Presenting Capital-Based Macroeconomics, An Overview Of The Austrian School And The Business Cycle

The recent surge in the prominence of Austrian economics is no surprise: with Hayek's Road to Serfdom recently becoming Amazon's most popular book, it is more than evident that more and more Americans are, if not converting away from Keynesianism (because it truly is far more a religion, and a flawed one at that, than an economic theory - after all any 'theory' that has been disproved as many times as John M. Keynes' mutated Frankenstein monster would have long been set to rest on the trash heap of failed social inventions) then certainly looking at far more plausible alternatives. Of which the Austrian school of economics is certainly one. For all those who are still confused about the far more rational and sensible approach of Austrian theory and Capital-based macroeconomics, the attached 50 minute presentation by Robert Garrison is a must watch.

And for those who wish to read more, courtesy of Mises, here is a detailed explanatory primer on Austrian Business Cycle Theory.

Austrian Business Cycle Theory: A Brief Explanation

Mises Daily: Monday, May 07, 2001 by Dan Mahoney

The media’s favorite phony solution to the economic downturn is for
the Fed to drop interest rates lower and lower until the economy
registers an upturn. What is wrong with this approach? Printing
money—which is what reducing interest rates below the market rate
amounts to—is an artificial means of recovering from the very real
effects of an artificial boom. This point, however, is completely lost
on most commentators, because they haven’t the slightest understanding
of the Austrian theory of the business cycle.

This article gives a brief overview of the theory, which provides an
explanation of the recurrent periods of prosperity and recession that
seem to plague capitalist societies. As Salerno (1996) has argued, the
Austrian business cycle theory is in many ways the quintessence of
Austrian economics, as it integrates so many ideas that are unique to
that school of thought, such as capital structure, monetary theory,
economic calculation, and entrepreneurship. As such, it would be
impossible to adequately explain so rich a theory in a short note. (See
Rothbard [1983] for greater details.) However, an attempt will be made
here to indicate how those relevant ideas come together in a unified
framework.

Man is confronted with a world of physical scarcity. That is, not all
of our wants and needs, which are practically limitless, can be met.
Outside of the Garden of Eden, we must produce in order to consume, and
this means that we must combine our labor with whatever nature-given
resources are available to us. As inherently rational beings, men have
come to recognize many ways of solving this problem, such as peaceful
cooperation under the division of labor leading to enhanced
productivity, and private property rights permitting economic
calculation so that different courses of action can be meaningfully
compared.

(This is not to say that man has perfect foresight and always
correctly anticipates the outcome, good or bad, of his actions; only
that man acts purposefully—and so always judges ex ante a course of
action to lead to a preferred state of affairs—and is capable of
distinguishing success from failure and acting accordingly.)

However, it would help to consider the course of economic development
from a simplified example, that of an isolated “Robinson Crusoe”
situation. The circumstance faced here is that one must somehow combine
one’s labor with available resources to produce goods for consumption
(e.g., food, shelter, etc.). For example, I can pick berries by hand,
and this will produce a certain level of consumption. However, if I wish
to have a greater level of consumption, I must create some means of
increasing my berry collecting—for example, by building a rod to knock
berries from bushes and a net to collect them as they fall to the
ground.

Unless these means are nature-given, however, I must build them
myself, and this will take time—time during which I cannot pick and
consume berries with my old method. Thus, during the time I am making my
new, presumably more efficient, method, I must have some way of
sustaining myself. This can only come about if I have saved (i.e.,
abstained from consuming) a sufficient amount of berries in the past, so
that I may work on other approaches now. (For more on this process, see
Rothbard [1993], ch. 1.)

Let us be clear about what is happening here: One is not simply
switching from consumption to production; rather, one is switching from
one form of production to another. One cannot consume something until it
has been produced, so all production processes involve foregoing
consumption. The question, though, is what must be done to switch to a
supposedly more effective means of production.

Obviously, if the rod-and-net system, presumably more productive, had
required the same amount of time to construct as the hand-picking
method, I would have engaged in this approach to begin with. Since
acquiring the increased productivity comes with a cost—namely, time
spent away from using the old method to facilitate production and, thus,
consumption—there must be some means of paying that cost.

Of course, not all lengthier production processes are more
productive. But at any given time, man always chooses those production
processes that can produce a given amount of output for
consumption in the shortest amount of time. A process that takes longer
to arrive at the final stage of output will only be adopted if it is
correspondingly more productive. In the Austrian conception, greater
savings permit the creation of more “roundabout” production
processes—that is, production processes increasingly far-removed from
the finished product. This is the role of savings, and we can ask what
determines a particular level of savings.

Time preference is the extent to which people value current
consumption over future consumption. The key point of the Austrian
business cycle theory is that interventions in the monetary system—and
there is some debate over what form those interventions must take to set
in motion the boom-bust process—create a mismatch between consumer time
preferences and entrepreneurial judgments regarding those time
preferences.

Let us return to the Crusoe example above, and consider attempts to
construct more productive means of berry extraction. What constrains me
in this endeavor is my level of time preference. If I so enjoy current
consumption that the thought of increased future consumption cannot sway
me from foregoing sufficient berry-eating now, my rod-and-net system
will not be built. In the context of fractional reserve banking,
printing up berry-tickets cannot change this fact.

As a numerical example, consider the case where hand-picking yields
twelve berries a day, and I am simply unwilling to go without less than
ten berries per day. Suppose further that my time preference falls so
that I am willing to save two berries a day for seven days (leaving
aside issues such as perishability, which obviously do not apply to a
monetary economy). I will then have a reserve of fourteen berries.
Assume I work one-fourth of a day on my new method of berry production
and spend the remaining three-fourths of the day on producing berries
with the old technique. The old method will give me nine berries a day,
and I can use one berry from my savings to meet my current consumption
needs.

If I can finish the rod-and-net system in fourteen days (the extent
of my reserve), then everything is fine, and I can go on to enjoy the
fruits of my labor (no pun intended). If I misjudge however, and the
process takes longer than fourteen days, I must temporarily suspend
production (or at least delay it) to fund my current consumption, as, by
assumption, I value a certain level of current consumption over
increased future consumption (the essence of time preference). The point
is, sufficient property must exist for me to lengthen the structure of
production, and this property can only come from (past) savings. If my
time preference does not enable sufficient property to become available
for creating this production process, my efforts will end in failure.

Lest it be thought this example is artificial, consider the situation
where my needs are nine berries a day. It would appear that I can still
work one-fourth of a day on the new technique without having a previous
cache of savings, since the remaining three-fourths day of labor with
the old method will meet those needs. Two things should be noted,
however. First, my time preference must first fall from a daily
consumption of twelve berries to nine berries. Second, and this is the
key point, had I saved previously, then I could spend that much more
time on building the new method, thus bringing it into increased
production of berries that much sooner. Savings remain key to this
process of capital construction, and savings are driven by time
preference. Indeed, time preference manifests itself in savings.

This same process of using savings to fund current production for
future consumption goes on in more complex economies. (Of course, with
the introduction of more than one individual, recognition of increased
productivity under the division of labor becomes possible, thus raising
man above the subsistence level and making possible a pool of savings.)
At any given time, the individuals in society are engaged in production
to meet some “level” of consumption needs. In order for more
lengthy—and, hence, if they are to be maintained, more
productive—processes to be entered into, it is necessary that some
individuals have refrained from consumption in the past so that other
individuals may be sustained and facilitated in assembling this new
structure, during which they cannot produce—and thus, not
consume—consumption goods with the methods of the old structure.

The thrust of the Austrian theory of the business cycle is that credit inflation distorts this process, by making it appear
that more means exist for current production than are actually
sustainable (at least in some renditions; see Hülsmann [1998] for a
“non-standard” exposition of ABCT). Since this is in fact an illusion
(printing claims to property ["inflation"] is not the same thing as
actually having property; see Hoppe et al. [1998]), the endeavors of
entrepreneurs to create a structure of production not reflecting actual
consumer time preferences (as manifested in available savings for the
purchase of producer goods) must end in failure.

Any kind of economy above the most primitive does not, of course,
engage in barter, but rather uses money as a medium of exchange to
overcome the problem of the absence of a double coincidence of wants. It
must be stressed, though, that apart from this unique role, money is
itself a good, the most marketable good. To be sure, money is valuable
to the extent that others are willing to accept it in exchange. However,
money itself must first have originated as a directly serviceable good
before it could become an indirectly serviceable good (i.e., money).
This is the thrust of Mises’s regression theorem (Mises [1981]; Rothbard
[1993], ch. 4).

Like any other exchange, one may find after the fact that it was not
to one’s liking; for example, one may find that the money good is no
longer accepted by “society.” There is nothing unique about money in
these respects. What is unique about money is its use in economic
calculation. Since all exchanges are, ultimately, exchanges involving
property, a common unit for comparing such exchanges is indispensable.
In particular, the amount of money as savings represents a “measure” of
the amount of property available for production processes. (Indeed, to
even maintain a given structure of production requires some abstinence
from consumption, so that production dedicated to maintenance instead of
consumption may be undertaken.)

Holding cash (in your wallet, in a tin can in the backyard, etc.) is
not a form of saving. Cash balances can increase without time
preferences decreasing, as they do when one saves. (In fact, one saves
because one’s time preference falls.) One can increase one’s cash
balances by decreasing one’s spending on consumer AND producer goods. To
save is to decrease one’s spending on consumer goods and increase one’s spending on producer goods.

The fact that saving usually involves an intermediary (i.e., a bank)
to permit someone else to spend on producer goods does not change this
fact. Money is inherently a present good; holding it “buys” alleviation
from a currently felt uneasiness about an uncertain future. (See Hoppe
[1994] and Hoppe et al. [1998] for a discussion of the nature of money.)
Lending out demand deposits, or claims to current goods, cannot
facilitate the purchase of producer goods (for the creation of future
goods at the expense of current goods), apart from the juridical issues
involved.

The crucial thing about money is that it permits economic
calculation, the comparison of anticipated revenues from an action with
potential costs in a common unit. That is, one acquires property based
on a judgment of the future by exchanging other property, and this is
impossible—or, rather, meaningless—to do without a common unit for
comparing alternatives. Money isproperty, and under a monetary
system which makes it appear that more property exists for production
than actually exists, failure is inevitable.

One need not focus on whether entrepreneurs correctly “read” interest
rates or not. Entrepreneurs make judgments about the future and, of
course, can always potentially be in error; success cannot be known now.
However, judgments will be in error when one is confronted with the
illusion of a greater pool of savings than actual consumer time
preferences would justify. This is precisely the situation established
by the banking system—as intermediaries between savers and producers, or
“investors”—as currently exists in the Western world. The system
ensures error, though of course it does not preclude success; thus, the
existence of genuine economic growth alongside malinvestments.

This analysis is not a moralistic insistence that an economy be
ultimately founded on something “real.” It is a recognition that mere
subjective wants cannot will more property into existence than actually
exists. Should a monetary system give the illusion that the time
preferences of consumers, as providers of property for production
purposes, is smaller than it actually is, then the structure of
production thus assembled in such a system is inherently in
error. Whatever plans appear to be feasible during the early phase of a
boom will, of necessity, eventually be revealed to be in error due to a
lack of sufficient property. This is the crux of the Austrian business
cycle theory.

h/t Fascist Soup and Michael

Comments

[phaesed]

Nice to see Garrison get the credit he deserves, his work is vital to the evolution of Austrian economics back to what Hayek envisioned.