Academic journal article The Quarterly Journal of Austrian Economics

A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis

Academic journal article The Quarterly Journal of Austrian Economics

A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis

Article excerpt

1. INTRODUCTION

The financial crisis and the events leading up to it have sparked a remarkable renewal of interest in Austrian Business Cycle Theory (ABCT). Several high profile investment advisers and financial commentators have employed the ABCT in their interpretation of the crisis. They have been inspired to revisit this theory as a result of the manifest failure of mainstream macroeconomists to foresee or explain the subprime mortgage crisis and its subsequent metamorphosis into a pandemic financial meltdown that led to the longest recession since World War II. Interest in the theory was reinforced by the fact that a number of economists and journalists associated with the modern Austrian school had warned of an emerging housing bubble during the Greenspan era when the conventional wisdom was that the Federal Reserve System had matters well in hand (Thornton, 2009).

Some prominent (and not so prominent) mainstream macroeconomists have not responded kindly to the sudden resurgence of interest in ABCT. But rather than openly subjecting the theory to rigorous, scholarly analysis in the standard research forums of academic journals and professional conferences, they have sniped at the theory on blog sites and in the popular press. Furthermore, in their haste to find flaws in the theory, they have disregarded the works of its originators and leading proponents, such as Ludwig von Mises, Friedrich A. Hayek, and Murray Rothbard. Instead they have drawn upon a single secondary source that portrays ABCT as a "monetary overinvestment theory" of the business cycle. The theory is thus described in the influential survey of business cycle theories published under the auspices of the League of Nations in 1937 by Gottfried Haberler (1963, pp. 33-72). (1) The result is that their criticisms are aimed at a theory that grossly misrepresents ABCT in essential respects.

The gist of their critiques is that ABCT cannot explain the positive correlation of consumption and investment that occurs over the course of the business cycle. In particular they allege that the theory predicts a slump in investment and capital goods' industries and a corresponding boom in consumer spending and retail sales during the recession. They therefore conclude that ABCT is manifestly in conflict with the stylized facts of the business cycle and should not be seriously entertained.

The central thesis of this paper is that ABCT, rightly understood, does satisfactorily account for the overconsumption boom and subsequent retail slump that were such conspicuous elements of the boom-bust cycle that played out over the past decade. In arguing my case, I clarify or reformulate ABCT on several points. First, I document and emphasize the neglected point that the Austrian theory is not an "overinvestment theory" of the business cycle and was never construed as such by its most notable proponents. Second, I explicitly extend the analysis of the effects of the central bank's manipulation of interest rates from entrepreneurial choice among the length of production processes to household choice among intertemporal consumption patterns. Most accounts of ABCT focus almost solely on the "malinvestments," that is, the intertemporal misallocations of resources, which are induced by the permanent gap between the loan rate and the natural rate of interest created by expansionary monetary policy. By formally integrating the "wealth effect" into ABCT, I am able to show how the illusory profits and inflated factor incomes and asset prices caused by money and bank credit expansion promote the falsification of households' assessment of their net worth and the distortion of their consumption/saving choices. Thus the overconsumption that is typically observed during the boom is established as a coordinate effect with entrepreneurial malinvestments in the production structure attributable to the same cause: the distortion of the interest rate by monetary expansion. …

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