand actually reflects.
Well done, kaju.
Let me add as an appendix that if that govt insitution "eliminates the problem of interest rates rising due to a scarcity of unbacked credit" by injecting credit into the system, it will eventually bring the value of the currency down to zero. Which is what has already started, and what awaits us in the future.