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ISSUES

Let’s review a few issues under the Austrian view.

Overinvestments

How about overinvestments? Although Austrians recognize that over-investments triggered by lower interest rates are indeed and issue, it would seem that mis-allocation of investments has, in general, a larger impact.

But for every general rule, there are exceptions. Over-investment becomes patently clear when we observe unusual bubbles such as the so-called “Dot-Com” or the Real Estate bubble.

Busts

What are busts and why are they important?

Busts are simply the natural manner in which free markets correct errors, rapidly and efficiently. When a company goes bankrupt, its capital (money and goods) are re-distributed among their creditors. The re-distributed capital is then re-assessed by their new owners and re-deployed according to real consumption preferences.

In this way, capital mis-allocation is re-allocated in a manner that serves customers and not according to the artificial view Central Banks created by printing money.

Business cycles

Standard economic theory measures business cycles through unemployment and total economic output. Austrians have shown that it is possible (under certain conditions) to undergo a full business cycle without significant change in unemployment.

Therefore, as the ABCT relies heavily on the temporal mis-allocation of resources, Austrians recommend that this parameter be used to measure cycles.

Unemployment

Austrians also explain the variations in employment based on the temporal mis-allocation of resources. In the boom phase, workers are hired to work into long term investments instead of immediate consumption. As the bust takes place, these workers are fired but cannot find employment until long term investments have been re-allocated to immediate consumption. Austrians call this the “primary depression” since it is due to asset mis-allocation.

However, since by then many companies are out of business and the re-allocation of resources takes time, unemployment soars and remains high for long periods of time.

To make matters worse, reduced incomes due to unemployment produce reduced consumption which reinforce each other (in engineering terms, this is called positive feedback and it is not good). Austrians call this the “secondary depression” since it is caused by the positive feedback effect.

Perpetual inflation, more-or-less

One way to avoid the bust phase of the business cycle (at least temporarily) is to keep printing. This is one of the reasons why Central Banks have “inflation targets”. Because they know full well that if they stop, the bust will be immediate.

The problem with this so-called “solution” is that it creates inflation as more money is created and it needs to chase the same amount of goods. Eventually, people begin to anticipate inflation and to protect themselves they raise interest rates.

In order to diminish interest rates, Central Banks need to accelerate printing, which in turn produces more inflation and the cycle feeds on itself. The bust comes when either inflation is so high that it begins to destroy the economy or something else busts (e.g. stocks or real estate) fueled by all that printed money with nowhere to go or the levels of mis-allocation become unsustainable for lack of sales.

Monetary policies

Austrians have proved that business cycles are caused by fiat money. Therefore the only possible advice as to the best possible monetary policy is hard money and decentralized banking.

In other words, if anything a government can do through a Central Bank will create booms and busts, the only solution is not to do it; the only sound game to play is not to play.

This is why monetary issues must be removed from government hands altogether. For as long as governments have any saying in monetary issues, there will be booms and busts.

Stability periods

Many have argued that the ABCT is incorrect, in that it does not explain why some countries have experienced low period of inflation for longer time frames with moderate unemployment. In a sense, these are the facts. However, the ABCT does not deal on cheats and special circumstances that may be valid for those periods of time. The ABCT concerns itself with the ultimate outcome of Central Banks printing money, which is always the same: booms and busts.

For example, as the USD is an international reserve currency, when printed it is removed from circulation and accumulated by foreign banks, which prevents it from creating inflation in the US. We have explained this mechanism in the lesson Gold Is A Shiny Beacon Of Hope.

Also, Banks may be too frightened to loan money and may choose to hold cash in Central Banks’ accounts. In this case, printed money never enters circulation and there is no inflation.

There are many other processes whereby printed cash can de “sterilized” (this is Central Banking jargon) thus preventing it from entering the economy and creating a boom and bust cycle. However, in the end, Central Banks can only postpone the debacle, they cannot stop it.

Changes in the Consumer Price Index are not good indicators of mis-allocation of resources.

Worse. The more printed money it is accumulated in the system, the worse the situation will be once those funds are released. As usual, there is no free lunch, not even for the almighty Central Banks.

Mathematics and Statistics

Is the ABCT a theory that can be Statistically measured or Mathematically modeled as other Economic Theories are? No, it is not. There are two main reasons:

  1. As explained in the lesson Austrian Economics In Theory, its cornerstone is the belief that value is subjective and personal. Therefore it is impossible to forecast with statistical or mathematical precision how a population of people will react in the future. However, the ABCT is capable of providing a general trend over long periods of time, which is far more than any other Economic Theory is capable of doing.
  2. The ABCT is a theory of causality. In other words, it is a theory that provides causes and effects and links them. This theory is about what causes the problems and what will those problems look like. It is not an agglomeration of supposedly-linked empirical facts without causes and effects.

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to The Austrian Business Cycle Theory - Part 3

 

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