ECON 378
Lecture Thirteen: The Austrian Theory of the Business Cycle
The ORIGINAL sources:
The principal Austrian works concerning the theory of the economic cycle [as of 1936] are: Mises, The Theory of Money and Credit (New York: Foundation for Economic Education, 1971; translation of the 2nd German edition, 1924; originally published in 1912); Mises, Monetary Stabilization and Cyclical Policy (1928) reprinted in On the Manipulation of Money and Credit, Percy L. Greaves, ed., Bettina Bien Greaves, trans. (Dobbs Ferry, N.Y.: Free Market Books, 1978; originally published as a monograph in German); Friedrich A. von Hayek, Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley, 1966; reprint of 1933 English edition, originally published in German in 1929); Hayek, Prices and Production (New York: Augustus M. Kelley, 1967; reprint of 1935 2nd revised edition, originally published in 1931).
The Austrian Trade or Business Cycle
First: Say's Law is correct.
Second: Markets are not perfect - but they are also not chaotic.
Third: Knowledge is the key.
Fourth: Signals that provide "correct" knowledge about individual preferences are also key.
The Austrian Theory of the trade or business cycle is one explanation of a boom and bust in an economy. It explains what happens during a boom (most especially brought on by increases in the money supply by the FED but also more generally -- could happen with fiscal policy as well but in a slightly different way).
Pay special attention to "mal-investment" and the knowledge issues that are explained.
Prices, interest rates, profits, losses -- they are all information signals to entrepreneurs about what to do with resources. The signals ultimately reflect the preferences of individuals in an economy if they are not distorted in some way. Unfortunately, they are distorted on a regular basis by government (most especially the FED in the case of the business cycle - but also fiscal policy as well).
Watch for these distortions: These distortions will lead to changes in resource allocation - not just regarding consumer goods, but also capital goods. This is "mal-investment" in that profitability is "false" in that it didn't come about due to preference/action changes per se and is short-lived.
According to Rothbard, to understand a theory of recessions (or depressions) we must understand three things:
1. “How is it that, periodically, in times of the onset of recessions and especially in steep depressions, the business world suddenly experiences a massive cluster of severe losses?”
2. The theory must account for the tendency of the economy to move through successive booms and busts – what is causing the boom and why the bust?
3. The theory must explain why the booms and busts are more severe in the “capital goods industries” – the industries making machines and equipment, the ones producing industrial raw materials or constructing industrial plants – and not as severe in the industries making consumers’ goods.
Rothbard says this is where the “underconsumption” theory of Keynesian economists fail. The theory says that consumers aren’t spending enough on consumer goods. As per Rothbard – “For if insufficient consumer spending is the culprit, then how is it that retail sales are the last and the least to fall in any depression, and that depression really hits such industries as machine tools, capital equipment, construction, and raw materials?”
Furthermore, it is these (capital) industries that really take off in a boom. Why?
So let’s first review Austrian capital theory:
Capital Goods - capital in an economy is a structure of physical capital and labor - as well as financial capital
vs. capital as a dollar amount and homogeneous physical amount.
The Hayekian triangle and it's meaning as a capital structure (higher order capital goods and lower order consumer goods - AND how the heterogeneous capital goods coordinate with one another to be productive and create a valued final good or service):
Let’s also Review Positive Time Preferences:
Relatively high (what does that mean about savings, future consumption and interest rates)?
Relatively low (what does that mean about savings, future consumption and interest rates)?
Shifting of the triangle and the "signal" to entrepreneurs (time preferences) and the interest rate:
So why would a "cluster of errors" take place? (Rothbard’s first point)
The Key Signal here is the interest rate:
But there is a “signal extraction problem”:
The “false signal comes from an increase in the supply of ‘additional credit’ . . . and . . . a lowering of the rate of interest, which falls below the level at which it would have been without their [monetary authority] intervention.” (Mises)
So here is where we have the “boom” explained (Rothbard’s second point):
This is when prices (and wages) increase due to the credit expansion. But not uniformly - some increase more than others. Again - directing resources in different directions.
“The upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises.” (Mises) (my bold)
Here's where Mises is talking about Say's Law - or the idea that the increase in demand (and the increase in prices and wages) is NOT due to an increase in productivity (an expansion of the pie - "the material means of production and the labor available have not increased;" - thus, scarcity of capital goods increases to the point where it is no longer profitable to continue the production in the "booming" industries.
And the “bust” explained:
Mal-investment (on two levels):
1. Retooling in the capital structure -- returning investment to where it should have been (capital vs. consumer goods).
“For the time-preferences of the public have not really gotten lower; the public doesn’t want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/savings proportions. This means that they redirect the spending back to the consumer goods industries, and they don’t save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers’ goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods.” (Rothbard)
This explains Rothbard’s third point.
2. Retooling in individual markets - injection effects and relative price changes -- resources allocated to unproductive markets.... (malinvestment)
As Garrison talks about in your reading:
The recession or downturn is when the market returns resources to where they should have been. If the government (including the FED) continues to distort signals (prices, profits, interest rates) -- the market is unable to work effectively at creating jobs and bringing unemployment back down. The recession (or depression) continues much longer than necessary.
“The economy will not be able to develop harmoniously and smoothly unless all artificial measures that interfere with the level of prices, wages and interest rates, as determined by the free play of economic forces, are renounced once and for all.” (Mises)
This is due to not only the signal distortions continuing - but also the increase in uncertainty created by all of the "false" signals of the past (and present) – including regulatory uncertainty.
So does this theory explain the recent boom/bust and recession?
Austrian economists think so.
In a way – this is what might be called “a perfect storm.”
Cast of Characters:
State and Local Governments
The U.S. Congress and the White House
Fannie Mae and Freddie Mac (Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation)
CRA - The Community Reinvestment Act (1970 - amended 1995)
Bank and Mortgage Market Regulators
Bond and Securities Ratings Firms
The FED
Banks (lending/financial institutions)
Wall Street Firms
Home Buyers
Time Line
1938 - Congress creates Fannie Mae
1970 - Congress creates Freddie Mac
Both institutions are Government Sponsored Enterprises -- meaning that they have a direct line of money from the government -- but in return are under political pressure.
1977 - Congress passes the (CRA) Community Reinvestment Act (requires banks to lend in neighborhoods of the geographic areas where they operate -- even in high risk areas).
1995 - Congress amends the CRA - banks had to lend to low income people and to minorities - or "face the wrath of government regulators." (Miller and Benjamin, p. 123).
1990s - 2000s (and actually earlier in some places) - State and local governments increased their "growth management" regulations (including "green space" movements and zoning laws). Those times "in which housing markets became unaffordable closely followed the approval of state growth-management laws or restrictive local plans." (Sowell, p. 13). These regulations decreased the available supply of land available for housing, increasing land values - thereby increasing housing prices. Most especially -- cities in coastal California, Las Vegas (where much of the land is govt. owned), New York, Washington, Miami, and the Phoenix area.
As housing prices rose in the areas above (from 2000 to 2005), this was conceived as a "national problem," - especially by Washington politicians. But: it wasn't really a national problem at all. Families in the vast majority of the country could still buy a house for a smaller share of their income than they could have a generation ago. (Sowell, p. 17).
Democratic and Republican members of Congress and both President Clinton and President Bush put pressure on banks and other lending institutions to lower their credit rating standards; reduce the minimum down payment requirements (in a growing number of cases, to zero); and introduce short-term flexible monthly payment methods that would only increase later on. (Ebeling)
2001 - 2004 (and actually throughout the 2000s) In steps our friend the FED. In these years it kept interest rates artificially at historically low levels. When adjusted for inflation, for part of the time interest rates were zero or negative. Mortgage rates were pushed down to barely two or three percent in real terms. (Ebeling)
Because of these moves by Congress and the White House and our friend the FED --
The BOOM
Homebuyers jumped in with both feet forward! The demand for houses skyrocketed. And housing prices started to go up in more places across the country. Fueling this demand were "speculators" -- house "flipping" became very popular (even sparking television shows on how to flip a house!) - An especially popular type of mortgage for these flippers (and others) was the Adjustable Rate Mortgage (ARM) -- low interest at first, increasing later.
Important Note about the FED's policy of low interest rates -- not only did this artificial signal tell entrepreneurs in the home building industry to invest in capital goods -- but it told entrepreneurs in other industries to do so as well. Housing (construction) was not the only industry that saw a “boom.”
Although, because of the actions of Congress and the White House -- the housing industry was flooded with capital intensive resources more so than other places -- mal-investment (in capital) took place in other industries as well -- from palladium mining to commercial plant expansion (Staib and Woods).
Banks (lending/financial institutions) were providing subprime loans under the pressure from Congress and the Bank and Mortgage Market Regulators. But they also knew that once they made the loan (and collected the fees from doing so) they could sell the high risk loan to another institution.
Freddie and Fannie were also under pressure from Congress to buy these high risk loans (they bought around 50% of them) - which really created a large market for them. (Also note that Freddie and Fannie gave huge amounts of money in campaign contributions).
In other words -- since the banks knew they could sell them to (eventually) Freddie and Fannie - this increased the incentive to keep offering subprime mortgages.
It was a matter of time before a substantial minority of borrowers could not or would not pay their mortgages. Partly because astute people predicted this (and so a lot of money was to be made), Wall Street Firms began to bundle several of these subprime mortgages together, these "synthetic subprime mortgage bond-backed CDOs - collateralized debt obligations" were created. Furthermore, well-known names in the financial world began to package, or sponsor mortgage and other debts such as credit card balances into what were called "structured-investment vehicles (SIVs) to investors.
These financial instruments had complicated terms - and people weren't sure where the ultimate risk really fell.
Furthermore, the Bond and Securities Ratings Firms were highly regulated and influenced by the Congress. Sowell talks about that the regulations in this industry created an “oligopolistic” industry – not much competition.
Between that and them not understanding these new financial instruments -- they rated them very highly -- therefore leading people to believe that they were not as risky as they actually were.
To add to this - many of the Wall Street Firms that were dealing in these instruments had close ties to Congress and the White House. In other words -- not only did these firms give large campaign contributions, but people in the SEC (Securities and Exchange Commission) would move to and from these firms.
So government and business are in cahoots with each other. This was happening between pretty much all of the characters in our story. Freddie and Fannie and Congress, the regulators and the Wall Street Firms, Congress and the Wall Street Firms, The FED and Congress, The FED and the Wall Street Firms, etc....
The BUST
began when people started to realize that their investments were bad. The result of the FED's interest rate manipulation in everyday terms: "a housing contractor is led by low interest rates to believe that consumers have abstained from purchasing more physical current goods and have instead saved their income to enable them greater consumption of future goods, thus allowing entrepreneurs to put those physical resources into long-term productive - and, the entrepreneur hopes, profitable - pursuits in the meantime. This leads the housing contractor to believe that there will be more physical bricks available for completion of homes in the future than will actually be available, and that consumers will have more funds available for the purchase of those homes in the future than they actually will." (Staib, Woods)
Once the Homebuyers began to stop paying on their mortgages -- these and real investments started to go downhill.
When the "future consumption" doesn't materialize, the mal-investment becomes obvious. The lay-offs, downsizing, cutting costs, etc. begin.
In this case there was mal-investment in terms of the real capital goods that went into housing and other production structures. But there was also a huge mal-investment in the financial markets in general (related, of course).
And of course, due to the credit expansion by the FED - creating injection effects (relative price changes among goods) - there was also mal-investment between markets.
The retooling begins -- resources need to move out of these places where they should not have been and into productive investments.
The bailouts by Congress lengthened the retooling period - not allowing the resources to move to where they would be more productive and where they would have created more jobs. And remember, this period is a painful period. So many economists would argue that Congress and the FED have lengthened the recession by their policies which have not allowed the retooling of resources to where their value really exists.
Furthermore, new legislation increases uncertainty -- also causing businesses to hold back on new investment and new hiring.
The bottom line: Rules - Incentives - Actions - Outcomes
(Changes made by The FED/Congress/Freddie/Fannie/Regulators - Changed the Incentives of the Banks/Wall Street Firms/Homebuyers - This led to Risky Actions - and the outcome was the Boom/Bust and the recession we have still today)
Institutions matter!!
Real Wealth Destroyed
According to Cochran, this latest recession (and its extension by government (both fiscal and monetary policy) – has decreased real wealth in the economy.
“A first thing to notice is the timing of the apparent rise and decline in median household income beginning in the mid 1990s.”
According to Austrians, the U. S. suffered back to back boom bust cycles, the dot.com bust and the housing bubble. These economy-wide boom-busts coincide with the two booms and busts in household income during the same period.
The argument, which is an often overlooked feature of a policy driven boom-bust is capital consumption and hence wealth destruction.
“Stimulus significantly increases the volume of resources that ultimately fall in the “sunk cost” category: at the end of the stimulus phase, some resources have already been committed to investment projects but are not yet productive; when the stimulus phase ends and it turns out that these projects are not going to be completed, these resources are “sunk” costs and not re-assignable to new projects.” (Ravier as quoted by Cochran).
This reduces productive capital in the economy – also making labor less productive – making it more difficult for employment to increase.
So boom-bust cycles have lasting impacts on households well beyond the recession itself.
Let's look at some stats:
DO ICE THIRTEEN