Business Cycles Explained: Austrian Theory

The Austrian theory postulates that entrepreneurs are tricked or fooled by government-engineered
increases in the money supply. Here’s a simple example of how the scenario runs: The
central bank inflates the supply of money. The real interest rate falls because there
are more funds to be lent out. As the real interest falls, entrepreneurs borrow more.
They undertake longer and more ambitious projects, and eventually, according to the Austrian
theory, those longer and more ambitious projects cannot be sustained, they turn a loss rather
than a profit, and eventually the boom becomes a bust.
[The Housing Bubble]
To consider a specific example, it’s been argued by many Austrians that the housing
bubble was in fact an illustration of Austrian business cycle theory. In the years 2001 to
2004, the Fed really was somewhat loose with credit, nominal interest rates were quite
low, there was a housing bubble. People borrowed a lot more money; they borrowed more than
they should have. People thought the good conditions, the low interest rates on mortgages,
the easy availability of credit, and the rising home prices would continue forever. That wasn’t
the case. Eventually the bubble burst, these trends were reversed, and we had a lot of
long-term construction projects and housing and mortgage decisions that turned out in
retrospect to have been big mistakes.
[Austrian Remedies]
Austrians propose some different remedies for stopping the problem in the first place.
To stop the problem in the first place, Austrians have argued we should either have a gold standard
or tighter money or some kind of monetary rule. The belief is it would then be harder
to fool entrepreneurs because, in terms of monetary conditions, it is believed they would
be more stable or at least entrepreneurs would know what to expect.
[Explaining the Great Recession]
Austrians and Keynesians give very different readings of the 1920s and the subsequent Great
Depression. According to a lot of Keynesians and also monetarists, there’s some critical
negative period between 1929 and 1932, and if only we had stopped aggregate demand from
contracting so radically, we would have had a much stronger economy. The Austrian view
is different. According to the Austrians there was a lot of loose money and monetary expansion
in the 1920s. Entrepreneurs took on projects which were too ambitious, and once those longer-term
projects are in place, Austrians often believe there’s not any way you can back out of
the jam you’re in, that a lot of those investments will turn bad. Now on this question I’m
not actually so much of an Austrian when it comes to the Great Depression, but that’s
one way of thinking about the difference between the two points of view. Austrians locate the
problem more in a kind of original sin of inflation, which once it has been committed
is very hard to get out of.
Monetarists and Keynesians tend to think that if you can boost aggregate demand or maintain
aggregate demand at the proverbial last minute that you’ll actually succeed in making the
cycle a much less severe one.
[Strengths and Weaknesses]
Strengths and weaknesses of the Austrian theory: What are they? I think one strength is that
we do see a lot of credit bubbles in history, and on average those credit bubbles are associated
with periods of loose monetary policy. The Austrian theory picks up some important part
of this story. There is too much credit put on the market, entrepreneurs are fooled, and
this is one factor that contributes to making for a recession or depression. But the Austrian
theory also has some weaknesses. One is that for a theory which stresses the virtues of
the market, it assumes that entrepreneurs are tricked rather easily. So say there’s
some inflation or an increase in credit. An entrepreneur doesn’t have to be genius to
say, “Hey wait a minute, there’s been some inflation. I saw this on Fox News; I
read about it in the Wall Street Journal. Maybe I shouldn’t overexpand my business.
There’s some inflation. Maybe now is time to just be a little more cautious.” It’s
also the case that looking back in history, a lot of business cycles are caused by monetary
contractions and not by the previous expansion. So there’s an awful lot of cases where the
Austrian theory wouldn’t even potentially apply.