The Austrian Theory of the Business Cycle
The previous two sections provide a stark contrast between Austrian and
Keynesian views. They show how an increase in saving can move the economy
along its production possibilities frontier, allowing for an increase in the
economy’s rate of economic growth (the Austrian view), and how an increase
in saving necessarily throws the economy off its frontier and into recession
(the Keynesian view). Simply put, markets work in one view and don’t work
in the other.
For the Austrians, the idea that markets work is not axiomatic. There is no
claim that markets are always guided only by the underlying economic reali504
Modern macroeconomics
ties – no matter what institutional arrangements are in place and no matter
what macroeconomic policies are pursued. In fact, the Austrian theory of the
business cycle is a theory about a policy-induced departure – first in one
direction and then in the other – from the economy’s production possibilities
frontier.
For Keynes, increased saving leads to recession. This proposition, however,
did not transform his paradox of thrift into an excess-saving theory of
recessions. As already indicated, Keynes believed that saving preferences
were not likely to change. The recession-inducing changes, in his view, were
almost always spontaneous changes on the demand side of the loanable funds
market.
Keynes and Hayek were critical of one another’s efforts to explain recessions,
but their assessments of one another’s books generated more heat than
light and failed to produce a head-to-head comparison of the contrasting
views. Despite all the interpreting, reinterpreting and reconstructing of
Keynesian ideas over the last three-quarters of a century, it is instructive to
compare (in this and the following sections) the Austrian and (original)
Keynesian views on the nature and causes of business cycles (see Garrison,
1989, 1991, 2002).
According to the Austrians, the market is capable of allocating resources in
conformity with intertemporal preferences on the basis of a market-determined
(natural) rate of interest. It follows, then, almost as a corollary that an interest
rate substantially influenced by extra-market forces will lead to an intertemporal
misallocation of resources. This latter proposition is the essence of the Austrian
theory of business cycles. The cyclical quality of the departures from the
economy’s production possibilities frontier derives from the self-correcting
properties of a market economy. Misallocations are followed by reallocations.
Note that the market is not judged to be so efficient as to prevent from the
outset all policy-induced misallocations. As Hayek (1945) has taught us, it
cannot allocate resources in accordance with the ‘real factors’ (consumer preferences,
technological possibilities and resource availabilities) except on the
basis of information conveyed by market signals, including, importantly, the
rate of interest. It is movements in the interest rate, along with the corresponding
movements in input prices and output prices, that give clues to the business
community about what those real factors are and about how they may have
changed.
The Austrian theory of the business cycle is a theory of boom and bust with
special attention to the extra-market forces that initiate the boom and the
market’s own self-correcting forces that turn boom into bust. We have already
seen that increased saving lowers the rate of interest and gives rise to a
genuine boom, one in which no self-correction is called for. The economy
simply grows at a more rapid rate. By contrast, a falsified interest rate that
mimics the loan market conditions of a genuine boom but is not accompanied
by the requisite savings gives rise to an artificial boom, one whose artificiality
is eventually revealed by the market’s reaction to excessively future-oriented
production activities in conditions of insufficient saving.
As with the graphical depiction of saving and growth, the analytics of
boom and bust is begun with an assumed no-growth economy in an
intertemporal equilibrium. The initial (market-determined) rate of interest (ieq
in Figure 9.10) also qualifies as the natural rate of interest. An artificial boom
is initiated by the injection of new money through credit markets. The central
bank adopts an interest rate target below the rate of interest that otherwise
would have prevailed. Its operational target rate, of course, is much more
narrowly defined than the broadly conceived market rates shown in the diagram.
The central bank achieves its interest rate target by augmenting the
supply of loanable funds with newly created credit. The Federal Reserve’s
Open Market Committee buys securities in sufficient volume so as to drive
the Federal Funds rate down to the chosen target. With this action, market
rates generally are brought down to a similar extent – although, of course,
some more so than others. The fact that long-term rates tend not to fall as
much as short-term rates may mitigate – but cannot eliminate – the general
effects of the credit expansion. Further, these general effects are independent
of which particular policy tool the Federal Reserve employs. Credit expansions
brought about by a reduction in the discount rate (now called the
primary credit rate) or by a reduction in reserve requirements could be
similarly described. All of the institutionally distinct monetary tools are
macroeconomically equivalent: they are all means of lending money into
existence and hence have their initial effect on interest rates.
For comparison, the central bank’s augmentation of credit depicted in
Figure 9.10 is set to match the actual shift in the supply of saving depicted in
Figure 9.8. Rather than create a new equilibrium interest rate and a corresponding
equality of saving and investment as was the case in a saving-induced
expansion, the credit expansion creates a double disequilibrium at a subnatural
interest rate. Savers save less, while borrowers borrow more. Note
that if this low interest rate were created by the imposition of an interest rate
ceiling, the situation would be different. With a legislated ceiling, borrowing
would be saving-constrained. The horizontal distance at the ceiling rate between
supply and demand would represent a frustrated demand for credit. A
credit shortage would be immediately apparent and would persist as long as
the credit ceiling was enforced.
Credit expansion papers over the credit shortage that would otherwise
exist. The horizontal distance between supply (of saving) and demand (for
credit) is not frustrated demand but rather demand accommodated by the
central bank’s injections of new credit. It represents borrowing – and hence
investment – that is not accommodated by genuine saving. In the final analysis,
of course, real investment cannot be in excess of real unconsumed output.
To say that credit expansion papers over the shortage is not to say that it
eliminates the problem of a discrepancy between saving and investment. It
only conceals the problem – and conceals it only temporarily. In summary
terms we see that padding the supply of loanable funds with newly created
money drives a wedge between saving and investment. The immediate effect
of this padding is (i) no credit shortage, (ii) an economic boom in which the
(concealed) problem inherent is a mismatch between saving and investment
festers, and (iii) a bust, which is the eventual but inevitable resolution to the
problem. (With this summary reckoning, however, we have got ahead of the
story.)
The double disequilibrium in the loanable funds market has as its counterpart
the two limiting points on the production possibilities frontier. Saving
less means consuming more. But with a falsified interest rate, consumers and
investors are engaged in a tug-of-war. If, given the low rate or return on
savings, the choices of consumers were to carry the day, the economy would
move counterclockwise along the frontier to the consumers’ limiting point.
Similarly, if, with artificially cheap credit, the decisions of investors were to
carry the day, the economy would move clockwise along the frontier to the
investors’ limiting point. Of course, neither set of participants in this tug-ofwar
is wholly victorious. But both consumer choices and investment decisions
have their separate – and conflicting – real consequences. Graphically, the
participants are pulling at right angles to one another – the consumers pulling
upward in the direction of more consumption, the investors pulling rightward
in the direction of more investment. Their combined effect is a movement of
the economy beyond the frontier in the direction of a ‘virtual’ disequilibrium
point that is defined by the two limiting points.
Having defined the production possibilities frontier in terms of sustainable
levels of output, we can allow for the economy to move beyond the frontier –
but only on a temporary basis. People are drawn into the labour force in
numbers that cannot be sustained indefinitely. Additional members of households
may take a job because of the unusually favourable labour market
conditions. Some workers may work overtime. Others may delay retirement
or forgo vacations. Maintenance routines that interrupt production activities
may be postponed. These are the aspects of the boom that allow the economy
to produce temporarily beyond the production possibilities frontier. However,
the increasingly binding real resource constraints will keep the economy
from actually reaching the virtual disequilibrium point – hence the ‘virtual’
quality of that point. The general nature of the path traced out by the economy
– its rotation in the clockwise direction – will become evident once we
consider the corresponding changes in the economy’s structure of production.
The wedge driven between saving and investment in the loanable funds
market and the tug-of-war that pulls the economy beyond its production
possibility frontier manifests itself in the economy’s capital structure as clashing
triangles. In the case of a saving-induced capital restructuring, the
derived-demand effect and the time-discount effect work together to reallocate
resources toward the earlier stages – a reallocation that is depicted by a
change in the shape of the Hayekian triangle. In the case of credit expansion,
the two effects work in opposition to one another. The time-discount effect,
which is strongest in the early stages, attracts resources to long-term projects.
Low interest rates stimulate the creation of durable capital goods, product
development and other activities whose ultimate pay-off is in the distant
future. The excessive allocations to long-term projects are called ‘malinvestment’
in the Austrian literature. The derived-demand effect, which is
strongest in the late stages, draws resources in the opposite direction so as to
satisfy the increased demand for consumer goods. The Hayekian triangle is
being pulled at both ends against the middle. Skousen (1990) identifies this
same internal conflict in terms of an early-stage ‘aggregate supply vector’ and
a late-stage ‘aggregate demand vector’
During the boom, resource allocations among the various stages are being
affected in both absolute and relative terms. As explained above, the economy
is producing generally at levels of output that cannot be sustained indefinitely.
And at the same time that the overall output levels are higher, the
pattern of output is skewed in both directions – toward the earliest stages and
toward the latest stages. Middle stages experience a relative decline and some
of them an absolute decline. While this characterization of the boom is
gleaned from Hayek (1967 [1935]) and Mises (1953 [1912] and 1966), there
remain some fundamental doctrinal differences (both terminological and substantive)
in the alternative expositions offered by these early developers of
capital-based macroeconomics (Garrison, 2004).
Richard Strigl (2000 [1934]), writing without reference to the Hayekian
triangle, provided an account of boom and bust consistent with the one
offered here. In his account, production activities are divided into three
broadly conceived categories: current production of consumables (late stage),
capital maintenance (middle stage), and new ventures (early stage). Policyinduced
boom conditions tend to favour current production and new ventures
at the expense of capital maintenance. The economic atmosphere has a ‘make
hay while the sun shines’ quality about it, and the economy seems to be
characterized by prosperity and rapid economic growth. However, the undermaintenance
of existing capital (the sparse allocations to the middle stages)
distinguishes the policy-induced boom from genuine, sustainable, savinginduced
economic growth.
In time, but before the new ventures (the early-stage activities) have come
to full fruition, the under-maintained capital (the attenuated middle-stage
outputs) must impinge negatively on consumable output. This is the essence
of intertemporal discoordination. The relative or even absolute reduction of
consumable output is dubbed ‘forced saving’ in the Austrian literature. That
is, the pattern of early-stage investment reflects a higher level of saving than
was forthcoming on a voluntary basis. The push beyond the production
possibilities frontier towards the virtual disequilibrium point is cut short by
the lack of genuine saving. The downward rotation of the economy’s adjustment
path in Figure 9.10 reflects the forced saving.
The forced saving is but one aspect – and not necessarily the first observed
aspect – of the self-reversing process that is characteristic of an artificial
boom. Increasingly binding resource constraints drive up the prices of
consumables as well as the prices of inputs needed to support the new
ventures. The rate of interest rises as overextended businesses bid for additional
funding. Distress borrowing (not shown in Figure 9.10) is a feature of a
faltering boom.
Many of the new ventures and early-stage activities generally are now
recognized as unprofitable. Some are seen through to completion in order to
minimize losses. Others are liquidated. The beginning of the liquidation
phase of the business cycle is depicted in Figure 9.10 by the economy’s
adjustment path turning back towards the production possibilities frontier.
As boom turns to bust, much of the unemployment is associated with
liquidations in the early stages of production. Too much capital and labour
have been committed to new ventures. The liquidations release these factors
of production, most of which can be reabsorbed – though, of course, not
instantaneously – elsewhere in the structure of production. For the Austrians,
this particular instance of structural unemployment is not something distinct
from cyclical unemployment. Quite to the contrary: the cyclical unemployment
that marks the beginning of the downturn has a characteristically
structural quality about it.
Under the most favourable conditions, the bust could be followed by a
recovery in which the structural maladjustments induced by the credit expansion
are corrected by the ordinary market forces. The structurally unemployed
resources are reabsorbed where they are most needed, and the economy
returns to a point on its production possibilities frontier. But because of the
economy-wide nature of the intertemporal disequilibrium, the negative income
effect of the unemployment may initially propel the economy deeper
into depression rather than back to the frontier. This secondary, or compounding,
aspect of the downturn is likely to be all the more severe if the
general operation of markets is countered by macroeconomic policies aimed
at preventing liquidation and at reigniting the boom.
The following section puts the Austrian theory in perspective by using the
capital-based analytics to depict the Keynesian view of economy-wide downturns.
For Keynes, the negative income effect that can compound the problem
of a discoordinated capital structure becomes the whole problem, the origins
of which are shrouded in the cloud of uncertainty inherent in investment
activities.
The previous two sections provide a stark contrast between Austrian and
Keynesian views. They show how an increase in saving can move the economy
along its production possibilities frontier, allowing for an increase in the
economy’s rate of economic growth (the Austrian view), and how an increase
in saving necessarily throws the economy off its frontier and into recession
(the Keynesian view). Simply put, markets work in one view and don’t work
in the other.
For the Austrians, the idea that markets work is not axiomatic. There is no
claim that markets are always guided only by the underlying economic reali504
Modern macroeconomics
ties – no matter what institutional arrangements are in place and no matter
what macroeconomic policies are pursued. In fact, the Austrian theory of the
business cycle is a theory about a policy-induced departure – first in one
direction and then in the other – from the economy’s production possibilities
frontier.
For Keynes, increased saving leads to recession. This proposition, however,
did not transform his paradox of thrift into an excess-saving theory of
recessions. As already indicated, Keynes believed that saving preferences
were not likely to change. The recession-inducing changes, in his view, were
almost always spontaneous changes on the demand side of the loanable funds
market.
Keynes and Hayek were critical of one another’s efforts to explain recessions,
but their assessments of one another’s books generated more heat than
light and failed to produce a head-to-head comparison of the contrasting
views. Despite all the interpreting, reinterpreting and reconstructing of
Keynesian ideas over the last three-quarters of a century, it is instructive to
compare (in this and the following sections) the Austrian and (original)
Keynesian views on the nature and causes of business cycles (see Garrison,
1989, 1991, 2002).
According to the Austrians, the market is capable of allocating resources in
conformity with intertemporal preferences on the basis of a market-determined
(natural) rate of interest. It follows, then, almost as a corollary that an interest
rate substantially influenced by extra-market forces will lead to an intertemporal
misallocation of resources. This latter proposition is the essence of the Austrian
theory of business cycles. The cyclical quality of the departures from the
economy’s production possibilities frontier derives from the self-correcting
properties of a market economy. Misallocations are followed by reallocations.
Note that the market is not judged to be so efficient as to prevent from the
outset all policy-induced misallocations. As Hayek (1945) has taught us, it
cannot allocate resources in accordance with the ‘real factors’ (consumer preferences,
technological possibilities and resource availabilities) except on the
basis of information conveyed by market signals, including, importantly, the
rate of interest. It is movements in the interest rate, along with the corresponding
movements in input prices and output prices, that give clues to the business
community about what those real factors are and about how they may have
changed.
The Austrian theory of the business cycle is a theory of boom and bust with
special attention to the extra-market forces that initiate the boom and the
market’s own self-correcting forces that turn boom into bust. We have already
seen that increased saving lowers the rate of interest and gives rise to a
genuine boom, one in which no self-correction is called for. The economy
simply grows at a more rapid rate. By contrast, a falsified interest rate that
mimics the loan market conditions of a genuine boom but is not accompanied
by the requisite savings gives rise to an artificial boom, one whose artificiality
is eventually revealed by the market’s reaction to excessively future-oriented
production activities in conditions of insufficient saving.
As with the graphical depiction of saving and growth, the analytics of
boom and bust is begun with an assumed no-growth economy in an
intertemporal equilibrium. The initial (market-determined) rate of interest (ieq
in Figure 9.10) also qualifies as the natural rate of interest. An artificial boom
is initiated by the injection of new money through credit markets. The central
bank adopts an interest rate target below the rate of interest that otherwise
would have prevailed. Its operational target rate, of course, is much more
narrowly defined than the broadly conceived market rates shown in the diagram.
The central bank achieves its interest rate target by augmenting the
supply of loanable funds with newly created credit. The Federal Reserve’s
Open Market Committee buys securities in sufficient volume so as to drive
the Federal Funds rate down to the chosen target. With this action, market
rates generally are brought down to a similar extent – although, of course,
some more so than others. The fact that long-term rates tend not to fall as
much as short-term rates may mitigate – but cannot eliminate – the general
effects of the credit expansion. Further, these general effects are independent
of which particular policy tool the Federal Reserve employs. Credit expansions
brought about by a reduction in the discount rate (now called the
primary credit rate) or by a reduction in reserve requirements could be
similarly described. All of the institutionally distinct monetary tools are
macroeconomically equivalent: they are all means of lending money into
existence and hence have their initial effect on interest rates.
For comparison, the central bank’s augmentation of credit depicted in
Figure 9.10 is set to match the actual shift in the supply of saving depicted in
Figure 9.8. Rather than create a new equilibrium interest rate and a corresponding
equality of saving and investment as was the case in a saving-induced
expansion, the credit expansion creates a double disequilibrium at a subnatural
interest rate. Savers save less, while borrowers borrow more. Note
that if this low interest rate were created by the imposition of an interest rate
ceiling, the situation would be different. With a legislated ceiling, borrowing
would be saving-constrained. The horizontal distance at the ceiling rate between
supply and demand would represent a frustrated demand for credit. A
credit shortage would be immediately apparent and would persist as long as
the credit ceiling was enforced.
Credit expansion papers over the credit shortage that would otherwise
exist. The horizontal distance between supply (of saving) and demand (for
credit) is not frustrated demand but rather demand accommodated by the
central bank’s injections of new credit. It represents borrowing – and hence
investment – that is not accommodated by genuine saving. In the final analysis,
of course, real investment cannot be in excess of real unconsumed output.
To say that credit expansion papers over the shortage is not to say that it
eliminates the problem of a discrepancy between saving and investment. It
only conceals the problem – and conceals it only temporarily. In summary
terms we see that padding the supply of loanable funds with newly created
money drives a wedge between saving and investment. The immediate effect
of this padding is (i) no credit shortage, (ii) an economic boom in which the
(concealed) problem inherent is a mismatch between saving and investment
festers, and (iii) a bust, which is the eventual but inevitable resolution to the
problem. (With this summary reckoning, however, we have got ahead of the
story.)
The double disequilibrium in the loanable funds market has as its counterpart
the two limiting points on the production possibilities frontier. Saving
less means consuming more. But with a falsified interest rate, consumers and
investors are engaged in a tug-of-war. If, given the low rate or return on
savings, the choices of consumers were to carry the day, the economy would
move counterclockwise along the frontier to the consumers’ limiting point.
Similarly, if, with artificially cheap credit, the decisions of investors were to
carry the day, the economy would move clockwise along the frontier to the
investors’ limiting point. Of course, neither set of participants in this tug-ofwar
is wholly victorious. But both consumer choices and investment decisions
have their separate – and conflicting – real consequences. Graphically, the
participants are pulling at right angles to one another – the consumers pulling
upward in the direction of more consumption, the investors pulling rightward
in the direction of more investment. Their combined effect is a movement of
the economy beyond the frontier in the direction of a ‘virtual’ disequilibrium
point that is defined by the two limiting points.
Having defined the production possibilities frontier in terms of sustainable
levels of output, we can allow for the economy to move beyond the frontier –
but only on a temporary basis. People are drawn into the labour force in
numbers that cannot be sustained indefinitely. Additional members of households
may take a job because of the unusually favourable labour market
conditions. Some workers may work overtime. Others may delay retirement
or forgo vacations. Maintenance routines that interrupt production activities
may be postponed. These are the aspects of the boom that allow the economy
to produce temporarily beyond the production possibilities frontier. However,
the increasingly binding real resource constraints will keep the economy
from actually reaching the virtual disequilibrium point – hence the ‘virtual’
quality of that point. The general nature of the path traced out by the economy
– its rotation in the clockwise direction – will become evident once we
consider the corresponding changes in the economy’s structure of production.
The wedge driven between saving and investment in the loanable funds
market and the tug-of-war that pulls the economy beyond its production
possibility frontier manifests itself in the economy’s capital structure as clashing
triangles. In the case of a saving-induced capital restructuring, the
derived-demand effect and the time-discount effect work together to reallocate
resources toward the earlier stages – a reallocation that is depicted by a
change in the shape of the Hayekian triangle. In the case of credit expansion,
the two effects work in opposition to one another. The time-discount effect,
which is strongest in the early stages, attracts resources to long-term projects.
Low interest rates stimulate the creation of durable capital goods, product
development and other activities whose ultimate pay-off is in the distant
future. The excessive allocations to long-term projects are called ‘malinvestment’
in the Austrian literature. The derived-demand effect, which is
strongest in the late stages, draws resources in the opposite direction so as to
satisfy the increased demand for consumer goods. The Hayekian triangle is
being pulled at both ends against the middle. Skousen (1990) identifies this
same internal conflict in terms of an early-stage ‘aggregate supply vector’ and
a late-stage ‘aggregate demand vector’
During the boom, resource allocations among the various stages are being
affected in both absolute and relative terms. As explained above, the economy
is producing generally at levels of output that cannot be sustained indefinitely.
And at the same time that the overall output levels are higher, the
pattern of output is skewed in both directions – toward the earliest stages and
toward the latest stages. Middle stages experience a relative decline and some
of them an absolute decline. While this characterization of the boom is
gleaned from Hayek (1967 [1935]) and Mises (1953 [1912] and 1966), there
remain some fundamental doctrinal differences (both terminological and substantive)
in the alternative expositions offered by these early developers of
capital-based macroeconomics (Garrison, 2004).
Richard Strigl (2000 [1934]), writing without reference to the Hayekian
triangle, provided an account of boom and bust consistent with the one
offered here. In his account, production activities are divided into three
broadly conceived categories: current production of consumables (late stage),
capital maintenance (middle stage), and new ventures (early stage). Policyinduced
boom conditions tend to favour current production and new ventures
at the expense of capital maintenance. The economic atmosphere has a ‘make
hay while the sun shines’ quality about it, and the economy seems to be
characterized by prosperity and rapid economic growth. However, the undermaintenance
of existing capital (the sparse allocations to the middle stages)
distinguishes the policy-induced boom from genuine, sustainable, savinginduced
economic growth.
In time, but before the new ventures (the early-stage activities) have come
to full fruition, the under-maintained capital (the attenuated middle-stage
outputs) must impinge negatively on consumable output. This is the essence
of intertemporal discoordination. The relative or even absolute reduction of
consumable output is dubbed ‘forced saving’ in the Austrian literature. That
is, the pattern of early-stage investment reflects a higher level of saving than
was forthcoming on a voluntary basis. The push beyond the production
possibilities frontier towards the virtual disequilibrium point is cut short by
the lack of genuine saving. The downward rotation of the economy’s adjustment
path in Figure 9.10 reflects the forced saving.
The forced saving is but one aspect – and not necessarily the first observed
aspect – of the self-reversing process that is characteristic of an artificial
boom. Increasingly binding resource constraints drive up the prices of
consumables as well as the prices of inputs needed to support the new
ventures. The rate of interest rises as overextended businesses bid for additional
funding. Distress borrowing (not shown in Figure 9.10) is a feature of a
faltering boom.
Many of the new ventures and early-stage activities generally are now
recognized as unprofitable. Some are seen through to completion in order to
minimize losses. Others are liquidated. The beginning of the liquidation
phase of the business cycle is depicted in Figure 9.10 by the economy’s
adjustment path turning back towards the production possibilities frontier.
As boom turns to bust, much of the unemployment is associated with
liquidations in the early stages of production. Too much capital and labour
have been committed to new ventures. The liquidations release these factors
of production, most of which can be reabsorbed – though, of course, not
instantaneously – elsewhere in the structure of production. For the Austrians,
this particular instance of structural unemployment is not something distinct
from cyclical unemployment. Quite to the contrary: the cyclical unemployment
that marks the beginning of the downturn has a characteristically
structural quality about it.
Under the most favourable conditions, the bust could be followed by a
recovery in which the structural maladjustments induced by the credit expansion
are corrected by the ordinary market forces. The structurally unemployed
resources are reabsorbed where they are most needed, and the economy
returns to a point on its production possibilities frontier. But because of the
economy-wide nature of the intertemporal disequilibrium, the negative income
effect of the unemployment may initially propel the economy deeper
into depression rather than back to the frontier. This secondary, or compounding,
aspect of the downturn is likely to be all the more severe if the
general operation of markets is countered by macroeconomic policies aimed
at preventing liquidation and at reigniting the boom.
The following section puts the Austrian theory in perspective by using the
capital-based analytics to depict the Keynesian view of economy-wide downturns.
For Keynes, the negative income effect that can compound the problem
of a discoordinated capital structure becomes the whole problem, the origins
of which are shrouded in the cloud of uncertainty inherent in investment
activities.
No comments:
Post a Comment