An Attack on the Austrian Business Cycle Theory

In my most recent post, I briefly explained what the Austrian Business Theory is. In this post, I will try to make some arguments against the Austrian Business Cycle Theory. The theory, in short, says that when the central bank extends the bank credit at an artificially low interest rate, this credit feeds a boom in the production sector, And once businesses realize that the higher demand wasn't relative rather overall caused by an expansionary policy, they try to re-adjust their capital. This re-adjustment process is, according to the ABCT, a recession.

Now, let's try to argue against one of the main assumptions on which the ABCT built on.

The first assumption or definition that was taken to build the foundation of the theory by Ludwig Von Mises is the notion of a natural rate of interest. The natural rate of interest, a defined by Swedish economist Knut WIcksell, is the rate that would balance the amount of capital demanded by the borrowers and the amount of capital saved by the savers in the economy. In other words, it is a market equilibrium price for the capital. F.A.Hayek explains the notion in Prices and Production (1935):

“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks."

The ABCT says that when the government or the central bank intervenes the market and controls the interest rate, the economy is distorted by this artificial interest rate.

However, the notion of the natural rate of interest could be attacked in a following way. This notion assumes that an equilibrium interest rate could be dictated by the market itself. If we want to see this natural rate of interest, we have to assume that savers and borrowers perfectly maximize the profit that can be made from the capital saved or borrowed. That perfect maximization, however, doesn't take a place in real world. When savers decide how much money to save for future, their decision depends on not only the prevailing interest rate but also how much money they have in their saving account or for how much time period they are saving etc. For the borrowers, they also don't react perfectly to the change in the interest rate. They might consider uncertainty in the economy or conditions on their borrowing. For these and many other factors that influence their saving and borrowing decisions, the definition of a natural rate of interest loses its assumption.

Therefore, from the very beginning of its story, which takes the notion of a natural rate of interest when it talks about how the central bank lowers the interest rate below a natural rate of interest, the Austrian explanation of business cycles is attacked by the other schools.

Meeting my own goal: A post on the Austrian Business Cycle Theory

Developed by Ludwig Von Mises and Friedrich Hayek, the Austrian Business Cycle Theory (ABCT) says that an artificially low interest rate, created by the government or a central bank, induces more investment in a production sector because investors now can find more money with an interest rate that is lower than a natural rate of interest. The artificially  low interest rate creates a production boom. Sooner or later, according to the theory, the investors realize the production is unsustainable and try to re-adjust the production and capital to other productions. At this moment, the economy is in a recessionary period.

When the interest rate is lower than a natural rate of interest, savers saves less and consumes more. At the same time, businesses borrow more money to invest in their projects. Businesses fail to see an increase in the demand for their products as an aggregate increase in the demand instead they think that the relative demand for their products has increased. To respond to the increase in the demand, businesses borrow more money and produce more. With a new cheaper money, investments that wouldn't have been done without an artificially low interest rate are made. These investments are called malinvestment by Austrian economists. When the businesses realize that this higher demand wasn't relative and the inflation is higher than they expected, they try to fix the mistake they made by changing the use of the capital and labor they have already obtained through the artificially low interest rate. Unfortunately, the process to make this adjustment takes some time because not all capital and labor can be used to produce a different product than the product they had been specified for. Therefore, this adjustment results in a period of unemployment and underemployment a.k.a a recession.

Moreover, the Austrian Business Cycle Theory explains one more thing that other business cycle theories don't explain. William J. Luther and Mark Cohen states this in their recent paper:

In particular, we have argued that the Austrian view is unique in suggesting that a monetary shock will distort the structure of production. An unexpected monetary expansion encourages early and late stage production relative to middle stage production. Hence, the Austrian theory claims that prices and production will increase in early and late stages relative to middle stages when the interest rate prevailing in the market falls below the natural rate.

In other words, the artificially low interest rate changes the structure of the production process.

According to the Austrians, the recent recession was the result of the Fed's low interest rate policy that followed 2001 recession.

Moreover, the theory has a implication on today's Fed's low interest policy. According to the Austrian Theory, the recession is a self-healing process of the economy after a boom and burst. Therefore, lowering the interest rate is seen as a problem by the Austrians. Here, WSJ covers some Austrian voices on the issue of the easy money policy in 2010:

Narayana Kocherlakota, president of the Minneapolis Fed, argued that a large part of today's unemployment problem is caused by issues the Fed can't solve, such as the mismatch between the skills of jobless workers and the skills that employers wanted.

The ABCT theory hasn't been prominent theory to explain the business cycles as others, such as Keynesian economics. Economists have done researches to study the empirical evidence of the theory, but most of them shows results against the ABCT explanation. (Here and here) But it is still important to look back at the ABCT theory and its ingredients to understand economy more and fix its errors, if there is, to solve the economics problems more successfully.