Austrian Business Cycle Theory

December 10, 2010


My understanding of business cycle theory is based on my brief study of the Austrian School of thought on business cycle theory as taught by the great scholars of the School (e.g., Ludwig von Mises, F. A. Hayek, Henry Hazlitt, Murray Rothbard, and more currently, Ron Paul, Peter Schiff, Judge Andrew Napolitano, Tom Woods, Marc Faber, Doug French, Mark Thorton, Jeffrey Tucker, etc.). The Austrian School requires one to think not only about the most obvious potential positive impact that a particular fiscal or monetary policy decision - such as price controls - would have for a particular [special interest] group, it requires that one consider other groups that would also be impacted by the policy and likely could be harmed by the same policy that is helpful to first group. The School requires one to think through not only the obvious results of a particular policy but those that may not be as readily apparent as well.


The economic school of thought is probably best described as a study of humanity vs. one of complex mathematical calculations and esoteric language like "aggregate consumption".


Rather, the Austrian School studies the nature of humanity and how commerce and trade would follow the natural laws of mutual self-interest in a lazze faire marketplace. This intuitive understanding of human action is the basis for Austrian economic theory.

The theory goes something like this. The central bank (The Fed in the case of the American economy) responding to a contraction of credit in the market (a sign of potential economic recession which the Austrians see as a natural corrective cycle and an encouragement for saving - delaying current consumption in favor of future consumption) artificially lowers interest rates to encourage continued borrowing and subsequent spending which they propose will "soften the landing" of a boom heading into the bust part of the business cycle. This is often accompanied by printing of currency (inflating the money supply to improve liquidity). These "interventionist" policies are counter-intuitive to the free market's natural response to a slowing economy. As such The Fed is telegraphing false assumptions to entrepreneurs which take the Fed's policy of lower interest rates to mean that they should borrow to create goods and services for future consumption when the free market is actually dictating they should slow or stop current production and begin saving capital until such time as interest rates lower in the free market which would dictate the need to use the saved capital to begin producing goods and services for future consumption again. The ultimate result (which everyone is now familiar with since the crash of 2008) is that there is an abundance of inventory of these goods and services which nobody is buying. What happens when there is an abundance of supply and little or no demand? You got it, prices fall.

The crash of the US housing market is an excellent example of what I just outlined. Let me explain. In the late 90's there was a stock market boom (tech and internet stocks in particular). When the free market saw that these dot com company stocks did not have the earnings to support their highly inflated prices, the sell-off began and we had a crash shortly after 9-11. Instead of letting the market run its course and correct itself, The Fed (under then Chairman Alan Greenspan) began lowering interest rates to again "soften the landing" of the crash. When the free market noticed that housing prices had not dropped but that interest rates where now at an all time low, housing entrepreneurs (like myself) borrowed inexpensive and readily available capital to produce homes that were increasing in price in some places as much as 20-30% in a single year. To an entrepreneur, this is a no-brainer. Cheap capital plus rapidly increasing prices equal massive profits. But the true free market was not dictating the production of more housing and the charge for hyper-supply was on. Everyone was getting into real estate. People who had never been involved previously were trying to get in on it and cash in on the huge profits available. This is what the Austrian's will call an artificial boom created by the low interest rate policy of The Fed. Eventually, the same thing that happened in the tech stock bubble happened in real estate. Prices rose too high to fast and people began to see that it was not sustainable and then we had a much bigger crash than what we would have suffered in 2001 had The Fed allowed the market to correct itself. If interest rates had been allowed to rise as dictated by the free market, the speculation in housing would not have happened. In fact, the rising interest rates would have discouraged housing production in the short term which would have eventually created a true shortage of housing that the free market would have responded to. This would have triggered a much quicker recovery (a year or two and it would have been all over) even if the short term pain was tougher medicine.

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