I'm in the process of completing a book addressing some of the economic problems associated with an elastic money supply (a currency with the ability to increase in volume based on demand), including how an ever-changing money supply affects the stock market. As part of this, I've attempted to synthesize the older and original writings on the Austrian Theory of the Business Cycle into one comprehensible document. An excerpt from this document is published below. I hope you enjoy it, and that it might help tie up any "loose ends" should you have any concerning this theory. Any comments you might have would be greatly appreciated.
The Austrian Theory of the Business Cycle puts economic concepts and relations together to not only explain how artificial booms are ignited and how they can continue for some time, but also to demonstrate how they necessarily must eventually end with a very real bust. The theory is however frequently misquoted and misunderstood as it is often applied to all situations involving an expansion of the money supply. This is not however what Mises and later Hayek had in mind when they developed the theory. Specifically, at the core of their theory was that an increase in money supply is brought about by an increase in bank credit where producers are the initial recipients of the newly created money. These producers would then use the newly created money they receive to invest in, and lengthen, the respective production processes. In its essence, the theory explains the economic consequences of a lengthening of the structure of production made possible only through an increase in credit and money.
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A frequently misunderstood theory: The Austrian Theory of the Business Cycle puts economic concepts and relations together to not only explain how artificial booms are ignited and how they can continue for some time, but also to demonstrate how they necessarily must eventually end with a very real bust. The theory is however frequently misquoted and misunderstood as it is often applied to all situations involving an expansion of the money supply. This is not however what Mises and later Hayek had in mind when they developed the theory. Specifically, at the core of their theory was that an increase in money supply is brought about by an increase in bank credit where producers are the initial recipients of the newly created money. These producers would then use the newly created money they receive to invest in, and lengthen, the respective production processes. In its essence, the theory explains the economic consequences of a lengthening of the structure of production made possible only through an increase in credit and money.
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The roots of the Austrian theory of the business cycle can be traced back centuries.
Our focus here will however be the theory as initially put forth by
Ludwig von Mises and further developed by Friedrich Hayek and others.
Over the years, this theory has been referred to by
many names. In his 1912 book The Theory
of Money and Credit, Mises coined it the “trade-cycle theory,” a doctrine
he stated “is called the monetary or circulation credit theory, sometimes also
the Austrian theory.” [1] In
this book we refer to this theory as the Austrian Theory of the Business Cycle
or Austrian Business Cycle Theory as this is what the theory is commonly
referred to these days. The latter name also readily allows us to shorten it to
ABCT, an easy to remember acronym.
As explicit in its name, the ABCT seeks to identify
and explain the underlying fundamental causes of what is commonly referred to
as the business cycle, i.e. broad-based expansions and contractions of economic
activities in an economy. Instead of merely identifying and explaining symptoms
of the business cycle as have become not only common place, but often the only
way these days in my opinion, any sound economic theory traces the problem all
the way back to its root causes. As Greaves once explained: “…science trace
cause and effect by going back and back and back until one cannot go back any
further.” [2] And
that is exactly what the ABCT does: it goes all the way back to the very reason
overconsumption and malinvestments can take place at all in the first place and
continue for some time. Most importantly, the theory also explains why both
must one day come to an end.
The Austrian theory of the business cycle was
developed at a time when banks lent money into existence mainly to businesses. Specifically,
though Mises recognised that the lower interest rates caused by credit
expansion attracted all producers who could use the borrowed funds, [3] the
ABCT focuses on what happens when business use these funds to lengthen the
production period. [4]
At the core of the theory lies the idea that artificial booms and very real
busts are brought about by a misdirection in production, i.e. malinvestments.
Hayek explained that this can only occur “…when the pricing process is itself
disturbed….” [5]
The theory therefore seeks to get to the bottom of what factors can possibly
disturb the “pricing process” and how these disturbances then create the
business cycle. As we’ve already seen, the creation of new money is normally
undertaken by banks by way of creating new deposits (money) through lending.
As, especially at the time when the theory was developed, bank lending was
usually done in the form of lending to businesses as mentioned above, the
theory focuses on what happens when businesses lengthen the production
processes with the newly created purchasing power they receive from the banks. In
many ways, the theory has already been explained in the foregoing chapters.
What remains now is to tie it all together in a comprehensible manner.
The elasticity of the money supply lies at the very
heart of the Austrian Theory of the Business Cycle for one simple reason; there
would be no broad based and large scale business cycles without it.
Consequently, if the money supply was largely inelastic there simply would be
no need for a theory of the business cycle at all as there would be no cycle to
explain. Unfortunately, the reality is that we have lived with an elastic money
supply to varying degrees for a very long time and most unfortunately we will likely
have to live with it for the foreseeable future. The people, organisations,
corporations and structures that have been built by design on, and which depend
on, sapping purchasing power from others against their will and knowledge for
their very existence are not easily untangled as history has shown. [6]
That’s why a sound theory of the business cycle was an asset for anyone in its
possession during the last century just as it will be for the foreseeable
future.
It would be of no economic significance if changes
in the money supply affected all
prices equally and at the same time. [7] As
prices in the real world are never affected equally and at the same time whenever
the money supply changes, a theory of the business cycle hence needs to
incorporate this fact in its analysis. Where and how the new money enters the
market are therefore of importance when it comes to understanding how money supply
changes affect the economy. Under existing monetary systems, someone will
always receive the new money first and be in a position to spend it before
others because, as Hayek puts it, “The influx of the additional money into the
system always takes place at some particular point.” [8]
Who this someone is largely depends on by what process the monetary inflation
takes place at that particular time, e.g. banks issuing business- or consumer
loans or banks and the central bank financing government deficit. The reality
is of course that additional money is constantly being injected into the
economy through many avenues. For example, mortgage lending is the dominant way
banks extend credit to individuals in many countries as this is encouraged, and
often financially supported, by governments. Real estate prices, and goods and
services associated with real estate are therefore prime beneficiaries of an
increased money supply.
In general, on what the new money is first spent,
how the recipients of the money from the first receivers spend or invest their
money and so forth in addition to the size and speed of the new money influx
determine how prices and the economy are affected. But these different processes
have one thing in common, independent on how the new money filters through the
economy, and that is “…that the different prices will rise, not at the same
time but in succession, and that so long as the process continues some prices
will always be ahead of the others and the whole structure of relative prices
therefore very different from what the pure theorist describes as an
equilibrium position.” [9] Prices
are therefore never affected to the same extent and at the same time whenever
the supply of money brings about changes in the structure of prices. [10] Changes
in relative prices brought about by
inflation are important for the Austrian theory of the business cycle as such
changes will alter the distribution of productive resources, at least for a
while. As individual prices and their interrelationships, rather than the
general level of prices as such, act as signals for market participants, more
will produced of those goods and services whose prices are now relatively
higher (as the prospects of profits increase) and less will be produced of
those goods and services that now fetch a relatively lower price (prospects of
profits decrease). That is to say, changes in relative prices prompt changes in
the structure of production. Furthermore, as the general level of
prices may continue growing at a rate deemed “stable” even if relative prices
are changing significantly, [11]
it follows that changes in relative prices are more important than the rate of
change in the general level of prices. [12]
The Austrian theory of the business cycle deals
with the particular situation where banks grant credit to businesses via the
loan market [13]
and in this way inflates the money supply. According to Garrison, the Austrian
theory of the business cycle, [14]
…emerges straightforwardly from a simple comparison
of savings-induced growth, which is sustainable, with a credit-induced boom,
which is not.
The essence
of the Austrian theory of the business cycle can be described as follows. When banks
expand credit, and with it new money, market interest rates are pushed below
the level they would have been absent an expansion of credit and money. This
lowering of the interest rate increases economic activity as credit is now more
plentiful than before and as it can be attained at a lower cost. Entrepreneurs
act accordingly as if actual savings has increased though it has not. That is,
entrepreneurs invest more than savings have provided for and they do so in a
lengthening of the production structure. [15]
This increase in investments pushes the prices of producer goods up and an
artificial boom ensues reflecting the extent of the credit expansion and the additional
investments such credit expansion brings forth. Many ventures that previously
would have been unprofitable are now found profitable given the cheaper and
more readily available credit offered by banks. [16]
More projects are as a result started than otherwise would have been the case,
including more projects with expected payoffs longer into the future. The
prices of consumer goods will increase as well, albeit at a slower pace than
for producer goods, as both salaries and the number of people working in the
producer goods industries increase. At least a part of this increase in total
salaries will be spent on consumer goods. But the supply of consumer goods has however
not yet increased as it takes time for the longer production processes that
were started to finally start producing consumer goods. [17]
It is this mismatch between the supply and demand for consumer goods that push
consumer goods prices up.
If the credit expansion was ended quickly, the
economic distortions would be smaller. However, once started, credit expansion
tends to continue as banks are able to create credit in excess of any limit set
by their own assets and customer deposits. The price premium component of the
market interest rate will rise, but it does not rise sufficiently to end the
credit expansion as it will lag the rate of increase in new credit granted. Furthermore,
the upward movement of the bank credit cycle sets in with full force as
fractional reserve banking allows banks to create credit and with it new money
based on customer deposits received which were originally created out of thin
air by other banks. As the credit expansion process continues, the stock of
consumer goods available is gradually depleted as the supply is yet to increase
or yet to increase sufficiently to offset the higher demand brought about by
the higher total salaries in the producer goods sector. When this process
continues, prices of consumer goods will eventually rise faster than prices for
producer goods as the economy was not sufficiently rich in the first place to
undertake both a lengthening of the production process and an increase in the production of consumer goods. The purchasing
power granted to the producers whom lengthened the production process was as a
result simply diverted from other sectors of the economy. Moreover, this
diversion of resources, set in motion by an increase in the money supply, was
done against the will of the market. [18]
A shortage of consumer goods manifests itself in the economy and the now
relatively higher price- and profit increases for consumer goods brings about pressure
toward a reduction or outright abandonment of investments in many of the new
projects that were undertaken. This pressure can be postponed through yet
higher doses of credit granted to the producer goods industries.
But the
credit expansion cannot continue indefinitely. Once people come to expect continued
price increases, panic will set in jeopardising the whole monetary system as
the value of the currency rapidly declines. Mises refers to this as the
“crack-up boom” as everybody becomes “...anxious to swap his money against
“real” goods, no matter he needs them or not, no matter how much money he has
to pay for them.” [19]
Banks, and especially central banks, will however usually put in place measures
to end or greatly reduce credit expansion before the onset of such a general
panic. A bust in the producer goods industries dependent on further cheap
credit, but which now face higher costs of borrowing, sets in and resources
move away from producer goods to consumer goods in an effort to re-establish
the preferred consumption-savings ratio of market participants. Interest rates rise
as people’s degree of preference for the present over the future has increased
(time-preference increases). The many who gained from the cheap credit and
investment boom will now suffer; the unemployment rate in the affected
industries will rise and a portion of the investments will be lost as it
becomes apparent they were in fact malinvestments. During the process,
resources were squandered and the economy as a whole is worse off a result.
The
economy now needs to be “repaired” and adapt to the new situation brought about
by the wasting of resources (losses) the credit expansion orchestrated, a
course which requires decreased consumption and increased savings. No further
injection of credit and money can repair the damages done to the economy; all
it can ever accomplish is to postpone the adjustment process and make the inevitable
downturn even worse. This is the case as further credit injections only serve
to further disturb the preferred consumption-savings ratio which has already
been pushed out of balance, i.e. what is needed is an increased rate of saving
instead of yet more consumption and depletion of resources. The savings that were
depleted during the artificial boom phase now need to be replenished to allow
the economy to prosper in a sustainable fashion going forward. The faster this
is allowed to happen the shorter the downturn will be.
Footnotes:
[3] See the introduction by Percy L. Greaves, Jr to The Causes of the
Economic Crisis (Mises, The Causes of the Economic Crisis And Other Essays Before and
After the Great Depression, 2006) .
[6] Many of these structures could not survive or have grown to their
current sizes based on voluntary taxes alone as tax payers would simply refuse
to pay all of their income in taxes in order to finance them, e.g. government
spending and the encompassing bureaucratisation, international organisations
such as the IMF, World Bank and the OECD.
[7] E.g. see (Hayek F. A., Prices and Production, 2nd ed., 1935, p. 5) .
[8] (The Austrian Theory of the Trade Cycle and other
essays, 1996, p. 97) .
[9] (Ebeling, Hayek, Mises, Rothbard, Haberler, &
Garrison, 1996, pp. 97-98) .
[10] See (Mises, Human Action, A Treatise on Economics, 2008, p. 409) .
[11] Any change in the quantity of money must always, according to
Hayek, influence relative prices whether or not it actually influences the
level of prices (Hayek F. A., Prices and Production, 2nd ed., 1935, p. 28) .
[12] Hayek explains that “…general price changes are no essential
feature of a monetary theory of the Trade Cycle; they are not only unessential,
but they would be completely irrelevant if only they were completely “general”
– that is, if they affected all prices at the same time and in the same
proportion” (Hayek F. A., Monetary Theory and The Trade Cycle, 1933, p. 123) .
Hayek
later explained that “There can also be no doubt that, in connection with these
secondary monetary complication [“…the effects of the further monetary changes
which may, and perhaps even probably will, but need not, be induced by this
first change”], general price
movements, apart from the changes in relative prices, will be of the greatest
importance, and that anything which stops or reverses the general price
movement may lead to induced monetary changes, the effect of which on the
demand for consumers’ goods, and producers’ goods, may be stronger than the
initial change in the quantity of money” (Hayek F. A., Prices and Production, 2nd ed., 1935, p. 158) .
[13] In the chapter in Human Action laying out the theory of the
business cycle, Mises explains: “In dealing with the consequences of credit
expansion we assumed that the total amount of additional fiduciary media enters
the market system via the loan market as advances to businesses. All that has
been predicated with regard to the effects of credit expansion refers to this
condition” (Mises, Human Action, A Treatise on Economics, 2008, p. 568) .
[15] This happens as the shorter production methods are already
exhausted as discussed earlier.
[16] Especially ventures with projected cash inflows long into the
future will benefit as they are more sensitive to interest rate costs and
discount rates.
[17] Remember, the
ultimate purpose of all production is to produce consumer goods. Increased
production of producer goods, which aim to increase the production of consumer
goods in the future, therefore depends on increased demand for consumer goods
when such increased supply finally makes it to the market.
[18] That is to
say, the diversion of resources on a grand scale to the producer goods industry
would not have happened if the money supply was inelastic as interest rates would
rise sharply effectively putting an end to the boom in this industry.
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