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Austrian Business Cycle Theory

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Michael posted on Fri, Jan 27 2012 10:55 AM

I have read and reread Tom Woods’s fantastic book, Meltdown. However, I’m stuck on a question concerning Austrian Business Cycle Theory. In particular, I would like to gain a better understanding of the impact of unutilized productive capacity in a market and its ability to absorb monetary stimulus without causing inflation (price run ups).

Tom’s book presents a simple but useful example involving a baker and a shoe maker.  The shoe maker can sustain himself through his production process by borrowing resources from a bank that were previously deposited by a baker who had produced and sold bread to a retailer. The shoe maker uses the borrowed funds to buy bread from a retailer. Produced shoes are sold to the baker and the shoe maker can repay his loan to the bank. No problem here. This economy is on a sustainable path.

Tom then introduces the monetary issue. Two shoe makers are now on the seen, but the baker only produced and sold enough bread to sustain one. When the bank prints up new dollars to lend to the second shoe maker, the latter finds that there isn’t enough bread to sustain him. This economy is not on a sustainable path. Sounds like a good validation of Say’s law, whereby supply (production) creates its own demand.

But what if the baker had not been operating at full capacity? What if shoe maker number 2 presents his printed dollars and the baker just bakes more bread? Now the baker, having produced and sold twice as much bread, can also buy a pair of shoes for his wife and both shoe makers can repay their loans from the bank.

Looked at another way, what if the bank had not printed the extra dollars? The way I see it (perhaps incorrectly), for lack of a medium of exchange the baker’s unutilized capacity would sit idle, his wife doesn’t get shoes and the second shoe maker doesn’t earn a living.

Looking at the broader economy, when we have unutilized productive capacity across industry, why would a certain amount of stimulus not be a good thing in terms of kick starting production?  I can see how at full capacity utilization money printing will just cause inflation. But what about at times of idle capacity?

My gut tells me I’m missing something here.

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Neodoxy replied on Fri, Jan 27 2012 11:25 AM

There are two huge problems with stimulus spending

1. It prevents prices from adjusting down to the point that they need to in order for the market to finally reach a recovery stage

Prices are bid up in a boom, they need to fall to such a point where people will buy again. For instance when the bust occurs people will likely lose their jobs, others will fear that they will lose their jobs, so they will stop spending so much and increase their personal savings. This means that prices need to fall to such a point where people are willing to spend again. Stimulus stops this from happening, it helps to bolster projects, and projects upon un-economical activities

2. It distorts the market which will lead to problems when stimulus is cut off

The structure of production aligns itself with the stimulus spending, businesses are used to providing for people with the income provided for them by the stimulus spending, so what happens when the people who were receiving stimulus lose a good portion of their income? This leads to a mini-recession as well as an additional degree of fluctuation with prices in general including industries that were funding the government.

For a somewhat tangential elaboration in another post of mine where I describe more about ABCT and Keynesian theory as well as problems in the Keynesian system see here

If you have more questions or if this doesn't fully respond to your problems then let me know.


At last those coming came and they never looked back With blinding stars in their eyes but all they saw was black...
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Dang, posted once and it disappeared.

Bottom line. The baker is not at full capacity for a reason, high costs of production and thus inability to lower prices and still profit.

But high costs for the baker don't just grow mysteriously like some weed. They too, have a reason. Somebody else is outbidding the baker for the resources the baker wants, making them too expensive for the baker. And yet, the other guy [call him Mr A] is paying those higher prices. That can only mean he has found a way to use them profitably. So profitably it's worth paying that high price for them.

But that's not  magic either. It's all happening because the consumers, the ultimate kings of the free market, want Mr A's stuff so badly and the baker's stuff so little that Mr A is making big bucks pleasing them, and the baker can't make ends meet.

The market has spoken. How will giving the baker a handout make his stuff more desirable? It won't. He has a zombie business, to the extent he built his machinery capable of producing more than people want. He has malinvested. Time for him to move on to something more profitable.

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For more on ABCT, check out the link from my sig.


This is also not directly related, but the discussion here may help with understanding of the economics.


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