Thursday, 16 February 2012

The flaws in Austrian Business Cycle Theory.

Austrian Business Cycle Theory (ABCT) consists of the following.

Fractional reserve banking allows commercial banks to lend at an artificially low rate of interest – a process which some Austrians claim is assisted by central banks. And that low rate of interest induces businesses to invest more than is optimum. At least that is what ABCT consists of to judge by this Wiki explanation, and these two von Mises explanations. See here and here.

The result is what Austrians call “malinvestments”, and so far so good. I.e. I agree with the argument so far. Indeed I argued that fractional reserve brings artificially low rates of interest here.

Moreover, the above Austrian argument could be STRENGTHENED by pointing out that it is not just BUSINESSES that invest too much: artificially low rates of interest also induce HOUSEHOLDS to invest more than is optimum in housing, cars and other “investment-type” consumer items. Certainly those who obtained NINJA mortgages were suckered into those mortgages by artificially low initial rates of interest or artificially low “repayment of capital” conditions.

Next, ABCT claims that the savings or resources to make the above malinvestments are just not there, particularly as the low interest rates will have induced less saving that would otherwise be the case. Thus the whole edifice supposedly collapses.

A fiat currency.

ABCT obviously works (or does not work) in slightly different ways depending on what monetary regime is involved. I’ll start with a bog standard 21st millennium economy and monetary set up: i.e. a fiat currency.

Assuming the economy is at full employment, the extra demand that that extra investment represents will result in excess demand which means inflation will start to loom. The relevant central bank / government will react by cutting demand (e.g. by raising taxes and/or interest rates), and that FORCES reduced consumption on the population at large.

Thus the Austrian claim that the resources are not there to bring about excess investment is not valid: the resources come from the above mentioned forced reduction in consumption.

An alternative to a fiat currency is a currency based on some commodity, like gold. But this makes little difference. Instead of inflation being controlled by governments and central banks, inflation is controlled by currency units being tied to gold. The result is the same as above: reduced consumption is forced on the population.

Inflation is not controlled.

Another possibility is that government / central bank FAILS to control inflation. Well in this case, those in possession of the extra money / credit created by banks simply steal purchasing power from existing holders of money (as indeed Austrians never tire of telling us). So here again, it is not true to say that the resources are not there to bring about the excess investment: the resources are effectively just stolen.

In fact, one of the above three explanations of ABCT is slightly different from the other two in that it claims the additional demand caused by banks’ creation of excessive credit / money results in inflation. Then, allegedly, when everyone realises the inflation will persist, panic sets in, as everyone tries to flee the currency and get into other assets, which exacerbates inflation still further.

That is certainly a plausible hypothesis. And certainly there is a hysteresis or “feed back” effect there. But it does not in practice seem to be a powerful effect: the rise in inflation in the 1970s did not lead to panic or hyperinflation. And where hyperinflation HAS taken place (Mugabwe, Weimar, etc), the prime cause was clearly irresponsible money printing.


Another flawed element of ABCT is thus. When the crash comes, according to ABCT, it allegedly takes a long time for the excess investments to be purged and replaced with more viable investments. This is nonsense and for several reasons, as follows.

1. The AMOUNT of excess investment is unlikely to be large for the simple reason that the EXTENT of interest rate reduction brought about by fractional reserve is small compared to the other costs involved in running a capital investment. To illustrate, in addition to interest rate charges, a capital investment involves writing off a portion of the investment every year – say roughly 10%. Plus there are other costs inevitably tied to any capital investment: energy consumption, repairs, etc: another 10%? In contrast, what is the extent of interest rate reduction brought about by fractional reserve? Impossible to say, but I’d guess one to four percent: that’s compared to the above 10 + 10 = 20%.

The latter 1 – 4% is also small compared to the loss or profit that can be made in individual investments. That is 30% p.a. losses or profits are common on individual investments.

2. The fact that an investment turns out to be excessive is not normally a reason to scrap the investment. It is near impossible to build a plant that is of EXACTLY the right capacity to meet demand over the next decade or so. Businesses never get this right. If a plant is 10% too large, it will just get run at 90% capacity. Indeed, the AVERAGE plant runs at only 80% capacity, or thereabouts.

3. Even if an investment IS SCRAPPED, what of it? The building, house, plant, etc can just sit there rotting away, or it can be bulldozed. That in itself does not stop those who were employed running the asset from finding alternative work. So the crucial question is whether those displaced from creating or running said assets can be easily allocated to other jobs.

Well the evidence seems to be, at least in the case of the current recession, that those thrown out of work in the construction sector (the sector most badly hit) have had no more difficulty finding alternative jobs than those in other sectors. See p.8 here and here.


I agree with the Austrian claim that fractional reserve brings an artificially low rate of interest. I agree that will probably tend to exacerbate economic instabilities. But the idea that fractional reserve is the FUNDAMENTAL CAUSE of instabilities or that fractional reserve is the basic cause of any sort of CYCLE is decidedly weak.

Put another way, I suggest the introduction of fractional reserve to a full reserve economy would result in superfluous investment rising to a new EQUILIBRIUM, and just staying there. There is little reason for artificially low interest rates to cause any sort of “cycle” as per the “Austrian Business Cycle Theory”.

P.S. (same day). Lengthening production processes. 

I should have mentioned that ABCT also claims that when interest rates drop, one of the forms of extra investment that employers go for is to LENGTHEN production processes. E.g. (to take a very crude example) people dig holes by making spades and using the spades to dig holes, rather than dig holes with their bare hands.) However, this lengthening of production processes inevitably involves extra capital investment, thus I don’t see much difference between straightforward extra investment which involves no lengthening of production processes and extra investment that does involve lengthening production processes. All the arguments that apply to the former, apply to the latter.

P.S. (same day). “money confers on those with authority to issue new money the power to pre-empt resources” – Victoria Chick, p.141, On Money, Method and Keynes. (Hat tip to Mary Mellor).



  1. This seems to be an honest attempt to understand Austrian theory.   Unfortunately you do not have a proper understanding of the theory.  Therefore you come to some wrong conclusions about what it says and what it predicts.

    Austrians do include housing as something that is effected by the artificially low interest rates.   How they distinguish the "what" here is not between business and households.   It is between goods close to and far away from consumption.    In their theory even houses and factories are consumption goods in that they are consumed as they wear out without additional investment in repairs.

    The theory doesn't state that there is a general over investment in business in general.    The over investment is in goods that are far away from consumption relative to those close to consumption.    Where the new money is injected matters.  The pattern can be effected by whether the new money is injected by commercial vs non-commercial banks for example, or even margin accounts.    A main issue is maturity mismatch.

    You've not understood quite a few other things about the theory and I don't blame you because it's not easy to fathom without reading the original texts.  These articles are somewhat lacking in that they do not spell out many important points.  Also be aware that there are economists floating around who either do not understand the theory or do not understand the implications of the theory who call themselves Austrians.   For example there is nothing about the theory from which one could conclude that hyperinflation must occur in our economy at this point.

    There is a lot I would have to cover to address all the points.    Price signals and the structure of production are very important to the theory.   I can't say you haven't understood because in skimming those articles I don't think it has been made clear. 

    I don't have time to address any other points right now.  I will try to make time but do not make any promises.

  2. Brian,

    If Austrians are saying that lower interest rates bring extra investment ONLY where those investments are “far away from consumption relative to those close to consumption” then they are even more out of touch with reality than I thought.

    First, there are bound the sectors of the economy were “far away” investments are much more technically feasible than others. So as to the latter, little far away investment will take place.

    Take the crude oil to petrol and diesel conversion process. That has consisted for the last century of three stages: get oil out of ground, transport to refinery, transport finished product to garages which sell petrol and diesel. Despite the astronomic increase in investment in this industry over the last century, the three stages are still the same.

    Second, even where far away investment is feasible, strikes me that some extra nearby investment is bound to take place as well. E.g. the final stage is the retail outlet: shops. If interest rates drop, retail outlets will become bigger/better.

    I hope to get round to answering your comments after my Peter Schiff article. But there is never enough time for anything!!!

  3. No rush on replying to the Peter Schiff article. I had originally written yesterdays comment in MS Word and the paragraphing did not come out properly. I will fix when I get a chance. I had to break into four sections because of the word limit and two posts from the middle appear to be missing.

    "If Austrians are saying that lower interest rates bring extra investment ONLY where those investments are “far away from consumption relative to those close to consumption” then they are even more out of touch with reality than I thought."

    Well they aren't. I'm not sure how you can come to the conclusion that they are "out of touch with reality" when you don't yet understand what they have to say. You have to go into learning mode before you can go into criticism mode.

    My first question would be. Do you understand that a change in interest rates will effect the profitability of an investment in say a hotel (which is consumed over a long period of time) in comparison to say investment in radish seeds which take 28 days from planting to harvest?

    Don't jump the gun here either. I doubt you understand the Austrian concept of distance from consumption fully. It's quite sophisticated and hardly "out of touch with reality". The distance from consumption can depend on how a good is used for example. Gas in your tank being used for a joy ride is very close to consumption. Gas in the tank of a tunnel drilling machine is far from final consumption because it is converted into another good used in production, the tunnel.

    Goods can also be used at different stages of production/consumption at the same time. A bridge could be used for production of a long term good and a short term good at the same time. For example, someone could pay a toll to take a pleasure drive on the bridge at the same time that a truck is using it to move cement. That bridge itself however is consumed over a very long period. Each car/truck that drives across does not fully consume it.

    Now one can construct simplified gedanken exercises from such concepts but that doesn't mean they are not based on reality.


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