The Austrian Business Cycle Theory is Flawed

Duckinstein posted on Sun, Aug 16 2009 5:01 PM

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Fallacies of the Austrian Business Cycle

Hey guys, I am a Liberal (not in the classical sense J ), who has taken an interest in reading Austrian Economics after a more free market oriented friend of mine used it to debate me. Although I have started only recently (and do not consider myself an expert) on the subject, I believe that I have a fairly good grasp of the Austrian structure of production and how it relates to boom and bust. I have read a variety of works including Tom Woods’ Meltdown and small sections of Jesus Huerta De Soto’s Money, Bank Credit, and Economic Cycles. It is in my opinion that although the Austrians present a solid theoretical construct of the structure of production and its relations to the business cycle, I believe that their arguments ultimately fail from their view of capital as a homogenous input, a lack of detail, and inconstancies in regards to their arrangement of production.  Thus the critique below will focus solely on what I believe to be fallacies of the Austrian Trade Cycle (from now on I will refer to it as the ABCT). I am not here to put in its place another Keynesian or Monetarist prescription, but instead lay out what I think are its defects and hopefully someone will answer my questions. To be honest I find that the ABCT is one of the better arguments of the cause of boom and bust due to its innovative idea of looking at the capital structure, but I still find that some parts of it are lacking (or I have just not been able to figure them out).

So, in order to make sure that both the reader and the writer are on the same page, I will juxtapose what the Austrians consider savings induced growth with the credit expansion and proceed from there with my criticisms. I can only hope that people who respond to my criticisms can give me the same amount of respect and detail in their arguments. Although I will not provide the diagrams (as I am sure you guys do not need them), I will make reference to the Hayekian Triangles. (Along with my readings I have looked at Roger Garrison’s Power Points:  http://www.auburn.edu/~garriro/macro.htm)

When society saves, funds go into cash balances and later into the market for loanable funds as investments. There is a decrease in the demand for goods in the lower stages, and a decrease in profits and investment in there for businesses. This means that people stop buying as many consumption goods, such as food, clothing, entertainment, iPods, cars, toys, etc.  There is a decrease in investment in those stages. Wal Mart will not create more retail stores, McDonalds less food joints, TJMax less clothes, and Linens and Things less household decorations.  In Garrison’s terms this is the derived demand effect ( “decreased consumption dampens the demand for the investment goods that are in close temporal proximity with consumable output”). However, the increase in the supply of loanable funds (and saying demand for investment stays equal) will lower the interest rate. The factors of production in these stages will be freed up and instead absorbed into the later stages of the production structure. The lower interest rate (caused by society’s increased savings) creates a greater demand for investment in the later stages, also known as the interest rate effect in Garrison’s terms (“A reduced interest rate, which means lower borrowing costs, stimulates the demand for investment goods that are temporally remote from consumable output.”)

In terms of the Hayekian Triangle, a part of the lower stages of production are taken off and instead used to expand the later stages. The output of consumer goods shrinks in height while the Triangle is lengthened (for a brief time). Because the factors of production were freed from the lower stages, the higher stages absorb the needed materials and are able to complete their expansions. The productive structure is lengthened, and a greater supply of goods will further lower consumer good prices and bring prosperity to society. In terms of the Hayekian Triangle now the hypotenuse of the entire triangle expands outward, reflecting society’s greater accumulation of wealth in the form of more capital and consumer goods.

But when the central bank expands credit beyond the supply of society’s saving, the interest rate is artificially lowered. Even though the interest rate is lowered society shows no desire to let go of consumption right now. People continue to buy consumption goods, purchase more food, clothing, entertainment, electronics, cars, toys, etc. Wal Mart continues to create more retail stores, McDonalds more food joints, TJ Max more clothes, and Linens and Things more household contraptions. There is no derived demand effect. However there is the interest rate effect and now businesses in the later stages of production expand their investments. Steel plants make more steel, mining companies mine more, plant construction booms, and a real estate market begins to grow. However, they will find that there has been no release of the factors of production in the later stages, and their prices begin to rise. In De Soto’s words, “with respect to supply, we must keep in mind that when credit expansion takes place without the backing of a prior increase in saving, no original means of production are freed from the stages closest to consumption….therefore the rise in the demand for original means of production in the stages furthest from consumption and the absence of an accompanying boost in supply inevitably result in a gradual increase in the market price of the factors of production (De Soto 363). This seems to be the main cause for the actual boom and eventual bust: no resources are freed in the present to aid the future. Tom Woods describes the “factors of production” with a little more specificity, saying “as the company works towards completing its projects, it will find that the resources it needs, such as labor, materials, replacements parts-called by economists “complementary factors of production”-are not available in sufficient quantities….the prices for these parts, labor, and other resources will therefore be higher than entrepreneurs expected, and business costs will rise” (Woods 69).

Business men who have embarked on their long term projects borrow more and more which starts to drive up the interest rate. Combined with the fact that the interest rates provoke borrowing from the earlier stages of production (businessmen there start to expand their retail stores, food production, etc) AND with the fact that consumers are borrowing credit for consumption (either durable, which counts as long term investment that originally provoked the boom, or plain consumption such as vacations which create an increased demand in the lower stages as well), society experiences a serious lack of “capital” in order to supply all of these ventures. It is as Ludwig von Mises says in “The Austrian Theory of the Trade Cycle” that “the material means of production and the labor available have not increased; all that has increased in the quantity of the fiduciary media which can play the same role as money in the circulation of goods” (p29). Either through hyperinflation (as the banks keep increasing the quantity of credit in order to push down the interest rate) or through a raise in the interest rate either naturally or by the banks do the businessmen in the higher order stages realize that their investments were wrong and a large slump in the capital goods industries occurs. Now the recession occurs as resources must be redirected away from the unprofitable capital goods industries. Without entering into the effects of the secondary depression, this is what the Austrians consider the actual bust: A poor structuring of resources in the capital goods industries.

In comparing these two seemingly different economic constructs, it seems that the main difference from savings induced growth and boom/bust is the fact that in saving the consumers postpone consumption and “release factors of production” for businessmen in the higher stages to use, whereas in boom/bust these “factors of production” are not freed and being used for current consumption. Only when these materials are “released”, only when the top of the Hayekian triangle is lobbed off and used for other stages can the growth be sustained. When they are still used, businessmen must pay more to bid them away with cheap credit which causes a rise in the interest rate and eventual crisis. Essentially it seems as though the “inputs” for the consumer good stages provided the needed inputs for the later stages. De Soto explains this succinctly, stating “in fact each increase in the demand for productive resources in the stages furthest from consumption is mostly or even completely neutralized or offset by a parallel increase in the supply of these inputs which takes place as they are gradually freed from the stages closest to consumption” (De Soto 324).

So what are these inputs, “real saved resources” (A common expression I heard in advocates of this particular theory), factors of production, etc? Is there any degree of specificity in them? Tom Woods gives a couple of examples (see above quote), but even those are pretty vague. What should make us believe that the “factors of production” for lower stages will be the exact resources needed for the higher stages? Can the construction materials used to make a new Dennys be used for the completion of a Power Plant? Take this rather silly but illustrative example; society saves 1% more of their cash income, the restriction of consumption came solely from the cutback of fast food. America instead decides that it does not require as much food and will used their savings for investments. The derived demand effect occurs in some food industries; they suffer from a decrease in demand and decide to free up resources. The resources freed are primarily food workers, grocery clerks, capital goods used in cooking and processing food, additional construction materials that could have been used for building more restaurants and stores, etc. Now, with or without the concept of full employment of resources (it is a variable for the business cycle, the theory can deal with whatever degree of resources are idle), these factors of production are the “real saved resources”.

Going back to the consumers investing their funds, the interest rate is lowered and the time discount effect occurs. According to the Austrians theory these resources should be fully incorporated into whatever resources are needed by the higher order businesses (See the De Soto quote above). For the theory to work correctly the resources would, because if businessmen needed more than were “given”, they would have to bid them away from earlier stages and raise costs and borrow more, and then not possibly complete any projects due to a lack of required materials.  In any ABCT I have read, there is little to no mention of the actual resources themselves and whether they need to be specific or not, all that is said is factors of production geared towards consumption can be used to fuel earlier production. Is there mention of training for different labor, specificity of capital goods, distance between where the factors of production were freed up and where they will be used, etc? No, all that I am aware of is that the capital blob of from any saving of resources can be used to fuel the expansion of earlier industries. This seems to be the fatal flaw in the Austrian argument, what one man saves may not necessarily be the resources that another man requires.  One man’s trash may really not be another man’s treasure.

There are other inconsistencies as well regarding the structure of production. In a similar tone in regards to “factors of production”, the Austrians make reference to the “higher stages”, and the “lower stages”. Well, what is the difference? I understand that the Austrians emphasis subjectivity in their economics, ranging from the basic fact of human action to marginal utilities and entrepreneurial decisions, but at what is the dividing point between the higher and the lower? Or in other words, when do businesses stop experiencing the derived demand effect and instead the interest rate effect?  How far into the structure of production or the Hayekian Triangle will the resources be free from?

Lastly, in regards to the Hayekian Triangle and structure of production, how does the Triangle exactly move outward? Garrison never explains this in his PowerPoints, instead in slide 24 simply showing an the entire triangle/economy grow due to increased savings without an explanation But, how exactly? I understand that increased saving creates capital goods which improve production and more efficiency and later cheaper consumer goods, but the process is never expanded from that in relation to the productive structure. The triangle and the economie's resources seem to be built off of itself, meaning that via saving factors from the lower stages supply the needed inputs for the higher stages. So where do the resources come from to move the entire triangle outward?How do consumer goods industries, which initially lose their factors of production for later stages, suddenly get factors of production and expand? The Austrians, despite their highly complex view of time,saving, and production in the economy do not reveal  these answers clearly.

Hopefully someone will be able to answer my questions regarding the structure of production and the homogeneous blob of capital resources.Remember that I am a fellow Liberal who has taken an interest in reading this material, I have only read a couple of books. Still I believe my understanding of the theory to be solid and these questions sufficient. If the Austrians and their view of Business Cycle/Growth is correct than these questions must be answered.