Austrian Business Cycle Theory: A Brief Explanation
by Dan Mahoney
http://mises.org/story/672

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 is property, 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.