The Austrian Business Cycle Theory The Madness of Monetary Policy L. von Mises D. Ricardo M. Rothbard I. Why are there business cycles? II. The capital structure. III. Interest, time and the unsustainable boom. ECO 285 – Macroeconomics – Dr. Dennis Foster

I. Why are there Business Cycles? Flaw of Capitalism/Market System Observable since late 1700s. Something inherent in the market. Under-consumption theory. “Insufficient spending” causes depression. J. M. Keynes K. Marx T. Malthus

No, Really, Why are there Business Cycles? Any theory must explain the following: Tendency towards repetitive cycles. “Mammoth” cluster of entrepreneurial errors. Why depression is more intense in K-goods. Why retail is the “last and least” to fall.

No, Really, Why are there Business Cycles? Hume/Ricardo & Classical Economics: It’s not markets, but banking that is the key. D. Hume Ludwig von Mises & the Austrians Central bank precipitates cycle by  i. Increased Investment unsustainable. Eventually, a recession results. Explains all the salient features of cycle. D. Ricardo F. Hayek

How should gov’t. address Business Cycles? Ludwig von Mises & the Austrians Stop inflating money in the first place! Don’t bail out troubled firms! Don’t inflate to get out of the depression! Don’t encourage more consumption! F. Hayek What are & have we been doing?

The Austrian Business Cycle Theory Part II – The Capital Structure

Capital Structure and the ABCT Stranded on an island ala Robinson Crusoe. Can gather 12 berries per day; need 10. Three options: Gather/consume 12 berries per day. Make a stick to gather more berries: This will take ½ day; can gather 14 berries/day. Build a net & stick®: This will take 4 days; can gather 20 berries/day. Conditions: Work must take place all at once. Depreciation = 20%/day delayed. Stored berries last up to 14 days. Need to consume 10 berries/day. L. von Mises

Capital Structure and the ABCT Observations: To consume, you must produce. To consume >12 berries per day, you must acquire capital (a stick or a net & stick®) To acquire capital, you need to save berries and decrease current consumption. The shorter term project is, initially, more favorable. So, save 2 berries per day for two days. Then gather berries for half a day and spend the other half day making the stick. L. von Mises

Capital Structure and the ABCT Now that you have the stick: You can produce & consume 14 berries/day. You can start thinking about building a net & stick®. Life is good! So, now you need to save 40 berries. At 4/day, that would take ten days. Given that this project takes 4 days, you would just exhaust you savings of berries on the 14th day, when they would otherwise start to go bad. [Q – Why is this better than building the net & stick® right away?] L. von Mises

Capital Structure and the ABCT Attack of the Yanet Jellen: You have a hard time remembering how many berries you’ve saved, so you mark this down on a log. After 5 days, you have saved 20 berries, but the YJ monster has added 20 marks to your log; you think you have 40. You start building the net & stick®… After two days, you run out of berries, but are only half finished. You must stop and save for 5 more days. That’s not long enough; investment is a complete loss! L. von Mises

Capital Structure and the ABCT Lessons: To consume, you must produce. To consume more you must save. Adding more money (marks on a log) doesn’t create more resources. When the false promise of this money is revealed, investment plans collapse and resources are wasted. Back in the real world, the Fed pumps money into the financial sector, not real resources. A boom ensues that cannot persist. L. von Mises

The Austrian Business Cycle Theory Part III – Interest, Time & the Unsustainable Boom

Interest & Time in the ABCT Interest rates: Usually referred to as the “time value of money.” It is a (real) price signal. It coordinates production across time. It changes as our time preferences change. We prefer more goods now; time preference rises; savings falls; interest rates rise. Or… less falls rises fall  time preference = want more current consumption and less future consumption.  time preference = want less current consumption and more future consumption.

Interest & Coordination in the ABCT Time preference rises … We save less. Interest rates rise. Investment plans most sensitive will be scrapped. Consumption goods prices rise. Resources reallocate from Investment to Consumption. Disruption depends on how fast preferences change. Time preference falls … We save more. Interest rates fall. Investment plans most sensitive will be started. Consumption goods prices fall. Resources reallocate from Consumption to Investment. Disruption depends on how fast preferences change.

The ABCT & the Unsustainable Boom The Fed MS to i and I (and employment) But, there has been no change in time preferences. The i sends the wrong signal and Investment projects start to compete with Consumption for resources. Initially may not be noticed; slack resources get used. Eventually, C and I will have to bid up resource costs. Inflation dampens I, so Fed further MS. Effects are only temporary. Fed actions will keep investment plans going even though inflation is pushing up interest rates as well. But, this only gets worse until the Fed halts its actions.

The Austrian Business Cycle Theory Some Final Thoughts There is no market mechanism that causes inflation. There is no market mechanism that causes business cycles. The inflation of prices is an effect, not a cause, of economic disruption. The problem of inflation … is not merely a problem of a deteriorating monetary unit. The problem … is that it cuts at the heart of the market process, producing at best intermittent and disruptive cyclical swings and at worst the disastrous cessation of market exchange. Taylor (p. 95)

The Austrian Business Cycle Theory The Madness of Monetary Policy L. von Mises ECO 285 – Macroeconomics – Dr. Dennis Foster