The Madness of Monetary Policy The Austrian Business Cycle Theory The Madness of Monetary Policy ECO 473 – Money & Banking – Dr. Dennis Foster D. Ricardo L. von Mises M. Rothbard I. Why are there business cycles? I. Why are there business cycles? II. The capital structure. II. The capital structure. III. Interest, time and the unsustainable boom.

I. Why are there Business Cycles? Flaw of Capitalism/Market System Observable since late 1700s.Observable since late 1700s. Coincides with Industrial Revolution/Capitalism.Coincides with Industrial Revolution/Capitalism. Something inherent in the market.Something inherent in the market. Will worsen until system collapses.Will worsen until system collapses. K. Marx

Why are there Business Cycles? Flaw of Capitalism/Market System Under-consumption theory.Under-consumption theory. “Excessive spending” causes inflation.“Excessive spending” causes inflation. “Insufficient spending” causes depression.“Insufficient spending” causes depression. –aka, too much saving!!! Need G to stabilize economy!Need G to stabilize economy! J. M. Keynes T. Malthus

No, Really, Why are there Business Cycles? Any theory must explain the following: Tendency towards repetitive cycles.Tendency towards repetitive cycles. “Mammoth” cluster of entrepreneurial errors.“Mammoth” cluster of entrepreneurial errors. Why depression is more intense in K-goods.Why depression is more intense in K-goods. Why retail is the “last and least” to fall.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.It’s not markets, but banking that is the key. Banks expand credit and fuel inflation.Banks expand credit and fuel inflation. –Because it is a “fractional reserve” system.  imports,  exports,  gold outflows.  imports,  exports,  gold outflows. Banks get nervous,  credit, causing recession.Banks get nervous,  credit, causing recession. D. Ricardo D. Hume

No, Really, Why are there Business Cycles? von Mises & the Austrians Central bank precipitates cycle.Central bank precipitates cycle. Effect is to  interest rates.Effect is to  interest rates. Leads to unsustainable increase in Investment.Leads to unsustainable increase in Investment. Eventually, the recession comes to correct for this unsustainable path.Eventually, the recession comes to correct for this unsustainable path. Explains all the salient features of cycle. Explains all the salient features of cycle. F. Hayek

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

Part II – The Capital Structure The Austrian Business Cycle Theory Part II – The Capital Structure

Capital Structure and the ABCT Stranded on an island ala Robinson Crusoe. Stranded on an island ala Robinson Crusoe. Can gather 12 berries per day; need 10. Can gather 12 berries per day; need 10. Three options: Three options: 1.Gather/consume 12 berries per day. 2.Make a stick to gather more berries: This will take ½ day; can gather 14 berries/day. 3.Build a net & stick ® : This will take 4 days; can gather 20 berries/day. L. von Mises 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.

Observations: Observations: 1.To consume, you must produce. 2.To consume >12 berries per day, you must acquire capital (a stick or a net & stick ® ) 3.To acquire capital, you need to save berries and probably decrease current consumption. 4.The shorter term project is, initially, more favorable. L. von Mises 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. Capital Structure and the ABCT

Now that you have the stick: Now that you have the stick: 1.You can produce & consume 14 berries/day. 2.You can start thinking about building a net & stick ®. 3.Life is good! L. von Mises [Q – Why is this better than building the net & stick ® right away?] 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 14 th day, when they would otherwise start to go bad.

Attack of the Yanet Jellen: Attack of the Yanet Jellen: 1.You have a hard time remembering how many berries you’ve saved, so you mark this down on a log. 2.After 5 days, you have saved 20 berries, but the YJ monster has added 20 marks to your log; you think you have You start building the net & stick ® … L. von Mises 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! Capital Structure and the ABCT

Lessons: Lessons: 1.To consume, you must produce. 2.To consume more you must save. 3.Adding more money (marks on a log) doesn’t create more resources. 4.When the false promise of this money is revealed, investment plans collapse and resources are wasted. L. von Mises Back in the real world, the Fed pumps money into the financial sector, not real resources. A boom ensues that cannot persist. Capital Structure and the ABCT

The Madness of Monetary Policy The Austrian Business Cycle Theory The Madness of Monetary Policy ECO 473 – Money & Banking – Dr. Dennis Foster L. von Mises I. Why are there business cycles? I. Why are there business cycles? II. The capital structure. II. The capital structure. III. Interest, time and the unsustainable boom.