Austrian Business Cycle Theory Explained PDF

**Austrian Business Cycle Theory, Explained** In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote4_GPSmkq1kUsSVCr3s26puw2jt...

**Austrian Business Cycle Theory, Explained** In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote4_GPSmkq1kUsSVCr3s26puw2jtwpdLDuS8IAYjW7ieDvM_pGcOH7uYoLgw) The "boom-bust" cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production. The proportion of consumption to saving or investment is determined by people's *time preferences* --- the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference" rate be, and the lower therefore will be the *pure interest rate*, which is determined by the time preferences of the individuals in society. A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components. Varying degrees of entrepreneurial risk bring about a *structure *of interest rates instead of a single uniform one, and purchasing-power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the "natural rate" or what is generally called the going "rate of profit." This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote5_UOBkSaqUlumUCAkiPgOPKpOacFJCHWpJ3uC6EJOnOqQ_bBOygrotbrAF) Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business?(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote6_36PHOrwT4U3apgiwvz0Zwp8dyTtt7tc9iDKWLvFYSk0_rMqxvSzT6pGV) The new money pours forth on the loan market and lowers the loan rate of interest. It *looks as if* the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in "longer processes of production," i.e., the capital structure is lengthened, especially in the "higher orders" most remote from the consumer. Businessmen take their newly acquired funds and bid up the prices of capital and other producers' goods, and this stimulates a shift of investment from the "lower" (near the consumer) to the "higher" orders of production (furthest from the consumer --- from consumer goods to capital goods industries.(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote7_CFcaTGHuyBpc7ydVwjLH2EchEuA3GmpZiES8O3Y4UI_njAswbbryl24) If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the old consumption--investment proportions. In short, people will rush to reestablish the *old *proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated. A favorite explanation of the crisis is that it stems from "underconsumption" --- from a failure of consumer demand for goods at prices that could be profitable. But this runs contrary to the commonly known fact that it is *capital goods*, and not consumer goods, industries that really suffer in a depression. The failure is one of *entrepreneurial demand* for the higher order goods, and this in turn is caused by the shift of demand back to the old proportions. In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption-investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful.(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote8_z-KLaM7h-6aRirOYnaBtAsgX9hUm83msF1IVHYPlNqo_npszSj3GsZ9M)  Businessmen were led to this error by the credit expansion and its tampering with the free-market rate of interest. The "boom," then, is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit's tampering with the free market. The "crisis" arrives when the consumers come to reestablish their desired proportions. The "depression" is actually the process by which the economy *adjusts *to the wastes and errors of the boom, and *reestablishes *efficient service of consumer desires. The adjustment process consists in rapid *liquidation *of the wasteful investments. Some of these will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816--1818 and deserted during the Panic of 1819); others will be shifted to other uses. Always the principle will be not to mourn past errors, but to make most efficient use of the existing stock of capital. In sum, the free market tends to satisfy voluntarily-expressed consumer desires with maximum efficiency, and this includes the public's relative desires for present and future consumption. The inflationary boom hobbles this efficiency, and distorts the structure of production, which no longer serves consumers properly. The crisis signals the end of this inflationary distortion, and the depression is the process by which the economy returns to the efficient service of consumers. In short, and this is a highly important point to grasp, the depression is the "recovery" process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the *necessary *and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, *requires *a "bust." Since it clearly takes very little time for the new money to filter down from business to factors of production, why don't all booms come quickly to an end? The reason is that the banks come to the rescue. Seeing factors bid away from them by consumer goods industries, finding their costs rising and themselves short of funds, the borrowing firms turn once again to the banks. If the banks expand credit further, they can again keep the borrowers afloat. The new money again pours into business, and they can again bid factors away from the consumer goods industries. In short, continually expanded bank credit can keep the borrowers one step ahead of consumer retribution. For this, we have seen, is what the crisis and depression are: the restoration by consumers of an efficient economy, and the ending of the distortions of the boom. Clearly, the greater the credit expansion and the longer it lasts, the longer will the boom last. The boom will end when bank credit expansion finally stops. Evidently, the longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment. Thus, bank credit expansion sets into motion the business cycle in all its phases: the inflationary boom, marked by expansion of the money supply and by malinvestment; the crisis, which arrives when credit expansion ceases and malinvestments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires.(https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnote9_Jes-O8d-ncvy9oY6IqpVqlXxH42Mc9RkTTPXaA6lVeA_cYn5cgfNaarg) What, specifically, are the essential features of the depression-recovery phase? Wasteful projects, as we have said, must either be abandoned or used as best they can be. Inefficient firms, buoyed up by the artificial boom, must be liquidated or have their debts scaled down or be turned over to their creditors. Prices of producers' goods must fall, particularly in the higher orders of production --- this includes capital goods, lands, and wage rates. Just as the boom was marked by a fall in the rate of interest, i.e., of price differentials between stages of production (the "natural rate" or going rate of profit) as well as the loan rate, so the depression-recovery consists of a rise in this interest differential. In practice, this means a fall in the prices of the higher-order goods relative to prices in the consumer goods industries. Not only prices of particular machines must fall, but also the prices of whole aggregates of capital, e.g., stock market and real estate values. In fact, these values must fall more than the earnings from the assets, through reflecting the general rise in the rate of interest return. Since factors must shift from the higher to the lower orders of production, there is inevitable "frictional" unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be. Unemployment will progress beyond the "frictional" stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed. The greater the degree of discrepancy, the more severe will the unemployment be.  - (https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnoteref4_GPSmkq1kUsSVCr3s26puw2jtwpdLDuS8IAYjW7ieDvM_pGcOH7uYoLgw)Siegfried Budge, *Grundzüge der Theoretische Nationalökonomie* (Jena, 1925), quoted in Simon S. Kuznets, "Monetary Business Cycle Theory in Germany," *Journal of Political Economy* (April, 1930): 127--28.\ Under conditions of free competition \... the market is \... dependent upon supply and demand \... there could \[not\] develop a disproportionality in the production of goods, which could draw in the whole economic system \... such a disproportionality can arise only when, at some decisive point, the price structure does not base itself upon the play of only free competition, so that some arbitrary influence becomes possible. Kuznets himself criticizes the Austrian theory from his empiricist, anti-cause and effect-standpoint, and also erroneously considers this theory to be "static."  - (https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnoteref5_UOBkSaqUlumUCAkiPgOPKpOacFJCHWpJ3uC6EJOnOqQ_bBOygrotbrAF)This is the "pure time preference theory" of the rate of interest; it can be found in Ludwig von Mises, *Human Action* (New Haven, Conn.: Yale University Press, 1949); in Frank A. Fetter, *Economic Principles* (New York: Century, 1915), and idem, "Interest Theories Old and New, " *American Economic Review* (March, 1914): 68--92.  - (https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnoteref6_36PHOrwT4U3apgiwvz0Zwp8dyTtt7tc9iDKWLvFYSk0_rMqxvSzT6pGV)"Banks," for many purposes, include also savings and loan associations, and life insurance companies, both of which create new money via credit expansion to business. See below for further discussion of the money and banking question.  - (https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnoteref7_CFcaTGHuyBpc7ydVwjLH2EchEuA3GmpZiES8O3Y4UI_njAswbbryl24)On the structure of production, and its relation to investment and bank credit, see F.A. Hayek, *Prices and Production* (2nd ed., London: Routledge and Kegan Paul, 1935); Mises, *Human Action*; and Eugen von Böhm-Bawerk, "Positive Theory of Capital," in *Capital and Interest* (South Holland, Ill.: Libertarian Press, 1959), vol. 2.  - (https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnoteref8_z-KLaM7h-6aRirOYnaBtAsgX9hUm83msF1IVHYPlNqo_npszSj3GsZ9M)"Inflation" is here defined as an *increase in the money supply not consisting of an increase in the money metal.* - (https://mises.org/mises-wire/austrian-business-cycle-theory-explained#footnoteref9_Jes-O8d-ncvy9oY6IqpVqlXxH42Mc9RkTTPXaA6lVeA_cYn5cgfNaarg)This "Austrian" cycle theory settles the ancient economic controversy on whether or not changes in the quantity of money can affect the rate of interest. It supports the "modern" doctrine that an increase in the quantity of money lowers the rate of interest (if it first enters the loan market); on the other hand, it supports the classical view that, in the long run, quantity of money does not affect the interest rate (or can only do so if time preferences change). In fact, the depression-readjustment is the market's return to the desired free-market rate of interest.