Austrian Business Cycle Theory Questioned
The Mises Institute received the following questions about the Austrian business cycle theory:
- How can an injection of credit bring about a general boom? Won't it merely transfer resources from consumer industries to capital goods industries? It seems to me that according to Mises the injection of credit would merely redistribute resources.
- If it is true that the injection just changes the structure of production (by lengthening it), and that this creates a cluster of error revealed when customers re-establish their time preferences, then doesn't the initial injection also create a cluster of "error" since resources will be bid away from consumer goods industries, making them appear unprofitable?
Wouldn't one say that there are a large number of business failures at the initial injection and at the "end" of the cycle?
An excellent paper for understanding this issue is Roger Garrison's Overconsumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle. I won't try to repeat the entire paper here, but the core of the answer to both questions is that when the banking rate of interest is below the natural rate of interest, the structure of production of the economy is pulled in two directions at the same time:
- consumer/savers faced with a lower rate of interest on savings and investment, will at the margin consume more and save less. This tends to shift productive resources toward the consumption end of the production structure.
- entrpreneur/borrowers, seeing the cost of capital fall, find that the marginally unproductive project has become productive, if the prices of the inputs do not rise before the project is completed. They undertake more investment projects, and proportionally more interest-rate sensitive projects, which are located furthest from the consumption end of the production structure.
Because the production processes that are undertaken at the long end of the productive structure take time, and depend on additional resources becoming available at forecasted prices some time after they are started, the forecasting errors do not show up immediately.
Comments (5)
Robert,
Why is the key item the interest rate and not simply the availability of additional credit that tends to bring it about?
One would assume that as additional credit is injected, ever more marginal ventures are actually able to procure funding. To the extent that they survive to the point of bidding for resources, the costs of most businesses will rise. To the extent that they survive to the point of actual production, the revenues of most companies will come under competitive pressure from the increased production capacity and both output prices and profits will tend to fall.
If I want to start up a business, I am far more likely to be stopped by an inability to access credit at all, than by an insufficiently low rate of interest that I would be forced to pay. Most variations in interest rates will look like mere noise to me as I contemplate enormous returns and enormous risk and uncertainty.
Regards, Don
Published: May 9, 2004 7:27 PM
Don,
I think that you are probably right about this. Some (Garrison?) I believe have argued that Mises theory needs to be understood in terms of the supply of "investable funds" which could enter the economy through banks, the bond market, or the stock market. Only banks can create money, but if more credit is available from banks, then that would affect the price of credit in other investable funds markets as well.
Robert Blumen
Published: May 9, 2004 7:40 PM
The answers to both questions is that capital investments add to the productive capacity so thie means that the capital-goods industries can expand without causing a absolute decline in consumption goods industries. When these expanded capital investments are ulimately revealed to be malinvestments, then that means that total productive capacity will fall once again. This is why the "forced savings" that expanded credit can create a short-term boom while the reversal of the process create the bust.
Published: May 10, 2004 4:25 AM
The injection of new credit, typically effected through either a reduction in the Fed rate or through open market operations, would certainly increase the supply of credit. It would not immediately increase the demand for credit unless projects previously viewed as unprofitable now appear to be profitable. As banks react to their increased or lower cost reserves by competitively searching for new loan candidates, the rate of interest will be bid downwards. This is the point at which the drop in interest rates really comes into play on the demand side. The present value of candidate project receivables, which typically occur much later in time than do project expenses, increases by far more than the present value of project expenditures. Therefore, many projects will suddenly appear to be profitable, even if real factors cannot support all producers' plans.
There is another sense in which "marginal" projects might find financing as bank reserves are increased: banks whose depositors are protected by deposit insurance would be more willing to take on the extra credit risk posed by "marginal" borrowers as competition reduces the expected margins to be earned from lending to "sound" borrowers.
Personally, I would like to see this theory updated to reflect the difference between real and financial capital, the term structure of interest rates, and the new financial technologies available to firms for managing financial capital risks.
Published: May 10, 2004 9:15 PM
Although the neo-Marxists do not put any special emphasis on the central banks' credit policy as compared with other state capitalist subsidies to accumulation, there is still an amazing degree of overlap between their analysis of over-accumulation (e.g., James O'Connor and Paul Mattick) and the Austrian concept of lengthening production structures.
O'Connor and Mattick see the system of monopoly capitalism as inherently unstable, with the economy balancing on a pinpoint between crises of under-consumption and under-accumulation. The only way to run existing over-accumulated industry at full output, and therefore to minimize unit costs, is to subsidize consumption. But the only way to keep existing capital investments profitable is to promote still further accumulation, which comes into direct conflict with the need to promote consumption of existing output. When the state is no longer able to promote further accumulation, and thus to render previous over-investments profitable, the resulting return of chickens to the roost predicted by neo-Marxists bears a very close resemblance to the Misean crackup.
Joseph Stromberg has done an excellent job comparing the two strands of theory as they relate to "export-dependent monopoly capitalism," in The Role of State Monopoly Capitalism in the American Empire
Published: May 11, 2004 12:13 PM