ABC Theory

Austrian Business Cycle Theory is the Austrian account of why the Business Cycle occurs. The Business cycle, is a common, though very loosely explained principle in economics. It says that the economy is always subject to ups and downs, booms and busts.

The mainstream economists, might attribute this to “animal spirits”, consumer “shocks”…In reality, they don’t really know very well.

The Austrian argument goes as follows.

The boom period is brought about, because of “easy money” policies. Easy money, normally comes in the form of low interest rates. So the Central Bank is printing off fresh money so that people can invest more. What they don’t realize is that this is giving investors a distorted view of reality. It makes projects seem profitable when in reality they are not.

Interest rates play a coordinating function. They coordinate production across time, or in other words, they align our inter-temporal preferences. The interest rate really signifies the weight people give to consumption today and consumption tomorrow.

The problem comes, when this interest rate is manipulated, and it begins to send the wrong signal. You might even call it price fixing. A low interest rate, should be indicating high levels of saving, and more future consumption. But in the case of the artificially lowered interest rate, all it means is that more money has been made available now, but this is at the expense of the future, because the money was brought into existence out of thin air, since it doesn’t signify any sacrifice in present consumption, it will affect prices, and in fact, low interest rates are dissuading consumers from saving, they are shouting at them to consume, to get more in debt.

So during the boom period, many projects have been started, perhaps restaurants have expanded, hired a couple more waiters, everything is looking good, but it cannot last. Eventually, the reality sinks in, this is when the price-readjustment process begins. According to Hayek, this happens when investors, all with the newly printed money in their hands go and buy up the resources, namely capital goods, the amount of which hasn’t increased. Why capital goods? Because a low interest rates incentivises long-term investments. Low interest rates, should mean a higher level of saving, and therefore, more production should be devoted to satisfying this future demand. But the fact is, that in this case, noone is atually saving, noone is giving up consupmtion today in favour of consumption in the future. In this way, we are produing less today, to satisfy our needs of tomorrow, but actually, noone is saving up for tomorrow, and people are still demanding things now. The lowering of the interest rates has created a misalingnment between demand and supply. This misalingnment manifests itself when the price of consumer goods and commodities starts to increase, since there is a shortage of supply providing for present demand. Eventually, a recession will ensue, that should alter the production structure and return things to normality, but this will entail a process of bankruptcie and debt deleveraging.

This theory brings up a lot of good points, it shows why interest rates are important, and the misalignment they cause. I think this kind of theory explains quite well what happened in the recent financial crisis. One of my few critiques of the Austrian School is that they try to apply this to every crisis that’s ever happened.

But this isn’t what happened for example in the 30s, when the Federal Reserve was still acting under the gold standard. I will write more about the 30s in my next post.

For now that is all folks.

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