Business Cycles for Introduction to Austrian Economics By Paul F. Cwik, Ph. D. Mount Olive College & The Foundation for Economic Education

“Prepare to get schooled in my Austrian perspective.” —Fear the Boom and Bust

We should probably start with, “What does a Business Cycle look like?”

Questions a Good Business Cycle Theory Needs to Answer: Why do a “cluster of errors” appear in an economic crisis? Why are there greater swings found in the earlier production stages and not in the production stages that are close to consumers?

Business Cycle Theories: Non-monetary Theories Keynesians Real Business Cycle Theorists Monetary Theories Austrians Monetarists New Classicals

Sources that refute Non-Monetary Theories: Monetary Theory and the Trade Cycle by Friedrich A. Hayek, [1929 (1933 English)] The Failure of the “New Economics,” by Henry Hazlitt [1959] America’s Great Depression, by Murray Rothbard [1963]

Austrian Business “Cycle” Theory? Some say that the Austrian Theory of the Business Cycle is a bit of a misnomer. Why? The theory has primarily focused on the causes of the downturn through the upper-turning point. Nevertheless, it is a theory of the whole business cycle.

Before we can show how an economy fails, we need to see it functioning properly.

Recall the “Magic” Formula for Economic Growth: We start with… Savings Investment Capital Accumulation Higher Productivity More Stuff Higher Living Standards

Recall the Structure of Production Time Value Output / Consumer Goods Markets

Production Possibilities Frontier Curve 5 A B C D E F Consumer Goods Investment Goods 10 15 50 25

Production Possibilities Frontier Curve Consumer Goods A2 C2 C1 A1 I1 I2 Investment Goods

Market for Investible Funds Interest Rate S im D Qm Quantity of Investible Funds

Putting the Model Together: Consumer Goods C0 C0 Time I0 Investment Goods Interest Rates S = Savers This model comes from the work of Roger Garrison (2001) i0 D = Borrowers S0 = I0 Investible Funds

Let us suppose that people become more patient. How does this change affect the model? What happens to consumption and savings decisions? How do investors and entrepreneurs react?

Suppose that people become more patient. Consumer Goods C0 C0 C1 C1 Time I0 I1 Investment Goods Interest Rates S = Savers S’ Suppose that people become more patient. What happens? i0 i1 D = Borrowers S0 = I0 S1 = I1 Investible Funds

Now, let us suppose that government places a price ceiling on interest rates. How does this change affect the model? What happens to consumption and savings decisions? How do investors and entrepreneurs react?

Consumer Goods C1 C1 C0 C0 Time I1 I0 Investment Goods Suppose that a price ceiling is placed on interest rates. Now, what happens? Interest Rates S = Savers i0 ic D = Borrowers S1 S0 = I0 I1 Investible Funds Amount actually available Credit Shortage Amount businesses want

Phases of the Business Cycle: Artificial Credit Expansion “Artificial Boom” Crunch Credit Crunch (and/or) Real Resource Crunch Recession Recovery

Updated April 19, 2010

The Unsustainable Malinvestment Boom Suppose that the interest rate is 5% and the firm is considering a project that will yield 4%. Will it engage in the project? Suppose the Central Bank lowers the interest rate from 5% to 3%. What will the firm do now?

Malinvestment Boom continues During the course of the artificial boom, malinvestments are built up. Consumers reduce savings with lower interest rates. Thus, we have an increase in consumption and an increase in investment. Ivan and the Brickyard.

The Initial Boom Phase of the Business Cycle Consumer Goods C1 C1 Unsustainable Boom Dueling Structure of Production C0 C0 Time I0 I1 Investment Goods Interest Rates S = Savers i0 S + New Money i1 D = Borrowers S0= I0 Investible Funds S1 I1

The Fed has a Choice: As the firms compete for resources, input prices are driven up making them look for more funding. Short-term interest rates rise from the firms’ actions. The central bank has a decision to make: either halt the expansion or expand the money supply at a faster rate. The central bank may choose to halt the expansion and increase interest rates out of a fear of rising price levels. The effect of this policy is a credit crunch. If, instead, the central bank continues along an expansionist policy, input prices rise and reflect the real resource crunch.

The Crunch: When the crisis hits, there are two problems facing the entrepreneur: increasing interest rates and rising input costs. With an increase in interest rates, there is an impact on both working capital and fixed capital. The longer lived the capital equipment, the greater the impact on its value. Interest rates will rise, but short-term rates will increase more than long-term rates.

Updated April 19, 2010

Updated April 19, 2010

CPI +0.6% for April 2008

The Liquidation Phase: Only through the process of converting the malinvestments into productive capital can the foundation for growth be achieved. Only the Austrian School argues that Liquidation is a necessary condition for recovery.

The Liquidation Phase: Continued The firms that invested during the artificial boom suffer the economic losses. They sell their capital equipment at a discounted rate to other firms. These other firms can turn an economic profit even at the previous prices because these firms have purchased the capital equipment at a discount. This liquidation process is how the malinvestments are converted into new fixed capital equipment. This process is necessary for normal economic growth to occur.

The Recession Illustrated: Consumer Goods C1 C1 C0 C0 C2 C2 Time I2 I0 I1 Investment Goods Interest Rates S’ S i2 = i0 S + New Money i1 D D’ S1 S0= I0 Investible Funds S2= I2 I1

So what happened in 2008? Each Business Cycle is unique. 2001 dot.com bust didn’t liquidate enough malinvestment and led to another bubble. Expansionary Monetary Policy was adopted to stimulate the economy. The Fed funds rate in 2001 is at 6%. In 2003, it is at 1%. However, to fight the bubble, the Fed raised rates, and in 2006, it was at 5.25%. “The basic point is that the recession of 2001 wasn’t a typical postwar slump…. To fight this recession the Fed needs more than a snapback…Alan Greenspan needs to create a housing bubble to replace the NASDAQ bubble.”—Paul Krugman, 2002. Community Reinvestment Act encouraged banks to take on more risk. Fannie Mae and Freddie Mac rules changed and encouraged them to buy mortgage-backed securities. (GSE’s only needed 3% held in reserve.) Money flows into Real-Estate. Sub-Prime Market Emerges—In 2006, 20% of all mortgages were sub-prime. 81% of those were securitized.

“The Fix”? Toxic Assets and Troubled Asset Relief Program (TARP): Of the $700b, $350b bought equity (preferred stock), not assets. The Fed led a massive increase in the money supply by buying anything and everything it wanted. FASB 157: New Mark-to-Market accounting rules went into effect June 15th, 2009. Home Affordable Modification Program (HAMP) was supposed to allow people to “renegotiate” new (smaller) loans. Stimulus Package, Bail-Outs and a huge Federal Budget adds to the fire.

Today the NBER and the news media focus on the recession, but times are still tough after the bottom of the trough. They focus on this. When we also need to focus on this. Technically, this is the recession. They focus on GDP. However, GDP is the Keynesian C+I+G+X-M; and, a 1% decrease is greater than a 1% increase.

It can be found on FEE’s web page: fee.org/distress-index/ FEE’s New Distress Index helps us to look at more than just the recession.

Recovery: Recovery is through the same process of normal growth. In other words, the “Magic Formula” Savings Investment Capital Accumulation Higher Productivity More Stuff Higher Living Standards

Implications: Keynesian Policy cannot pull an economy out of a recession. Expansionist Monetary Policy cannot pull an economy out of a recession. Downturns are created by increasing input prices, not just increasing interest rates. Fixed capital equipment has to be sold-off. Increasing savings is needed for the transformation to occur.

Keynesian Policy cannot pull an economy out of a recession Keynesian policies are designed to keep aggregate demand high. Any increase in aggregate demand will put pressure on input prices to also rise. The problem illustrated above is that after the crunch phase, the return on capital has fallen considerably. In order to maintain profitability by increasing output prices, the output prices have to either keep pace with or outstrip the increases in the input prices. The output levels cannot be maintained due to the real resource crunch that is pressuring input price increases.

Expansionist Monetary Policy cannot pull an economy out of a recession Expansionist monetary prescriptions for curing a recession are to stimulate investments by keeping interest rates relatively low and stabilizing the growth of the money supply. Such prescriptions also cannot pull an economy out of a recession, since it ignores the malinvested capital that is locked into unproductive arrangements. The case study of the failure of employing both Keynesian and Monetarist prescriptions is Japan since 1990.

Implications: Fixed capital equipment has to be sold-off at reduced prices in order to transform the malinvestments does not seem to explain the duration of the recession phase. Capital’s specificity is a stumbling point that tends to reduce the smooth transition of the fixed capital into productive structures. Capital is not an amorphous mass, a homogeneous blob of “K.” Capital goods have differing degrees of specificity, complementarity and substitutability. It is not simply a question of lowering the price and then plugging the machine into another production process.

Typically, projects need to be integrated into other existing firms Typically, projects need to be integrated into other existing firms. Austrians have long argued that merely investing capital does not lead to economic growth, but correctly arranged capital structures guided by the market process are the mechanism for growth. Rearranging prices is simply not enough to pull an economy out of a recession. Some of the more specific capital may have to be thrown away—scrapped—if no other firm could make a profit from it. A liberalization of merger and acquisition laws could improve the situation. Furthermore, the elimination of other obstacles found in bankruptcy laws could help expedite the transfer of malinvestments into productive ventures.

Increasing savings is needed for the transformation to occur In order for the second firm to purchase the capital equipment from the first firm, the purchaser will need funds. Newly created credit will only start the boom/bust cycle again. Only real savings can allow the transformation process to occur. A government interested in helping an economy out of a recession has to then do the following: first, not interfere with the price adjustment process; second, not reinflate the money supply; finally, try to increase the amount of savings in the country. It could do this through liberalizing its laws to allow for increased savings to flow in from abroad and it could also cut taxes on domestic savers. By increasing the amount of savings, the amount of malinvestments that could be transformed into profitable investment increases. Increasing the amount of savings available for investment quickly can shorten the duration of a recession.

Conclusions: The most significant point is that the Austrians were correct to spend so much energy explaining the cause of the business cycle. It is only an understanding of the cause that allows us to determine the best policies to follow to generate an economic recovery. If the government follows policies that are contrary to the Austrian prescription, the situation will not only fail to improve, it will worsen. The lesson is that as long as output prices stay up (through Keynesian policies) or if the Monetarists keep interest rates from rising (or maybe push them lower), or if input prices are rising (a real resource crunch), we will have a recession. The only way out is through the painful but necessary liquidation process.

Conclusions: The best means to transform malinvestments into viable economic activities is through increasing savings. This means that one of the government’s most effective policies is to cut taxes on the savers. Those who are savers are usually labeled as “the rich.” Unfortunately, the prescriptions of “get government out of the market” or a “tax cut for the rich” tend not to be politically popular. Nevertheless, it is the duty of the economist to present the truth. The economist cannot state that the government should do nothing. Such a strategy was tested in the 1930s. The modern economist needs to present the case that the government caused the recession and only by removing the government from the equation can the economy truly recover.

By Paul F. Cwik, Ph. D. PCwik@moc.edu Business Cycles By Paul F. Cwik, Ph. D. PCwik@moc.edu