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
Mises expects credit growth to lead to wages growth, which is clearly inaccurate. The US has had massive credit growth since 1980 yet wages have been stagnant every year since. All that extra credit has been swallowed up by asset bubbles.
The model also seems to ignore absorption of unemployment into new businesses.
Now there is a solution to such credit growth, and that is what the Bank of England used to do up to the seventies. The banks had to maintain reserve asset ratios to ensure that they had adequate reserves. If the Bank of England felt that credit growth was going too fast they demanded banks deposited reserves with the BoE. This forced banks to curtail lending and could be done collectively or individually. Such a model could have been used to stop banks expanding their own leverage and becoming systemically dangerous.
David, I agree with you in many of those points but i don’t think any of it invalidates ABCT. For example, for the reasons you point out about wage inflation, I often point out that the inflation Mises speaks to here is really asset-price inflation. Without wage growth, you get asset price inflation expanding the collateral and the apparent capital used to issue more credit instead of income growth adding demand as the fuel for additional credit.
In any event, as I said in my synopsis, it is the nexus of the prevailing rate of interest and credit growth that is the key. When the Fed inserts itself and pushes the rate of interest on loans lower than the private sector would have dictated without the intervention, you ask what the consequences are. Whether the Fed’s intervention gets their by changing private portfolio preferences, suppressing risk premia, or increasing demand for treasuries is irrelevant. What IS relevant is whether long-term private sector interest rates are “artificially” low.
Von Mises is telling us he believes this will induce misallocation of resources and I am betting that is exactly what we will soon discover has happened.
Yes but Mises is not alone in predicting that very low interest rates creates bad investments. Minksy, Hayek and Keynes also described identical patterns to a bubble creation. So the issue should not be that bubbles happen but how do you stop them? Hayek and Keynes were clear that you had to act counter cyclically to avoid the bubble in the first place.
My thought about ABCT. One thing that seems at fault is the idea that such investment must take resources from other companies such as labour and capital. Well labour is in oversupply right now with 18% under employed in the US and with banks flush with money capital should also not be a problem. So according to Mises the next collapse will happen closer to full employment, which will be years away. Though I suspect that it will happen long before then. When interest rates rise the returns on assets will be found to be much lower and so that might be a trigger for some problems.
Almost any idiot can buy an apartment complex with cheap funding and make money on it as long as they can fill the apartments. Low interest rates might make marginal investment opportunities profitable, but really should you consider such an investment when the returns are so low? This is all covered in microeconomics. Investment with rates of return that exceed interest rates will get the go ahead. Though if management start investing in low return options simply because interest rates are low then they really are gambling dangerously. When rates rise which they must, eventually then these investments will fail.
I do agree that with the Fed imposing severe financial repression on savers that they are having to make riskier investment choices to get adequate returns. This can be see with pension funds making big investments into hedge funds, whose returns can be higher but the outcome is that they are in reality no better off because of fees and charges. There are significant downsides to such financial repression. In driving safe investments into riskier trades you risk wiping out a nations financial capital in Ponzi schemes or other frauds. Madoff did so well for so long because he offered rates that people wanted and with apparent safety. Unless interest rates are higher then this will happen again. If people can get 5% from deposits then they will require 7% plus from stocks because of the higher risks of capital losses. If businesses have to pay 7% dividend yield then they will be only investing in projects that exceed that level. If you have very low rates then the incentives to manage them properly disappear. If rates are higher then managers will need to be active to reduce problems earlier because of the cost of funds will make management failures apparent more quickly.
What is really needed is a cap and collar for interest rates, so that mal-investment is cleared out when returns fall below the collar. How much further would US residential housing fall if interest rates were 5%? Also rather than raising rates too high use other instruments such as withholding banks capital to curtail excess lending.
As for this misallocation of resources it is already happening. It is still in housing and commercial real estate because those assets are not correctly valued. The only issue is what will trigger its collapse. There are already concerns in the UK that any recovery will lead to a rise in interest rates which will trip up many households who are just managing to hold on. That must be the same in the US.
Just as an aside, did any of these theorist model for of a massive injection of cheap (slave) labour as well as sudden disregard for worker health and safety sometimes euphemistically referred to as globalisation.
Generally I favour the Austrian’s view of things because of their stance on the pretense of knowledge when faced with a complex system. I’m sure we’d all benefit if Economists were made to take some form of hippocratic oath – first do no harm – before starting their studies.
I’m also very much looking forward to Nassim Taleb’s new book and his ideas on “anti-fragility”
Practically I’d be happy with anything that brought some honesty to the monetary system and I think the best hope for this is via some form credit control/guidance mechanism.
“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.”
An increase in wages or aggregate demand may or may not translate into an increase in prices of consumption goods. Consumer prices depend on the input costs of production and other factors such as competition. Wages can go up due to higher productivity without placing upwards pressure on consumer prices. If a producer raises his prices he may realise a lower profit due to the actions of competitors.
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