The Austrian Business Cycle Theory – Insufficient (but NOT Wrong) at Explaining the Current Financial Crisis

Recently a fellow Austrian commented on my post Austrian Economists Need to Get Their Business Cycle Theory Straight. I will post his statements from Correction on the Austrian Business Cycle Theory and comment on them when necessary:

One criticism that has come up is that the Austrian theory does not fit the fact that during the boom years there was both an increase in capital-goods and in consumer-goods. The assumption is that the Austrian theory suggests that during the boom years there is an increase in the production of capital-goods and a decrease in the production of consumer-goods.  This is incorrect.  The Austrian theory takes into consideration an increase in both, which is what causes unsustainable economic growth.

No, this was not my criticism. First of all, I am not criticizing the ABCT as such. It explains properly all the events that ensue upon credit expansion of credit that is used to purchase capital goods. But it leaves out the possibility that the majority of new credit might not be used to purchase factors of production, but to purchase consumer goods instead. In fact, such an event, as Rothbard himself admits does NOT fall under the workings of the ABCT:

Mises did not deal with the relatively new post-World War II phenomenon of large-scale bank loans to consumers, but these too cannot be said to generate a business cycle. Inflationary bank loans to consumers will artificially deflect social resources to consumption rather than investment, as compared to the unhampered desires and preferences of the consumers.

But they will not generate a boom-bust cycle, because they will not result in “over” investment, which must be liquidated in a recession. Not enough investments will be made, but at least there will be no flood of investments which will later have to be liquidated. Hence, the effects of diverting consumption investment proportions away from consumer time preferences will be asymmetrical, with the overinvestment-business cycle effects only resulting from inflationary bank loans to business.

I am merely pointing out that what happened over the past 20 years is simply not covered by a theory that primarily focuses on the excessive extension of business credit.

My criticism is not that it doesn’t explain why we had an increase in both capital and consumer goods. A theory that deals with government intervention doesn’t assert absolutes. It merely analyzes why certain developments deviate from what would have happened in the unhampered market. We may very well have both capital and consumer goods production rise in absolute terms throughout the entire episode of credit expansion.

What I am saying is that it doesn’t explain why over the past 20 years, inside the US businesses have produced more consumer goods than they would have, and produced fewer investment goods than they would have, had the market been unhampered. The relative ratio of consumer goods produced to capital goods produced grew, for the most part, constantly from 1981 through 2006:

By the way: Even if you wanted to count houses as capital goods for whatever reason, you would STILL end up with a relative growth in the production of consumer versus capital goods.

It is this phenomenon that the conventional ABCT simply doesn’t cover and, I may add to Mises’ defense, doesn’t want to cover. We will see later to what misconceptions, misinterpretations this leads when we try to apply Mises’ business cycle theory to current and recently past events.

The difference is that the Austrian theory forecasts that the capital-goods sector will be hit harder than the consumer-good sector, and so far that has proven to be true.

Ironically, it is precisely this that has not proven to be true. One look at the current employment and business landscape shows us: Most people are losing their jobs and most businesses are failing or reporting losses in real estate, residential construction, autos, and mortgage banking. In addition to that we are on the brink of a collapse in commercial real estate due to unprecedented shop and mall vacancies.

Throughout the boom years an excessive number of huses was built, and excessive number of homes were flipped, an excessive number of cars was produced, strip malls, nail salons, beauty salons, Starbucks cafes, and the like popped up left and right. Numerous people were employed in all these fields and in that field which fueled it all: banking.  Naturally everyone frets about a decline in the production of consumer goods, simply because this constituted until recently over 90% of production in the US (again, see chart above).

Meanwhile, we were able to witness the opposite trend when it came to the capital goods industry. Factories and production of machinery was, as a tendency, outsourced to China, Mexico, Germany, Japan, and other countries. It would be, at the very least, quite a stretch to say that our recent excesses were visible in the capital goods industry, while they were everything but screaming at you in the consumer goods sector.

Again, this change in ratio between consumer and capital goods production is not covered by the conventional ABCT.

In fact, the entire theory bases its argument on the fact that there was a decrease in the rate of savings during the years of the money supply boom.  It is believed that businesses are pushed to invest when there is a rise in the rate of savings, due to a fall in the interest rates of loans.  In the case of a credit boom, the artificial decrease of interest rates due to the expansion of the monetary base by the Federal Reserve leads businesses to invest.

… and to invest means to purchase factors of production, capital goods. And factors of production are purchased when loans for such purposes are made. But when the majority of excessive loans are made for the purpose of purchasing consumer goods, viz mortgage loans, car loans, credit cards and the like, investment falls behind, purchases of capital goods fall behind, and consumption along with the production of consumer goods gains in relative terms against the production of capital goods, as I explained above. Thus much more than pushing businesses to invest, the recent credit expansion pushed consumers to consume.

At the end of this boom, whether when the Federal Reserve decelerates the creation of money or when the people lose confidence in the value of the currency being used, businesses find that without a corresponding increase in the rate of savings their investments failed to pay off, because nobody put aside savings to purchase these once future-goods.  And so, it would only make sense that there was an increase in consumer spending during the boom years.

Again, the author is going to have a hard time to explain contemporary phenomena via the above paragraph. First of all, the boom came to a halt when lenders realized that money that was loaned out would not be paid back, when people began to foreclose on loans at an accelerating pace. The loaned money was spent on consumption, and thus did not increase the borrower’s productivity to pay off his loans. But contrary to what the author said above, these goods were already purchased. All the homes, cars, and credit cards that could never be paid off were already obtained in the past, it is not that people expected them to be purchased in the future. It is not true that “investments failed to pay off, because nobody put aside savings to purchase these once future-goods”. The goods were purchased in the past, what was lacking in the future was money earned to repay the loans made, due to a lack of increased productivity.

When it became clear that most loans would never be paid back a scramble for real, earned cash ensued along with evaporating credit claims, a deflation. This is the exact opposite of a “loss of confidence in the currency used”.

When people realized they hadn’t saved enough, they cut down on consumption. When they cut down on consumption, all those consumer based businesses that at this point made up over 90% of the US economy were facing inventory overhang, they now have to cut prices, cut production, some of them have to go out of business. This is what we are in right now. The only way the US is going to come out of this malaise it to cut down on the production of consumer goods from previous levels, and make room for the production of capital goods, a restoring of the balance back to historical averages in the ratio between the production of consumer vs. capital goods.

Economic historian Thomas Woods explains it for the layman:

The central bank’s lowering of the interest rate therefore creates a mismatch of market forces. The coordination of production across time is disrupted. Long-term investments that will bear fruit only in the distant future are encouraged at a time when the public has shown no letup in its desire to the consume in the present. Consumers have not chosen to save and release resources for use in the higher stages of production. To the contrary, the lower interest rates encourage them to save less and thus consume more, at a time when investors are also looking to invest more resources. The economy is being stretched in two directions at once, and resources are therefore being misallocated into lines that cannot be sustained over the long term (Woods, Meltdown, 68).

Interestingly I talked to Tom Woods about precisely this: Again, he correctly argues what happens during an expansion of business credit. Yes, I do understand it. I wrote about it myself in what I call the production business cycle. But he does not explain how increased consumption demand from consumers is actually met with increased production from producers of consumer goods vs. just price increases of consumer goods. He then pointed me to Robert Murphy’s article The Importance of Capital Theory, which is perfect because ironically it confirmed my thesis. In response to this article I wrote:

Robert Murphy’s Sushi is actually a perfect example for what I propose to call the consumption business cycle. In his example, more resources are allocated to the production of consumer goods (gathering rice, catching fish), and fewer are being allocated to the upkeep of capital goods (maintenance of boats and fishnets).

During the equilibrium state 25 people were employed in the capital goods industry. After Krugman’s advice it’s only 10 people, out of which only 5 perform the criucial task of boat maintenance. He perfectly explains the phenomenon of increased consumption and corresponding production of consumer goods, but it does not occur due to a channeling of resources away from short term projects toward longer term projects. In fact, it occurs due to the exact opposite. Resources are taken from projects that yield an output at a later point in time (maintaining boats), and are directed toward projects that yield an immediate output (collecting rice, fish, and combining the two).

The Austrians’ focus on the capital-goods industry is simply based on the fact that the capital-goods industry is usually hit worse than that of consumer-goods. At the end of the boom stage, ventures that were once considered profitable are found to be unprofitable. There is a sudden decrease in investment. Capital-goods which were manufactured for new investment projects are suddenly found unused, as businesses are no longer willing to risk investment.

But please, look around you. Do you think this crisis primarily came about due to an overhang in the production of industrial robots, unfinished production facilities, an excessive number of energy plants, oil rigs, and the like? Is this what you see when you walk through the streets, look at the news, read the papers?

Isn’t it rather obvious that we are primarily faced with a massive overhang in consumer goods, such as houses, cars, strip malls, Starbucks branches, nail salons, beauty salons, energy drinks, shampoos, fast food stores, kitchen appliances, flat screen TVs, etc. ?

Isn’t it, furthermore, obvious that we have, at least as a tendency, lost most of our productive capacity to foreign countries, precisely because we have neglected it relative to consumer goods?

You can change reality by squeezing it into a concept that doesn’t apply to what actually happened. But then you have done just that: You have changed reality. The purpose of scientific discourse, however, is to interpret reality, not to violate it. :)

This may come about due to an increase in the interest rate, or because it is a time of uncertainty (a more likely explanation for the current recession, given that interest rates are still near zero).  A drop in demand for consumer-goods necessarily follows. There is an increase in frictional unemployment, as workers which once labored in the capital-goods industry must find employment elsewhere (Rothbard, America’s Great Depression, p. 21).  Also, a degree of economic uncertainty contributes to an increase in the rate of savings, and households are forced to save due to an increase in household debt during the boom years (credit was easy to access, allowing households to spend beyond their paycheck).  Rothbard writes in America’s Great Depression:

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 higher order goods, and this in turn is caused by the shift of demand back to the old proportions (Rothbard, 19).

As can be seen the Austrians do not claim that during a credit boom there is a lack of increase in the demand for consumer goods.  In actuality, the claim is the exact opposite.  Austrians criticize the simultaneous increase in demand for capital and consumer goods, given that they believe that true economic growth is brought about through capital accumulation, or savings.

And again, this completely misses the point. I never said that the Austrians claim that there is a lack of increase in the demand for consumer goods. I said that the conventional ABCT, as even admitted by Rothbard himself, was not conceived to explain an expansion of consumption credit and the ensuing tendency in the economy to produce relatively more consumer goods than capital goods.

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