Ludwig von Mises on Austrian Business Cycle Theory
Yesterday, John Carney at CNBC had a nice little post comparing Hyman Minsky’s Financial Instability Hypothesis with some of the thinking by Friedrich von Hayek behind Austrian Business Cycle Theory.
Von Hayek wrote:
It is best to begin our investigation by considering once again the situation of a single bank, and asking how the manager will react when the credit requirements of the customers increase in consequence of an all-around improvement in the business situation… Among the factors that determine the volume of loans granted by the bank, only one has changed; whereas previously, at the same rate of interest and with the same security, no new borrowers came forward, now, under the same conditions of borrowing, more loans can be placed. On the other hand, the cash holdings of the bank remain unchanged…
…While expansion by a single bank will soon confront it with a clearinghouse deficit of practically the same magnitude as the original new credit, a general expansion carried on at about the same rate by all banks will give rise to clearing-house claims which, although larger, mainly compensate one another and so induce only a relatively unimportant cash drain. If a bank does not at first keep pace with the expansion it will, sooner or later, be induced to do so, since it will continue to receive cash at the clearing house as long as it does not adjust itself to the new standard of liquidity.
…By creating additional credit in response to an increased demand, and thus opening up new possibilities of improving and extending production, the banks ensure that impulses towards expansion of the productive apparatus shall not be so immediately and insuperably balked by a rise of interest rates as they would be if progress were limited by the slow increase in the flow of savings. But this same policy stultifies the automatic mechanism of adjustment that keeps the various parts of the system in equilibrium and makes possible disproportionate developments that must, sooner or later, bring about a reaction.
John rightly points to this passage as "a theory about banking as an endogenous destabilizer of the economy." And this certainly fits with the Minsky view of the world. Von Hayek is saying that even without a central bank, the business cycle is endogenous. To my eyes it reads almost as if von Hayek is talking about Keynes’ famed "animal spirits" but in the context of credit.
Let me give you a quote from Ludwig von Mises from 1936 on Austrian Business Cycle Theory (highlights added). Here, von Mises takes the view that it is in having "bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably". Nevertheless, whether you believe the genesis of the credit expansion is Federal Reserve interest rate policy, animal spirits, fiat currency or fractional-reserve banking, what should be clear is that it is the lower rate of interest that creates the credit growth. The question is whether this lowering of rates is beneficial over the long-term. Von Mises argues it is not:
"The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated. The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise."
"This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in."
"Some enterprises cut back their scale of operation, others close down or fail. Prices collapse;crisis and depression follow the boom. The crisis and ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared "profitable" in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be "profitable." The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about. In is case the thing to do, first of all, is to curtail consumption and, by economizing, to build up new capital funds in order to make the productive apparatus conform to the actual wants, not to artificial wants which could never be manifested and considered real except as a consequence of the false calculation of "profitability" based on the extension of credit."
- The Austrian Theory of the Trade Cycle, Ludwig von Mises, Gottfried Haberler, Murray Rothbard, Friedrich von Hayek
- Was ‘Post-Keynesian’ Hyman Minsky an Austrian in Disguise?, John Carney, CNBC