WEBVTT NOTE The Austrian Theory: A Summary 1 00:00:00.000 --> 00:00:05.120 The Austrian Theory A Summary by Roger W. Garrison 2 00:00:05.120 --> 00:00:11.440 Grounded in the economic theory set out in Carl Menger's Principles of Economics, and 3 00:00:11.440 --> 00:00:19.280 built on the vision of a capital-using production process developed in Eugen Boehm-Bawerk's 4 00:00:19.280 --> 00:00:24.240 Capital and Interest, the Austrian Theory of the Business Cycle remains sufficiently 5 00:00:24.240 --> 00:00:44.240 is simply distinct to justify its national identification, but even in its earliest rendition in Ludwig von Mises' Theory of Money and Credit, and in subsequent exposition and extension in F. A. Hayek's Prices and Production, the theory incorporated important elements from Swedish and British economics. 6 00:00:44.240 --> 00:00:48.920 Ludwig sells interest and prices, which showed how prices respond to a discrepancy between 7 00:00:48.920 --> 00:00:54.240 the bank rate and the real rate of interest, provided the basis for the Austrian account 8 00:00:54.240 --> 00:00:59.280 of the misallocation of capital during the boom. The market process that eventually reveals 9 00:00:59.280 --> 00:01:05.680 the intertemporal misallocation and turns boom into bust resembles an analogous process 10 00:01:05.680 --> 00:01:11.040 described by the British currency school, in which international misallocations induced 11 00:01:11.040 --> 00:01:18.360 by Credit Expansion are subsequently eliminated by changes in the terms of trade and hence 12 00:01:18.360 --> 00:01:20.520 in specie flow. 13 00:01:20.520 --> 00:01:26.500 The Austrian theory of the business cycle emerges straightforwardly from a simple comparison 14 00:01:26.500 --> 00:01:32.560 of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. 15 00:01:32.560 --> 00:01:37.760 An increase in saving by individuals and a credit expansion orchestrated by the central 16 00:01:37.760 --> 00:01:49.620 is a phenomenon in the capital banks, set into motion market processes whose initial allocational effects on the economy's capital structure are similar, but the ultimate consequences of the two processes stand in stark contrast. 17 00:01:49.620 --> 00:01:55.620 Saving gets us genuine growth, credit expansion gets us boom and bust. 18 00:01:55.620 --> 00:02:05.620 The general thrust of the theory, though not the full argument, can be stated in terms of the conventional macroeconomic aggregates of saving and investment. 19 00:02:05.620 --> 00:02:13.620 The level of investment is determined by the supply of and demand for loanable funds, as shown in figures 1a and 1b. 20 00:02:13.620 --> 00:02:18.620 Supply reflects the willingness of individuals to save at various rates of interest. 21 00:02:18.620 --> 00:02:24.620 Demand reflects the willingness of businesses to borrow and undertake investment projects. 22 00:02:24.620 --> 00:02:28.620 Each figure represents a state of equilibrium in the loan market. 23 00:02:28.620 --> 00:02:34.620 The market clearing rate of interest is I, as shown on the vertical axis, 24 00:02:34.620 --> 00:02:41.620 And the amount of income saved and borrowed for investment purposes is A, as shown in the horizontal axis. 25 00:02:41.620 --> 00:02:50.620 An increase in the supply of loanable funds, as shown in both figures, has obvious initial effects on the interest rate and on the level of investment borrowing. 26 00:02:50.620 --> 00:02:57.620 But the market process plays itself out differently depending upon whether the increased supply of loanable funds 27 00:02:57.620 --> 00:03:04.620 Derives from increased saving by individuals or from increased credit expansion by the central bank. 28 00:03:04.620 --> 00:03:10.620 Figure 1a shows the market's reaction to an increase in the thriftiness of individuals, 29 00:03:10.620 --> 00:03:16.620 as represented by a shift of the supply curve from S to MS prime. 30 00:03:16.620 --> 00:03:24.620 People have become more future-oriented. They prefer to shift consumption from the present to the future. 31 00:03:24.620 --> 00:03:27.740 Future As a result of the increased availability 32 00:03:27.740 --> 00:03:33.220 of loanable funds, the rate of interest falls from eye to eye prime, enticing businesses 33 00:03:33.220 --> 00:03:38.060 to undertake investment projects previously considered unprofitable. 34 00:03:38.060 --> 00:03:43.860 At the new lower market clearing rate of interest, both saving and investment increase by the 35 00:03:43.860 --> 00:03:50.580 amount A-B. This increase in the economy's productive capacity constitutes genuine growth. 36 00:03:50.580 --> 00:03:55.780 Sector 1B shows the effect of an increase in credit creation brought about by the central 37 00:03:55.780 --> 00:04:02.700 bank, as represented by a shift of the supply curve from S to S plus delta M. Here, it is 38 00:04:02.700 --> 00:04:07.980 assumed that people have not become more thrifty or future-oriented. The central bank has simply 39 00:04:07.980 --> 00:04:14.160 inflated the supply of loanable funds by injecting new money into credit markets. As the market 40 00:04:14.160 --> 00:04:19.420 clearing rate of interest falls from I to I prime, businesses are enticed to increase 41 00:04:19.420 --> 00:04:24.680 Thanks to this investment by the amount AB, while genuine saving actually falls by the amount AC. 42 00:04:24.680 --> 00:04:35.160 Patting the supply of loanable funds with newly created money holds the interest rate artificially low and drives a wedge between saving and investment. 43 00:04:35.160 --> 00:04:40.660 The low bank rate of interest has stimulated growth in the absence of any new saving. 44 00:04:40.660 --> 00:04:48.960 The credit-induced artificial boom is inherently unsustainable and is followed inevitably by a bust as investment falls back into line with saving. 45 00:04:48.960 --> 00:04:55.960 Even in this simple loanable funds framework, many aspects of the Austrian theory of the business cycle are evident. 46 00:04:55.960 --> 00:05:00.440 The natural rate of interest is the rate that equates saving and investment. 47 00:05:00.440 --> 00:05:05.000 The bank rate diverges from the natural rate as a result of credit expansion. 48 00:05:05.000 --> 00:05:14.160 When new money is injected into credit markets, the injection effects, which the Austrian theorists emphasize over price level effects, 49 00:05:14.160 --> 00:05:26.160 Take the form of too much investment, and actual investment in excess of desired saving, negative b, constitutes what Austrian theorists call forced saving. 50 00:05:26.160 --> 00:05:42.160 Other significant aspects of the Austrian theory of the business cycle can be identified only after the simple concept of investment, represented in figures 1a and 1b, is replaced by the Austrian vision of a multi-stage time-consuming production process. 51 00:05:42.160 --> 00:05:49.160 The rate of interest governs not only the level of investment, but also the allocation of resources within the investment sector. 52 00:05:49.160 --> 00:06:00.160 The economy's inter-temporal structure of production consists of investment sub-aggregates, which are defined in terms of their temporal relationship to the consumer goods they help to produce. 53 00:06:00.160 --> 00:06:09.160 Some stages of production, such as research and development and resource extraction, are temporarily distant from the output of consumer goods. 54 00:06:09.160 --> 00:06:17.160 Other stages, such as wholesale and retail operations, are temporally close to final goods in the hands of consumers. 55 00:06:17.160 --> 00:06:31.160 As implied by standard calculations of discounted factor values, interest rate sensitivity increases with the temporal distance of the investment sub-aggregate, or stage of production, from final consumption. 56 00:06:31.160 --> 00:06:35.760 The interest rate governs the inter-temporal pattern of resource allocation. 57 00:06:35.960 --> 00:06:39.560 For an economy to exhibit equilibrating tendencies over time, 58 00:06:39.760 --> 00:06:43.560 the inter-temporal pattern of resource allocation must adjust 59 00:06:43.760 --> 00:06:47.760 to changes in the inter-temporal pattern of consumption preferences. 60 00:06:47.960 --> 00:06:52.560 An increase in the rate of saving implies a change in the preferred consumption pattern 61 00:06:52.760 --> 00:06:57.960 such that planned consumption is shifted from the near future to the remote future. 62 00:06:57.960 --> 00:07:04.960 A savings-induced decrease in the rate of interest favors investment over current consumption, as shown in figures 1a and 1b. 63 00:07:04.960 --> 00:07:11.960 Further, and more significant in Austrian theorizing, it favors investment in more durable over less durable capital, 64 00:07:11.960 --> 00:07:17.960 and in capital suited for temporally more remote rather than less remote stages of production. 65 00:07:17.960 --> 00:07:23.960 These are the kinds of changes within the capital structure that are necessary to shift output from the near future 66 00:07:23.960 --> 00:07:29.320 The more remote future, in conformity with changing intertemporal consumption preferences. 67 00:07:29.320 --> 00:07:33.980 The shift of capital away from final output, and hence the shift of output towards the 68 00:07:33.980 --> 00:07:38.040 more remote future, can also be induced by credit creation. 69 00:07:38.040 --> 00:07:43.640 However, the credit-induced decrease in the rate of interest engenders a disconformity 70 00:07:43.640 --> 00:07:49.380 between intertemporal resource usage and intertemporal consumption preferences. 71 00:07:49.380 --> 00:07:53.720 Market mechanisms that allocate resources within the capital structure are imperfect 72 00:07:53.720 --> 00:07:59.020 are perfect enough to permit substantial intertemporal disequilibria, but the market process that 73 00:07:59.020 --> 00:08:04.360 shifts output from the near to the more remote future when savings preferences have not changed 74 00:08:04.360 --> 00:08:09.740 is bound to be ill-fated. The spending pattern of income earners clashes with the production 75 00:08:09.740 --> 00:08:14.800 decisions that generated their income. The intertemporal mismatch between earning and 76 00:08:14.800 --> 00:08:20.820 spending patterns eventually turns Boehm into bust. More specifically, the artificially 77 00:08:20.820 --> 00:08:32.820 The very low rate of interest that triggered the boom eventually gives way to a high real rate of interest as over-committed investors bid against one another for increasingly scarce resources. 78 00:08:32.820 --> 00:08:45.820 The bust, which is simply the market's recognition of the unsustainability of the boom, is followed by liquidation and capital restructuring, through which production activities are brought back into conformity with consumption preferences. 79 00:08:45.820 --> 00:08:52.300 Mainstream macroeconomics bypasses all issues involving intertemporal capital structure 80 00:08:52.300 --> 00:08:58.940 by posing a simple inverse relationship between aggregate net investment and the interest rate. 81 00:08:58.940 --> 00:09:04.540 The investment aggregate is typically taken to be interest inelastic in the context of short-run 82 00:09:04.540 --> 00:09:11.740 macroeconomic theory and policy prescription and interest elastic in the context of long-run growth. 83 00:09:11.740 --> 00:09:17.500 Further, the very simplicity of this formulation suggests that expectations, which are formulated 84 00:09:17.500 --> 00:09:24.740 in the light of current and anticipated policy prescriptions, can make or break policy effectiveness. 85 00:09:24.740 --> 00:09:29.100 The Austrian theory recognizes that whatever the interest elasticity of the conventionally 86 00:09:29.100 --> 00:09:33.380 defined investment aggregate, the impact of interest rate movements on the structure of 87 00:09:33.380 --> 00:09:38.060 capital is crucial to the maintenance of intertemporal equilibrium. 88 00:09:38.060 --> 00:09:42.380 Changes within the capital structure may be significant even when the change in net investment 89 00:09:42.380 --> 00:09:48.180 is not, and those structural changes can be equilibrating or disequilibrating depending 90 00:09:48.180 --> 00:09:53.140 on whether they are savings-induced or credit-induced, or more generally, depending on whether they 91 00:09:53.140 --> 00:09:55.140 are preference-induced or policy-induced. 92 00:09:55.140 --> 00:10:00.980 Further, the very complexity of the interplay between preferences and policy within a multi-stage 93 00:10:00.980 --> 00:10:06.380 intertemporal capital structure suggests that market participants cannot fully sort out 94 00:10:06.380 --> 00:10:11.380 and hedge against the effects of policy on product and factor prices. 95 00:10:11.380 --> 00:10:16.360 In mainstream theory, a change in the conventionally defined investment aggregate not accommodated 96 00:10:16.360 --> 00:10:22.140 by an increase in saving, commonly identified as overinvestment and represented as negative 97 00:10:22.140 --> 00:10:27.900 B in figure 1B, is often downplayed on both theoretical and empirical grounds. 98 00:10:27.900 --> 00:10:33.340 In Austrian theory, the possibility of overinvestment is recognized, but the central concern is 99 00:10:33.340 --> 00:10:38.460 is with the more complex and insidious malinvestment not represented at all in figure 1b, which 100 00:10:38.460 --> 00:10:44.460 involves the intertemporal misallocation of resources within the capital structure. Conventionally, 101 00:10:44.460 --> 00:10:50.300 business cycles are marked by changes in employment and in total output. The Austrian theory suggests 102 00:10:50.300 --> 00:10:54.660 that the boom and bust are more meaningfully identified with intertemporal allocations 103 00:10:54.660 --> 00:11:00.420 of resources within the economy's capital structure, followed by liquidation and capital 104 00:11:00.420 --> 00:11:02.500 Capital Restructuring 105 00:11:02.500 --> 00:11:09.060 Under extreme assumptions about labor mobility, an economy could undergo policy-induced intertemporal 106 00:11:09.060 --> 00:11:14.420 misallocations and the subsequent reallocation with no change in total employment. Actual 107 00:11:14.420 --> 00:11:20.180 market processes, however, involve adjustments in both capital and labor markets that translate 108 00:11:20.180 --> 00:11:25.280 capital market misallocations into labor market fluctuations. 109 00:11:25.280 --> 00:11:29.140 During the artificial boom, when workers are bit away from the late stages of production 110 00:11:29.140 --> 00:11:34.580 into earlier stages, unemployment is low. When the boom ends, workers are simply released 111 00:11:34.580 --> 00:11:40.300 from failing businesses, and their absorption into newer surviving firms is time consuming. 112 00:11:40.300 --> 00:11:45.060 Mainstream theory distinguishes between broadly conceived structural unemployment, a mismatch 113 00:11:45.060 --> 00:11:51.060 of job openings and job applicants, and cyclical unemployment, a decrease in job openings. 114 00:11:51.060 --> 00:11:56.240 In the Austrian view, cyclical unemployment is, at least initially, a particular kind 115 00:11:56.240 --> 00:12:03.240 The theory of structural unemployment, the credit-induced restructuring of capital has created too many jobs in the early stages of production. 116 00:12:03.240 --> 00:12:14.240 A relatively high level of unemployment, ushered in by the bust, involves workers whose subsequent employment prospects depend on reversing the credit-induced capital restructuring. 117 00:12:14.240 --> 00:12:24.240 The Austrian theory allows for the possibility that while malinvested capital is being liquidated and reabsorbed elsewhere in the economy's intertemporal capital structure, 118 00:12:24.240 --> 00:12:31.440 Unemployment can increase dramatically, as reduced incomes and reduced spending feed upon one another. 119 00:12:31.440 --> 00:12:38.240 The self-aggravating contraction of economic activity was designated as a secondary depression by the Austrians, 120 00:12:38.240 --> 00:12:43.240 to distinguish it from the structural maladjustment that in their view is the primary problem. 121 00:12:43.240 --> 00:12:50.040 By contrast, mainstream theories, particularly Keynesianism, which ignore the inter-temporal capital structure, 122 00:12:50.040 --> 00:12:52.640 deal exclusively with the downward spiral. 123 00:12:52.640 --> 00:13:05.640 Questions of policy and institutional reform are answered differently by Austrian and mainstream economists because of the difference in focus as between intertemporal misallocations and downward spirals. 124 00:13:05.640 --> 00:13:15.640 The Austrians, who see the intertemporal distortion of the capital structure as the more fundamental problem, recommend monetary reform aimed at avoiding credit-induced booms. 125 00:13:15.640 --> 00:13:21.640 Hard money and decentralized banking are key elements of the Austrian reform agenda. 126 00:13:21.640 --> 00:13:34.400 Mainstream macroeconomists take structural problems, intertemporal or otherwise, to be completely separate from the general problem of demand deficiency and the periodic problem of downward spirals of demand and income. 127 00:13:34.400 --> 00:13:47.400 Their policy prescriptions, which include fiscal and monetary stimulants aimed at maintaining economic expansion, are seen by the Austrians as the primary source of intertemporal distortions of the capital structure. 128 00:13:47.400 --> 00:14:03.400 Although the purging in the 1930s of capital theory from macroeconomics consigned the Austrian theory of the business cycle to a minority view, a number of economists working within the Austrian tradition continue the development of capital-based macroeconomics.