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
I. Why are there Business Cycles?
Flaw of Capitalism/Market System
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Observable since late 1700s.
Coincides with Industrial Revolution/Capitalism.
Something inherent in the market.
Will worsen until system collapses.
K. Marx
Why are there Business Cycles?
Flaw of Capitalism/Market System
• Under-consumption theory.
• “Excessive spending” causes inflation.
• “Insufficient spending” causes depression.
– aka, too much saving!!!
• Need G to stabilize economy!
J. M. Keynes
T. Malthus
No, Really, Why are there Business Cycles?
Any theory must explain the following:
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Tendency towards repetitive cycles.
“Mammoth” cluster of entrepreneurial errors.
Why depression is more intense in K-goods.
Why retail is the “last and least” to fall.
No, Really, Why are there Business Cycles?
Hume/Ricardo & Classical Economics:
• It’s not markets, but banking that is the key.
• Banks expand credit and fuel inflation.
– Because it is a “fractional reserve” system.
•  imports,  exports,  gold outflows.
• Banks get nervous,  credit, causing recession.
D. Ricardo
D. Hume
No, Really, Why are there Business Cycles?
von Mises & the Austrians
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Central bank precipitates cycle.
Effect is to  interest rates.
Leads to unsustainable increase in Investment.
Eventually, the recession comes to correct for
this unsustainable path.
 Explains all the salient features of cycle.
F. Hayek
How should gov’t. address Business Cycles?
von Mises & the Austrians
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Stop inflating money in the first place!
Don’t bail out troubled firms!
Don’t inflate to get out of the depression!
Don’t encourage more consumption!
What are
we doing?
F. Hayek
The Austrian Business Cycle Theory
Part II – The Capital Structure
Capital Structure and the ABCT
• Stranded on an island ala Robinson Crusoe.
• Can gather 12 berries per day; need 10.
• Three options:
1. Gather/consume 12 berries per day.
2. Make a stick to gather more berries:
This will take ½ day; can gather 14 berries/day.
3. Build a net & stick®:
This will take 4 days; can gather 20 berries/day.
Conditions:
• Work must take place all at once.
• Depreciation = 20%/day delayed.
• Stored berries last up to 14 days.
• Need to consume 10 berries/day.
L. von Mises
Capital Structure and the ABCT
• Observations:
1. To consume, you must produce.
2. To consume >12 berries per day, you must acquire
capital (a stick or a net & stick®)
3. To acquire capital, you need to save berries and
probably decrease current consumption.
4. The shorter term project is, initially, more favorable.
So, save 2 berries per day
for two days. Then
gather berries for half a
day and spend the other
half day making the stick.
L. von Mises
Capital Structure and the ABCT
• Now that you have the stick:
1. You can produce & consume 14 berries/day.
2. You can start thinking about building a net & stick®.
3. Life is good!
So, now you need to save 40 berries. At 4/day, that would take
ten days. Given that this project takes 4 days, you would just
exhaust you savings of berries on the 14th day, when they would
otherwise start to go bad.
[Q – Why is this better than building the net & stick® right away?]
L. von Mises
Capital Structure and the ABCT
• Attack of the Yanet Jellen:
1. You have a hard time remembering how
many berries you’ve saved, so you mark
this down on a log.
2. After 5 days, you have saved 20 berries,
but the YJ monster has added 20 marks
to your log; you think you have 40.
3. You start building the net & stick®…
After two days, you run out
of berries, but are only half
finished. You must stop and
save for 5 more days. That’s
not long enough; investment
is a complete loss!
L. von Mises
Capital Structure and the ABCT
• Lessons:
1. To consume, you must produce.
2. To consume more you must save.
3. Adding more money (marks on a log) doesn’t
create more resources.
4. When the false promise of this money is revealed,
investment plans collapse and resources are
wasted.
Back in the real world, the
Fed pumps money into the
financial sector, not real
resources. A boom ensues
that cannot persist.
L. von Mises
The Austrian Business Cycle Theory
The Madness of Monetary Policy
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