The Austrian Theory of the Business Cycle | David Howden

I had introduced my lecture yesterday on banking with a bit of an oddity and the oddity was if everybody remembers that to talk about banks is a little bit strange because we don't talk about other businesses we don't really talk about other industries in economics but then we sent to out banks and the reason why we have lectures devoted and and studies directly devoted to banking is that banks control the money supply at least partially private banks through their control of the deposits and central banks through their control of currency and reserves and money since it permeates through the economy has very systemic effects and so the banking system is very important to understand in order to understand the supply of money and money is important to understand so that you can understand system systemic effects on the general economy Austrian business cycle theory is a theory that deals with one of those systemic effects in particular and so just to begin I wanted to find a business cycle in fairly general terms and and Murray Rothbard in America's Great Depression he refers to clusters of errors and he asked the question why is it that under normal times of course some entrepreneurs some business people make mistakes you see some businesses earning losses or going out of business having bankruptcy but then periodically you seem to have surges where all businesses seem to suffer at the exact same time and it's a little bit of an oddity right because we understand since we don't have perfect foresight that companies and businesses and entrepreneurs will make errors of course if we had perfect foresight about the future we wouldn't have to worry about this but then every so often there seem to be periods of time like recessions or crises or busts whatever you want to call them where everybody seems to make mistakes at the exact same time or everybody's mistakes become apparent at the exact same time and so when we speak about the business cycle really what we're referring to our clusters of errors and we're trying to find one reason why it is that all entrepreneurs are making errors at the exact same time now in answering that question of course you could look at different factors and try to find the link that connects everybody together but the obvious one should be money because money is the medium of exchange it's one half of every exchange that takes places has got money on one side of it and so changes to the money supply are one of the few goods that has the possibility to have systemic or far-reaching effects throughout the whole economy so as subsidiary questions we could ask what do these clusters of errors actually signify when you when you have a period of time or you see a you see a scenario where everybody is making errors at the same time what does that actually mean and that's what we refer to as the bust phase of the business cycle or even the business cycle in general and then also we can add to that what's the common link between these clusters of errors what's what is the process through which these error cycles seem to repeat themselves over and over and then of course how could we stop or avoid those clusters of errors from happening again now if you've taken an economics class before if you're an economic student you'll see something which is a little bit strange about Austrian economics actually we're the normal ones and other economics is a little bit strange and that is you will start your studies in normal mainstream economics taking principles of microeconomics principles of macroeconomics you'll move up to intermediate microeconomics intermediate macroeconomics there's always this distinction between micro and macro and there's not this same distinction in Austrian economics it's I take it quite personally because students come to me and they asked quite frequently is it necessary for me to take intermediate Micro before intermediate macro some some question like that and of course it mainstream econ there's there's very little link between the two so one doesn't hinge critically on the other of course in Austrian economics the two are integrated into a whole so it's you don't have to make this this clear distinction and really what we can get at is what's the proper level of aggregation by which we should speak about different economic phenomenon macro economics the macro prefix suggests that we're dealing with some level of aggregation if we're dealing with business cycles in general of course we're dealing with some level of aggregation we're not talking about specific errors made by an entrepreneur or business person we're speaking about economy-wide errors so the level of aggregation must matter and I just want to do a brief contrast with a couple of other business cycle theories so first we'll start with Keynesian since that would be the one that most people are familiar with and of course in Keynesian macroeconomics theory you deal with the national income account statement you deal with GDP and the determinants thereof and you've got a level of aggregation which is sufficiently high that you can't see the trees for the forest so to speak you can't see what the individual problems are all you know is what this broad mass aggregate of investment expenditures or consumption expenditures are doing all you know is that income is going up or down but you don't really know what's going on within that mass of income so Keynes aggregates at this high level which makes it very difficult if not impossible to really tease out the problems of the business cycle and then if you wanted to look at the monarchists Friedman aggregates at an even higher level because the monitors start with the equation of exchange so that doesn't even deal with the specific components of GDP like consumption or investment expenditures it's just about GDP as a whole so they don't fare any better than Keynesian Theory does in this respect and when we speak about aggregation it's important not to aggregate at too high a level because if you do so then you're not able to see relative price adjustments for example during a business cycle we know that some prices are getting out of whack or being misaligned with other prices housing prices are booming stock prices are booming but if you over aggregate you're not able to see these differences and relative or specific prices actually changing and furthermore you can't see changes in the quantities of specific goods that are being bought and sold or the industries that are really booming or busting and in the Austrian Theory we don't overly aggregate and so we have what we can refer to as different orders of goods we don't just have investment goods in general we have different types of investment goods different orders of investment goods but we'll refer more to that in a couple minutes now when Ludwig von Mises lays the groundwork for Austrian business cycle theory he does it in his 1912 book the theory of money and credit and Mises at the time is really laying a foundation for what we may refer to as a monetary theory of the business cycle and he builds off the currency school economists of the 19th century who were trying to understand why it was that there was a new type of business cycle a series of booms and busts that emerged in the 19th century that didn't seem to exist in previous periods of time and if you look back in the 19th century there was this more or less regularity - booms and busts where every ten years you had a boom and then a bus that followed another decade later you'd have another boom peaking and a bus so on and so forth and the currency school economists are trying to understand why this happened and I don't want to get too much into the currency school economists because it's a little bit of a separate discussion but their main emphasis was on banknotes yesterday in my banking lecture I referred to the fact that modern fractional reserve banks can issue deposits without having to back them fully by reserves that's the essence of the fractional reserve bank the currency school if you focused more on private banks issuing notes and not backing them fully by gold or reserves if you will and this led them to understand that the over issuance of banknotes not completely backed by gold at the time led to a series of bank runs people would realize that the banks don't have enough gold to honor all of the notes that they've issued periodically people would run to the banks and mass do withdrawal requests the banks would run out of reserves would run out of golds in order to in order to honor those requests and a crisis a banking crisis would pursue and what the currency school economists achieved was that they more or less identified a specific type of business cycle the downside was that they focused narrowly on the banking system they weren't able to elaborate it to systemic economy-wide effects it was much more limited to one specific industry the banking industry and some some loosely associated industries as well and Mises and the theory of money and credit is able to expand on this general idea but to focus on the economy as a whole not just the banking system but that was the core of his understanding of how it is that the general economy the real economy was able to enter into this boom and bust phase and in doing so what he does is shifting the focus not on banking crises in particular but on intertemporal deaths equilibrium and by intertemporal debt Librium what we're referring to is a mismatch that's happening over time between our plans our consumption plans and our production plans where everything is not synchronized in a way where our plans can be successfully completed so investors are starting production plans or projects that are not able to be completed because there's not a synchronization over time with other investors projects or plans and consumers are facing the exact same problem and in trying to search for a reason of why it is that there's this intertemporal des equilibria which has been created Mises focus is on the role of credit creation and its effect on the interest rate and of course the interest rate if you listen to dr. herb earners lecture this morning on the rate of interest the interest rate is impacted by the creation of credit a greater supply of credit increases the supply of present goods depressing the the market rate of interest and as the market rate of interest is depressed it also has knock-on effects disrupting or changing at least consumption and production plans and so Mises uses the banking system he Springs from the currency schools focus on the banking system and the over issuance of banknotes to see the effects that this has on the rate of interest and then uses the rate of interest to understand the effects that that will have on the economy as a whole now before I go further into describing more thoroughly what an Austrian business cycle theory is I want to lay out what it's not because over the last couple years and especially since the crisis there's been a real revival in interest among some mainstream economists - Austrian business cycle theory good thing the unfortunate part is it's often mischaracterized in very simplistic terms and the most frequent way that it's mischaracterized is as an over-investment theory it gets described as a theory that explains why it is that there seems to be too much investment too many people buying houses too many entrepreneurs building factories or building cars or whatever on the eve of the boom turning to bust and so the theory one theory characterizes Austrian business cycle theory as too much investment it overheats the economy we've got too many goods and well has just got a bust and we have to get rid of this oversupply these excess inventories of goods so that's one Mis characterization of of Austrian business cycle theory a related Mis characterization is that it's just naturally occurring like some people believe that the economy just booms and busts and there's not much that we can really do about it and that it's it's just that entrepreneurs every now and again do too much investment and that's the way that they are that's not especially helpful by the way in understanding and understanding any business cycle theory and that's also not what Austrian business cycle theory is about as core and yet another way to interpret it or misinterpret it rather is that entrepreneurs are led to make market failures they're led to make mistakes or they're prone to make mistakes which have to get solved out by the recession or which are exposed by the recession and so these are ways that the Austrian business cycle theory has been characterized over the last couple years especially since the crisis but it doesn't accurately describe what it is so when we speak of an Austrian business cycle we need a couple of components there's a couple of elements that you've already learned over several lectures between yesterday and today which are necessary to describe it so first we have to go back to carl menger and Menger is focus on defining what a good is and what are the differences between different types of goods of course karl menger was able to establish that there's not just goods in general there's what we can refer to as different orders of goods higher order goods and lower order goods and lower order good would be well the lowest order would be a consumption good something that's ready for you to consume right now and of course that consumption good just didn't come from nowhere it had to be made by higher order goods these are the necessary input factors and so one example that rothbard uses in in man economy estate is the production of a ham sandwich and when you're finally ready to eat it that's the lowest order good but of course in order to eat it you needed to have bread and ham and you need a knife and you needed input factors and these are all higher-order goods that we can talk about and earlier today and professor written hours lecture on capital structure capital theory he also referred to different orders of goods different orders of capital goods you have some capital goods that are closer to final output producing consumption goods then you have higher order capital goods which are less directly related to the production of consumption cuts now we have bohm-bawerk and his theories on the rate of interest which professor urban are talked about in his lecture this morning and we understand that the rate of interest is a naturally occurring phenomenon which we can represent or we can describe as being the value spread between one satisfaction today and want satisfaction in the future so to the extent that you value satisfaction the present more highly than the future we have a positive rate of interest which expresses this this value differential and then finally we've got meeseeks attention or focus to inter tap intertemporal coordination and when Mises ties together when he discusses intertemporal coordination really what he's doing is weaving together the different orders of goods that karl menger described and the role that the rate of interest that bohm-bawerk has elaborated on to make it a consistent theory and when we refer to intertemporal coordination we refer to two things at the same time on the one hand we need production plans to be synchronized with consumption plans they what we produce needs to be what people are wanting to consume and at the same time production is not just one specific stage production involves many different orders of capital goods and they all need to be synchronized with one another you can only make your ham sandwich if somebody previously made ham not going to get into the details of that and you can only make your ham sandwich if somebody previously made a knife and the knife manufacturer could only make the knife if somebody previously refined metal or so on and so forth and so intertemporal coordination requires consumption and production plans being in sync with one another now the most succinct way that you can summarize or characterize an Austrian business cycle is by its two components the first one is what we can call over consumption and over consumption is the idea that during a boom phase people have a tendency to consume more than would otherwise be the case and not only that they consume more than is sustainable given savings patterns elsewhere in the economy and so during a boom and I will elaborate this as we give some examples later on in the lecture we should be able to see that there is this overconsumption come to it and then at the same time and perhaps more importantly the component in Austrian business cycle theory which is most unique is the idea of malinvestment now when I a moment ago told you about the mischaracterization of Austrian business cycle theory and this revived somewhat revival that it's had in the mainstream since the crisis I was referring to the fact that many mainstream economists construe it as being an over-investment theory that investors are just doing too much and that's what needs to be cooled off later on during the recession it is true in a way that investors are being led to take on more investments that would otherwise be the case but that's not really the story and it's a subsidiaries story if anything the important thing is what we call malinvestment it's the temporal ordering of all the investments that investors have been making and what's necessary is that we have a consistent pattern of production plans that feed into one another so that every stage of the production process has the inputs which are necessary for it for the entrepreneur to complete his or her plans and what's important is that we don't start unsustainable investment projects we don't start plans that can't be finished or completed fully and so this malinvestment refers to the structuring of capital the structuring of higher-order goods not necessarily the absolute level of it now if malinvestment can refer to unsustainable investment projects it's important to understand what we mean by unsustainable and the Austrians are very good at defining the difference between sustainable and unsustainable growth because we should recognize that not every boom is going to be unsustainable not every boom necessarily needs to lead to a bust right you can have you can have secular economic growth you can have boom phases which are there for good reasons and predicated on good positive sustainable factors but not all of them are so and to that extent we need to understand what is it that would define an unsustainable growth phase now sustainable in this sense means backed by real savings a sustainable investment is one where the resources enabled the resources being used in that investment process have been freed up by somebody not consuming them or somebody else in the economy not using those resources so the only way you can build a house is if somebody decides to not use the bricks for some other purpose right no two people can't use the same bricks at the same time the only way that you can build a ham sandwich is if somebody else decides not to use that ham right if they restrain from eating that ham it's available for you to use the same thing must hold true for money right the only way that you can use money in a production process in a sustainable way as if somebody else restrains themselves from spending that money so we define sustainable growth as growth which is built off the back of real saving savings here defined as not consuming people don't consume we accumulate savings and then we can invest sustainably now that begs the question of what we refer to by unsustainable growth and there's two forms that all refer to the one form is unsustainable growth which is built on the back of credit which has been created by the central bank yesterday in my banking lecture I referred to the primary means through which the central bank can increase the money supply it's open market operations one means is that it can create currency and issue currency out of thin air all it has to do is print up currency which is not very expensive buy bonds from banks and issue the currency into the system and of course entrepreneurs could use that currency to start investment projects but it's not going to be predicated on anybody not consuming or anybody saving ahead of time it's just going to be built on the back of the central bank's whims or perhaps more importantly we can focus on the fractional reserve banking system because the fractional reserve banking systems essence is an ability to issue loans against deposits and in effect create deposits out of thin air and so if either of these phenomenon occur central bank's issuing credit or fractional reserve banking system issuing credit we have the ability to finance entrepreneurial ventures without anybody constraining themselves from consuming and that's what we can define as unsustainable growth or that's what will lead later to unsustainable growth a one final thing before I go into the nuts and bolts of Austrian business cycle theory I want to introduce what I call high X Maxim it's a great little quote I think increasingly I think it's more and more important in a article he wrote in 1937 hi rights before we can meaningfully ask what might go wrong we should first understand how things could ever go right I like it because of course it makes sense before you start analyzing problems you should understand why would the problem even exist in the first place why should things go right and you can't just dive into a problem with out first understanding how things would go right I take it to heart because increasingly as I as I teach introductory economics I see young students coming in and they care about the problems of the world's global warming or you know whatever have you and they want solutions right away but they don't want to go through all the work to understand how things go right they just want to dive into solving the problems and unless you do that critical step of understanding how it is that things go right form a consistent theory to understand how plans would actually work out you can't very well understand why things are going wrong so Hayek's maxim is a good good dictum to have in the back of your mind so I want to introduce Austrian business cycle theory by way of two analogies and the two analogies are going to allow us to tease out the difference between sustainable and unsustainable economic growth the first one is a Robinson Crusoe analogy Robinson Crusoe washes up on a desert island doesn't have anything to his name right he doesn't even have clothes let's assume he washes up on the desert island and the first thing that he does when he gets his act together is realizes he's hungry and he looks for something to eat so luckily there's some bushes with berries on the desert island and he starts picking off berries the only problem with picking berries to try to stay alive is you probably have to work every waking moment of your life to get enough calories to stay alive so Robinson Crusoe spends his whole days picking berries it's not a very productive way to produce berries but it gets the job done now the only way he can grow economically have economic growth is if he becomes better at picking berries becomes more productive at picking berries the only problem right now is Robinson Crusoe needs to spend all of his time picking berries to stay alive that he doesn't have much scope for that but he thinks about things and he looks around and he notices at the top of the trees are much more densely populated by berries than the bottom branches and if only there's a way that he could reach taught branches he would be much more productive right instead of picking all these little berries at the bottom he could get the big ones at the top and he thinks about any says well the easiest way I could get at the top berries is if I had a suitable branch in order to do it the only thing is there's no suitable bench right where I am and I need to go out and find one but if I go and find one that means that I'm not able to pick berries and if I don't pick berries then I'm not gonna be able to stay alive because I need to eat and so Robinson Crusoe has a bit of a problem if he wants to improve his lot if he wants to grow economically he needs to become more productive if he wants to become more productive he needs to make an investment the investment is he needs to build a stick or find a stick in order to find the stick he needs to not work but if he's not working he doesn't have any food in order to eat so he's gonna die or go hungry or be uncomfortable and so Robinson Crusoe comes up with a solution and the solution is he's going to restrain his consumption he'll set aside some berries every single day and make a stockpile and then he's going to take a morning off picking berries and he's gonna go out with his stockpile of berries to keep himself fed and he's gonna search for a stick so for a week he saves a couple of berries every day and he builds a little stockpile and that stockpile by the way is savings its unconsumed resources he withheld his desire to eat got his stockpile of berries savings and he sets out into the wilderness and he eats the berries along the way he uses up his savings as he searches for a stick and then finally he finds that suitable stick and he gets back just before his stalk of savings runs out so he doesn't have to go hungry and then when he gets back there he starts using the stick and he reaches all the berries on the upper branches and all of a sudden he's much more productive and his lot has been improved and we can analogize this by saying he's he's experienced economic growth right he's better off than he was previously and maybe you could extend the example you say well if you want to have even more economic growth maybe needs to have a spear to catch fish or something like that but of course just to find a sphere or to build fire he needs to take even more time off producing berries so he would have to set aside more berries which by the way is a little bit easier now given that he's more productive set aside more berries then go ahead on the task of building fire finding a sphere of producing a sphere so on and so forth and that's how economic growth happens now in this simple analogy there's couple of steps that he's gone through that lead to sustainable what we refer to as sustainable economic growth the first step is that we can understand that savings were a prerequisite and a necessary prerequisite for the growth to happen if if Robinson Crusoe did not constrain from eating berries initially he wouldn't have been able to sustain himself while he partook in the time-consuming production process of finding a suitable stick so the saved berries were necessary for him to actually do the investment later on if he wanted more growth he would have to do more or better investments but that would just necessitate more savings right he would have to save up more berries restrain his consumption habits even further in order to free up enough berries to pursue a longer production process or a more intensive production process and then finally we can understand the relationship between savings and consumption the only way Robinson Crusoe can save more is if he consumes less he can consume more that's fine but if he does so he won't have savings available and if he doesn't have savings he can't partake in production processes you could summarize this by saying that growth goes right in the sense that it's sustainable when savings and consumption patterns are consistent Robinson Crusoe's growth was fully consistent fully sustainable because his savings habits were consistent with his consumption habits now that's a simple example but we can expand on it a little bit and we can modify it to see how things might go wrong so Mises and human action introduces another simple analogy which you can call the master builder example and the master builder is imagine that you have a home builder who sets out to construct a whole bunch of homes and normally of course if you want to build homes you need resources to do so and where do those resources come from they have to be freed up from somebody else so somebody will have to not consume some resources or not use some resources so the master builder has bricks and cement and shingles etc etc to complete the houses but then imagine a scenario where something fools the master builder into thinking there's a greater supply of bricks available than is an actual fact and the Builder starts by building 10 houses but there's only enough bricks for seven let's say and you don't know when you just start building houses you know they're they're halfway completed you don't know you have a big pile of bricks there it looks sufficient to finish the job but it only has the illusion of looking sufficient to finish the job and so the master builder keeps building the houses a little bit higher a little bit higher and eventually you would imagine you would get to a point where your pile of bricks is not looking sufficiently large to finish all these projects and so the illusion that he had more bricks then was then was needed to complete these houses led him to start more investment projects more building projects than would be sustainable and now he's faced with a tough decision which is what do I do I started 10 houses but I only have enough bricks for seven so he's got a couple of options abandon the project completely yeah there's better options than that tear down two of the houses that would free up some bricks to use to complete the other uncompleted houses but what we've got here is an example of an unsustainable investment project he has undertaken an investment that was not backed by a sufficient amount of savings and then it became obvious later on where when it became obvious rather later on that the savings were insufficient he had to change his investment plans and pursue a second best option and from this analogy we can tease out a couple of important facts the first is that the mere illusion of savings can encourage investment or even if you lied today to the master builder about how many bricks were in existence or just skewed his expectations of how many were in existence you can imagine he would start taking on more investments build more houses than would otherwise be the case in second fact we can tease out is that the lack of resources did not enable him to finish all these projects unless you have enough bricks you can't build all of the houses that you immediately set out to and so the solution to that was that some of his investment projects had to be abandoned Salvage the best that they could be so you tear them down take the bricks out so that you can complete the other investment projects and the lesson from meeseeks master builder analogy is that growth goes wrong or growth is unsustainable when savings and consumption patterns are inconsistent with one another in this story the savings are in consist insufficient to complete the investments why not the savings would be insufficient because people's consumption habits were not reduced to a low enough state that freed up the savings for the investment so then we try to understand well what's the relationship between the illusion or where it's the cause of the illusion that there's more savings available than is actually the case and we can focus maybe most specifically on the fractional reserve banking system because as we went through in the lecture yesterday on banking the fractional reserve banking system allows savings to be created or might I shouldn't say savings but the illusion of savings to be created without anybody renunciate inconsistent consume a good and that frees it up for somebody else to use but in fractional reserve banking that's not the case at all somebody can make a deposit and the bank can only hold a fraction of it on reserve and issue a loan for the remainder and that loan of course gets deposited in another Bank so on and so forth and through this whole process we can create a supply of credit which is available for people to use but it's not created by anybody restraining their consumption habits to begin with and through this process there's a couple of effects that stem from it the first is that credit creation by the fractional reserve banking system allows for a greater quantity of investments to be undertaken than what otherwise would be the fact otherwise be the true but more importantly we see that the decrease in the rate of interest due to the credit creation alters what we call the time structure of production it skews the types of investments that investors are actually doing and in particular if favor is longer-dated or more distant investment projects at the expense of shorter dated investment projects now at the same time that lower rate of interest has a real effect on people's consumption habits the real effect on people's consumption habits is that it actually motivates them to consume more as the rate of interest Falls you would have a lower propensity to save money and you would want to go out and start consuming more buy more furniture for your house or or buy new accessories for your car or go on another vacation so on and so forth and so at this very time where people start taking on more investments which would normally require a greater amount of save the lower rate of interest demotivates savings on the hand by the hand of consumers and so we have a complete disconnect between the needs of the producers or the needs of the investors and the resources and the desires of consumers and their savings habits saving habits because it's important and I feel very strongly about this miss characterization of Austrian business cycle theory as a theory of over investment I want to just make a brief comment to bond about it because it's easy to see from what I just said that you could construe the theory as being one of over investment in fact my exact words were the lower rate of interest induces a greater amount of investment that would otherwise be the case but that's not where all the action is the action is in the malinvestment the skewing of the time structure of production what does it even mean to say that too much investment is taking place if you think about it investment is just doing something today so that you can get a payoff in the future to say that there's too much investment going on is to say or taking place today is to say that there's gonna be too much activity or too much wealth created in the future as a result it's not a sensible position to have the problem isn't that there's too much investment taking place is that the investment is taking place along lines or in patterns which doesn't lead itself to being sustainable or the investments are not going to be able to be completed to fruition the better way to characterize what's going on is to focus on malinvestment and in particular we will say that the structure of production has been upset by credit creation by the banking system and a lowering of the rate of interest and when I refer to the structure of production what I'm specifically referring to is the ordering of all of the capital goods or industries that are necessary to produce a consumer good to give you a concrete example the consumer good you're gonna buy as a car the car could only be produced by putting together tires and engines and metal components etc etc and the tires could only be produced by somebody producing rubber vulcanizing rubber and the rubber could only be produced by a plantation over in malaysia farming rubber trees so on and so forth so we have a structure of production where all of these steps along the way are all linked together and they're all dependent on one another so when I say the structure of production has been upset and that's what malinvestment is there's two ways that I'm referring to the first way is what you can call a drive demand effect the derived demand effect is that the lowering of the rating of interest has caused people to want to consume more than would otherwise be the case and of course entrepreneurs respond to this increase in consumption habits by focusing their attention on these areas of the structure of production those which are most closely related to the consumer goods industry an analogy I like to use in the back of my mind is during a boom over consumption is more people buying furniture and cars and things like that and entrepreneurs respond by opening up more big-box stores more retail outlets that's at that very far end of the structure of production and it's necessary in order to meet this derived demand that people have from there increased consumption habits and then at the same time there's an interest rate effect as the interest rate Falls longer-dated investments are favored over shorter dated investments and so we see a temporal restructuring of the structure of production a long dated investment by the way would be something like R&D pharmacy investments might take 30 years in order to break even if they ever break even that's a very long dated investment lower rates of interest stimulate those types of investment projects a short dated investment project might be oh I don't know repaving the parking lot of your store to attract more customers or an advertising campaign to attract more customers and so this interest rate effect favors investment in the higher stages of production or the earlier stages of production those further from final consumption and what we see is that a tug-of-war develops because in the structure of production where you have stages closest to final consumption is stages farther from final consumption you have resources being pulled to the far stages and resources being pulled to the early stages and not much attention paid to the middle stages the easiest way to understand this Hayek in prices and production introduces what we now call a Hayekian triangle and a Hayekian triangle is a simple way to understand the linking between all these different stages of production this diagram by the way if you aren't is taken from Roger Garrison's book time and money it's probably the best book for a higher level understanding or look at the business cycle and what we see on this structure of production are this high Hayekian triangle is that on the y-axis we have the total value of consumer goods which is being produced cars vacations food etc but of course those consumer goods are only produced through this time-consuming process that links together all the different stages of production retail stage is the one closest to final output you go to the store to buy the good but the store has only got the goods only got to the store through the distribution channel that's a different stage of production and higher up from that the goods were only available because they were manufactured the goods were only able to be manufactured because raw resources had been raw materials had been refined and they were only refined because previously they'd been mined and they were only mined because there was R&D in order to do so if you wanted to add another stage on this and so all of these stages are linked together to produce a final amount of consumer goods and when I talked of the demand the derived demand effect what I was referring to was that since people are over consuming and have increased their consumption demands business investment moves into these late stages this is my analogies of big-box stores and bigger expenditures on retail spaces and at the same time the interest rate effect is motivating investors to make investments down here at the very early stages mining and R&D in our example and the tug of war that exists can be illustrated like this and the early stages of the structure here we have a boom phase which is going on that's the MAL investment the shifting of capital goods earlier into production and the overran consumption phase can be illustrated in this capital is being reallocated into the late stages of production to meet this derived demand effect and meanwhile in the very middle here the tug of war is getting tense resources are not being dedicated there but of course for the structure of production to be consistent there needs to be a steady flow of goods that flow from the far stages to the later stages and so this dearth of investment in the middle here is going to create problems later on now before I get to the problem I just want to focus a little bit on what the boom of an Austrian business cycle actually looks like and so dr. Klein I called her Klein the beautiful I think as opposed to climb the Eldar to make the distinction yesterday dr. Klein talked about Kantian effects what we refer to as Kantian effects in her lecture on money and a Kantian effect is the recognition that yes when we increase the supply of money prices are going to increase also but the Kantian effect is the recognition that is not a uniform increase in prices we can speak of it as being a wave that money always gets injected into specific industries or specific investment projects and that creates income for people involved in those industries and as they spend that increase in income that pushes up prices in those areas that they spend money on and we can think of a wave of price inflation permeating out from the original spot where money is injected for example during a boom since one of the places where you will see money injected initially into the economy is through the real estate sector after all fractional reserve banks if you loans primarily for mortgages and people get their mortgages and they buy houses so of course you see housing prices in real estate prices and land prices especially start increasing and that increases the income of builders and people own land who sell it but of course then those people turn around and and spend their income and the goods that they spend their income on so if you're a builder it might be on trucks and then we'll see the price of trucks go up and then there's people who produce trucks and they have a higher income now and then they turn around and they sell it people who drive big trucks know people who produce big trucks some I don't know like to go on vacation and so the vacation industry starts seeing prices go up and we'll see this wave emitting from the origin of where money was injected into the economy and so the boom can be described as following that wave of money and it should be no surprise if you think about it in these terms that when you look at a boom the real estate sector is typically the focal point or big cities where a lot of credit is injected initially especially in New York City is a focal point in many booms now when the bust comes we can describe it in a couple different ways the easiest way to understand why the bust actually had to happen was that we're facing a resource constraint and entrepreneurs are realizing that there's an insufficient amount of resources available to complete all the projects that they've previously undertaken that's like meeseeks master builder example a different way that you can understand this is to recognize that as this wave of inflation permeates out from the original investment prices start increasing and prices are also increasing because of the growing scarcity scarcity which is caused by more investments taking place and there are resources available to complete them and as these market rates of interest as these increases in prices force market rates of interest higher they make marginal profits unprofitable and people abandon them this could be a housing project which is abandoned this could be an RD venture which has been abandoned and once these projects are abandoned people lose jobs the bus starts to set in they take it one step further Mises rights in human action of what he refers to as a crack-up boom a crack up boom is the logical conclusion if of a central bank increasing supplies of money to ward off this recession to ward off the bust and ending up with a hyperinflationary recession as prices keep spiraling out of control now in that sense when Austrians speak about the bust or the recession phase were completely different from mainstream economists because the bust for us is actually quite a healthy phenomenon all it's doing is exposing all of the errors that were done in the past it's not a problem in and of itself the problem was actually the unsustainable boom and all the investments that took place over the preceding years that shouldn't have taken place and so the bust or the recession is just allowing consumers and producers to reassert their preferences in a sustainable way and all it's trying to do is allow previously undertaken but ultimately unprofitable or unnecessary projects to be abandoned so that the resources can be freed up to pursue something else in meeseeks masterbuilder example this would be a bust could be the exposing of some home builders who didn't have enough bricks to finish their projects and of course those houses need to be torn down those tore those projects need to be abandoned to free up bricks so that other houses can be completed but that's not the problem in and of itself the initial problem was to many home builders started building too many homes at the same time the recession is just trying to clean up the mess that was previously previously undertaken and the final note that I'll say is that delaying a recession in this way doesn't allow the structure of production to return to normalcy which is important we need to have a structure of production which is consistent so that all of our production plans can be linked together to produce consumer goods to the extent that the boom miss allocates capital along the structure of production it creates problems that need to be resolved which is exactly what the recession is trying to do any effort to try to stop the recession prematurely or any effort that tries to halt this reallocation of capital along the structure of production is only going to serve to delay the recession delay the recovery rather longer than would otherwise be the case if anybody has any questions because I know it's a complex topic we can talk about them afterwards here because I've run out of time or otherwise you can ask me during office hours later today thank you you

Channel: misesmedia

Views: 7,549

Rating: 4.9597316 out of 5

Keywords: Economics, ABCT, Business Cycle, Austrian, Austrian School, Mises, Howden, Mises University, Auburn, lecture, Boom, Bust

Id: trHlLzKWZ3Q

Length: 43min 32sec (2612 seconds)

Published: Thu Jul 18 2019