Thoughts after reading Paul F. Cwik’s piece Austrian Business Cycle Theory: A Corporate Finance Point of View” and looking over his Ph.D. dissertation ” An Investigation Of Inverted Yield Curves And Economic Downturns.” Econtalk podcasts with Pete Boettke and Don Boudreaux also influenced this piece.
The Austrian Business Cycle Theory (ABCT) explains the boom and bust of the market economy. The Austrians highlight monetary policy-primarily the artificial expansion of credit- as the reason for the boom and bust; Murray Rothbard, one of the intellectual titans of Austrian economics, has said that such actions by central bankers lead to a cluster of errors in the business cycle, and ultimately put the economy into recession.
Recessions most often occur, according to the ABCT, because a distortion in the money supply creates a distortion in the relative prices of goods. Resources shift accordingly because it looks (to the naked eye) as if there is an underlying change in the economy.
Central bankers give artificially created money (ACM) to banks. In so doing, they inflate the currency; this leads to a decrease in short-term interest rates. As interest rates decline, investments that hitherto looked unprofitable begin to look worthwhile because the cost of investing (which is affected by the interest rate) has declined.
Since Mises and Hayek, Austrians have focused on how the price of time, i.e. how interest rates, affects the economy. Hayek theorized that money was an all important part of the business cycle because it affected the entire economic system.
In other words, it had system-wide implications. If the money supply increased, interest-rates system wide would decrease. This would lead to a system-wide distortion of investments and create a boom and bust cycle.
Austrians believe the coordination of resources is central to economic stability. But resources don’t coordinate automatically. Entrepreneurs and investors rely on nominal prices to understand where the market is and where it is going. Nominal prices, in other words, shape economic coordination.
But what if those nominal prices get out of whack? That’s what Austrians fear. As George Mason University economist Don Boudreaux says: individuals “don’t look out in the world and see the real underlying economic phenomena. [The] Window of economic prices [i.e. nominal prices]…is a cloudy window.”
The injection of ACM makes things murkier for individuals trying to get a sense of the economy. The ACM will hide things and lead to mal-investment. That is, good money chases bad investments because the ACM has lowered interest rates.
Things seem fine during the boom period, but the boom is unsustainable because ACM will not last forever. Austrians emphasize the lag time that takes place from when ACM enters the system until inflation comes about. Printing money doesn’t devalue the currency overnight and neither consumers nor investors will see an increase in price in the near term.
The boom is fueled by consumer spending and excessive investment. Unfortunately, the capital needed to sustain investment projects runs out (if it was ever there to begin with) because individuals have the incentive to buy now rather than save for later. Individuals over-extend themselves during the boom; when the ACM stops entering the system, people realize that interest rates will rise and the cost of things will increase.
Austrians say this time is a self-correcting one in which mal-investement is liquidated because investment plans are unsustainable. This will take time and some sectors (notably the financial sector and economically productive sectors) will suffer economic losses. But this time-in which recession occurs-is necessary for individuals to move their resources back to the margins and look for more profitable investments. This is a time when supply will once again get in sync with demand.
This self-correcting time is called a recession. Economists have tried to understand what puts an economy into recession for centuries. Since the 18th century, Austrians have argued that recessions are caused by mal-investment. Jean-Baptiste Say, an intellectual progenitor of the movement, argued that market disequilibrium took place when the proportions of supply/demand were out of sync. This reflected mal-investment in the economy and led to a slowdown in the business cycle.
The Austrians’ critics-the Malthusians in the 19th century and the Keynesians in the 20th century- claimed that recessions resulted from an absence of aggregate demand in the economy and that excessive supply (a glut of goods) was to blame for the economic slow down. To them, supply and demand were separate entities. Demand must be pumped back into the economy for growth to occur.
Austrians disagreed. They maintained that supply and demand were inter-related, a position articulated by Benjamin Anderson in his 1949 work Economics And The Public Welfare: “every commodity is either a supply of its own or a demand for other commodities.”
Laissez-faire was seen as the key to economic prosperity When the economy soured, Austrians insisted that government should stay out of the economy. They claimed that the mal-investment which had occurred would be liquidated, new capital formations would take place, and the economy would pick up again.
This view remained widely accepted until the Great Depression. Then, the interventionist ideas first promulgated by Thomas Malthus came back into fashion.
Why did that take place? The neo-Malthusian prescriptions provided a specific plan to get people back to work and promised to get the economy moving again. John Maynard Keynes articulated these ideas persuasively and his General Theory claimed the public sector could manage the business cycle and create full employment.
With massive unemployment around the globe, people were willing to take Keynes at his word. He had a plan and the articulate, erudite British economist charmed people around the world with his “revolutionary” General Theory.
The Austrians failed, according to Professor William L. Anderson, because they continued pushing laissez-faire when the global economy was in depression and millions were out of work. In other words, the Keynesians won the public relations battle over mal-investment liquidation.
Mal-investment liquidation plays a critical part in helping the economy recover; that point cannot be emphasized enough. Companies need this period to get rid of their bad investments and build up their capital formations in order to invest in new things and start growing again. This was a time to re-organize and get investment and production patterns in line with consumer demand.
Interventionists insisted that mal-investment liquidation led to under-consumption in the economy and created a demand-deficiency. They called for governments to pump money into the economy through fiscal policy (deficit spending) or have central banks print money and inject ACM into circulation.
These policy prescriptions horrified Austrians. They believed this would either exacerbate a recession or lead to an unsustainable recovery, marked by the boom-and-bust cycle.
Government policy, according to the Austrians, should encourage capital formation and should not interfere with the price adjustment which took place as businesses were liquidating their mal-investments. Nor should it re-inflate the money supply. Only real savings-not inflated ones-would shorten the length of the recession and lead to real, sustained economic growth.
So what should government do in the midst of recession? It should cut taxes on the rich. The wealthy would use their tax rebates to invest back into the economy, prompting the capital formation needed for investment and growth.
Unfortunately that’s not what governments do. They attempt to use fiscal and monetary policy to stimulate demand in an ailing economy. In other words, they follow the Keynesian play-book.
Keynesians like to brag about their triumphs. They point to deficit spending getting the United States out of the Great Depression. They highlight President Obama’s stimulus plan which took an economy that was falling off a cliff when Mr. Obama assumed office in January 2009 and was out of recession by the middle of that year. These interventions show that deficit spending has worked in the past and will work in the future.
Let’s accept this premise. Government stimulus “worked” and the economy came out of recession because of deficit spending. The ATBC would caution those enthusiastic about the “economic growth” that came after the recession ended and warned that this “growth” likely occurred because intervention had launched a boom-and-bust cycle.
This began with QE, an attempt to inject liquidity into the market by printing money.This will stimulate demand; Paul F. Cwik notes: “with the decline in short rates, the cost of financing short-term consumer purchases (with credit instruments such as credit cards) falls. Thus, an immediate result of the monetary injection is an increase in demand for consumer goods.”
Low short-term interest rates reward spending now. Products are cheaper if you buy today than they would be if you bought tomorrow. And sentient individuals-from consumers, to entrepreneurs, to businesses, and corporations- realize this and start spending their money rather than investing it for the future.
Millions of people do so. These individual decisions drive up the cost of things over time. During this period, individuals deplete their savings because they are using their capital to buy now.
This will get the economy going in the short-run, but fears of inflation will develop over time. The central bank will respond by hiking interest rates, putting the breaks on an economic recovery. This is called the Fischer effect, a move that crunches credit in an attempt to combat inflation. Increased interest rates will create tremendous demand for short-term treasuries.
More often than not, firms without investment grade bonds (often small businesses) will look for short-term credit options to finance their investments. When hundreds/thousands of individual consumers/entrepreneurs/small businesses do so, the demand for short-term loans (referred to as yield) will begin to steadily rise.
Over time, the yield curve will start inverting. An inverted yield curve signals that short-term rates are higher than long-term rates. For instance, the rate on a 6 month treasury would spike to 4% while the rate on a 10 year treasury would remain steady at 3%. The inverted yield curve usually means a recession is right around the corner.
Paul F. Cwik argues that inverted yield curves were a reflection of mal-investments. His doctoral dissertation (which studied this problem) concludes: “when short-term rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted.”
An inverted yield slope is an anomaly. The longer the treasury note, the greater yield one would expect to earn. That is reflected in a normal yield curve, which is shown with an upward slope. Inverse shields, on the other hand, show a downward slope.
Cwik’s research suggests that an inverted yield curve means that a recession is coming in the next four or five quarters. His dissertation notes: “an inverted or humped yield curve has occurred no more than 5 quarters before every recession since the mid-1950s. Except for the Q3: 1990-Q:1 1991 recession, the yield curve has inverted in every recession since the 1960s.”
Austrians know how to fix an inverted yield curve: Let the mal-investment liquidation begin. Keep government out of the economic “recovery” and yield curves will begin to normalize. A recession is necessary because companies need this time to rid themselves of bad investments and build up their capital formations, so that they can begin growing again. It is a time to re-organize and get investment and production patterns in line with consumer demand.
Put more simply: laissez-faire. Let new capital formations develop. Allow real savings to occur. Then watch the economy grow again.
 My next piece on Austrian Economics will focus on the Austrian Capital Theory.