The Austrian Theory of the Business Cycle

The TheoryBanks expand credit, artificially lowering the interest rate and thus making previously unprofitable ventures profitable. As capitalists begin to spend on these new projects the price of labor and capital rise. This is the boom. But paradise wont last. Eventually the banks will have to stop expanding credit because as soon as the public realizes that the inflation will not stop panic will set in in the form of hyper inflation. When the banks do stop expanding credit the natural rate of interest re-asserts its self (the interest rate that reflects actual savings). This causes interest rates to rise revealing projects that there made profitable by the lowered interest rate as “malinvestments” that are no longer profitable. Resources, including labor, must be reallocated to their proper places in the economy. This is the bust.Unstated AssumptionsMy first line of criticism is that there are conditions which must be met for this theory to play out that are not always present in the economy. Firstly, as current times demonstrate, it is not always the fact that if credit is expanded and the interest rate lowered that that credit will be loaned out. Liquidity preferences must be in good condition for such to take place. Secondly, it assumes the economy is at equilibrium. The reason that this theory requires full employment is because if the economy is in disequilibrium such that some resources are underemployed then there can be an increased purchasing of those goods with out a raise in prices. Obviously, the economy is not always at at, or near, equilibrium. Thirdly, it assumes that an expansion of credit will primarily be spent on production goods rather than in final goods. It must assume this because if one invests in a final good then a future change in interest rates will not change one's accounting profit. As an example: if a bank lends the money to consumers for credit cards and then the interest rates rise the banks will have still made an accounting profit from their loans. Given these considerations, we can already see that this theory has limited applications. Demonstrably FalseFurther, the theory has not stood up to empirical scrutiny. Mition Friedman recognized that if this theory was true we should see a correlation between the size of the boom and the size of the bust. He there fore assembled the data from nearly a century of cycles in the united states. He concluded “there appears to by no systematic connection between the size of an expansion and of the succeeding contraction” [1]. The theory also predicts that a recession will see rising interest rates. Yet this is often the opposite of what we see. In the recession of 2008-2009 the fed dramatically lowered short and long term interest rates [2]. Clearly, a theory which states that recessions are caused by rising interest rates can not explain ones in which interest rates fall. Logically FlawedThe most important criticism of the ATBC is a theoretical one. 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. They would try to ditch their currency for things with more stable value, objects of barter, in hopes of avoiding it. The currency would become worthless. In other words, people would panic and cause hyper inflation [3]. There is no doubt that Mises and Hayek believes this because of their own personal experience with the matter. But the proposition is easily revealed as false. Nearly everyone in the American economy has expected continuous inflation for decades. But there has been no panic and so no hyperinflation. Given such a climate, a central bank can continuously expand credit, at a mild rate so as to not scare people, and permanently artificially increase investment. Sources:1. http://www.google.com...2. http://www.economy.com... (Pg 2)3. http://mises.org...