Austrian Theory of the Business Cycle

A transcript of the Lew Rockwell Show episode 017 with Guido Hulsmann.

Listen to the podcast

ANNOUNCER:  This is the Lew Rockwell Show.

ROCKWELL:  Thanks so much to Dr. Guido Hulsmann for being with us today to discuss the Austrian Theory of the Business Cycle.  Now that sounds abstruse but not really because it affects the pith of everyone’s life who is listening to this podcast.

Guido, let me mention, is professor of economics, holds a chair at the University of Angers in France.  He’s a senior fellow of the Mises Institute, author of a number of books and scholarly papers, most recently his magnificent biography, Mises: The Last Knight of Liberalism.

But, Guido, here we are in the Western world in a recession, maybe a depression, if we want to use the more honest word, or Murray Rothbard used to say, of course, really “a panic and a crash.”  That’s what they used to call it in the 19th century until that became too politically incorrect.  I guess, now, even “recession” is too politically incorrect.  But we’ve been in an artificial boom since 9/11.  Now we’re in the bust phase.  But Austrian economics can explain this; can explain what’s happened, why it’s happened.  And it’s very useful for people to know exactly what the Federal Reserve and its allied institutions and special interests have done to us.

HULSMANN:  Absolutely, Lew.  We have been in a boom since 2001.  But we should not forget that in 2001, we had a very short [amazon asin=193355018X&template=*lrc ad (right)]crash of the stock market.  So we had a boom already before.  In a way, we’ve been alternating between booms and crashes for the past 30 years and even beyond this for the past 200 years or so.  More precisely, ever since governments tried to interfere systematically with the money supply through central banks.

This is a model that the world has adopted from the British.  The British were the first to introduce the model of central banking following the proposals of David Ricardo, in particular, who, in 1816, wrote a small booklet in which he proposed the establishment of a central bank that should issue a paper currency linked to gold, but not to gold coins, but only to gold bullion so as to discourage the redemption of the paper notes against metallic money.  Ricardo realized full well that if the citizens had a free choice between metallic money on the one hand and paper notes on the other hand, precisely because they lack sufficient information and general economic knowledge to evaluate these instruments correctly, they would always prefer the sure thing and opt for silver coins and gold coins.  And therefore, he wanted to out-rule this possibility and make sure that the population used only paper notes.

So, on this model then, very largely on this model, the Bank of England operated as a monopoly provider of bank notes as from 1844.  And the decades that would follow after 1870, most of the rest of the world adopted the same system.  So a central bank, monopoly provider of national paper currency and, on the basis of which, then commercial banks issued demand deposits in excess of metallic deposits that were in the vaults.  So we have the combination, therefore, of monopolistic central banking, plus fractional-reserve banking on the side of commercial banks.  This system in itself is inherently unstable because it is liable to bank runs.  In the case of the commercial banks, this is most obvious because if you issue more demand deposits in excess than you have of metallic currency in your vaults, it is not possible for the bank to give suite to all customers coming at the same time and demanding a redemption of their demand deposits.  So let’s say the bank issues demand deposits in the order of $1,000 but it has only $100 or only $50 cash on hand, if all customers come at the same time and write checks on their demand deposits, it’s not possible for the bank to give suite to this to satisfy these redemption demands, and so it goes bankrupt because it cannot fulfill its contractually binding obligations.

But it is very similar also in the case — and of this old system, in the case of the central bank because the central bank, too, is ultimately a fractional-reserve bank.  The central bank, too, issues a money substitute, a legal representative of money in the paper notes in excess of the reserves it holds in its vaults.  So if all users of the money, all the citizens came at the same time to the offices of the central bank and presented their notes for redemption, it would not be possible for the central bank to give suite to this and to satisfy these redemption demands, so it, too, would go bankrupt.[amazon asin=147934706X&template=*lrc ad (right)]

Now, this seems to be a theoretical consideration, but in actual practice, that is exactly what happened about every 10 years in the case of the British economy.  Banks, that is the central bank, plus the commercial banks had increased their issues of legal titles, that is, of demand deposits and of paper money in excess of underlying reserves on and on throughout a certain period.  That was the boom period.  And then, when the slightest business difficulty developed, some unanticipated event, for example, a bad harvest, and it was necessary then for customers to have recourse to a greater amount of money, the banks were unable to satisfy these greater redemption demands, and so the whole system, the whole monetary system collapsed under the domino effect.  Because if one bank goes bankrupt, its demand deposits or the checks that can be written on these demand deposits lose all their value, so therefore, you get a shrinking of the money supply.  If the money supply shrinks, then it will be more difficult for companies to sell their goods at the prices at which they had been sold before.  So they, too, turn to their banks to get additional credits.  The banks cannot do this again, so more banks go bankrupt, more businesses go bankrupt.  And so you have a textbook crash.

This happened, as I said, about every 10 years.  And the problem was ultimately solved by what is called abandoning the gold standard or by what President Nixon, in 1971, called “closing the gold window.”  That is, by allowing the central bank to no longer redeem its notes into underlying metallic money.  That is a very paradoxical situation maybe in which the central bank can still insist that its own legal credits still be served as promised but in which it no longer is under the legal obligation to serve its own liabilities.  So if a customer presents itself and wants to have his money, the bank can refuse and say, well, you better keep your paper note in your wallet.

In such a case, we have a change of a monetary system.  Whereas, before, we had a fractional-reserve banking system based on some form of metallic money, typically a gold standard.  After such a suspension of payments, we get a new monetary system in which we have paper money.  The difference is not immediately visible on the physical, on the visible surface of things because the dollar bank notes have not changed.  For example, in between 1970 and 1972, Americans were still using the same dollars but their economic nature had completely changed.  In 1970, the dollars were legal titles for underlying gold.  And it’s true that Americans, an average citizen could not redeem them for gold, but other people could do this, most notably, foreign central banks.  But in 1972, such a redemption was no longer possible in principle.  So even foreign central banks were no longer allowed to do this.  And as a consequence then, the dollar was no longer a legal title representing something else, something underlying it, but it was a good in its own right.

Now in the case of a paper money system, the problems that I mentioned before no longer seem to exist.  It’s no longer possible for a central bank to go bankrupt.  Whereas, before, a central bank was liable to a bank run, too many customers showing up at the same time demanding redemption of their notes and the bank not being able to fulfill this demand.  This problem can no longer exist now because the bank no longer is under the obligation to redeem these notes into something else, so it cannot go bankrupt.  And it can, quite to the contrary, issue ever more money of this type, print ever more money tickets, and provide them to the rest of the economy.

Now, one might think that this is a very beneficial situation because then a business cycle is no longer possible.  The slightest or even the greatest business contingency, the greatest crisis situation on the stock markets but also in general business could be solved by a central bank pumping ever more money into the economy.  So you might think, well, that’s wonderful, we are now ready and can create a new age in which the business cycle will be a thing of the past.  And that’s actually what many economists thought at the time.  The past 37 years have taught them otherwise.  The business cycle is not gone.  It’s well and alive.  And it’s probably stronger than ever before.

And the reason why this is so can be given by Austrian Business Cycle Theory, as you have said before.  And, in fact, the Austrians have, for a very long time, been the only ones who seriously attack this problem because the others thought that when there was from time to time a crisis situation, that this was due to extraordinary circumstances and had nothing to do with our monetary system and, in any case, could be solved very easily by monetary policy.  Today, the number of economists thinking that monetary policy can solve just about any crisis is shrinking by the hour.  And I guess that’s one of the reasons why more and more people are getting interested in Austrian Business Cycle Theory, not only practitioners, investment advisors, also investors, but also people responsible for monetary policy.  I’m very pleased that virtually all of my books have been bought and very quick by the German Bundesbank.[amazon asin=1620871610&template=*lrc ad (right)]

So what’s the explanation that we can find in Austrian Business Cycle Theory?  There are two mechanisms that are stressed by this theory, and they are related.  The basic mechanism is the one first discussed by Ludwig von Mises in his 1912 book The Theory of Money and Credit.  And here, Mises stressed that a central bank policy of artificially increasing the money supply might entail a boom/bust sequence.  And this comes in the following way.  In a steadily operating economy, the number of business projects that are being started is, among other things, being limited by the interest rate.  Now, what the central bank does by increasing the money supply and, if it sells the increased money supply in the form of credit on the financial markets, it has the possibility to decrease the interest rate.  If the supply increases and demand remains as before, then the price will decrease so the interest rate will diminish.  Now, this seems to be very beneficial at first sight, but Mises pointed out that that’s not actually true.  And in his explanation, he stressed the difference between the number of business projects that are being started and the number of business projects that can actually be completed.  It doesn’t help you much if you start all kinds of things and you do not bring them to a good end.  That’s what your mother tells you the first year of school and, in the case of good mothers, even before this.

Now, in business, it’s the same.  It doesn’t help us if we start too many business projects that we cannot lead to a good end.  And we cannot lead them to a good end if we do not have the real resources necessary to feed and equip our workers, the human beings, in particular, during the time necessary for production.  Now, what expansionary monetary policy does then, sort of to say, in the best of all cases, is to decrease the interest rate, thereby, prompting entrepreneurs, encouraging entrepreneurs to start more investment projects than they otherwise would have started.  But what this policy cannot do is to increase the quantities of real resources that would be necessary to complete all these projects.  So the end of the story is clear from the outset: sooner or later, entrepreneurs, even those who operated under the initial delusion that they could terminate all things that they had started, realize that the real resources necessary to do this are simply not there, so they have to stop.  And that’s exactly the crisis situation.  The situation in which they have to stop is characterized for them by the fact that their buying prices are running away as compared to the likely selling prices that they can realize.  Now, that’s the process that Mises described for the first time in 1912 and that later Austrian economists, most notably, Friedrich August von Hayek and Murray Rothbard and other economists, most recently, Huerta De Soto, and still others have pointed out.

Now, in our day, there is a very similar mechanism that comes into play and is complementary to the one first described by Mises, and this mechanism, at the center of this mechanism is the phenomenon of moral hazard.   Moral hazard is irresponsibility on the side of a decision maker who uses more resources in his plans and in his decisions than he otherwise would because he thinks that other people will supply the needed resources to complete the projects. [amazon asin=1933550090&template=*lrc ad (right)]

There’s a notion that first emerged in the insurance industry denoting irresponsible behavior of insured persons.  For example, if somebody buys car insurance, he is likely to drive more recklessly because he will be insured by the company, so other people, other subscribers to the insurance will pay for the harm that he creates.  And that’s also the reason why insurance companies impose certain codes of conduct, rules of behavior of safe driving on drivers in order to rule this out.

Now, in the case of central bank policy, the existence of central banks, we have a very similar phenomenon.  Because central banks are there — because central banks are there that produce paper money, they can bail out every market participant, in principle, to an unlimited extent.  Producing paper money costs nothing.  Producing a $100 note, for example, costs just a sheet of paper and a little bit of good ink, far less in price than the $100 note that is being produced.  Producing $100s in the form of electronic money costs even less.  And today, central bank policy is conducted primarily with electronic money, which is also called central bank liquidities.

Now, the trick is that the market participants know that this possibility exists, that the central bank is determined to follow up on this mission and that in the past they have exactly behaved this way.  They have bailed out market participants that were big enough to provoke a domino effect entailing the bankruptcy of many other market participants.  So because they know that this policy is possible and likely to be pursued, they start behaving recklessly.

And this expresses itself in two primary phenomena that we can observe today and that we have been reading all about in the past few months in the financial press.  On the one hand, reduction of equity ratios and, on the other hand, neglect of the risk side of investment and unilateral focus on the return side, the possible return side of an investment.  So financial companies, banks and other investment companies operating on the financial markets have systematically reduced their equity ratio; that is, the amount of the proper resources in the total balance sheet that they control.  They have not been doing this only in the past 37 years but way longer, because we’ve had central bank policy for a much longer time, but on a dramatic scale in the past 37 years.  As a consequence, therefore, when you have lower equity ratios, companies become more vulnerable.  Equity is the shock absorber in times when something goes wrong.  In times that companies incur heavy loses, they will pay for this out of their equity.  But if there is virtually no equity there in the company, then it immediately has a repercussion on its liabilities.  It will not be able to pay back all the debts it has contracted and, therefore, its creditors will be negatively affected.  And so we get a domino effect entailing the meltdown of the financial market, very potentially.

The second form of behavior that I have mentioned is the unilateral focus on the possible returns of an investment and neglect of the risk side, which we could observe, for example, in the case of the subprime market and various other segments of the financial markets, and which has resulted from the perception of the investors that the central bank stands up to back them.  So they were, in a way, acting very rationally.  We cannot say that they were behaving recklessly.  They were behaving cautiously and rationally given the circumstances.  And the circumstances were defined by the presence of a lender of last resort.  That’s the function of the central banks.

So the very fact that a central bank exists, which has the technical wherewithal to bail out virtually every market participant, creates a moral hazard on a massive scale.  This has led, in the past 10 or 15 years, first of all, to the dot.com stock market boom and, in the past six or seven years, to the real estate boom.  And each time, we could observe that investors behaved exactly the way described by Austrian theory, reducing their equity and engaging in investments without much sufficient consideration for the risk side.[amazon asin=146997178X&template=*lrc ad (right)]

ROCKWELL:  Guido, thank you very much.

And for anybody who wants to learn more about this, I want to recommend an article, which you can find on LewRockwell.com, by Murray Rothbard, and it’s called Economic Depressions: Their Causes and Cure.  Also take a look at Murray’s wonderfully written little book called What Has Government Done to Our Money?  It talks about central banking, about inflation, about the Fed, about the business cycle.  These are two good places to start.

And, Guido, thank you very much for helping us understand all this today.

HULSMANN:  With pleasure.

ANNOUNCER:  You’ve been listening to the Lew Rockwell Show, produced by LewRockwell.com, the best-read Libertarian website in the world.  Thanks for listening.

ROCKWELL:  Well, thanks so much for listening to the Lew Rockwell Show today. Take a look at all the podcasts. There have been hundreds of them. There’s a link on the upper right-hand corner of the LRC front page. Thank you.

Podcast date, August 12, 2008