Saturday, December 5, 2009

The Applicability of the Austrian Theory of the Business Cycle for Analyzing and Interpreting the General Features of the Current Economic Crisis

By Richard Ebeling

If Austrian business cycle theory is a "religion," then some of its fundamental analytical components are ones that every economist "worships."

First, supply and demand. Every economist believes and teaches their students that if price is below market-clearing, or equilibrium, there will be a discrepancy between quantity demanded and quantity supplied of a good.

And every economist and finance professor will tell his students that the discounted present value of any asset or investment will be increased if the rate of interest is lowered. And that, other things held equal, the present value of longer-term assets and investments will increase in value (or price) more than shorter-term assets and investments with any such decrease in the rate of interest.

If this is true, that a monetary expansion that artificially pushes market rates of interest below what would have been (without the monetary expansion and interference), their market-established "clearing" or equilibrium, level must bring about a discrepancy between the quantity demanded for loanable funds for investment purposes and the quantity supplied of people's savings for lending purposes.

This discrepancy (or shortage at an artificially too-low a rate of interest) is "filled" by the central bank with fiat money that is lent to those who wish to borrow that artificially excessive amount of funds for investment purposes.

So the number and types of investment projects undertaken under this situation is in excess of the actual amount of savings that income earners are willing to put aside to lend as a "real" basis to support investment activities with some of the scarce resources of the society.

And, furthermore, since the rate of interest has been artificially lowered in this way due to Fed monetary policy, this, now, tends to increase the present value of longer-term investments to a greater extent than shorter-term investments.

This tends to create a "bias" among borrowers to undertake investment projects that have longer-terms horizons that would have been the case if the rate of interest had remained higher at its market-determined level.

These two ingredients, that virtually every economist would agree with, are the "religious inspirations" for Austrians to conclude that, in general, business cycles are the result of manipulated interest rates that stimulate investment activity in excess of available savings in the economy. And why, in general, these investment projects tend to be of a longer-term nature.

Now, of course, each historical period has its own particular and individual features and characteristics. And the recent bubble phase of the current business cycle is no different.

In this case, Fed agencies such as Fannie Mae and Freddie Mac, were at the same time artificially biasing a large number of these longer-term investments into the home buying market by subsidizing and guaranteeing the uncredit worthy who wished to buy houses at those artificially low rates of interest.

So if home mortgage rates are low along with other interest rates due to Fed monetary expansion and you then couple this with zero down payments, and no job or credit history standards to extend a home loan, then we should not be surprised that a good amount of this fiat money created by the Fed and funneled into the economy through the banking system ends up in created a bubble in the housing market.

Hence, the applicability of the Austrian Theory of the Business Cycle for analyzing and interpreting the general features of the current economic crisis.

Dr. Richard Ebeling is a faculty member in the Economics department at Northwood University in Midland, MI, and the "discoverer" of the lost papers of Ludwig von Mises.


  1. Right on. Thank you, Richard.

  2. Richard provides a nice summary of the applicability of the Austrian BC theory to the causes (and by implication the cures) of the current crisis.

    The theory provides both prediction and diagnosis, but the ability to predict that credit distortion, and other distorting policies (like the massive push to increase home-ownership by distorting risk) will ultimately produce a bubble and a crash, in no way means that its precise timing can be predicted. Paradoxically, if one could predict its precise timing (especially the turning points) it would not occur, because eveyone would take steps to avoid the crash and the boom would never get started. Rather the reality is that, though many people may suspect a bubble that will eventually burst, many also want to take advantage of it while it lasts and nobody wants to get out too soon - so many end up getting out too late. This is a common aspect of human behavior in many similar situations. And this is what is predictable and it is also perfectly rational. The pattern is sadly predictable even though the details are not.

    Of all the explanations of the crisis it is the most plausible.

  3. The analysis logically leads to "credit and money expansion creates bubbles and malinvestment (ie. business cycle)", but there is a missing link to say "business cycles are caused by credit and money expansion".

    In other words, the causality analysis does show one possible cause of the business cycle. But you jumped to saying that the business cycle in generally the result of this cause, and that tampering with the money supply is the main cause.

    To take an analogy, yes, earthquakes cause many traffic accidents, but that does not mean that most traffic accidents are caused by earthquakes.

  4. Julian Coveur. What are you talking about?

    If you knew Austrian Economics you would not have come up with this criticism. But you must be so smart you think you have proven Mises wrong.

    What do you think the Austrian definition of the business cycle is? Now were not talking plagues or pestilence, earthquakes that would have caused a recession without fiat currency and central banking. Likewise massive Gold finds probably caused booms (I am a builder not an economists, don't have time to know economic history well, so I won't go past my limited abilities, maybe you should try that) but these are not modern business cycles. Fiat currency and Central Banking cause modern day business cycles. If these are gotten rid off then we'll talk about the causes of your type of economic fluctuations.