A Graphical Introduction to the Austrian Business Cycle Theory
By: Gaurav Mehra
Twitter: @g__mehra
Email: gmehra@uwo.ca
For a pdf version of this article: Intro to ABCT – Final
Business cycles, simply put, are the fluctuations of economic growth about an economy’s long-term trend. Identifying the symptoms of business cycles is simple enough but identifying their cause is a much more formidable task. Indeed, many theories have tried and many have failed to provide convincing causational links. Many economists and politicians have even come to accept business cycles as an inherently pernicious trait of capitalism. This article attempts to explain, to the best of its author’s ability, a relatively forgotten and anti-conventional theory that aims to explain business cycles; the Austrian Business Cycle Theory (ABCT). Named after its origin in the Austrian School of economic thought, this theory places emphasis on the rate of interest. Specifically, the theory argues that when the rate of interest is set arbitrarily by monetary authorities different from where the market would have it, there is an adverse affect on the structure of production which serves as one of the main catalysts behind the booms and dreaded busts of the business cycles.
This article is presented in a fairly informal tone and employs the use of a graphical framework in which the workings of the ABCT can be conceptually understood. All of the graphs presented belong to and have been reproduced with the permission of professor Roger Garrison of Auburn University. For a more comprehensive and better explained account of the ABCT, professor Garrison’s book ‘Time and Money’ more than meets the challenge[1].
To see how ABCT works, we’ll need an understanding of four major concepts:
- Production Possibility Frontier (PPF)
- Loanable Funds Market (LFM)
- Structure of Production
- Stage Specific Labour Markets
We will use these four concepts in unison to demonstrate and differentiate between sustainable growth, supported by savings, and unsustainable growth, which is supported by increases in the money supply – much like what is done today by various central banks.
Production Possibilities Frontier (PPF)
The PPF in the context of ABCT illustrates the necessary trade off between investment and consumption (figure 1). The idea behind this is simple. The more you consume, the less money you have to invest with and so the less you invest. Similarly the more you invest, the less money you have to consume with and so the less you consume. Investment in this case represents gross investment, which comprises replacement capital, i.e. investment used to replace the worn out capital already in use, and net investment; which is the new capital created (gross capital = replacement capital + net capital)[2]. A key point to note is that in conventional theory, consumption and investment require no such trade-off[3], an increase in consumption spending does not necessitate a decrease in investment spending and vice-versa.
Figure 1 – Only points on the PPF are efficient. Anything inside the PPF is inefficient as either more can be consumed or invested at the given point and anything outside of PPF is unsustainable as the economy does not have enough resources to sustain such a level consumption and investment.
Sustainable economic growth is represented by an outward shift of the PPF, as now higher levels of both consumption and investment can be achieved. The rate of this growth depends on many factors.
Suppose that the savings preference of individuals changes and they become thrifty, deciding to save more. This is a signal that they want to consume less now and more in a later period, and there will accordingly be a movement down along the current PPF as consumption decreases, leading to an increase in investment and the economy will grow at a faster rate in the future (figure 2). Note that the rate of growth is higher than it would have been had the savings preference of individuals not shifted allowing for a higher level of investment.
Figure 2 - Had individuals not decided to save, the economy would have grown at a slower pace than it would have had they saved. This is because a decrease in consumption today allows for increased investment, which ultimately leads to more production and consumption in the future.
But how does an increase in savings by income earners lead to an increase in investment by entrepreneurs and why does this lead to a higher economic growth rate in the future? To explain this, we must introduce the concept of the market for loanable funds.
Market for Loanable Funds (MLF)
The market for loanable funds brings the savers and borrowers of an economy together; it can be adequately represented through a simple supply and demand graph (figure 3). Savings comprise the supply of loanable funds, while the willingness of individuals (entrepreneurs, corporations, etc.) to borrow money and take on investable business projects comprise the demand for loanable funds. According to ABCT, the interest rate in the economy should be set where demand and supply equilibrate as determined by the market. The interest rate plays a key role in ABCT, and later we shall see what happens when interest rate is not set at the interest rate as determined by the market for loanable funds[4].
Figure 3
Returning to our previous example, if individuals decide to become more future oriented and save, then the supply of loanable funds increases, which is represented by a shift of the supply curve to the right. When this happens, the interest rate falls and total investment increases as the business community takes advantage of the lower interest rate (since the cost of borrowing money, also known as the rate of interest, has gone down). This is considered sustainable growth because the drop in the rate of interest is brought about by an increase in savings.
Figure 4 shows how the market for loanable funds and the PFF work together in professor Garrison’s graphical framework.
Figure 4 – The increase in savings leads to a decrease in the interest rate which leads to increased investment and less consumption.
The notion that a lower interest rate spurred on by an increase in savings will lead to less consumption and more investment which will ultimately lead to increased consumption in the future is contrary to the conventional notion that a decrease in consumption spending would lead to a surplus of inventories which would eventually lead to production cuts, layoffs, and ultimately less investment resulting in a recession (the “Paradox of Thrift”). This Keynesian belief had not accounted for the fact that retail inventories are not representative of all investments, but only a portion of investments, and that although a reduced interest rate brought about by increased saving will be accompanied by a reduction of investment in inventories, it can cause an increase in what are described as ‘early stage’ investments. To understand this concept, we must introduce the notion of the structure of production.
The Structure of Production
ABCT is unique in the fact that it disaggregates investment, or more accurately production, into various stages based on time. This disaggregation can be represented graphically through a figure called the ‘Hayekian Triangle’, appropriately named after its conceptualizer, FA Hayek (figure 5).
Figure 5
The Hayekian Triangle represents the structure of production. It can also be viewed as a timeline in which investments take place[5]. Furthest to the left represents early stage investments, those that are furthest away from the consumer. These are investments that require the most time to come into fruition, such as research & development, mining, etc. As we move further to the right, we come across progressively later stage investments. These are investments that are to come into fruition relatively soon and are thus closer to the consumer. For example, in the middle of the triangle we can find investment activities such as refinement and distribution and all of the way to the right we can find investment activities such as retail.
The triangle itself can increase or decrease in length in response to consumer preferences (see figure 6). The length of each stage represents the amount of resources allocated to that stage while the height is representative of the value of consumable output produced at the final stage. It is important to note that at any given time, all of the stages are at work, however the amount of resources allocated to each stage and the output produced, may vary. For example, when people decide to save money, they send two seemingly conflicting signals to the market.
The first signal; the decrease in consumption, results in a corresponding decrease in demand for late stage investments. This is because if individuals have decided to save more, they are signalling that they are forgoing current consumption; thus investments in later stages such as retail inventories, which are for the purpose of immediate consumption, make no sense. The second signal; the lower interest rate arising from the increase in savings, stimulates demand for investment goods as more enterprising individuals will seek to take advantage of the lower financing rate. Furthermore, since a decrease in the interest rate would make long-term projects that produce cash flows in the future appear more attractive than projects that generate short-term cash flows,[6] more investment will be directed into early stage investments, which, through inner workings of the market, happens to match up with consumer preferences.
This coordination of investment and consumer preferences is what ABCT claims to be the most important function of interest rates and why they should not be set artificially by the central bank but only by individuals through the market.
Under the conventional aggregated model of the economy, these two signals are seemingly conflicting since in the model AD=C+I+G+(X-M), the investment term ‘I’ encompasses all investments without regard to stage. Thus, a decrease in late stage investments which would decrease ‘I’ and an increase in early stage investments which would increase ‘I’ cannot be adequately captured by such an aggregated model.
In the ABCT however, we can see that when an increase in savings leads to a decrease in the rate of interest, the structure of production increases in length to reflect the influx of investment into the earlier stages of production and decreases in height to reflect the decrease in consumer spending (figure 6).
Figure 6 – A decrease in the interest rates brought upon by an increase in savings leads to the lengthening of the production structure reflecting increased investments in the earlier stages of productions such as R&D and decrease in height representing reduced current consumable output.
As shown earlier, an increase in savings in the present period leads to higher growth in a future period. With an initial increase in savings and subsequent decrease in consumption, the amount of consumption falls below the projected consumption for the current period. The economy then adjusts and quickly surpasses the old projected trend as the increased savings makes funds available for investment in the current period, which ultimately results in more production and consumption in future periods – more than would have been possible had the additional investments not taken place (figure 7).
Figure 7
Stage Specific Labour Markets
Continuing the trend of aggregation, conventional theory also employs an aggregate labour market and wage rate, where the quantity of labour employed and the average wage paid is representative of the entire labour market. As we saw with production, disaggregation reveals different stages of production and following from that we also have different, or more accurately, stage specific, labour markets. As demonstrated before, an increase in savings decreases the demand for late stage investments and increases the demand for early stage investments; we should expect to see a similar fluctuation for labour demand in each of the respective stages of production. This is known as the wage rate gradient (figure 8).
Figure 8
The influx of early stage investment implies an increase in labour demand for those employed in early stage production related industries. As such, more individuals in this stage are employed at a higher wage rate. Conversely, the opposite is true for those employed in late stage production related industries. The demand for their labour falls and thus fewer individuals are employed at a lower wage in this stage.
Putting the pieces together.
Figure 9 illustrates how these concepts all work together in graphical harmony.
Figure 9 – The increase in savings leads to a drop in the interest rate, which leads to an increase in investment that results in the augmentation of the structure of production causing fluctuations in stage specific labour markets.
It is important to stress that when the Market of Loanable Funds determines the interest rate, it functions as an inter-temporal coordinator. Essentially, the interest rate coordinates the time preference of consumers with the investment decisions made by entrepreneurs. When individuals save more it means that they want to postpone consumption to a future period, this, as we saw leads to increased investments in the earlier stages of production because the cash flow generated by long term investments becomes relatively higher due to the lower interest rate’s affect on discounted cash flows and since these investments will come into fruition sometime in the future, which is exactly when individuals would want to consume more, the market rate of interest is serving as an inter-temporal coordinator. Similarly if people save less, signalling that they want to consume more now, interests rates will increase and entrepreneurs will invest more in late stage investments (again, because the increase in interest rate makes short term discounted cash flows relatively more valuable than long term cash flows) such as retail goods, which are available for immediate consumption– matching up with consumer preference.
However, when a monetary authority artificially sets interest rates as is the current case, the inter-temporal coordination function of the interest rate gets thrown out of whack, which is what ABCT believes to cause the booms and busts that plague capitalistic economies. This is what we’ll examine next.
It’s all about credit expansion.
As touched upon briefly before, conventional policy is all about increasing aggregate demand (AD = C+I+G+(X-M)). When the Central Bank decides to reduce the interest rate with the intent of boosting borrowing by consumers in order to spur economic activity and increase AD, it does so by increasing the money supply – essentially by loaning it into existence. This is done by Central Bank through a process called open market operations, where it buys government bonds with newly printed money. This newly printed money then enters the economy thus increasing the money supply. This newly printed money proxies for real savings, and causes the supply curve of the loanable funds market shifts to the right as it normally would, but this time the shift is not supported by an increase in savings and consequentially not representative of a shift in consumer preferences (figure 10).
Figure 10
The newly created money drives a wedge between investments and savings. The business community borrows more, taking advantage of the lower interest rate shifting their demand curve to the left, while consumers respond to the lower interest rate by saving less and consuming more now that the incentive to save is weakened[7]. This phase is known as the ‘boom’. Business activity increases, more investments are made – especially into long-term projects, investors get high returns on their investments, consumers spend more money, and aggregate demand increases.
Remember, it is the newly created money and not actual investible resources that uphold the discrepancy between the investments and savings. This is the antecedent to the bust. The lower interest rate increases investment activity, implying a rightward movement along the PPF towards investment. However, savers are now saving less, which implies a leftward moving along the PPF towards consumption. This ‘tug of war’ precipitated by credit expansion pushes the economy to an unsustainable point outside of the PPF (figure 11).
Figure 11
The low interest rate stimulates investment into the early stages. However since the lowered interest rate is misallocating resources into early state investments (what ABCT calls malinvestment) when resources should really be directed into late stage investments – because consumers are saving less and consuming more, many of these early stage investments wont ever be profitable. Further more, when the economy becomes too ‘hot’ due to the credit induced boom and the central bank is forced to increase interest rates to taper inflation, many of these long term investments which were undertaken during the boom under the discounted cash flow calculation of low interest rates will now seem unprofitable not only because they don’t match up with consumer preferences but because the rise in interest rates will make the financing costs too burdensome relative to the decreased value of cash flows. Once the central bank contracts the supply of credit, businesses and investment projects that once seemed profitable during the boom period will now go bankrupt, be scrapped or sold at losses. Employment will fall and as a result so will spending, leading to a contraction of aggregate demand and ultimately GDP, all of which is known as the dreaded ‘bust’.
We have just seen the mechanics of the boom and the bust. The Austrian prescription is to avoid the boom in the first place, so that there will be no bust. If the interest rate is allowed to be set by the market – which by its very nature knows the consumption and savings preferences of the millions and millions of individuals that comprise it, and not by a group of central bankers, the economy can then experience sustainable growth. It is when the central bankers get involved and lower the interest rate in a typically injudicious attempt to boost economic activity that we see such calamities and economic fluctuations.
Rejected by the majority of mainstream economists, ABCT is not without its criticisms. Although the majority of criticism directed towards ABCT comes from a lack of understanding of theory itself, which is of course because many economic institutes fail to teach their students the theory, there are those criticisms that do posses validity. It is obvious that the ABCT has quite a ways to go in its development, but in any case, it nonetheless provides an exceptionally unique and interesting insight into the inner workings of markets and the nature of business cycles.
END NOTES
[1] Professor Garrison’s book can be purchased here: http://www.amazon.com/Time-Money-Macroeconomics-Structure-Foundations/dp/0415771226
[2] Capital is defined as hard goods that can be used in the production of other goods such as factories, machinery and other equipment.
[3] Conventional theory rests upon increasing Aggregate Demand (AD) as a means of increasing a country’s GDP. AD is equal to consumer spending plus investment plus government spending plus exports minus imports (AD = C+I+G+(X-M)) hence an increase in C doesn’t necessitate a reduction in I, a notion that ABCT holds to be false.
[4] Today, interest rates are not set by the market but are set by central banks such as the Federal Reserve and the Bank of Canada at a rate they deem appropriate. They do this by increasing the supply of money. By increasing the supply of money, the interest rate (can be thought of as the cost of money) falls. It is important to note that the increase in money does not represent and increase in savings and it is this very fact that according to ABCT is the culprit of monetary policy induced booms and bust.
[5] Investment must necessarily take place in one stage or another of the triangle. Also, we have displayed 5 stages but this is just for the purposes of explanation, a complex modern economy can have 100’s of different stages.
[6] Businesses use discounted cash flow (DCF) models when analyzing investment opportunities. With lower interest rates, DCF models attribute a relatively higher value to future cash flows as they are discounted to a lesser degree through time. This relative increase in future cash flow value stemming from a decreased interest rate may suggest that the cash flows to be generated in the future will justify the short term costs of financing the project, hence the long term project makes sense to undertake.
[7] The incentive to save in this case is the return savers receive on their savings (the interest rate) which has been lowered by the Central Bank
Twitter: @g__mehra
Email: gmehra@uwo.ca