The Austrian Business Cycle: Part 1

Classical economics understood the broad economy as generally falling under three distinct markets, those being the labor, goods/services, and money markets. If one of these markets fell out of step, then the other two would follow, leading to disequilibrium outcomes. However, under generally free market conditions, these three markets should also be able to fall back in sync without outside intervention and restore equilibrium conditions.

The cycle of disequilibrium and equilibrium is most often referred to as the Business Cycle, and until John Maynard Keynes published his General Theory, it was understood that the free market was capable of insulating the shocks and managing the equilibrium states of these markets most efficiently. The foundation for this understanding was centered around Say’s Law, which essentially states that production precedes demand. In other words, the economy is driven by people producing goods and services in order to either trade for other goods and services or receive income that can then be spent on other goods and services.

This is very distinct from the modern understanding of the factors that drive the economy (which trace their origin to Keynes). Today, economists tend to believe that spending is the relevant factor for economic performance, and gluts in production (products of a bust in the business cycle) have to be addressed with more spending. The only way this can be the case is if Say’s Law is not true.

Turning back to the business cycle, questions arise as to the causes behind it. It is generally accepted that the first/main market of the three relevant economic markets to go out of sync is the money markets (comprised of investment, savings, interest rates, etc.). Once the money markets crash, the goods and services markets fall out of sync, leading to layoffs and restructuring of firm employment in the final labor markets. Keynes promoted the idea that the money market was prone to disequilibrium due to the inherent irrationality of investors. The idea of animal spirits and the subsequent terminology for Bull and Bear markets can trace their origins here.

However, is it really the case that investors are irrational creatures, easily spooked by a change in the winds of fate, which causes inherent instability in the larger system? Praxeology would suggest otherwise. According to praxeology, a person behaves rationally when he is pursuing his goals through the best means available to his knowledge. If those means, in reality, are in fact suboptimal for achieving said goal, the person still using those means cannot be judged as irrational unless he is aware of this fact.

For investors to be irrational, as Keynes believes they are, they would have to be using their savings and funds in such a way that is knowingly suboptimal for gaining returns. This is unlikely, to say the least. However, we still observe the phenomena of business cycles, and if it is not due to the inherently irrational nature of investors, then what can it be attributed to? This is where the Austrian economists can provide some insight.

Money markets, like all markets, coordinate savers with borrowers through the use of prices. In this case, the relevant form of prices is the interest rate. Interest rates coordinate savings with investment through incentivizing appropriate behavior depending on the current rate, while simultaneously providing aggregated information about present and future consumption trends. For example, if interest rates are at a low level, this means that either the supply of savings is high, or the demand for loans is low.

In either case, it tells savers that the most efficient use of their savings and resources is more likely to be in present consumption rather than tied away in loans and investments. The same applies to high-interest rates. High-interest rates either mean that the supply of savings is low, or that the demand for loans is high. Regardless, this means that firms (generally the borrowers in this market) will put off long-term investment projects in favor of satisfying consumer consumption trends in the present since the interest rates are telling firms that consumers are keeping more money on the goods and services market than in the money market.

In cases of very high-interest rates, savers will respond by deferring current consumption (of non-essential goods first generally) in order to make gains from the higher interest rates, which over time will increase the supply of savings, reducing the interest rate. When interest rates are prolongedly low, savers will tend to pull their money out of savings and spend. This intricate process of resource coordination often works efficiently, given interventions into the market are prohibited or diminished. In the next blog, we will go over what happens when these observations fail to materialize, and the causes behind it.


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