Today we are going to take a look at one of the cornerstones of the Austrian School of Economics: the Austrian Business Cycle Theory (ABCT). We are going to spend some time on this topic because it is of critical importance to you. Your future, or more precisely the economic future of your country, can be forecasted using this theory. It is powerful stuff indeed! Let’s begin.
AUSTRIAN BUSINESS CYCLE THEORY
Origins
As with any other theory, it stands on the shoulders of giants. This theory wasn’t a completely new and revolutionary discovery by the Austrians, but they did add many new elements to previous ideas; they provided a fresh point of view and, more importantly, they gave it cohesion.
At its most basic, the theory emerges from comparing the origins of money and their effects on business. Austrians noted that economic growth was sustainable when fueled by genuine savings (e.g. gold and silver) and was not sustainable when fueled by inflation (i.e. money printing by Central Banks).
Based on this simple observation, they walked the steps both types of money (savings and inflation) take in the market and arrived to their destinations. Genuine savings gives us genuine growth while inflation gives us booms and busts.
Once they have done so, they retraced their steps and started asking a simple question: why? As the answers pored-in, they knew they have found the reasons behind the two opposite market outcomes and a theory to back them up.
The ABCT requires two different explanations. ABCT must be explained in part using “standard” or “non-Austrian” economics (more precisely called macroeconomic aggregates) and in part using Austrian insight. Let’s take a look at both.
The “standard” explanation
In order to provide a rational explanation, we need to understand what drives business investments. In general terms, they are dependent upon the availability of loans as most businesses begin with a loan.
Genuine growth
In the simplest scenario the availability of loans depends of peoples’ savings.
People save because they make a conscientious effort not to spend today so that they may have something tomorrow (in economic terms this is called a time preference). By performing this sacrifice, people either expect to need those funds in the future or they expect to be rewarded by their patience. This reward is called interest rate.
Strictly speaking, loan availability is determined by the equilibrium between the saved money and business desire to borrow. It is a classic example of supply and demand.
If people decide to save more, then the supply of money available to be borrowed increases. As this supply is competing with saved money from other savers, its reward decreases (i.e. interest rates drop). When interest rates drop, businesses that previously were not profitable suddenly become profitable. Therefore, business borrows money and the economy grows.
We must point out that the amount of money that was borrowed by business is exactly the same amount of extra money that was saved by the people. This is genuine growth.
Booms and Busts or fake growth
Let’s now consider what happens when a Central Bank prints money. In this case we will assume that people have not increased their savings, which remains at the initial level (in economic terms, people’s time preference did not change).
As the amount of money for borrowing increases, the interest rate drops same as before. This is so because money from savings is indistinguishable from money printed by the Central Bank. In so doing, businesses borrow to begin new economic endeavors just as before. This is the boom phase which creates fake growth.
However, the amount of money that the Central Bank printed is fixed; this printing is a one-time deal. Once the printed money has been loaned out, whatever is left is whatever people saved originally.
The problem is that by this point business are hooked on the new, low interest rate. They depend on it. They made all their economic and financial calculations based on it. When they go for more, they find that they can only have more money if they are willing to pay the old, genuine savings interest rate which is much higher. Suddenly, their businesses calculations revert to the same results they obtained with genuine savings alone; this is, not profitable. Businesses go bankrupt. This is the bust phase.
The Austrian explanation
Austrians added a brand new level of understanding of the effects of Central Bank printing on business activities. This understanding is based on the effects of artificially lowering interest rates.
Austrians view economic activities, or more precisely, the planning of economic activities in a business as a multi-stage process. This makes sense. Typically business will begin with research or raw materials and end with sales. One happens before the other. The former takes much more time to complete than the latter.
But how do interest rates affect these stages? If a stage takes a long time to complete and by itself will produce no profits, then interest rates are very important. For example, if a company needs to fund R&D for a few years before any product can be sold, the amount of money they need to borrow will be large. Similarly a company may decide to expand its production capacity with new buildings and machines. Therefore, the amount of interest they will be paying, will also be large. Interest rates matter a lot because they will be paying them for a long time. Therefore, when interest rates drop, business may decide to invest more in R&D or production capacity (also called capital goods as they are known to economists).
On the other hand, if a stage takes very little time to complete and will produce profits quickly, then interest rates are not that important. For example, if a company is already selling a product, they may decide to increase production (these products are called consumer goods). They may borrow to do so, but as soon as the extra product is ready, they will begin selling them and generating more profits. These profits will be able to pay-off the loan quickly and therefore the amount of paid interest will be low.
In general terms, the farther away a stage is from the consumer, the more critical interest rates are.
Genuine growth
When people genuinely save more and interest rates drop, this indicates to business that people are deferring consumption to a farther future (i.e. their time preference has changed).
For business this means that it is better to invest for the longer term since consumption is dropping. What’s the point of having a higher volume of products if people are buying less? It is better to take advantage of low interest rates and fund R&D or manufacturing expansion to prepare new products that will entice customers to buy or have them ready for the future when people’s time preference changes again into more consumption.
What this means is that business re-allocates resources from something that will produce immediate profits (consumer goods) to something that won’t (capital goods). This re-allocation is in itself time (and money) consuming. It cannot happen overnight. It is not instantaneous. When business make these decisions they are locked-into them for a period of time. This is OK if the savings shift is genuine, because these plans coincide with people’s preferences. When the time comes, business will be ready to serve their customers (and make profits).
Booms and Busts or fake growth
Same as before, we assume that peoples’ saving habits have not changed. When Central Banks begin to print, they lower interest rates. This sends the same message to business as a genuine drop in interest rates would do. Therefore, businesses react accordingly planning for longer terms. They shift resource allocation from immediate consumption to long term investment and future consumption. This is the boom phase.
Long term investments usually involve durable goods (they need to last a long time). This means they are more expensive and time consuming to set-up.
Once the printing is finished and the interest rate returns to its original (and natural) value, businesses are set-up in exactly in the opposite manner customers demand. Customers want a certain level of consumption now, while businesses are set-up to provide consumption in the future. Businesses notice that there is no demand for future goods.
Once businesses realize the error, they will try to revert their resource allocation. But these allocations (because they are long term) are durable and expensive. They cannot be reversed overnight, not to mention all the loses they will generate because they won’t be providing any future profits. In other words, businesses find themselves set-up for waiting and can’t generate sufficient sales now, while at the same time they need to service new debts that won’t be creating profits in the future. Furthermore, since all businesses are now in the same position, they attempt to re-finance their debts at the same time and bidding raises which means that interest rates rise. Businesses go broke. This is the bust phase.
Note: please see the Glossary if you are unfamiliar with certain words.
Continue to The Austrian Business Cycle Theory - Part 2
