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Empirical Proof of the Austrian Theory of the Business Cycle

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krazy kaju Posted: Mon, Feb 23 2009 9:40 AM

Many people today want to know whether or not there is any evidence that proves that the Austrian theory of the business cycle is correct. Many empricists and positivists critique the Austrian school for being too reliant on logic and reason and not reliant enough on evidence. Epistemological arguments aside over emiricism's and positivism's inapplicability to the social sciences, there is evidence that proves that the Austrian theory of the business cycle is correct.

First, however, one must know what Austrian theory predicts would happen preceding a bust to be able to know whether or not Austrian theory holds up to empirical analysis. The Austrian theory of the business cycle is rather simple. It divides the goods an economy produces into two parts: higher order goods, whose profitability relies on interest rates, and lower order goods, whose profitability relies on consumption. In a free market, interest rates are dictated by savings, so there never is any unsustainable booms or consequent busts. There are booms and busts, however, in an economy where the government creates a central bank or intervenes to promote fractional reserve banking. Central banks and banks with fractional reserves extend the supply of credit beyond the supply of savings, lowering interest rates below the market level. When interest rates are lower, higher order industries (those depending on low interest rates) become more profitable. They consequently hire more workers and may raise wages. However, since society's basic time preference of saving vs. consumption has not changed, these workers will not save more than they otherwise would have. In other words, these workers with new jobs and higher wages will consume more, making lower order industries (those depending on consumption) more profitable. The rising profitability of lower order industries means that they will have more money to outbid higher order industries of resources necessary for production - labor, land, plastic, steel, and other commodities. Thus, higher order industries become less profitable and must decrease how many workers they hire, lower wages, or start laying off workers. This decreases consumption, making lower order industries less profitable and forcing them to decrease wages or lay off more workers. This becomes a "vicious cycle," throwing us into the bust phase of the business cycle.

So does the evidence support the Austrian theory of the business cycle? Do higher order industries hire more workers in booms and start laying them off or lowering wages before busts? Are consumption based industries only effected secondarily? The evidence seems to confirm Austrian analysis:

First, investment, which is necessary for the profitability of higher order industries, decreases prior to a bust.

Second, we see personal savings fall, meaning a rise in consumption prior to busts.

Third, we see construction employment decreases prior to economic down turns (note that the recession of 2001 was one mainly effecting higher order industries other than construction):

Durable (higher order) goods industry employment falls right before an economic downturn.

Service-industries (lower order) increase employment right up to the onset of the recession:

This evidence clearly indicates that the Austrian theory of the business cycle holds up to empirical scrutiny.

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Great job, this should be posted on the front page.

I have a question though. You say that "Durable (higher order) goods industry employment falls right before an economic downturn", but I would think that the fall in higer order employment would not happen till after the malinvestment had been "found out". Or, what I mean is, there would not be a cycle based decline in higher order goods till the "bust" was already underway. Whereas we start seeing a decline in late 2006 in these charts, but this may be explained as non-cycle based movements.

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Strictly speaking, barring malformed/omitted concepts or errors in deduction, the ABCT is valid whenever the conditions necessary for it obtain. The proper question is, can the ABCT explain the phenomenon that occurs regularly in many capitalist societies? That's a thymological question (for some reason a lot of Austrians forget about thymology), i.e. of whether and when a given economic theorem applies, and that is an empirical matter. Just offering this as clarification. I wouldn't call this an empirical "proof" of the ABCT, as much as I'd call it proof of its applicability. Roderick Long discusses this matter in his book on Wittgenstein and Austrian econ, as does Plauche in his paper on Aristotelianism and praxeology. Both are short and worth reading. So is this.

Freedom of markets is positively correlated with the degree of evolution in any society...

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