A Primer on Austrian Business Cycle Theory

One of the most important contributions of “Austrian Economics” to the field of finance has been their formulation of the Austrian Business Cycle Theory (ABCT), which is one of the few truly integrated theories on why economies boom and why they subsequently bust. The ABCT is of course not widely accepted by mainstream economists today, for it is near-antithetical to the current dominant Keynesian position that governments exist to smooth out the ebbs and flows of the business cycle, with the solution to virtually any economic downturn simply being more debt-based spending and a corresponding reduction to economy-wide savings.

Yet this is precisely where the ABCT lays blame for the unending swings from boom to bust, arguing that it is in fact the unending creation of money and the continued “management” of the economy by the official sector which gives rise to the unsustainable artificial boom which must inevitably end in ruin. The boom is thus the problem, and the bust is merely a re-alignment of the economy back to a more sustainable state of legitimate economic growth. This, however, is precisely the opposite view held by conventional economists today, with central bankers and government policy-makers presuming that it is the bust, not the boom, that must be fought both tooth and nail through a lowering of the interest rates and corresponding expansion of the money supply.

ABCT begins with the general premise that savings, or capital, is a commodity like any other, and just like any commodity, it too has a price. As investors and businesses seek out loans to make investments, savings comes to constitute the “supply”, investment the “demand”, and the interest rate the “price”. A low interest rate (ie. a low price of capital), is indicative of a relatively large supply of savings relative to investment demand for those savings, whereas a high interest rate (ie. a high price of capital) indicates a relatively low supply of savings in relation to the investment demands of borrowers. In other words, a high interest rate implies that there exists a relatively scarce pool of stored savings within society, and a low interest rate implies that there is currently an abundance of savings available to be loaned out to risk-taking businesses and entrepreneurs.

When the central bank artificially reduces the interest rate below the level it would have otherwise been due to simple supply and demand of savers and borrowers, it engages in a form of price control that subsequently distorts the structure of production and weakens the overall economy. Central banks are, in effect, providing a signal to businesses and other borrowers that an abundance of savings exists to fund various projects at rock-bottom interest rates. It further indicates that individuals have chosen to delay current consumption for future consumption, signaling to producers that pent-up future consumer demand exists for their products and justifying an investment in projects aimed at increasing their production further down the line.

It is critical of course to remember that “savings” is merely unconsumed production. A baker who bakes bread sells his bread for money which he then uses to purchase eggs, but it should be obvious that the baker could not have bought the eggs unless he had first baked the bread. If we consider the case where not all of the money that was used from the sale of the bread is used to purchase eggs, then this surplus constitutes the bakers savings. But, clearly, this savings originated from production. We must always remember that in the causal chain of production and consumption, production is the origin from which all other things flow. Some of this production is consumed in the form of spending, whereas some is saved and invested in order to increase future production. The amount of savings in the economy is therefore the pool of real (physical) capital produced by society available to fund future investments. It cannot simply be conjured into thin air with the wave of the hand of some altruistic central banker, no matter how low interest rates are lowered.

The artificial lowering of interest rates, then, leads to increased borrowing and the subsequent rapid expansion of business spending on various projects which would have been otherwise unprofitable at the previously higher interest rate. Because this money is simply “printed” into existence through private commercial banks, it is money that is not backed by real wealth – it is simply paper money unsupported by the past production of real goods and services. The simultaneous expansion by all businesses throughout the entire economy now begins to give the appearance of a general and widespread “economic boom” as the various investments by businesses in factories, machinery, and commodities begins to trickle down to all the ancillary industries as well as the wages of its employees. The employees in turn begin to spend their higher wages on consumer goods and services, further serving to stimulate demand until the entire economy has seemingly entered into a wondrous new era of economic prosperity.

But the problem will eventually become manifest in the simple truth that one cannot invest what has yet to be produced. Real savings represents actual goods and “things” that exist in the economy which is the end result of legitimate production, whereas the newly created money conjured into existence was simply paper wealth created out of thin air with no corresponding real wealth with which to back it. As all businesses begin to expand simultaneously given the low interest rate, they will ultimately come to discover that they have all been simultaneously misled, for there is simply not enough actual physical capital in society to fund all the investments. The pool of real funding was smaller than they had been led to believe due to the artificial manipulation of the interest rate by central bankers, and as a consequence a large portion of the newly started projects will fail to be completed at the expected costs that had been anticipated.

Before this point of realization is ultimately reached, however, the large increase in the money supply resulting from the lowering of the interest rate begins to increase general prices of goods and services throughout the economy. Because the injections of money were not backed by the creation of additional goods and services within the real economy, the continuous increase in the money supply subsequently results in a process of “too much money chasing too few goods”. As general prices begin to rise at an increasing rate, it eventually causes the central bankers of the day to raise interest rates in order to maintain some semblance of credibility as they attempt to meet their mandate of “price stability”. As the interest rates rise, those projects which were only profitable at the much lower interest rate begin to fail, leading to either the complete or partial destruction of the capital used to fund the unsound mal-investment in the first place. The failure of so many businesses simultaneously not only leads to a widespread economic downturn and an increase in the unemployment of workers from industries that are no longer profitable, but also to the depletion of the capital pool with no corresponding increase in productivity to show for it.

The bust then is far from the problem, but is in fact the point of recognition where unprofitable projects are exposed as being uneconomical mal-investments and a gross misallocation of capital. It has exposed the boom as a period of unsustainable growth based on an inaccurate reading of the available capital in society which must inevitably end in ruin. In order for a genuine economic recovery to once again get under way, society must begin a period of both under-consumption and increasing savings. The pool of funding within the economy must once again be replenished in order to fund additional future investments, ultimately leading to a sustained period of higher production and eventually, at the end of the cycle, consumption.

And yet we all know how this story will ultimately end. The central bankers of the day, witnessing this wide-scale economic bust unfolding before their very eyes, resolve to stimulate aggregate demand and “fight” the recession by once more lowering the interest rate and expanding the economy-wide supply of money. The corrective economic bust which is necessary to purge all the preceding mal-investment has as a result been unceremoniously truncated, with a newfound economic boom once again rising from the largess of consumption-based stimulus and debt-financed speculation.

And yet each subsequent boom-bust cycle serves only to diminish the productive structure of the economy, since the pool of funding necessary to support robust economic growth is over-time silently eroded. Each time the central bank lowers the rate of interest below that which would otherwise be arrived at by a free-market society, it causes businesses to extract from the pool of real savings in the economy in order to pursue unsustainable projects which in the end serves only to destroy existing capital. The low interest rate too has the effect of enticing society to save less for the future and consume more in the present, thus further impinging on the pool of capital necessary to fund future investments in productivity-enhancing endeavors. The end result of these perpetual boom-bust cycles is a gradual depletion of the pool of funding necessary to drive investment in productivity. As a result, the economy grows gradually weaker over time, coming to depend more and more on the trough of easy money and low interest rates to fuel consumption-based spending, and less on those investments in productivity which have historically been the basis for increasing standards of living over time.