The Madness of Monetary Policy The Austrian Business Cycle Theory The Madness of Monetary Policy ECO 473 – Money & Banking – Dr. Dennis Foster D. Ricardo L. von Mises M. Rothbard I. Why are there business cycles? II. The capital structure. III. Interest, time and the unsustainable boom.

I. Why are there Business Cycles? Flaw of Capitalism/Market System Observable since late 1700s.Observable since late 1700s. Coincides with Industrial Revolution/Capitalism.Coincides with Industrial Revolution/Capitalism. Something inherent in the market.Something inherent in the market. Will worsen until system collapses.Will worsen until system collapses. K. Marx

Why are there Business Cycles? Flaw of Capitalism/Market System Under-consumption theory.Under-consumption theory. “Excessive spending” causes inflation.“Excessive spending” causes inflation. “Insufficient spending” causes depression.“Insufficient spending” causes depression. –aka, too much saving!!! Need G to stabilize economy!Need G to stabilize economy! J. M. Keynes T. Malthus

No, Really, Why are there Business Cycles? Any theory must explain the following: Tendency towards repetitive cycles.Tendency towards repetitive cycles. “Mammoth” cluster of entrepreneurial errors.“Mammoth” cluster of entrepreneurial errors. Why depression is more intense in K-goods.Why depression is more intense in K-goods. Why retail is the “last and least” to fall.Why retail is the “last and least” to fall.

No, Really, Why are there Business Cycles? Hume/Ricardo & Classical Economics: It’s not markets, but banking that is the key.It’s not markets, but banking that is the key. Banks expand credit and fuel inflation.Banks expand credit and fuel inflation. –Because it is a “fractional reserve” system.  imports,  exports,  gold outflows.  imports,  exports,  gold outflows. Banks get nervous,  credit, causing recession.Banks get nervous,  credit, causing recession. D. Ricardo D. Hume

No, Really, Why are there Business Cycles? von Mises & the Austrians Central bank precipitates cycle.Central bank precipitates cycle. Effect is to  interest rates.Effect is to  interest rates. Leads to unsustainable increase in Investment.Leads to unsustainable increase in Investment. Eventually, the recession comes to correct for this unsustainable path.Eventually, the recession comes to correct for this unsustainable path. Explains all the salient features of cycle. Explains all the salient features of cycle. F. Hayek

How should gov’t. address Business Cycles? von Mises & the Austrians Stop inflating money in the first place!Stop inflating money in the first place! Don’t bail out troubled firms!Don’t bail out troubled firms! Don’t inflate to get out of the depression!Don’t inflate to get out of the depression! Don’t encourage more consumption!Don’t encourage more consumption! F. Hayek What are we doing?

Part II – The Capital Structure The Austrian Business Cycle Theory Part II – The Capital Structure

Capital Structure and the ABCT Stranded on an island ala Robinson Crusoe. Stranded on an island ala Robinson Crusoe. Can gather 12 berries per day; need 10. Can gather 12 berries per day; need 10. Three options: Three options: 1.Gather/consume 12 berries per day. 2.Make a stick to gather more berries: This will take ½ day; can gather 14 berries/day. 3.Build a net & stick ® : This will take 4 days; can gather 20 berries/day. L. von Mises Conditions: Work must take place all at once. Depreciation = 20%/day delayed. Stored berries last up to 14 days. Need to consume 10 berries/day.

Observations: Observations: 1.To consume, you must produce. 2.To consume >12 berries per day, you must acquire capital (a stick or a net & stick ® ) 3.To acquire capital, you need to save berries and probably decrease current consumption. 4.The shorter term project is, initially, more favorable. L. von Mises So, save 2 berries per day for two days. Then gather berries for half a day and spend the other half day making the stick. Capital Structure and the ABCT

Now that you have the stick: Now that you have the stick: 1.You can produce & consume 14 berries/day. 2.You can start thinking about building a net & stick ®. 3.Life is good! L. von Mises [Q – Why is this better than building the net & stick ® right away?] So, now you need to save 40 berries. At 4/day, that would take ten days. Given that this project takes 4 days, you would just exhaust you savings of berries on the 14 th day, when they would otherwise start to go bad.

Attack of the Yanet Jellen: Attack of the Yanet Jellen: 1.You have a hard time remembering how many berries you’ve saved, so you mark this down on a log. 2.After 5 days, you have saved 20 berries, but the YJ monster has added 20 marks to your log; you think you have You start building the net & stick ® … L. von Mises After two days, you run out of berries, but are only half finished. You must stop and save for 5 more days. That’s not long enough; investment is a complete loss! Capital Structure and the ABCT

Lessons: Lessons: 1.To consume, you must produce. 2.To consume more you must save. 3.Adding more money (marks on a log) doesn’t create more resources. 4.When the false promise of this money is revealed, investment plans collapse and resources are wasted. L. von Mises Back in the real world, the Fed pumps money into the financial sector, not real resources. A boom ensues that cannot persist. Capital Structure and the ABCT

Can’t you just start a new boom when the old one goes bust? “If we discovered that, you know, space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits took secondary place to that, this slump would be over in 18 months.”

Part III – Interest, Time & the Unsustainable Boom The Austrian Business Cycle Theory Part III – Interest, Time & the Unsustainable Boom

Interest rates: Interest rates: Usually referred to as the “time value of money.” Usually referred to as the “time value of money.” It is a (real) price signal. It is a (real) price signal. It coordinates production across time. It coordinates production across time. It changes as our time preferences change. It changes as our time preferences change. We prefer more goods now; time preference rises; savings falls; interest rates rise. Or… We prefer more goods now; time preference rises; savings falls; interest rates rise. Or…  time preference = want more current consumption and less future consumption.  time preference = want less current consumption and more future consumption. Interest & Time in the ABCT fall less falls rises

If our time preference rises and we want more current consumption, S LF falls and i rises. Interest and the Loanable Funds Market i* S LF = (real) saving D LF = investment interest Loanable funds LF* S’ LF i’ LF’ If our time preference falls and we want more future consumption, S LF rises and i falls. S” LF i” LF”

Interest & Coordination in the ABCT Time preference rises …  We save less.  Interest rates rise.  Investment plans most sensitive will be scrapped.  Consumption goods prices rise.  Resources reallocate from Investment to Consumption.  Disruption depends on how fast preferences change. Interest rates are signaling the market that resources are more highly valued in producing current consumption goods than in producing future consumption goods. Do we want to force interest rates down?

Interest & Coordination in the ABCT Interest rates are signaling the market that resources are more highly valued in producing future consumption goods than in producing current consumption goods. Do we want to keep interest rates low? Time preference falls …  We save more.  Interest rates fall.  Investment plans most sensitive will be started.  Consumption goods prices fall.  Resources reallocate from Consumption to Investment.  Disruption depends on how fast preferences change.

The Fed  MS to  i and  I (and employment) The Fed  MS to  i and  I (and employment) But, there has not been a change in time preferences. But, there has not been a change in time preferences. The  i sends the wrong signal and Investment projects start to compete with Consumption for resources. The  i sends the wrong signal and Investment projects start to compete with Consumption for resources. Initially may not be noticed; slack resources get used. Initially may not be noticed; slack resources get used. Eventually, C and I will have to bid up resource costs. Eventually, C and I will have to bid up resource costs. Inflation dampens I, so Fed further  MS. Inflation dampens I, so Fed further  MS. Effects are only temporary. Effects are only temporary. Fed actions will keep investment plans going even though inflation is pushing up interest rates as well. But, this only gets worse until the Fed halts its actions. The ABCT & the Unsustainable Boom

Some Final Thoughts There is no market mechanism that causes inflation. There is no market mechanism that causes inflation. There is no market mechanism that causes business cycles. There is no market mechanism that causes business cycles. The inflation of prices is an effect, not a cause, of economic disruption. The inflation of prices is an effect, not a cause, of economic disruption. The problem of inflation … is not merely a problem of a deteriorating monetary unit. The problem … is that it cuts at the heart of the market process, producing at best intermittent and disruptive cyclical swings and at worst the disastrous cessation of market exchange. Taylor (p. 95) The Austrian Business Cycle Theory

The Madness of Monetary Policy The Austrian Business Cycle Theory The Madness of Monetary Policy ECO 473 – Money & Banking – Dr. Dennis Foster L. von Mises