Austrian Business Cycle Theory for the Intelligent Layman

It is the position of the Austrian school of economics that the sole cause of economic depression is due to the calamitous nature of credit expansion. Given that only central banks (banks given special privilege by government decree) have control over the production of fiat currency, it is only these banks that are able to increase the supply of money in an economy. The dangers of credit expansion are numerous, but none more than the creation of business cycles (otherwise known as the “boom-bust” cycle or “depressions”). To explain the nature of business cycles, and the role central banking plays in them, we must abstract into theory quite a bit. Before I may explain the mechanics of how an economy goes wrong, I must explain, as Friedrich Hayek correctly notes, how it might ever go right. A thorough understanding of economic growth is thus required.

I: Economic Growth is Determined by Savings

Every human being who earns an income, whether by inheritance or labor, has two choices on how they might handle their money. Those choices are to spend or to save. Human beings, as biological creatures, have certain needs that must be met for survival. It is obvious, thus, that not everyone can save all of their money. To labor and abstain from spending is tantamount to starvation. Clearly, some portion of income must be spent on food, if absolutely nothing else. 100% of one’s income cannot be saved perpetually. If 100% of everyone’s income were spent on consumption (and therefore 0% on savings), however, then all of our mechanical tools and equipment, our housing, and our gadgetry would slowly depreciate into nothingness. Without a base of saved income to replace depreciating capital, the technological progress man has made would disappear and human society would be reduced to the living standards that preceded the discovery of agriculture. Man as a social, moral, intellectual being could not exist if everyone devoted all existing resources to current consumption. Our current ratio, therefore, between spending and saving, must be somewhere between these two extremes. We neither consume nor save 100% of our incomes, but rather we choose some portion of both.

The extent that we save our money and invest it in the production of goods that will increase our efficiency will determine the speed of our growth. An example might be a clerk saving (and therefore abstaining from spending) some amount of his income every week to purchase a pencil sharpener in a month, rather than him enjoying a minute amount of extra consumption. This will leave the clerk more productive in the long run. In the first situation, the clerk abstains from consumption in the hope that, with the pencil sharpener, he can labor more productively, command a higher wage, and consume more in the future. In the second situation, the clerk decides to continue consuming and sharpens his pencils at work with a knife – a messy and time-consuming process. It should be clear that the clerk will be able to enjoy permanently more consumption as a result of his saving and subsequent investment than he would if he continued to spend the greater portion of his income. If we imagine the clerk had saved even more than in the first example, and after 6 months was able to purchase a typewriter, his future capacity for consumption would be that much greater than simply his initial investment in a pencil sharpener. In short, the greater amount the clerk saves and invests the greater amount will he be able to reap in the future. Repeated on a macro scale, this is the process by which everyone sees their standard of living (or “amount of consumption”) rise. It is by genuine saving.

II: Savings is Determined by Time Preference

The precise ratio of spending-to-saving will be determined by an individual’s time preference. The time preferences of Johnny may be such that he enjoys spending his allowance on jawbreakers (he prefers immediate consumption), whereas the time preferences of Timmy may be such that he saves his allowance to purchase a lawnmower where he can earn more than his original allowance (by mowing the lawns of neighbors) and thereby purchase more jawbreakers than Johnny. This abstention has its costs, however. The cost is that Timmy is giving up the immediate satisfaction he could be having and delaying it for the future. This is because Timmy realizes that his future satisfaction will be far greater than his current and this makes up for the decrease in utility Timmy experiences by waiting. Due to time preference, Timmy prefers an amount of consumption X+1 in the future over X right now. Every human being has time preference. Every human being prefers achieving Utility X sooner rather than later (this must logically be the case or humans would never consume). Therefore, the only reason we should ever choose to abstain from consuming is that the utility we stand to gain by waiting is greater than Utility X. If the purchase of a Popsicle grants me equal utility now as it would tomorrow, I will always purchase it now. Saving is therefore an act of expectation. It is an act in the hopes that the extra utility achieved by the investment will offset the disutility created by waiting. The size or length of a person’s time preference is described by its height. The spendthrift has a much shorter time preference than those who are frugal with their money. The spendthrift spends his money hastily because the cost of waiting is so high, he prefers utility X now versus utility X+1 later down the road. It is the frugal man, who has a longer time preference, who has a lower cost of waiting and can therefore reap a psychic profit from his investment. For all human action, there is arithmetic. The acting man must decide if his increase in utility brought about by investment is worth the cost of waiting due to his time preference. It may be arranged as follows: net return = current value of future consumption – current opportunity for consumption – cost of waiting. The difference between what is and what will be must be greater than the cost of waiting for any investment acting man makes to be profitable. If I know I can command an interest rate of 100% on $10 per day, the decision to loan the money must be derived at via the mathematical formula just explained. I must decide if the additional $10 I will possess offsets the cost of waiting an extra day to use the original $10. If I planned to do nothing with it, the investment would clearly be worth the money. However, if I needed the money for cab fare to meet a friend for lunch, the cost of waiting an extra day for more money is not worth the pay off. This is how acting man decides whether to spend or save his money.

III: The Rate of Interest is an Expression of Time Preference

Let us assume that a large portion of a community becomes more forward-oriented; that their time preferences are lengthening. Perhaps many children are being born and the parents decide to save for a college fund, or many adults are starting work and must save for retirement. Whatever the case, if the community at large decides to become more forward-looking, it is clear that they will save more. They will trade current consumption for future consumption. Accordingly, there will be more savings in the economy than previously. Each person who decides to withhold current consumption will generate extra savings. This extra savings represents capital. It is irrelevant whether the monetary units are gold coins, paper banknotes, or bottles of whisky. Accumulated capital that is not consumed is saved; it is, for all intents and purposes, invested (even in the rare condition of hoarding could stored money be considered invested). As the amount of savings increases, the natural market rate of interest will decline. There is more capital stored, and therefore the price of capital declines. The marginal utility of each unit of capital becomes less valuable, and will therefore command a lower price.

It is important to remember that the rate of interest is determined by the volume of savings, and hence by the time preferences of individuals. If a man were offered a 4% rate of interest for $100, he would have to compute whether the increase in money compensates his cost of waiting due to his natural time preference. He would have to decide if $100 now is worth more than $104 in 3 months. If it is not, he does not loan the money. The rate of interest at which capital is paid is primarily determined by time preference. There are other considerations, however; the rate of interest may be higher to compensate for entrepreneurial risk (the probability a bank will err in investing money in profitable enterprises), risk premium (the probability a bank will disappear with entrusted assets), and price premium (if inflation is to be expected). In a static model, the plain rate of interest is determined solely by time preference. This is called originary interest. In the real-world dynamic economy, the market rate of interest is made up of more than simply originary interest, but it is important to remember that the rate of interest is made up of each individual’s desire to either save or spend, and that is determined by time preference.

IV: How Changes in the Rate of Interest Affects Monetary Calculation

In a community, due to arbitrage, there is but one prevailing rate of interest. This is simply known as the rate of interest. It is the price paid for the loan of capital. The interest rate’s only function is to connect savers with borrowers. It is to connect those who are forward-looking and want to save capital, with those who desire to spend more than they earn and invest capital. This is primarily what banks do. They connect individuals with an abundance of capital to individuals with a scarcity of capital. The interest rate, as a price, naturally behaves like any other price on the market. The price of wheat, for instance, connects the individuals who desire to purchase wheat with the individuals who desire to sell wheat. Naturally, a uniform price of wheat emerges and this is the market price of wheat. Similarly, the rate of interest coordinates the price for capital. Those individuals who borrow from the savers must expect to invest this stored capital in profitable lines of production if they expect to repay the principle and interest. Thus, all savings that enter into the “loanable funds market” are loaned out for investment.

If we take the earlier example, where a community becomes more forward-oriented, we concluded the result would be an increase in savings. As the savings rate increases, there is a concomitant drop in the rate of interest. Naturally, a larger pool of savings will give an incentive for lenders to lower the rate at which they lend. Accordingly, patterns of investment must be altered in light of the new information. Entrepreneurs, who used to base their calculations off, say a 7% rate of interest, must now recalculate their expected profitability at a 4% rate of interest. This type of entrepreneurial process of computing profitably of certain sectors is termed monetary calculation. Naturally, the drop in the rate of interest will lead to an increase in total investment. More importantly, it will lead to an increase in investment of higher-order or early stage capital goods As the price of capital declines, investors will find greater incentives to embark upon more roundabout production processes. Changes in the interest rate are felt most strongly by lines of production that take a longer period of time; whereas being felt much less intensely in lines of production that take a shorter period of time. Accordingly, when the interest rate declines, there will be a relative boom in lines of production that take more time to complete versus lines of production that take less time to complete. Goods such as copper, steel, clay, bricks, land, and other early stage goods (including intangible goods such as “product development”) will experience a higher demand. These are termed “early stage goods” because they are the earliest units of capital inputs on time-consuming processes (such as housing construction). Secondary goods would then be mortar, wheelbarrows, wooden frames, etc. Capital goods such as cash registers, fiber optic cable, and jet engines will be stimulated relatively little. These are lower-order or late stage capital goods. The distinction between goods is one of substitutability. Clay and lumber can be substituted into other adjacent industries very easily – retail management cannot be.

Now that it is more profitable to invest in longer production processes, investors will be more attracted to them. This consequence of a decline in the interest rate aligns perfectly with the time preference of individuals. As individuals become more forward-looking, they save more in preparation of consuming in the future. This leads to a decline in the interest rate, and thus an increase in early stage capital goods. This investment in early stage goods will not pay off until some time. The building of homes, for instance, takes a long time before the project is completed. As the interest rate declines, investors are prompted to invest in lines that will take a long time to reach fruition. This aligns perfectly with the decision of savers to prepare for the future. Although some refer to the determination of the rate of interest as a “market process,” this term is misleading. A process (or the “market system”) inherently implies there is some larger machination at work – that the market is more than the sum of its parts. This perspective has done considerable harm. The determination of the interest rate was not set by the “market” which is after all, a network of individuals, and cannot as much “set” an interest rate as it can toast a bagel. The rate of interest is determined by the choices and preferences of individuals.

The changing choices of individuals, then, are the cause of the changing investment decisions. Decisions to invest in earlier stage production are made because individuals are more forward-looking. Production and consumption meet harmoniously in the future. It is the time preferences of individuals that determine the structure of production – the direction and orientation of productive enterprise in society. If people suddenly become more short-sighted and eager to consume in the immediate future, there will be less capital available for investment and long-term projects will be discouraged. New productive enterprises will be built in light of the shortage of capital. The structure of production will become taller and thinner to represent the new demands of consumers. If people suddenly become more forward-oriented and less eager to consume now rather than later, there will be additional savings to invest in longer production processes. New projects will be undertaken due to an increase in the volume of savings. The structure of production will flatten, and widen to represent a shorter propensity to consume and a longer propensity to save. Moreover, brand new industries will emerge to take advantage of the increase in time preference. The poorest tribes in Africa and Asia do not have industries devoted to the production of microprocessors because the time preferences of the individuals in those locales were not sufficiently long enough to accumulate capital. If the individuals in our society were to become less future-oriented, we would likewise find many such higher-order industries disappear. The existence of longer and more roundabout production processes requires the existence of an equally long time preference. It would be an interesting fantasy to imagine what industries entrepreneurs might decide to build if we all chose to save more of our incomes than we do today.

V: The Final Result of Saving

We have seen how an increase in savings leads to investment in more time-consuming lines of production as the interest rate declines. The final result of this process is the same as with the clerk in our earliest example. The clerk’s prosperity, or labor productivity, or general satisfaction once you include the future consumption, is increased simply by virtue of his saving. By saving a little, he is able to invest in moderately efficient lines of production; by saving a large amount, he is able to invest in incredibly efficient lines of production. The process by which saving turns into increased efficiency for a whole community is only slightly more complicated. When a community at large saves their capital, it is saved in banks which promise a certain rate of return. They can guarantee this return because they have the ability to find entrepreneurs who will finance projects that are more valuable than the rate of return given to the savers. The amount of profit the investor earns on his venture, the more he has succeeded in satisfying latent consumer desire. The entrepreneurs, selected by a cruel market test, are more often than not correct in determining profitability. Their project completes, they secure a profit, and they return the principle and remaining interest on the loan. These business ventures are the manner in which large groups of people see their standard of living rise in response to the amount they save. We have already gone over the benefits of having a lower time preference for an individual saver; it is no different for groups of people. The lower their cost of waiting to consume, the more they collectively save, the greater their investments will return. In short, this is the process by which we experience economic growth. All human societies have grown by the accumulation of saved capital and subsequent transformation into productive enterprises. This is the healthy and sustainable method of growth. It is the manner in which all men see their standard of living rise.

VI: Fiduciary Media and Inflation

There is a specific policy that has become fashionable around the world to stimulate growth. It is called credit expansion. It is the issuance of bank notes in excess of reserves. The supply of money is broken up into 3 parts: base money (commodity money) – this includes the physical gold coins, or assets that people trade; money substitutes – this includes all claims on money such as bank notes, CDs, demand deposits, and all forms of claims on actual physical money; fiduciary media – these are money substitutes created in excess of the volume of money currently in circulation. All money substitutes cover an exact claim on base money; fiduciary media is a money substitute that has a claim on nothing. It is the difference between what is in circulation and what is in the reserves. The banker that issues bank notes to cover his customer’s reserves has added nothing to the supply of money. The customer deposits his money in the bank, thus reducing money in circulation, and the banker gives him a note that entitles the holder to immediate and fully convertible redemption for his money. It is a note of paper given in substitute for money. The emergence of paper money is due to entrepreneurial foresight in predicting that individuals prefer carrying easily divisible units of paper than heavy, thick metal coins. As such, paper banknotes became popular as a substitute for money – not as money directly. It was always treated as money due to the nature of it always being available for immediate convertibility to base money. Now imagine – the banker issues more bank notes than he has in his reserves. He will be adding money substitutes in excess of what has been voluntarily given to him. These additions to the supply of money are called fiduciary media. The issuance of fiduciary media is a necessary condition for fractional-reserve banking.

The issuance of fiduciary media is undertaken by central banks. It is only they who have state-sponsorship in “printing money.” Most often, the printing of money is for fiscal reasons. The federal government has wars to fight, or expensive social programs to offer – and it requires financing beyond conventional taxation. The issuance of fiduciary media is a type of inflation. Not to be confused with the effect of inflation, which is higher prices for goods, inflation itself is the expansion of the money supply. Inflation can be seen in a country on a gold standard as new specie enters the borders, in the case of 16th century Spain – or it can be seen in a country where the ability to control monetary fluctuations is in the hands of a select few, such as the United States and other modern nations. The issuance of fiduciary media for fiscal expenditure does not engender business cycles, merely the conventional consequences of inflation. The effects of such inflation will be reserved for later sections. We are presently interested in the consequences of extending fiduciary media into the loanable funds market.

VII: Fiduciary Media and the Loanable Funds Market

The reasons for such policy making need not concern us much; often, those in charge of central banks wish to use the “monetary powers at their discretion” to lower the market rate of interest. They do this for various reasons: to reduce unemployment, to increase exports, to increase aggregate investment, etc. For whatever reason, it has become fashionable and expedient banking policy to create bank notes over the amount of reserves, and to loan them to commercial banks in the aim of the lowering of the rate of interest. It must be understood that only banks that are given government sanction are allowed to behave in such ways. If any small branch began printing exact copies of US dollars in order to “flood” the loan market of currency, it would immediately become arraigned for counterfeiting and fraud. In the longer run, customers of the bank would realize their savings are being swindled and are the subjects of rampant inflation. No private or small bank is given the discretionary power to create fiduciary media – it is only the bank of the nation itself (Such as the Federal Reserve, the Bank of England, etc). This act is called credit expansion. The central bank is expanding the volume of bank credit beyond what individuals voluntarily choose to lend out in the form of savings. It is an artificial increase in the supply of saved capital.

If fiduciary media is deposited into commercial lending channels – the loanable funds market – in the guise of lowering the rate of interest, several immediate consequences follow. Initially, the plan is successful. By adding money into the loanable funds market, the market rate of interest is lowered. This allows for increased investment, an increase in exports to other nations (ceteris paribus), and increased employment. All of whom are familiar with monetary policy as explained in introductory macroeconomic courses will, of course, be familiar with the aims and goals of such policymaking. As the rate of interest is lowered, this will lead to more investment in the same manner as we have already described in previous sections. Entrepreneurs will adjust their decisions, and monetary calculation will lead them to invest in more projects, and in more roundabout production processes. It is very important to remember that this increase in investment did not come from an increase in savings, but from an increase in money. The entrepreneurs are led to invest in long-term investment projects due to a lowering of the interest rate because of the infusion of fiduciary media into the loan market. The fiduciary media, once inside the loan market, acts like accumulated savings. It is not. Just as money is not to be equated with capital, this injection of fiduciary media is not to be confused with a genuine addition of real savings. It is money masquerading as savings. Once we acknowledge the unnatural manner in which the rate of interest is lowered and entrepreneurs begin investing in long lines of production, it becomes immanently clear that poor decisions will be made. After all, consumers have not changed their time preferences; they have not decided to become more forward-looking. And yet, entrepreneurs begin investing as if they had been. An intertemporal capital discoordination develops as investors are constructing projects that individuals have not decided to sponsor.

VIII: The Effects of Inflation

There are many effects of such discoordination. In the first place, as entrepreneurs loan capital at the new interest rate, they will tend to invest it in higher order capital goods. The industries that sell such goods will experience a boom relative to other industries. The boom these industries feel under credit expansion is different than the boom they feel under a natural process of investment due to savings. Unlike under credit expansion, the money spent on higher order capital goods must come at the expense of the individual’s consumption. Remember, the individual is choosing to abstain from consuming in order to save more. They are drawing their income from consumption to saving. Under credit expansion, this is not the case. Under credit expansion, individuals did not choose to alter their patterns of spending and saving; they did not pull money out of “spending” and put it into “saving.” They are continuing to spend as they always have. The extra money that entrepreneurs are spending on higher order capital goods comes from inflation. The dollars they are borrowing were newly printed. Thus, credit expansion includes both the effects of inflation and the effects of capital discoordination. The effects of inflation are the secondary, but by no means unimportant, consequence of credit expansion.

As these capital goods industries experience an increased demand for their products, they will sell in greater quantities and at higher prices. With new demand, they will also lure employees away from their current occupation. This is true of natural growth as well. Any industry that is experiencing increased demand (and increased profits) will attract employees from other industries to work for them because they require more labor to increase output. Furthermore, they are now in a position to pay higher wages due to an increase in revenue stream. This is how labor responds to changes in demand. Labor mobility in an unhampered market is due to changing demand of consumers. As such, because these new industries can pay higher wages, they attract large amount of workers from across production sectors. As the industries that experience higher demand receive revenue, they in turn spend it in any number of industries.

The process of inflation is underway. Despite what some prominent economists have to say on the matter, inflation is not an instantaneous phenomenon, nor does it affect all industries equally. The industries that receive new money first are in a position to purchase more while the price is still low. Later industries, that receive money from previous sources, are in an inferior position as they have had to wait longer than the first industries did until they came into cheap money (via wages, purchases of lower-order capital goods, etc) and the prices of everything they purchase go up. It is in this way that inflation helps some, and inflation hurts some. In this specific situation, inflation via credit expansion helps entrepreneurs and the owners of industries that produce higher-order or early stage capital goods. It is by inflation that these industries can finance the higher wages they agree to pay to new workers.

As long as the central bank wishes to accomplish its goals, it becomes clear that it must continue its process of issuing fiduciary media. A one-time injection of cash in the loanable funds market will create a temporary increase in investment – a temporary increase in employment. It is clear to the bankers that they must continue their operation if they want sustained employment or production. The process of printing and issuing fiduciary media must continue. Not only must it continue, but it must accelerate. This particular fact is overlooked even by some economists in the Austrian school. The issuance of fiduciary media must continue at an accelerating rate if the industries that produce higher-order capital goods are to maintain a relative revenue advantage over the other industries and hence maintain employment. The process must accelerate because a targeted employment rate (which is the same as a targeted inflation rate) requires increasing additions of fiduciary media. The process is similar to the process of earning compound interest on saved capital. Let’s say I deposit $100 in a bank promising 10% interest every year. The following year they fulfill their promise and pay the interest of $10. The next year, they must pay more as the principle has increased from $100 to $110. They must pay $11. The following year, they owe $12.10, and so on. Similarly, the additions to the supply of money must keep pace with the existing supply.

One reason for its unsustainable nature has already been outlined. For other reasons, the boom is also unsustainable in the long run. As the demand for higher-order capital goods increases, the industries providing such goods will raise their prices. With an increased cost of production, the profit margins of speculative entrepreneurs will be narrowed or wiped out. At the beginning of the boom, entrepreneurs are in an advantageous position as the recipients of new money. They can thus artificially demand more products and labor for their projects. As the inflation hits the producers of higher-order capital goods, however, their prices rise in response. The entrepreneurs are no longer in a position to demand extra product. Therefore, the “stimulating” effect new money has will be short-lived if the monetary authorities do not accelerate the infusion of credit into commercial banks. In order to maintain the stimulating effect – and subsequently increase employment, exports, investment, etc – it becomes necessary to increase the relative rate of inflation (in addition to increasing the absolute rate of inflation that we described earlier). Essentially, it becomes necessary for bankers to exponentially increase the rate of inflation if they wish to maintain the relative relationship of prices that credit expansion creates. All attempts to reduce the natural rate of interest via credit expansion must result in inflation, and sooner or later a complete abandonment of the currency system involved.

IX: Early Effects on Changes in the Structure of Production

Inflation and manipulation of the interest rate have large consequences on the structure of production. Recall from earlier sections that the structure of production is an expression of time preference of individuals and hence reflects their proclivity to save or to consume. As entrepreneurs are led by artificially low interest rates to invest in certain lines of production, the structure of production changes to suit this. It becomes wider as total investment increases. Visually, the Hayekian structure of production is represented as a right triangle. The bottom side represents investment through time, and the upstanding leg represents consumption. In times of normal saving, the triangle would become flatter as consumption must be reduced in order to release the capital necessary for investment. The triangle becomes flatter, but wider. This is not the case during credit expansion. As I have noted previously, because the time preferences of individuals has not changed – so their spending patterns have not changed. They continue to demand goods sooner rather than later. Hence, due to a low interest rate, this compels them to consume more. Rather than their spending patterns determine the interest rate, it is now the interest rate that determines their spending patterns.

As individuals receive less income from saving capital, they will find it more and more in their best interest to consume it sooner. This leads to increased demand in lower-order or late stage capital goods industries. People begin consuming more, and industries arise as a reflection of this desire. The structure of production transforms again. As people consume more, it becomes taller (the leg represents consumption) as well as wider (the base represents investment). The triangle becomes distorted. This is precisely when we see the “boom” during credit expansion. Consumption has increased and investment has increased. GDP figures are going northward and the effects of inflation have a lot of the population optimistic. The boom, however, will prove to be unsustainable.

X: Later Effects of Changes in the Structure of Production

If the monetary authorities decide not to increase the rate of inflation relative to the existing price relationship between producers and entrepreneurs, then entrepreneurs will find a harder time drawing profits from their enterprises. If the rate of inflation is not increased, the prices of higher-order capital goods will increase and the profitability of entrepreneurial investment diminishes. Ultimately, the prices of higher-order capital goods become so expensive that many projects that were initially embarked upon cannot be completed. Projects that were planned as costing less than expected profits ended up costing more than the sum of money entrepreneurs could loan. Capital is sunk into projects that are unprofitable and cannot be completed. Even the projects that are able to find financing will not necessarily find profits. Remember, that despite the lowered interest rate, individuals have not changed their time preferences and have not decided to postpone consumption for the future. Projects that are completed for the future will not find adequate revenue to justify their expense. Both projects that can find financing as well as those that cannot find financing are called malinvestments. They are investment projects that do not align with consumer desires. If an entrepreneur decided to take out a loan and invest the capital in a project to produce exclusively size 32 bowling shoes, the completed business venture would never find profit as the entrepreneur did not invest capital in accordance with consumer desire. We would describe his failure as a result of entrepreneurial error. Malinvestments are a type of entrepreneurial error – brought about by incorrect market signals as opposed to poor foresight on the part of the entrepreneur himself. This explanation of boom and bust accounts for what Lionel Robbins refers to as the “cluster of errors” entrepreneurs make when in a depression. They are led to invest in projects that cannot, initially or ultimately, find profits. They are led to invest in lines of production that consumers will not patronize.

The ensuing malinvestments and direct consumption on part of the consumers are a type of capital consumption. It is a manner of impoverishment. Much as if enemy planes and bombers wiped out manufacturing plants, so too does credit expansion reduce our producing capacity. It turns real savings into projects that consumers did not desire. It is a destruction of wealth.

XI: The Final Result of Credit Expansion

We have remarked earlier that credit expansion is not a policy that can be sustained indefinitely. Sooner or later, the process of artificially expanding credit by credit expansion must come to a stop. Whether this is due to timidity on the part of central bankers to drown the economy in inflation or to the inability on the part of entrepreneurs to find profits for their investment is a matter of historical inquiry and is irrelevant to theoretical discussions on the subject. In either case, projects that were financed by cheap credit must be liquidated (or simply abandoned) once it becomes clear that low interest rates were an illusion. Once the magical ever-flowing waterfall of inflation is at an end, entrepreneurs cannot possibly finance their projects and must immediately halt production and fire their laborers. If they cannot resell their semi-fixed production processes, they must be abandoned as a complete waste of resources. Laborers, enjoying the ability to commanding high wages in the higher-order capital goods industries, will be reluctant to return to occupations which promise them less remunerative wages. Once disruptive labor legislation and rigid labor union policies are included, it is not difficult to see how mass unemployment can result from a sudden change in investment. In an unhampered market, labor is mobile to move where it commands the highest prevailing wage. Insofar as labor is not mobile, it is due to labor union exclusion and “pro-labor” state legislation, such as the minimum wage. Persistent mass unemployment is not a necessary outcome of business cycles; it is only a necessary outcome of state intervention in the labor market.

Once it is realized that entrepreneurs have erred in their monetary calculation to invest in lines of production in accordance with individual time preferences, they will fix their balance sheets to account for their losses. Many of them become bankrupt. The existing capital stock diminishes as savings were transformed into unproductive assets. Wood, brick, and mortar that could have found profitable employment in various industries are deliberately used to make homes. These homes, due to entrepreneurs contracting their balance sheets, become priced at less than they would be in a free market. The cost of production exceeds the sale price of the finished product, and resources are wasted. Society is that much poorer.

In conclusion, we come to find that, far from monetary policy behaving as a boon to productive enterprise, it is a real curse. Credit expansion gives entrepreneurs the wrong signals to invest, leading to malinvestment and capital consumption. It leads to the general impoverishment of society as entrepreneurs borrow capital to invest in lines of production that consumers did not dictate, as well as leading individuals to consume their income rather than save it. The natural consequence of credit expansion is nothing shocking once we realize the exact role savings plays in economic growth. What other consequence could there be when entrepreneurs are diverted from producing what consumers actually want?




Works Cited:

–          Mises, Ludwig von. Human Action. New Haven, Conneticut: Yale University Press, 1949.


–          Böhm-Bawerk, Eugen von. Capital and Interest. London: Macmillan and Co, 1890.

–          Wicksell, Knut. Interest and Prices. New York, New York: Sentry Press, 1898.

–          Menger, Carl. Principles of Economics. New York: New York University Press, 1871.

–          Hayek, Friedrich. Prices and Production. London: George Routledge and Sons, Ltd, 1931.

–          _____The Pure Theory of Capital. Chicago: University of Chicago Press, 1941.

–          Mises, Ludwig von. Human Action. New Haven, Conneticut: Yale University Press, 1949.


2 thoughts on “Austrian Business Cycle Theory for the Intelligent Layman

  1. Jonathan Finegold Catalán

    I still have to read the entire thing (you posted this essay on the old blog, right?), but the first sentence strikes out,

    It is the position of the Austrian school of economics that the sole cause of economic depression is due to the calamitous nature of credit expansion.

    I don’t really remember; does Mises explicitly state this? There are many Austrian economists who do not hold that to be true; e.g. Ludwig Lachmann. Intertemporal discoordination is one of various causes (even if it is the best and/or only understood cause).

    Maybe it depends on how we define “depression.”

    1. Mattheus von Guttenberg Post author

      I did post it on the old blog. This is one of the pieces I did for school, so I had it saved on my computer when the blog went bust.

      I was using depression interchangeably with business cycle (because it’s for the layman). Although technically you’re right, “depression” is an ambiguous word.


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