Business Cycles Explained: Austrian Theory

Check out Prof. Cowen’s popular econ blog, Marginal Revolution.

What is the central claim of Austrian Business Cycle Theory? Cowen boils down the Austrians’ boom-bust explanation:  when the government manipulates the money supply, entrepreneurs get false ideas about the economy and make unsustainable decisions. When the central bank inflates the supply of money, the real interest rate falls because there is more money to be lent out. Since money is cheaper to borrow, entrepreneurs ramp up investment and take on riskier long-term projects—a boom often follows. But the man-handled market environment doesn’t hold. False hopes lead to failures and an apparent boom, well, busts.
Tyler points to the housing bubble as a case study. Between 2001 and 2004, the Federal Reserve played fast and loose with credit.  Booming borrowing to invest in housing inflated the housing bubble. But when house prices fell, these long-term investments proved to be unprofitable and brought on the bust.
How can we escape the cycle? Austrians propose that we steer clear of inflation—institute a gold standard or a monetary rule to avoid financial disaster. The rationale: a tighter money market means a more stable monetary supply that will enable entrepreneurs to keep expectations and investments in check. For many Austrians, kicking inflation takes on additional urgency based on their claim that once inflationary effects occur, the only corrective is to let investments fail and re-allocate remaining resources.
The Ideas in Action:
Turning to the Great Depression and our current financial crisis, Cowen explains that Austrians and Keynesians explain the downturns quite differently. For Keynesians and monetarists, both big busts could have been avoided if there was an increase in aggregate demand.
 Austrians, on the other hand, blame the effects of loose monetary policy misleading entrepreneurs. Which theory does historical evidence support? One point in the Austrian corner: many credit bubbles, the Great Depression and recent recession included, correspond with periods of loose monetary policy.
But the Austrian angle has its shortcomings. First, put yourself into the mind of a bright entrepreneur for a moment; if you can reliably predict that loose money leads to riskier long term investments, wouldn’t you exercise caution while taking on new projects in easy-money times? Second, we have to look at more than two historical case studies; in a broader field of view, we can find many economic downturns that have been caused by monetary contractions rather than expansions.

7 Comments

  1. Matt Wavle

    The too big to fail mentality, and the bailing out of failing companies is just plain wrong.

  2. littledeaths

    The problem with the author’s assessment is that there are booms and bust naturally in the economy that are much smaller. While to an inverter it seems like a quick down and up tick in reality the markets was being held up by the easy money. What they would expect would work much better with sound money.

  3. ndvo

    It is not that simple to say that businessmen can learn about inflation and be careful with it. First of all, businessmen are not always educated men. Indeed, there are plenty of people who start their business very small and that don’t really pay attention to economic or political news or debate. Second, inflation distorts the information based on which the businessmen takes their decision. An inflation of say 5% a year does not tell the businessmen anything on whether people will buy more tables next year. The price of the table does. As the price of the table goes up, if it does so before, or more, than the other prices a particular entrepreneur deals with, he tends to make the decision to invest in making more tables. This decision will be difficult to revert in the future. Third, businessmen and the people in general are indeed learning about government interventions and adapting their behavior. Mises himself pointed that the bubbles are prematurely burst as people realize them. This is actually one of the main reasons that led the US government to inflate the real state business. Politicians actually went to television to say that the real state market had never in history faced a large fall. They used the real state market because the public was used to think of it as secure, as "real", there could be no way the prices of all houses would go down.

    The weakness pointed out about Austrian theory is actually a strength. That’s because: 1- it’s hard for people to understand the impact of inflation because it distorts the basic information; 2- Austrians foresaw that people would slowly learn about inflation and fear it; 3- the bubbles are inflated precisely in the markets that governments can see that people trust.

  4. Stephen Dincher

    Couldn’t agree more. I’ll touch on the second weakness he lists. The monetary contractions that caused those busts are ALWAYS a result of the expansion that precedes it. The monetary contractions are the corrections that are necessary to stabilize the economies. I’m surprised at the ignorance of this professor’s comment on that subject. As if the expansion, if left to go on forever, would have been fine and dandy, but damn that contraction! Seems absurd that he would even consider that a reasonable interpretation of the data.

  5. Yevhenii Usenko

    To say that Austrians are sometimes wrong with the conceit of ‘expansion of money’ and that sometimes there are monetary shortages that cause busts, you should at first notice the main statement of Austrian theory: stable money. This conceit doesn’t only mean that there should be no inflation, but also no deflation. This is the definition of stability.

  6. Lukas Koube

    i actually didnt really like this video. i have seen far better lectures on the topic. most Austrians see a recession as a good thing, not a product of “original sin”. a recession is simply a reallocation of resources to more productive sectors. inflation and a boom period artificially stimulate some sectors, and draw resources into them that are unsustainable. 

    furthermore, you cant simply say “business men wont get tricked” because there are 1000 explanations for the same phenomena. furthermore, not all prices are rising, it is uneven and it is difficult to separate this bubble from the naturally varying prices of the market.
    if a cafe owner sees the price of bacon increase, they dont know if it is bc of demand, supply, or inflation. this means that the decisions they make have a much higher chance of being wrong.

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