Austrian Business Cycle Theory

I’ve long promised a post on Austrian Business Cycle Theory, and here it is. For those who would rather get straight to the conclusion, it’s one I share in broad terms with most of the mainstream economists who’ve looked at the theory, from Tyler Cowen , Bryan Caplan

and Gordon Tullock at the libertarian/Chicago end of the spectrum to Keynesians like Paul Krugman and Brad DeLong.

To sum up, although the Austrian School was at the forefront of business cycle theory in the 1920s, it hasn’t developed in any positive way since then. The central idea of the credit cycle is an important one, particularly as it applies to the business cycle in the presence of a largely unregulated financial system. But the Austrians balked at the interventionist implications of their own position, and failed to engage seriously with Keynesian ideas.

The result (like orthodox Marxism) is a research program that was active and progressive a century or so ago but has now become an ossified dogma. Like all such dogmatic orthodoxies, it provides believers with the illusion of a complete explanation but cease to respond in a progressive way to empirical violations of its predictions or to theoretical objections. To the extent that anything positive remains, it is likely to be developed by non-Austrians such as the post-Keynesian followers of Hyman Minsky.

Update There’s a fascinating discussion linking to this post here. In French, but clear and simply written. Anyone with high school French and a familiarity with the issues should be able to follow the main points.

First, some history and data. Austrian Business Cycle Theory was developed in the first quarter of the 20th century, mostly by Mises and Hayek, with some later contributions by Schumpeter. The data Mises and Hayek had to work on was that of that of the business cycle that emerged with industrial capitalism at the beginning of the 19th century and continued with varying amplitude throughout that century. In particular, it’s important to note that the business cycle they tried to explain predated both central banking in the modern sense of the term and the 20th century growth of the state. The case of the US is of particular interest since the business cycle coincided with a wide range of monetary and banking systems: from national bank to free banking, and including a gold standard, bimetallism and non-convertible paper money.

This NBER data goes back to 1857, but there was nothing new about the business cycle then (Marx, for example, had been writing about it for a decade or more). The US experienced serious “panics”, as they were then called in 1796-97, 1819 and 1837 [1] as well as milder fluctuations associated with the British crises of the 1820s and 1840s.

The typical crisis of the 19th century, like the current crisis, began with bank failures caused by the sudden burst of a speculative boom and then spread to the real economy, with the contraction phase typically lasting from one to five years. By contrast, recessions since 1945 have generally lasted less than a year, and have mostly been produced by real shocks or by contractionary monetary and fiscal policy.

According to the theory, the business cycle unfolds in the following way. The money supply expands either because of an inflow of gold, printing of fiat money or financial innovations that increase the ratio of the effective money supply to the monetary base. The result is lower interest rates. Low interest rates tend to stimulate borrowing from the banking system. This in turn leads to an unsustainable boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if price signals were not distorted. A correction or credit crunch occurs when credit creation cannot be sustained. Markets finally clear, causing resources to be reallocated back towards more efficient uses.

At the time it was put forward, the Mises-Hayek business cycle theory was actually a pretty big theoretical advance. The main competitors were the orthodox defenders of Says Law, who denied that a business cycle was possible (unemployment being attributed to unions or government-imposed minumum wages), and the Marxists who offered a model of catastrophic crisis driven by the declining rate of profit.

Both Marxism and classical economics were characterized by the assumption that money is neutral, a ‘veil’ over real transactions. On the classical theory, if the quantity of money suddenly doubled, with no change in the real productive capacity of the economy, prices and wages would rise rapidly. Once the price level had doubled the previous equilibrium would be restored. Says Law (every offer to supply a good service implies a demand to buy some other good or service) which is obviously true in a barter economy, was assumed to hold also for a money economy, and therefore to ensure that equilibrium involved full employment

The Austrians were the first to offer a good reason for the non-neutrality of money. Expansion of the money supply will lower (short-term) interest rates and therefore make investments more attractive.

There’s an obvious implication about the (sub)optimality of market outcomes here, though more obvious to a generation of economists for whom arguments about rational expectations are second nature than it was 100 years ago. If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make ‘bad’ investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there’s no reason to think that market outcomes will be optimal in general.

A closely related point is that, unless Say’s Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.

Finally, the Austrian theory didn’t say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.

The credit cycle idea can easily be combined with a Keynesian account of under-employment equilibrium, and even more easily with the Keynesian idea of ‘animal spirits’. This was done most prominently by Minsky, and the animsal spirits idea has recently revived by Akerlof and Shiller. I suspect that the macroeconomic model that emerges from the current crisis will have a recognisably Austrian flavour..

Unfortunately, having put taken the first steps in the direction of a serious theory of the business cycle, Hayek and Mises spent the rest of their lives running hard in the opposite direction. As Laidler observes, they took a nihilistic ‘liquidationist’ view in the Great Depression, a position that is not entailed by the theory, but reflects an a priori commitment to laissez-faire. The result was that Hayek lost support even from initial sympathisers like Dennis Robertson. And this mistake has hardened into dogma in the hands of their successors.

The modern Austrian school has tried to argue that the business cycle they describe is caused in some way by government policy, though the choice of policy varies from Austrian to Austrian – some blame paper money and want a gold standard, others blame central banks, some want a strict prohibition on fractional reserve banking while others favour a laissez-faire policy of free banking, where anyone who wants can print money and others still (Hayek for example) a system of competing currencies.

Rothbard (who seems to be the most popular exponent these days) blames central banking for the existence of the business cycle, which is somewhat problematic, since the business cycle predates central banking. In fact, central banking in its modern form was introduced in an attempt to stabilise the business cycle. The US Federal Reserve was only established in 1913, after Mises had published his analysis.

Rothbard gets around this by defining central banking to cover almost any kind of bank that has some sort of government endorsement, such as the (private) Bank of England in the 19th century, and arguing for a system of free banking that would avoid, he asserts, these problems. But, on any plausible definition of the term, the US had free banking from the Jackson Administration to the Civil War and that didn’t stop the business cycle (Rothbard offers some historical revisionism to argue that the Panic of 1837 didn’t really happen, but that wasn’t what US voters thought when they threw the Jacksonians out in 1840). And free banking in late 19th century Australia (our first quasi-central bank was the Commonwealth Bank established in 1915) didn’t prevent a huge boom and subsequent long depression around 1890. Overall, the US was much closer to free banking throughout the 19th century than in the period from 1945 until the development of the largely unregulated ‘shadow banking’ system in the 1990s, but the business cycle was worse then (how much worse is a matter of some controversy, but no serious economist claims it was better).

To sum up, the version of the Austrian Business Cycle Theory originally developed by Hayek and Mises gives strong reasons to think that an unregulated financial system will be prone to booms and busts and that this will be true for a wide range of monetary systems, particularly including gold standard systems. But that is only part of what is needed for a complete account of the business cycle, and the theory can only be made coherent with a broadly Keynesian model of equilibrium unemployment. Trying to tie Austrian Business Cycle Theory to Austrian prejudices against government intervention has been a recipe for intellectual and policy disaster and theoretical stagnation.

373 thoughts on “Austrian Business Cycle Theory

  1. The OCC’s listing is a bit more spread out:
    This will do as a start.
    The Fed?

    Do you want more? If you are a banker you are subject to most, if not all, of these. Add in the 50 state based US regulators, the various charters that the US banks are subject to, the CRA (particularly as recently amended) and you have a bit of reading to do. Be fair – if you are a banker you would need to understand and implement them all.

  2. Just to clarify on the capital reserve ratio issue: the US certainly passed legislation during the reign of Volker to remove minimum ratios, the UK has one of the murkiest and lightest regulatory regimes in the world (only Iceland is more lightly regulated) and Aust does have guidelines/regulations under APS 112 and 113 but it is MASSIVELY watered down since the 1950s/1960s when Nuggest Coombs was at the helm. Actual capital controls were in place, so that in some months if the banks had lent their quota, they couldn’t lend anymore.

    Ahhh…..the good old days of the ’50s….

  3. ABOM,
    Sorry – wrong. Follow the link to the ASIC site. If you want more, the international regulations at the BIS website show the current (Basel I) regulation of bank capital ratios (current in the US, superseeded elsewhere) and the new (for the US) Basel II calculation method.
    The Basel II publication is over 400 pages long in its full version. Go for it – I have had to read and understand it.
    If you say that banks do not have black line capital ratios you are absolutely and demonstrably wrong.

  4. And you’ve not listed ONE piece of “INCREASED” regulation AFTER the removal of GS, let alone “piles more”.

    Admit it. You’ve lost.

    Go back to looking up APS 112 and 113 one more time.

  5. Andie,

    Please give up. I can’t stop laughing over you trying to argue that Basel II was “increased” regulation. It’s like beating up on a tiny child. Please someone stop this fight.

    On Basel II (from someone who should know):

    About the shadow banking system and the absolute DISASTER of UNREGULATED (totally UNREGULATED) OTC derivatives:

    Someone stop this fight…even I’m embarrassed by beating up on this guy.

  6. ABOM,
    If you want to live in ignorance I cannot stop you. I have to deal with this stuff – you obviously choose not to. If you care to look (I doubt you have) you will note that there is a lot of stuf on the Fed’s, the OCC’s and the FDIC’s sites that have ben published after the removal of Glass-Stegall – but you don’t want to know. Fine. Call for more regulation. Just don’t fool yourself that you are anything other than another person who is far more interested in being an ignorant blowhard than someone actually trying to do something about it.

  7. ABOM says

    “Ron Paul is the paradigm free-marketeer, but when it came to removing Glass-Steagall, he voted against it, saying effectively “I’m for deregulation, just not THIS deregulation.”

    Thankyou ABOM.

    Im all for the end ideal, but I think the core issue is a malfunctioning financial system and the removal of Glass Steagall might not have been the root cause but it poured petrol on the fire.

  8. That last comment is for Andie.

    I’m over arguing the Andies of the world. The zombie banks have “Killed us all to some extent” (Jim Sinclair).

    I’ve countered every single point he’s raised and he still doesn’t get it.

    Thank God you’re there Alice. I would have killed myself in despair without your sanity.

  9. ABOM,
    I would rather be too close to the fire than so far away from it that you do not even know how it started – or even if it is burning.
    As for “countering every single point” all I can say is BS. For example if you look at Basel I (all 30 pages of it) and then (let’s keep this simple shall we) just compare it to Basel II at 400 pages I’d be fascinated to see how this is deregulatory.
    I would argue that it is better (it moves regulatory capital closer to the economic capital) but it is certinaly more intrusive.
    But of course Ron Paul knows all, doesn’t he?

  10. 361# Pass the MacAllen ABOM! I think we should kill ourselves together and we may as well go out in style..

  11. ABOM,
    Good to see you still indulge in your rather juvenile debating tricks – in this case addressing the audience rather than your interlocutor. This one is normally a sign that you are happy to appeal to the baser instincts of the uninformed rather than engage.
    Again, don’t try to fool yourself that you are doing anything other than trying to ignore the points.

  12. Additionally – it is interesting that you point to a piece by Das. He is one of those that informed my view that the banks should not be bailed out – as on one of the (evidently several) links that you have not followed to inform yourself of my view – in this case the link in comment 343.
    Sad, ignorant, Ron Paul follower. The second and third points in that sentence are probably redundencies.

  13. What do you think of the Das article, getting away from the childish name calling that both of us have engaged in? Did you see the title of the article I posted? Do you agree with his analysis of the HISTORY of “deregulation” and its damaging effects (“debauchery” is the word he uses).

    This was, after all, the bone of contention.

    Let’s chew on that, rather than the flesh of our respective children.

  14. ABOM,
    OK, this time actually read what he said. Nowhere has he said this is due to deregulation and he has repeatedly shown why this is due to existing regulation – for example:

    Central bankers fueled the liquidity bubble through excessive monetary growth and low interest rates. The “Greenspan Put” repeatedly bailed out banks and investors from poor decisions or irrational exuberance underwriting excessive risk taking. Asset price bubbles rolled merrily along; waves of risk mis-pricing moving through different markets. The current credit crisis has its origins in the Federal Reserve’s interest rate cuts of the early 2000s that helped engineer the housing bubble.

    How on Earth can you get this down to a failure of the process of deregulation? The rest of what he says about excessive risk taking clearly arises from that. He is perfectly clear about it.
    In any case you are asking me a question of the type of “now we are here, how do we get out?” My answer is clear – we should not be here in the first place. Unwinding ourselves from the naive view that everything can be solved by putting more rules in place will start when we accept that this fundamental idea is wrong.
    Sure – I have some ideas on “where to from here” and I will work it up into a blog post soon, but the first step to healing a system like this is to accept that the direction we have been heading in (more and more rules) is the wrong one. If so-called “libertarians” are calling for more regulation I see precious little hope of that.
    Still, from a personal point of view this is probably a good thing. I make much of my income out of advising businesses how to cope with the current regulation. Get rid of it and I may have to find a new client base. Still – I live in hope.

  15. 369# Just as well no Macallan left ABOM – what I really need is a large general anaesthetic…the faster the better. It was all there in the Das article 2007 ..most of what I already suspected (shame about the warnings from the other fed reserve link in 2003 unheeded..).
    Zombie “indiscriminate” de-regulation, zombie Greenspan i rate policies and banks turn into monstrous feral zombie gaming houses. The perfect storm.

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