Dear Mises Forums members,
Below is my take on the Austrian Business Cycle Theory. I hope you find it useful.
Stages
1. Money Supply Increase causes a general
2. Credit Supply Increase, which causes a general
3. Interest Rate Decrease, which causes a general
4. Longer Term Investment Increase, which causes a general
5. (a) Demand for Labor Increase and (b) Demand for Capital Goods Increase, which cause a general
6. (a) Wage Rate Increase and (b) Capital Goods Price Increase, the first of which causes a general
7. Credit Demand Increase, which causes a general
8. Interest Rate Increase, which, along with 5(b), causes a general
9. Longer Term Investment Decrease back to normal
There is nothing inherently circular about this progressive response to artificial credit expansion. The theory might even be called the Austrian Business Blip Theory (ABBT) were it not for the government's recurrent interventions into the markets for money and credit.
Causal Explanations
1-2. The money supply increase in the present system is in the form of bank money. This bank money is made available as new and additional credit.
2-3. The interest rate is the price of credit. Increases in supply cause decreases in price. Therefore, a general increase in the supply of credit will cause a general decrease in interest rates.
3-4. The lower the interest rate, the more viable are longer term projects funded by investment borrowing.
4-5. Longer term production processes generally require more labor and goods than shorter term production processes.
5-6. Wage rates are the price of labor. Increases in demand cause increases in price. Therefore, a general increase in the demand for labor will cause a general increase in wage rates.
6-7. This is my own either new or independently formulated contribution. I've been avidly reading works and listening to lectures to try to understand the ABCT. It was tough at first, partially because I was trying to foist up price inflation as the dominant element in my understanding of it. It only started making sense when I let that drop and read and listened more carefully; this led me to realize that what the theory was chiefly concerned with was not price inflation but artificial credit expansion and its temporary effect on the interest rate.
Then it all started to click, but still only incompletely. In expositions of the theory, the explanation of the boom phase generally made sense to me, but things would always get muddy concerning how the boom became a bust. Often the explanation would focus on why the bust was, according to capital theory, inevitable, with Hayekian triangles, and Bohm-Bawerkian insights into what the interest rate represents. I in no way doubt the veracity of these analyses, but too often the concrete human motivations and actions that actually embody the turn from boom to bust was left out. Even when those concrete motivations and actions were present, the causal links didn't quite make sense to me. For example, I would often read that workers, after getting their raises in stage 6, would (a.) go out and spend their additional money, and that would bring their savings and consumption back to their normal ratio according to their time preference and that this led to (b.) not enough savings being available to see all the long term projects in stage 4 to their completion. But in everything I've read or listened to, it's never been explained (at least for my understanding) exactly how (a.) leads to (b.). Again, I in no way doubted that it does happen; it seems theoretically necessary. But how?
Then, motivated by the recent post asking for a concise explanation of the ABCT, I started trying to construct the above step-by-step explication. I tried to make it as clear and direct as possible. But, I kept getting stuck at stage 7. I kept asking myself, "what is the bridge from 6 to 8?" Then I thought, "stage 8 is just the opposite of stage 3. Just as an increase in the supply of credit brought about lower interest rates, higher interest rates must come about from either a decrease in the supply of credit or an increase in the demand for credit." Then it finally hit me: the savings-to-consumption ratio is indeed essentially what determines the interest rate, but not immediately so. The concrete human action that embodies the reestablishment of the normal savings--to-consumption ratio is more borrowing. People generally have an income-to-debt ratio they're comfortable with, according to their time preference. If they get a raise, they don't suddenly become more thrifty than before; so they borrow more, generally in proportion to the increase in their wages.
7-8. This increased demand for credit then raises the interest rate, which causes, along with the increased capital goods prices (6b),...
8-9. the long-term projects from stage 4 to no longer be profitable. Boom gives way to bust.
Regarding the 6-7 analysis, I know I could very well be wrong. Or I could be right and silly at the same time, if that was what ABCT scholars were saying all along, and I was just dull to it. In any case, I thought I'd share my thought processes with you, my fellow travelers, who are also trying to teach themselves economics (and political philosophy, history, etc.) as best they can.
I would very much like to hear any comments and corrections you would like to offer.
Sincerely,
Daniel J. Sanchez
Austrian Theory of the Business Cycle in 9 steps (Soliciting comments)
I will read and provide my thoughts when I have the time.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
I'm not qualified to beat this up, but if we can come up with something simple and direct like this, I can see a lot of uses for it.
Yeah, I made this a favorite to come back to and check out later. Looks very interesting and it does look simple and direct. I'm definitely going to look at this and think about it before the weekend is out.
Thanks, Giles and wilderness,
I eagerly await your thoughts regarding the soundness of this; I highly respect both of your opinions.
liberty student:if we can come up with something simple and direct like this, I can see a lot of uses for it.
Me too: another reason (besides the request I mentioned) I drew this up was that, even though analogies (like Peter Schiff's circus analogy) are highly useful for education and argumentation, an explicit distillation can also do a lot of good.
I like it, but there is one key thing it is missing:
In addition to the pressures of capital good price inflation which create increased credit demand, the reduced rate of interest causes marginal savers to save less. This will require even greater increases in the money supply to maintain low interest rates. These reduced savings end up entering the market as greater consumption and asset speculation.
Thus there is greater consumer price inflation, in addition to the higher wage rates, because even with a static wage rate, greater income is dedicated towards consumption.
And there is greater asset speculation, as savings formerly put in CD's or being held in cash will enter stock, real estate, precious metal, etc. markets.
So you have overconsumption, malinvestment, and speculative bubbles at the same time. These lead to capital consumption, unprofitable liquidiations, and painful price adjustments, respectively.
And there is the final threat of currency collapse. If the credit creators refuse to stop printing and lending money, no matter how risky this environment becomes, it could face hyperinflation/abandonment.
Check my blog, if you're a loser
Hi meambobbo,
Thanks for the excellent considerations.
meambobbo:In addition to the pressures of capital good price inflation which create increased credit demand
Just to clarify: my contention is that it is artificial labor demand and its concomitant wage inflation that causes increased credit demand, not capital good price inflation.
meambobbo:the reduced rate of interest causes marginal savers to save less. This will require even greater increases in the money supply to maintain low interest rates.
But wouldn't the savings rate already be factored into the reduced rate of interest? The reduced rate of interest is already the market-clearing price of credit given the new level of the money supply and the time preferences of savers and borrowers. Just like when any other good increases in supply, prices get bid down; but the extent to which they are bid down is limited by the supply discouraged and demand encouraged at any given time by the prices having been lowered as much as they have already. This leads to prices equilibrating, but equilibrating at a lower level.
I'm highly curious about asset inflation/speculation, though. And the hyperinflation threat is indeed an important part of the story that should be added so people new to the theory can understand why the interest rates can't be held artificially low forever. I'll definitely add that: thanks!
Daniel J. Sanchez:But wouldn't the savings rate already be factored into the reduced rate of interest? The reduced rate of interest is already the market-clearing price of credit given the new level of the money supply and the time preferences of savers and borrowers
I'm trying to wrap my head around it. It seems that consumer price inflation and the interest rate of certificates of deposit would be the main prices considered by the marginal saver. The price of CD's would likely drop along with the interest rate as the money/credit supply is expanded, but consumer price inflation which reduces the real interest earned will come later.
So yes, you are right. The reduced marginal saving and increased spending/speculation due to nominal rate decreases should occur at the beginning, and play little part in a cyclical pattern. But real rate decreases due to price inflation will occur later.
Daniel J. Sanchez:I'm highly curious about asset inflation/speculation, though.
The best way to understand it is to think of money as being a giant speculative bubble that rarely deflates or pops. Money is a speculative asset without an end buyer. As more and more people use some commodity as money without its supply increasing, its price (or purchasing power) will rise. Thus, it makes sense that people chose precious metals as money, which were (usually) unable to have their supplies drastically increased.
If the money's purchasing power is being eroded, people's behavior will shift to hold different forms of assets to preserve purchasing power. As the money bubble deflates, stock and real estate bubbles grow. Demand shifts from holding money or denominated assets (such as CD's) to those other areas.
Of course, there are good reasons why these bubbles will pop as soon as the money supply stops being increased, as there was a reason money was (and still is) THE speculative bubble. Real estate is not portable or divisible. Corporate stocks are not fungible commodities and can only be compared in terms of commodity or money prices, which prevents them from being money (or at least preventing any method of reliable calculation). And precious metals are disadvantaged by legal tender law, taxes, and prohibitions on minting.
Hyperinflation is literally the bursting of the money bubble. Government resorts to inflation, which lead the people to speculating on assets. As government continues to inflate, the asset bubbles grow bigger, while money (or money denominated) savings decrease. Eventually, people find it more worthwhile to get rid of all their money and resort to barter if they can't use alternate currencies. Once people have lost confidence in a currency as the easiest means of saving and facilitating trade, it swiftly loses more and more purchasing power, and it unwinds as chaotically as any other bubble, but is much more powerful, because as I said, it's the biggest bubble of all.
Maybe this will make it clearer:
1) The currency is abandoned as a means of long-term saving. Assets denominated in the currency are abandoned. (ex. T-bills)
2) The currency is abandoned as a means of short-term saving. This refers to cash and bank account savings.
3) The currency is abandoned as a means of indirect trade.
So it seems that the artificial credit-induced long-term investment bubble would happen even with a one-time monetary expansion. But the price inflation-induced asset bubbles only happen with continuous monetary expansion.
Tell me if this makes sense:
In any given market condition, there will generally be one asset which is optimal for your #1 (longer-term saving), due to a good level of and balance between purchasing power storage and liquidity; also there will be one asset optimal for #2 (short-term saving) due to the same considerations as #1, but leaning more toward liquidity. Of course, nothing says people must have only two such categories. Savers may have a diverse spectrum of savings desired for their various balances between purchasing power storage and liquidity. And often, the optimal asset for several different categories will be the same: the common currency.
If the currency is being devalued at a certain small rate, it might then become less attractive as a means of extremely long-term saving than some other asset class, which has a lower rate of real depreciation than other asset classes. Then if the currency is devalued faster, it might then become less attractive as a means of mid-term savings than that same asset class. And if it is devalued faster still, it might become less attractive as a means of short-term savings than that asset class.
So in an asset bubble, over-and-above the appreciation due to monetary expansion, there is a premium given to certain assets by virtue of their role, not just as a good, but as a store of purchasing power. Certain assets are better stores of purchasing power than others. Savers realize this and buy up those assets, increasing the prices of those assets and thereby sending the market a signal regarding the superior money-ish (in terms of storing purchasing power) qualities of that particular class of asset to other savers, who also pile in. Thus whatever is seen as a superior means of saving will have its value spiral upwards, due to the tremendous demand brought about by all of society replacing money with it for a certain portion of their savings.
But once the currency devaluation stops, money is seen as the optimal store of purchasing power for longer-term saving again, since it doesn't depreciate in-and-of-itself (outside of policy-induced depreciation) like most other assets do. So people flock back to money, and the asset price bubble pops.
Does that sound right?
Sounds good to me, but I am definitely no expert.
As far as the length and size of the money injections, definitely the longer and more widespread, the larger the cycle. We just had a GLOBAL cycle prolonged for a LONG time. Thank you, central bank coordination.
As far as one-shot injections, this can radically alter behavior if large enough. FDR's plan to change the dollar from 1/20 oz of gold to 1/35 caused massive bank runs and collapsed half the banks. If people tried to quickly jump into popular assets, reducing money's purchasing power, there may be more "one-shots" down the road. It's not really about what has happened, but expectations of what will happen. Is the injection viewed as a one-time thing, or a sign of more to come? With government control of money and credit, there is far less certainty in rational economic planning, which I believe will ultimately drive people towards precious metals.
Notice that the FED has recently attempted such a one-shot and it has resulted in a steady stream of growth. Banks know it would be foolish to try to make all their loans for the year on the same day. And they themselves need a cushion to absorb still undetermined losses. Thus, besides direct government spending, the FED can't pump money into circulation in a one-time manner. Conversely, Greenspan didn't add a [terribly] huge amount of reserves for bank to lend against, but they lent heavily anyway.
Here is a new iteration. This one is more complicated, but more complete, because in it I attempt to integrate asset bubbles into the theory. My thanks to meambobbo for stimulating my thought in the direction of trying to figure out this crucial other aspect of the business cycle. After some meditation, this is what I came up with:
2. (a) Credit Supply Increase and an ongoing (b) Purchasing Power of Money Decrease, the first of which causes a general
4. (a) Longer Term Investment Increase, and, aided by 2(b), a (b) Sharp Demand for Particular Assets Increase, the first of which causes a general
9. (a) Longer Term Investment Decrease back to normal, and along with the completion of 2(b), a (b) Sharp Demand for Particular Assets Decrease.
The above describes a finite expansion of the money supply. There is nothing inherently circular about this progressive response to artificial money and credit expansion. The theory might even be called the Austrian Business Blip Theory (ABBT) were it not for the government's recurrent interventions into the markets for money and credit.
1 to 2(a). The money supply increase in the present system is in the form of bank money. This bank money is made available as new and additional credit.
1 to 2(b). The new and additional money is progressively distributed throughout society, bidding up prices as it goes along, and thereby progressively reducing the purchasing power of any given currency amount.
2(a) to 3. The interest rate is the price of credit. Increases in supply cause decreases in price. Therefore, a general increase in the supply of credit will cause a general decrease in interest rates.
3 to 4(a). The lower the interest rate, the more viable are longer term projects funded by investment borrowing.
2(b) and 3 to 4(b). Because the currency unit gets a smaller return (the low interest rate), and is also losing purchasing power (higher prices), it becomes less attractive as a means of saving than certain other asset classes (like houses).
4(a) to 5. Longer term production processes generally require more labor and goods than shorter term production processes.
5 to 6. Wage rates are the price of labor. Increases in demand cause increases in price. Therefore, a general increase in the demand for labor will cause a general increase in wage rates. Also, an increase in demand for capital goods will cause an increase in the prices of capital goods.
6(a) to 7. This is my own either new or independently formulated contribution. I've been avidly reading works and listening to lectures to try to understand the ABCT. It was tough at first, partially because I was trying to foist up price inflation as the dominant element in my understanding of it. It only started making sense when I let that drop and read and listened more carefully; this led me to realize that what the theory was chiefly concerned with was not price inflation but artificial credit expansion and its temporary effect on the interest rate.
7 to 8. This increased demand for credit then raises interest rates.
8 and 5(b) to 9(a). The higher interest rates, along with the increased capital goods prices (6b), cause the long-term projects from stage 4 to no longer be viable. Boom gives way to bust, as businesses rush to reallocate resources away from the non-viable longer term ventures to viable shorter-term ventures.
8 and the completion of 2(b) to 9(b). An increase in the money supply must be finite (or at least abbreviated), or else hyperinflation will result. Any finite increase in the money supply will cause a finite increase in prices. The new money will progressively bid up prices, but eventually the new money will reach all sectors, and then prices will stop generally rising. Thus, the money will stop losing purchasing power (and actually start gaining purchasing power, as money naturally does in a market), while the particular assets that had replaced money as a means of saving start to depreciate (as real assets tend to). These changes, along with the increase in the rate of interest, completely reestablishes money's attractiveness as a means of saving. Savers flock out of the asset classes they had flocked into, and back into money, causing the prices of those assets to plummet.
Regarding the 6(a)-7 analysis, I know I could very well be wrong. Or I could be right and silly at the same time, if that was what ABCT scholars were saying all along, and I was just dull to it. In any case, I thought I'd share my thought processes with those of you who are also trying to teach themselves economics (and political philosophy, history, etc.) as best they can.
Edit: I made a mistake: Everywhere in this post where it says "CD" it should read mortgage-backed securities.
Daniel,
I am not well versed in the economic aspects. I am familiar with some aspects and maybe this will help me worm my mind into what you wrote here in order to conceptualize. I don't know if malinvestment is to be explicitly considered in the ABCT or not. I know it also has to do with credit expansion, which you mentioned. The malinvestment becomes a drag on individual businesses especially if they grow so large it begins to outweigh what real money (assets or currency) a business actually has to offer in the form of payments on its obligations. For instance, the investment firms, AIG and crowd, over-invested or promised obligatiosn in payments that they could not deliver upon. As long as the market was bringing money into these firms, then the money going out could be equally met. Yet once their overhead became so large they could no longer meet their expanses, then a problem. These firms sold CD's and insurance (credit-swaps) on these CD's (mortgage investments) and as long as the prices of houses went up, then people made virtual money on these virtual investments. They look good for a portfolio to show worth of a company, but if they were actually paid out in currency, a run on these investments to have them cashed in, the firms promised more than they actually had to give back if investors wanted currency instead of CD's, their credit-swap, etc...
So to use the housing bubble as an example which most of these virtual assets in Wall Street sat upon and still do, when people don't have the money to pay their loans/credit and thus these malinvestments by the banks don't bring returns houses close up/foreclosures. Banks trying to get as much money back as possible so they don't get hit hard by all their malinvestments try to get the money invested in the houses back by selling the houses at lower prices (to get some kind of return on these malinvestments). The CD's and thus credit-swaps backing up the CD's (virtual assets) in Wall Street are invested in the housing sector. As the housing prices drop then so do the value of these Wall Street virtual assets. Therefore investors want the money on these virtual assets because as anything on Wall Street, when the prices of these virtuals drop, then investors want to come out of the deal with more money than they put into these virtuals. So they sell. The credit-swaps were insurance on the price of these virtuals too, so, this really makes it difficult for the firms that promise a certain value on these virtuals by providing insurance on them if these virtuals drop in value. So the investors when they sell are promised by the insurance credit-swaps a certain amount of return in their sellings. Well the Wall Street firms did promise more than they actually had in currency to pay out. Once the investors realize that a lot of people invested especially in these virtuals of CD's and credit-swaps and they also realized these firms could never pay out all the money to all the investors, then there are runs on these virtual accounts (the assets) in the Wall Street firms. No investor wants to be left holding nothing due to a firm going under. It's the same idea as a run on the bank. The Wall Street investment firms promised more than they had. There stocks fall. Confidence falls. People don't know who to trust anymore. Which businesses are tied to what firms (AIG is tied to numerous upon numerous businesses, my brother through a railroad company has insurance that leads back to AIG for instance). So people panic basically as the stocks keep dropping cause it was all a speculative bubble. More promised than the firms actually had to give back. The banks had malinvestments so they lent out more than they ever do (fractional reserve banking; fiat money system).
So now the government steps in and promises returns on everything. This is all to stop the panic. The government through the Federal Reserve could keep printing money to go through all these investment firms and banks to bring returns to all the investors/customers that are selling and just want out cause they just don't know (1) how far the virtual prices will drop and thus the investors will lose the money they put in and they don't want that (2) these firms could collapse so the investors don't want to lose their investments. So now the government is the creditor of last resort backing up all these promises to investors by firms that promised more than they actually had. Once this process starts that when all the information usually comes out as to how crippled these firms are, except, years ago it could be seen that these firms were offering payments to too many investors, more than the firms could actually pay back.
The housing prices could drop. The banks made bad investments by loaning too much and then they have to eat those loans when the people can't pay those loans back. So the banks get crippled some go under and housing prices will drop and the free market resets itself cause those houses were priced way too high to begin with. They were priced too high and weren't allowed to drop due to forces in the market that are happening right now. The government bails out the fiat banks (I don't even think they are fractionally reserved cause the U.S. dollar is not backed by gold so not backed by any commodity like gold or silver means these are actually fiat banks) and thus the banks don't lose their money due to the malinvestments. Housing prices drop, but since prices throughout the market aren't allowed to drop due to government propping up (if firms, banks, and badly invested businesses collapse then prices would drop everywhere cause malinvestments are bubbles, virtual money that isn't actually there like those credit-swap promises, CD's, and fiat loans by the banks.). The malinvestments are the credit bubbles cause of the investments built on these investments (houses) that can't be paid for (bad loans/bad credit by banks). When the loans are not paid for banks become insolvent. Investment firms invested on houses (most were AIG, Goldman Sachs, Bear Sterns, etc...) see their investments drop in value. Investors want out. The veil is pulled down, as the malinvestment and real worth of these firms come to light. Investors pull out. Firms don't have the capital to meet all their promises to investors. Government steps in keep the promises these firms and banks promised (investment assets and bank's solvent accounts).
The interest rates pushed down artificially by the government makes credit abundant and makes investment on futures look profitable. Yet the banks founded on fiat can never hold water if their credit system of loans aren't paid due to malinvestment (bad loans). Investment firms investing in houses and other assets (but this was a housing bubble example, but other sectors of the economy intertwine) see their investment prices drop as houses are dropping in worth because they are being foreclosed and thus losing value, and thus banks sell them at lower price just to get some kind of return. The artifical lowering of interest rates is just that. Artificial and has nothing to do with the actual needs in the economy. So people see them drop and think good time to invest, when actually a bubble is forming. Bubbles are malinvestments, returns that can't happen.
This is long, but I'm trying to understand what you wrote. I think I have a handle on understanding what you wrote, but I couldn't write what you wrote, Daniel. You are more knowledgeable on this than I. So maybe using what I wrote you can condense it down and point out how this fits into your Steps on the ABCT.
Looking forward to learning.
Perhaps you could send this to somebody like Walter Block; I'm sure he would be able to point out any problems.