Understanding Austrian Business Cycle Theory

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It's not hard
to understand why so many people drop economics after taking an
introductory mainstream course in the subject. The theory and the
practice just don't fit. It doesn't make any sense. They think it's
their fault — that they're not clever enough to understand it. So
they abandon it and take their talents elsewhere.

Had they taken
an introductory course based on Austrian economics I daresay the
outcome for most would have been different. What the Austrians say,
in a nutshell is, cut intervention to a minimum and then just leave
the thing alone.

Unfortunately,
government intervention in free markets leads to unseen problems
down the line which leads to more intervention, more unseen problems,
more intervention and so on. Most of the difficulties and complications
in economics arise from trying to explain just why intervention
in free markets makes things worse.

What has become
clear to me is that at the heart of Austrian economics lies the
Austrian Business Cycle Theory (ABCT).

When I first
came across it I encountered the same problem which many find with
mainstream economics — reconciling the theory and the practice.
In particular, Bryan Caplan
gave me something to think about when he said that ABCT …

” … requires
bizarre assumptions about entrepreneurial stupidity in order to
work: in particular, it must assume that businesspeople blindly
use current interest rates to make investment decisions."

I struggled
here. A great deal of reading followed until I came across this
article by Bob Murphy. Then I understood the problem. The reason
I was having trouble was because I didn't really understand ABCT.
I didn't understand ABCT because I didn't understand Austrian Capital
Theory (ACT). This article saved me so much time — not just because
of the article itself but in particular because of the references
he provided. I read all of them and more. By the end of it the conundrum
posed by Bryan Caplan and much else besides was resolved.

Investment
decisions are made by people running real businesses in the real
world, not academics. Because of government intervention no one
knows what the "true" rate of interest should be. Even
if a business knows that rates have been artificially lowered by
government are they likely to do nothing as competitors grab this
cheap money and put it to work on interest-sensitive investments?
Hardly, they fear that they'll be running the risk of being put
out of business — so they pile in too.

The point is
made here in a quote I lifted from this
gem
of an article by Gottfried Haberler:

"May
I be allowed to quote an example given by Mr. Keynes in a lecture
before the Harris Foundation Institute last year. u2018No one believes
that it will pay to electrify the railway system of Great Britain
on the basis of borrowing at 5 percent. . . . At 3 1/2 percent
it is impossible to dispute that it will be worthwhile.
So it must be with endless other technical projects.'"
(Emphasis added).

The real benefit
of all this reading was to bring home the utter
complexity
of the production process and the time elements involved.
Also, understanding the sheer
folly
of government intervention and the short-term benefits
it yields.

In retrospect,
the most useful reading for me was firstly, "Money
and the Business Cycle"
by Gottfried Haberler — this is
where all the pieces came together. Secondly, this PowerPoint
presentation by Roger Garrison — in a word — excellent! And thirdly,
Murray Rothbard's "Economic
Depressions: Their Cause and Cure"
— this pulled everything
together by putting the whole thing in a historical perspective.

The reading
was hard work and took time but was necessary in order to understand
what is going on right now. Governments are busy trying to re-inflate
their economies. They appear to want to avoid deflation at all costs.

But we've been
here before. The problems we are facing are not new. The solutions
which are being tried are not new. That these solutions will not
work is not new. So why on earth are governments doing something
which they know will only make things worse later on?

The only sense
to be made of it is that it has little to do with economics and
everything to do with governments staying in power.

Deflation is
visible and it's horrible — businesses fail, people lose their jobs,
relationships come under pressure, marriages break, crime rates
rise and so on — it also leads to governments being kicked out of
office!

Inflation is
different — it's not as easy to see or understand and the blame
can be shifted away from governments:

"Define
inflation as rising prices and … you'll think that oil sheiks,
credit cards and private businesses are the culprits … Define
inflation in the classic fashion as an increase in the supply
of money and credit, with rising prices as a consequence, and
you then have to ask the revealing question u2018Who increases the
money supply?' " — Lawrence
W. Reed

Here's a quote
from Gordon
Brown
last week:

“If the monetary
system is not working as well as it should; if there’s no likelihood
of huge inflation in the next period of time; if you are not crowding-out
private investment then government must play its role.”

The wrongness
of what is being said here is now clear — in fact, it can be seen
visually thanks to Roger Garrison's PowerPoint presentation. I'll
leave it to others better qualified than I to explain what is wrong
about this and other such statements. Just in the last few weeks
alone this has been done by Frank
Shostak
, Thorsten Polleit,
George Reisman, Ed
Bugos
and, almost inevitably, Bob Murphy, here
and here. Of course, I
must not forget Gary North — his writing is so even and so clear
— his latest article here
is a very good example of what I mean.

As long as
writing of the above calibre continues the message will get across
— carried by all the people who increasingly read it on the internet.
Maybe the process has already started. In this
reference
, following the recent G-20 summit, there is one recommendation
which could easily be missed. Under the section "Tasking of
Ministers and Experts" there appears the following — it refers
to governments …

"[m]itigating
against pro-cyclicality in regulatory policy."

Pity they couldn't
say it in plain English. But, if I understand it correctly, is this
an admission by government officials that booms and slumps are in
fact caused, or made worse, by government intervention?

January
24, 2009

Chris
Clancy [send him mail]
is Associate Professor of Financial Accounting at Zhongnan University
of Economics and Law in Wuhan, Hubei Province, People’s Republic
of China.

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