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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15 thoughts on “The Austrian Business Cycle Theory – Insufficient (but NOT Wrong) at Explaining the Current Financial Crisis”

  1. Yes, you are correct in point out what the ATBC does and does not cover, and in explaining why the original author is wrong. However, I fail to see the relevance of employment number in your rebuttal. Lastly, other theories explain the massive demand for consumer goods, in particular, the extremely durable good that is housing. Tom woods in his book Meltdown explains where the money or credit for the housing bubble came from, but he also explains why that money of credit went to housing.

  2. Well, regarding employment: you don’t think the necessity to shed a huge number of jobs gives you a good first impression as to how well a particular industry is currently doing?

  3. Housing can be considered a higher order good, not a lower-order consumer good. It can also be considered an investment, since it will require a higher rate of savings and the use of loans to pay off. There was a discussion on how the classical ABCT applies to housing on the forums:

    As such, housing is a perfect example of how the capital-goods industry was hit a lot harder than the consumer-goods industry. One of the major problems that seem to exist is a lack of understanding of what constitutes the lengthening and widening of production, and what constitutes a consumer-good.

  4. A house purchased for the sake of living in it is absolutely NOT a capital good. Neither does it turn out any consumer goods in the future, nor does it help us bridge any production processes. In fact, it does the exact opposite. It requires more maintenance throughout the period of ownership, thus withdraws even more resources without contributing to any increased production. I could point you to Mises’ definition of capital goods:

    “At the outset of every step forward on the road to a more plentiful existence is saving–the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e. tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods.”

    I am guessing by your definition, if I buy a Porsche Boxter on credit to cruise around in the city, this would also constitute a capital good because “it will require a higher rate of savings and the use of loans to pay off”?

    And I guess if I buy a Maybach I am buying even more of a capital good, and am even more contributing to a shortening of the production period?

    And what if I buy a lifelong membership to a Luxury Spa, pay everything upfront, but do this by obtaining a loan? I guess this would also be a capital good by your definition?

    What about the fact that the purchases and sales of capital goods are actually relatively increasing to those of consumer goods during the current crisis? (see my chart) How do you explain that?

  5. @Nima
    Yes, it is probably necessary to shed jobs but it wouldn’t necessarily be in proportion to the capital malinvestment in the industry. That is to say that I think it is possible for consumer goods industries to proportionally shed more jobs than the capital goods industries during the correction, although the capital malinvestment was heavier in the capital goods industry. Anyway, the ATBC doesn’t cover this, and as you’ve said, doesn’t want to cover it.

  6. @Nima
    Of course, buying a house to live in it is not a capital goods, however, buying a house to flip it, or hold on to it for a couple years until it appreciates, does render a house a capital goods. The point is that you cannot determine whether a good is a capital good or a consumer good simply by looking at it. Instead, what determines its status are the intention of the owner. I’m sure you already knew this, but I figure I’d point this out for clarification since a hell of a lot of people bought houses as capital goods.

  7. But when I buy something, thinking it is an investment, it doesn’t automatically make it a capital good. If suddenly everyone were to buy tomatoes because they think they will appreciate in 2 years, and the entire economy is aligned to produce nothing but tomatoes, does this mean we will have an overhang in capital goods?

    Your point, I believe, is a different one. The same good can be now consumer good, now capital good, based upon its actual use. A pickup truck can be used to drive around visit friends, etc, consumption, but it can also be used to transport logs from the forest to a wood chopping hut, production.

    Whether or not a good qualifies as a capital good depends in what it is USED for, not what fantasy someone conjures up in his mind: A house that someone buys to occupy is just that , a house that he lives in, a shelter for him and his family, nothing more, nothing less. Whether he believes it or not is immaterial to the praxeological role that the house plays in the economy.

  8. If a house is used to allow a laborer to survive the elements, then that house is a capital-good. It is a capital-good which allows the laborer to go to work the next day to provide a consumer good or service. Nobody buys a house “just to occupy”; there is a rational reason why they are occupying that house, and most of the time it is to allow them to continue working. It is the same reasoning for buying an automobile, which a consumer-good farthest that is farthest away from present-consumption. That brings up another valuable point. The fact that a house requires a lot of savings in order to pay off, by putting off present goods, means that it is an investment that is farthest away from the consumer.

  9. “If a house is used to allow a laborer to survive the elements, then that house is a capital-good. It is a capital-good which allows the laborer to go to work the next day to provide a consumer good or service. Nobody buys a house “just to occupy”; there is a rational reason why they are occupying that house, and most of the time it is to allow them to continue working.”

    Please ask around. Ask people you know who bought a house if they bought it so they could escape the state of inability to survive the elements, and to continue working, if that was their reason. No, it is actually very simple, people do buy residential homes “just to occupy” them. And the desire to occupy a home, and the subsequent purchase of it, are very rational actions. You seem to be implying that they are not.

  10. @Nima
    Yes, that is what I meant. In retrospect, I should have said “actions” instead of “intentions”. Thank you for the correction.

  11. It seems to me that the problem here is that your concepts of “capital goods” and “consumer goods” are different than the majority of Austrians. “Strip malls, nail salons, beauty salons, Starbucks cafes, and the like” are all capital goods. The lattes, french manicures, and haircuts that these places specialize in are consumer goods. Rothbard was correct when he said that we don’t have to worry about too many double mocha frappuccinos. What we worry about is Starbucks deciding to open another location or higher more workers (which are also considered capital goods btw). Let’s look at an example.

    Say that banks are creating money out of thin air and giving it out as loans. The consumers who get these loans decide to buy Starbucks coffee with the money. Because the demand has increased for the coffee, we know (from supply and demand) that the price of the scarce coffee will go up. This could be considered a “coffee bubble”, but when this “coffee bubble” pops all that will happen is that prices of coffee will go back down to their original levels. No problem. Starbucks adjusts their prices accordingly and everything hums along smoothly.

    Now say that Starbucks misreads the increase in demand as genuine instead of a bubble. Meaning they believe that people actually want to spend more money on coffee, and not just that people have a lot of cheap credit burning a hole in their pockets. Starbucks may decide to hire more people to cope with the increased demand, they might open another location to take advantage of untapped markets, or they may begin buying twice as many coffee beans so they won’t run out. These would be investments in capital goods. Now, when the dreaded “coffee bubble” pops because the banks stop their loose lending practices, Starbucks will find that it cannot afford to pay those extra employees, keep open that extra store, or use all the coffee beans they bought. These investments went bad so to speak.

    Note that if Starbucks didn’t increase their investments in capital goods then everything would have been relatively fine when demand returned to its previous pre-bubble levels just as Rothbard states. By not increasing investing in capital goods it could be said that they were “leaving money on the table”, but in reality is was fake, inflationary money so that isn’t really a bad thing.

    It is true that if you consider a new Starbucks store a consumer good then it would appear that there was an increased investment in consumer goods and the ABCT would appear to be lacking an account of this. But this is just an illusion because what you think is a “consumer good” is actually a “capital good.” You see, you just have a different idea of what constitutes a “capital good” and what constitutes a “consumer good.” There is nothing wrong with this per-say but you need to understand what you are really presenting is a semantics argument. If you feel that the term “capital good” is too ambiguous then feel free to argue for a new one. It doesn’t throw into question the soundness of the ABCT however.

  12. “What about the fact that the purchases and sales of capital goods are actually relatively increasing to those of consumer goods during the current crisis? (see my chart) How do you explain that?”

    The only chart that I see is the one showing “US True Consumption as % of GDP” so this must be the one you are referring to. This chart is in no way showing a comparison between consumer and capital goods. This chart shows the comparison between savings and consumption, not capital spending and consumption spending. You cannot use it to prove what you are trying to say.

    Savings is NOT capital spending. Savings can lead to capital spending but doesn’t necessarily have to, especially when the central bank has artificially low interest rates and a fractional reserve banking system. In this case the spending can be created out of thin air by inflationary money creation.

    All that chart shows is that the U.S. is saving less and consuming more. It gives us no information on capital goods vs consumer goods.

  13. @Jonathan Finegold Catalán

    So I explained to you why a house is not an investment good, but a consumer good. Let’s say that in spite of this continue to disagree on that point. Fine. Let’s assume, just for the sake of your argument, that a house is an investment good, and look at the corresponding data. This chart shows only purchases of private consumer goods (EXCLUDING residential investment) vs. ALL other components of GDP:

    See? Even if we made the most favorable assumptions to support the conventional ABCT as an explanation of the recent crisis, the numbers STILL wouldn’t add up …

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