The Austrian Theory of the Business Cycle

Upon reviewing Spawktalk’s explanation of the theory and his objections there was a critical issue with his explanation of the theory of the business cycle. He pulls a minor side note and claims it as the whole.The TheoryBanks within a free market where competing currencies exist do not “artificially lower the interest rate.” Government and bank monopolies can, but free market banks cannot because the customer base will shift to another currency if arbitrary rates are used. Banks are driven by the marketplace forces of supply and demand.The theory states that when there is greater saving, banks have a greater supply of money to lend, leading to a reduction in the cost that they can charge which is expressed in a lower interest rate. This is an accurate, not artificial, reflection of the demands of the market, which has indicated by saving that their immediate consumption levels have been met and they would prefer to defer consumption to a later point in time. High savings indicate low consumption now and higher consumption later. Low savings indicate high consumption now and lower consumption later. [1]Spawktalk explains the boom as, “[when artificially lower interest rates are offered] previously unprofitable ventures [become] profitable [causing] the price of labor and capital to rise.” This is correct. The lower interest rates increases the number of capital investments, creating a greater demand for labor and capital, increasing the price for both.My adversary then explains the bust as a result of “public [realization] that the inflation will not stop” forcing banks to stop expanding credit returning the system to its natural level “[causing] interest rates to rise[,] revealing… malinvestments… [which are corrected.]”The public realization of inflation or lack thereof, has almost nothing to do with the bust except that it exacerbates the situation as it did in the Great Depression. Mises himself writes, “The fact that the two movements occur in opposite directions, so that they cancel one another, had been emphasized by Mill in order to show that the increase in the rate of interest caused by inflation would be counteracted by the circumstance that the additional quantity of notes, if issued by the banks (and the additional quantity of gold so far as it was used productively), have a reducing effect on the bank-rate of interest.”[2]The bust is due to prices created by supply and demand when the new products that were created by the incorrect investments. The artificial supply of money or low interest rates that were created by the government (not banks) served as a substitute for what normally would have taken place, savings. Since the consumers do not have the savings to use for consumption, there is lower demand for the products. Low demand means prices must be dropped, bringing the profitability of businesses into question. It isn’t merely the new ventures that have had their profitability reduced, every other product/service that has similar desirability as the new product also has its prices drop due to the high supply and low demand in the sector. Lower prices mean lower profits, which mean reducing overhead, which means layoffs, closing down factories, etc. Of course some businesses will go bankrupt as well, which means that they don’t repay their debt, which can lead to bank failures as well.Incorrect Unstated Assumptions Spawktalk expresses concerns regarding “conditions which must be met.”Condition 1: “Liquidity preferences must be in good condition [for credit to be offered]”The Austrian business cycle is only applicable and discusses the effects of lending that is actually made and how the results will play out. If you look at any other economic model, they all make the same assumption. The question is whether one model more accurately evaluates the potential exchanges that exist. If an intervention is introduced to the scenario, it cannot be used to undermine the accuracy and effectiveness of the model. Government voided contract law for investors on a whim, forcibly confiscated property, and more which prevents sound lenders from taking risks they otherwise would have taken. These factors are just as relevant as Mother Nature. You may have well said, ‘it assumes that earthquakes or big snowstorms haven’t interfered with the marketplace.’ Condition 2: “it assumes the economy is at equilibrium.”This is false. Mises wrote, “In the changing economy, there is no uniform rate of originary interest; there only prevails a tendency toward the establishment of such uniformity.” [3]Condition 3: “it assumes that an expansion of credit will primarily be spent on production goods rather than in final goods.”The ATBC makes no such assumption. Here are the assumptions: lenders seek to lend at the highest profit rates for the shortest term; additional credit will fill low risk short term loans quickly additional credit to offer will accommodate higher risks and/or longer terms. There is no assumption that the credit will go to longer terms or to higher risks, but the fact is that it tends to. Spawktalk's claims that the ATBC is “Demonstrably False” Milton Friedman’s assertion that the size of a boom and bust should correlate did not address Hayek’s concept of Bottlenecks or overlapping efforts of government to force "booms" during the busts. “The self-reversing effects of a money/credit injection exist even if the monetary increase occurs when unemployed resources already exist. The final outcome of the process may be delayed but does not change.” [4]Spawktalk writes, “The theory also predicts that a recession will see rising interest rates” which is correct, but the fact that they didn’t rise is not a result of the market. When the interest rates are determined by the FED, the market has in no way determined them freely as the ATBC would indicate. The FED is not market driven, it is politically driven and its decisions are arbitrary.Spawktalk writes, “A theory which states that recessions are caused by rising interest rates can not explain ones in which interest rates fall.” Yes, it can, and the explanation is a simple one: intervention by third parties making arbitrary changes without letting the market do it will let you do whatever you want to the rate which will subsequently produce a boom or bust later on.A misunderstanding of the terms leads my adversary to conclude it is Logically FlawedSpawktalk writes, “The theory was formed by thinkers such as Von Mises and Hayek who believed that people would panic once they realized that inflation was continuous.”Panic is a very small portion of the theory and it wasn’t simply an expectation that inflation would be continuous, it was that it was continuously increasing or continuous at a very high level. Nobody was panicking about a 1-4% per year inflation rate, and neither Hayek nor Mises made a suggestion that they would. Fear of inflation purchases are easily supported by the increase in precious metal purchases when inflation rates rise.Spawktalk maligns the credibility of Mises and Hayek with the statement, “There is no doubt that Mises and Hayek believes this because of their own personal experience with the matter.” Mises and Hayek were and are considered two of the most intellectually honest, skilled and educated economists in history. Insinuating that their personal experiences dictated their positions in economics is an ad homenim attack. If you have issue with their position, attack the position.[1] The Theory of Money and Credit, Mises http://mises.org... pp339-346[2] The Theory of Money and Credit, Mises http://mises.org... pp363[3] Interest, Credit Expansion, and the Trade Cycle, Mises http://mises.org...[4] Austrian Business Cycles, Plucking Models, and Real Business Cycles p10 http://mises.org...;