My Regurgitation of Austrian Business Cycle Theory

[cstreeter]

I have posted my simplistic understanding of Austrian business cycle theory on my political blog on my website at: http://www.thestreeters.net/politics/.

I would welcome honest critique (especially from the fellows) of my new found love for the school.

Thank you.

Chris Streeter

Aspiring Austrian Thinker

[gocrew]

@cstreeter

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

It doesn’t have to be in response to a contraction in the credit market.

@cstreeter

This is often accompanied by printing of currency.

Actually, the main way the Fed lowers interest rates is by injecting currency (buying securities, for instance). The Fed sets the rate of their discount window, but it does not control other interest rates. It targets a certain rate and by buying securities with money created out of thin air increases supply of credit and therefore can push interest rates downward, but the actual interest rate is not necessarily, and usually isn’t exactly, what the Fed targeted.

@cstreeter

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 has 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.

This needs a little cleaning up.

Prices clear markets. An interest rate is the price of credit. When an interest rate rises, more people are induced to save and fewer are induced to borrow; when the interest rate drops the reverse is true. The interest rate will clear the market, i.e., it will balance the demand for loans with the supply of savings. When the Fed injects liquidity into the banking sector, probably by buying securities, it increases the supply of lendable funds (although this new injection of lendable funds is not backed by any real savings). This lowers the interest rate, which induces entrepreneurs to borrow money for projects which, at the old interest rate, did not seem to be profitable. However, it also induces consumers to spend more, rather than save at the now lower interest rates. While entrepreneurs are focusing on projects for the future, consumers demand more goods now… the economy gets stretched at both ends. In the middle, workers are taken from capital maintenance to work on new projects (housing mainly in the most recent version of boom/bust). Capital then decays without the same rate of replacement (in the 1930’s we experienced an entire decade of consumed capital!).

If you want to read an excellent article on this, read Bob Murphy’s Sushi Economy, which can be found on this very site.

The inventory of consumer goods doesn’t actually experience a glut; it gets stretched just like anything else. The reason housing prices fell is because that’s where the boom was, in durable consumer goods projects.

@cstreeter

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.

The dot com crash was another Fed induced bubble.

I think you have a vague idea of the theory, but need to work on details a bit. In particular, you should concentrate on explaining why things during the boom are not sustainable.

@cstreeter

Prices rose too high to [sic] fast and people began to see that it was not sustainable

Explain why it is not sustainable.

[filc]

I think you have a great post but I think you could stand to learn a bit more about it’s details. If your interested you should send a request to the Mises Academy asking to purchase access to their Business Cycle theory class content.

[cobracarg]

that is a very vague description of the ABC, im sure anyone who has studied the ABC for a while can tell by that description that the person who wrote it just got into studying the theory…

[filc]

On the flip side your not going to explain ABCT in so few of words. So a best effort is tried here.

[MnoruS]

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.

Not necessarily that the free market is telling businesses to save until rates are lower. It’s that businesses will be going by whatever the consumption and investment preferences are, i.e. the interest rate.

Of all the ABCT texts I’ve read, the single most crucial one to read is Hayek’s ‘Prices and production,’ specifically pp. 265-273 as paginated in ‘P&P and other works.’ I don’t know if others would agree with me on this.