The Austrian Business Cycle Theory
The Madness of Monetary Policy
M. Rothbard
D. Ricardo
L. von Mises
I. Why are there business cycles?
II. The capital structure.
III. Interest, time and the unsustainable boom.
ECO 473 – Money & Banking – Dr. Dennis Foster
Why are there Business Cycles?
Mises & the Austrians
•
•
•
•
Central bank precipitates cycle.
Ludwig von Mises
Effect is to  interest rates.
Leads to unsustainable increase in Investment.
Eventually, the recession comes to correct for
this unsustainable path.
F. A. Hayek
Capital Structure and the ABCT
• Lessons:
1. To consume, you must produce.
2. To consume more you must save.
3. Saving creates resources for investment in capital.
4. Adding more money doesn’t create more resources.
5. When the false promise of this money is revealed,
investment plans collapse and resources are wasted.
The Fed pumps money into
the financial sector, not real
resources. The resulting
boom cannot persist; aka
“the hangover theory.”
Can’t you just start a new boom
when the old one goes bust?
“If we discovered that, you know, space aliens were planning to attack and we
needed a massive buildup to counter the space alien threat and really inflation and
budget deficits took secondary place to that, this slump would be over in 18 months.”
The Austrian Business Cycle Theory
Part III – Interest, Time &
the Unsustainable Boom
Interest & Time in the ABCT
• Interest rates:
 Usually referred to as the “time value of money.”
 It is a (real) price signal.
 It coordinates production across time.
 It changes as our time preferences change.
• We prefer more
falls
less goods now; time preference rises;
savings rises
falls; interest rates rise.
fall Or…
•  time preference = want more current
consumption and less future consumption.
•  time preference = want less current
consumption and more future consumption.
Interest and the Loanable Funds Market
S’LF
interest
SLF = (real) saving
S”LF
i’
i*
i”
DLF = investment
LF’ LF*
LF”
Loanable funds
If our time preference rises and we want more
current consumption, SLF falls and i rises.
If our time preference falls and we want more
future consumption, SLF rises and i falls.
Interest & Coordination in the ABCT
• Time preference rises …
 We save less.
 Interest rates rise.
 Investment plans most sensitive will be scrapped.
 Consumption goods prices rise.
 Resources reallocate from Investment to Consumption.
 Disruption depends on how fast preferences change.
Interest rates are signaling the market that
resources are more highly valued in producing
current consumption goods than in producing
future consumption goods.
Do we want to force interest rates down?
Interest & Coordination in the ABCT
• Time preference falls …
 We save more.
 Interest rates fall.
 Investment plans most sensitive will be started.
 Consumption goods prices fall.
 Resources reallocate from Consumption to Investment.
 Disruption depends on how fast preferences change.
Interest rates are signaling the market that
resources are more highly valued in producing
future consumption goods than in producing
current consumption goods.
Do we want to keep interest rates low?
The ABCT & the Unsustainable Boom
• The Fed MS to i and I (and employment)
• But, there has not been a change in time preferences.
• The i sends the wrong signal and Investment projects
start to compete with Consumption for resources.
• Initially may not be noticed; slack resources get used.
• Eventually, C and I will have to bid up resource costs.
• Inflation dampens I, so Fed further MS.
• Effects are only temporary.
Fed actions will keep investment plans
going even though inflation is pushing up
interest rates as well. But, this only gets
worse until the Fed halts its actions.
The Austrian Business Cycle Theory
Some Final Thoughts
• There is no market mechanism that causes inflation.
• There is no market mechanism that causes business cycles.
• The inflation of prices is an effect, not a cause, of economic
disruption.
The problem of inflation … is not merely a
problem of a deteriorating monetary unit. The
problem … is that it cuts at the heart of the
market process, producing at best intermittent
and disruptive cyclical swings and at worst the
disastrous cessation of market exchange.
Taylor (p. 95)
The Austrian Business Cycle Theory
The Madness of Monetary Policy
L. von Mises
ECO 473 – Money & Banking – Dr. Dennis Foster