In today’s work from Robert Wenzel’s 30 day reading list, “Economic Depressions: Their Cause and Cure,” Murray Rothbard explains the business cycle. He first provides a critique of the “New Economics,” or Keynesian understanding of the boom-and-bust cycle, and then presents the Austrian Business Cycle Theory (ABCT).
Rothbard presents three fundamental flaws in the Keynesian viewpoint, which fails to accurately pinpoint the real cause of economic depressions. They are as follows:
1. “[T]here is nothing in the general theory of the market system that would account for regular and recurring boom-and-bust phases of the business cycle.”
He explains that most Keynesian economists separate their theories for how prices form and how the market functions into one theory and in a separate theory explain business cycles. This allows them to hold contradictory views regarding how the economy functions and what should be done to relieve depressions, recessions, and downturns. The Austrian however understands that “knowledge of the economy is either one integrated whole or it is nothing.”
2. “The market economy […] contains a built-in mechanism, a kind of natural selection, that ensures the survival and the flourishing of the superior forecaster and the weeding-out of the inferior ones.”
In other words, the market economy relies on the profit and loss test and in order to survive, firms must endure this constantly to remain in business. What allows them to survive is successfully forecasting the needs and wants of consumers and being able to provide the goods and services that are in demand at the appropriate time. Since many firms do manage to accomplish this, it seems odd that from time to time all or most of these profitable firms find themselves on the verge of bankruptcy at roughly the same time.
Keynesians don’t have a sufficient answer for this, since their typical explanation is a lack of aggregate demand, or under consumption. But a lack of aggregate demand shouldn’t lead to such devastating losses in a group of the best entrepreneurs, and especially not in such a systematic fashion. Something else must account for this phenomenon.
3. “Invariably, the booms and busts are much more intense and severe in the ‘capital goods industries…’”
If under consumption were to blame for the depressions, it follows that the producers of consumers’ goods would be the first and hardest hit, rather than those making higher order goods, which are the ones used to produce final goods. But, just the opposite happens. Rothbard asks if “insufficient spending is the culprit, then how is it that retail sales are the last and the least to fall in any depression, and that depression really hits such industries as machine tools, capital equipment, construction, and raw materials?”
He also notes that it is these industries which see the highest growth in investment during the boom phase of the cycle. Consider the last two major credit bubbles: the bubble in tech stocks a decade ago and the one in housing shortly after. Both bubbles were in industries that supplied capital goods – web space (capital equipment) in the former, and construction in the latter.
Before moving into the ABCT, Rothbard briefly explains fractional reserve banking, and how together with a central bank, the two set the stage for boom-and-bust cycles. He provides an example using a hypothetical credit bubble induced by inflation of the money supply, followed by a contraction and ultimately a bank run.
In essence, banks hold currency (generally gold and silver) and issue paper notes as claims on that currency. The notes can then be used to redeem the specie on demand, but often are used as money in everyday transactions. Banks then issue loans with the deposited funds to investors or consumers, such that more claims to gold or silver are in circulation than actually exist in the bank.
This all works so long as depositors trust that their money is secure in the bank and can still be redeemed. Meanwhile, the increase in available credit and demand deposits (which is inflation) bids up prices and leads to bubbles. Eventually the banks must contract the amount of money in circulation or risk a run; either case amounts to a deflating of the bubble and the bust phase of the cycle begins. Once the bust levels out and banks are comfortable again, the process resumes.
Rothbard is careful to note that such an arrangement as above is not the product of a free market. For all of the banks to inflate as they do in unison, there must be a central bank and government regulations that permit it. He also notes that it was “only when central banking got established that the banks were able to expand for any length of time and the familiar business cycle got underway in the modern world.” So rather than a structural failure in the market economy being the cause, it is the “systematic intervention by government in the market process” that leads to the boom and bust.
And here is where Rothbard introduces and details Ludwig von Mises’ Austrian Business Cycle Theory. Its foundations are in David Ricardo’s observation of the increase in money supply and credit leading to an inflationary boom. But Mises expanded on that analysis and noted that another effect was the lowering of interest rates below their “free market level.” This lowering of rates induces investment in capital goods in anticipation of a higher future demand that is, in reality, nonexistent.
This entire process can take years to manifest itself, all the while the boom persists for years, building slowly into a massive bubble. As long as the banks continue to inflate and the credit keeps coming the bubble will continue and prices will continue to rise as a result of the inflation. But once the inflation slows it all comes crashing down. The classic analogy is of a man who drank too much the night before and has the choice between a hangover and continued drinking. One is immediately painful but short-lived, while the other merely prolongs the ultimate consequence, and only makes things worse in the end.
So we see that Mises’ theory addresses each of the above problems that Keynesian economists fail to answer. The business cycle occurs regularly due to fractional reserve banking enabled by central banks; the natural selection of the market is interrupted and distorted by the manipulation of credit, and entrepreneurs are deceived as to the realities of consumer demand; and the capital goods industries take the brunt of the depressions because lower interest rates induce those firms to invest in new capital more so than in other sectors of the economy.
Lastly, Rothbard gives advice on what should be done to relieve current booms and prevent future busts. His recommendations are: immediately stop inflating, for this is what brings on the cycle and allows bubbles to expand; do not bailout faltering businesses because it prolongs and worsens the depression by propping up failed ventures; do not prop up wages or prices, don’t spur consumer spending and reduce government expenditures. In short, do nothing but allow the market to re-equilibrate.
Basically governments should do exactly the opposite of what has been done for the past four years. Interest rates have been lowered to practically zero through inflation; consumers have been incentivized to buy cars, houses, refrigerators, replacement windows and a whole host of other products; banks, insurers, car manufacturers, energy companies, and entire countries have been bailed out; minimum wage laws have increased, new insurance mandates have been implemented, and government spending has never been higher. And yet, little has really improved.
Mises predicted the crash of 1929 years before it happened, as did a number of Austrians in the years preceding the housing crash, notably congressman Ron Paul. In fact, Austrian economists have a pretty good track record in warning about problems in the economy. It’s high time more people started listening to their warnings and quit paying any attention to the Keynesians who’ve not only been clueless as to the cause of all this malaise, but are promoting the very policies which lead to and prolong depressions.