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Monetary Central Planning and the State, Part 9: The Austrian Theory of the Business Cycle


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The Austrian theory of the business cycle was first developed by Ludwig von Mises. He built the theory on the earlier contributions of his Austrian teacher, Eugen von Böhm-Bawerk, and the writings of the Swedish economist Knut Wicksell.

We saw that the Austrian economists, especially beginning with Böhm-Bawerk, had emphasized that all production takes time and that every production process necessarily involves a period of production from the time a production process is undertaken to the time when a finished good is ready for sale and ultimate use by the consumer. The Austrians also explained that for time-consuming processes of production to be undertaken, savings was needed. Savings was needed to free up resources from more direct consumption uses so that they would be available for investment in the formation and maintenance of capital and for supplying goods and resources to sustain those employed in “roundabout” production processes.

Savings arose out of the time preferences of market participants who were willing to forgo present uses and consumption of goods and resources and transfer them to those who wished to utilize those goods and resources in the processes of production. The market interactions of suppliers of and demanders for those resources generated market rates of interest that balanced savings with investment. At the same time, the available savings resulting from the inter-temporal market exchanges set the limits on the periods of production that could successfully be undertaken and maintained, given the fund of savings available to sustain them in the long run. (See “Monetary Central Planning and the State-Part VIII,” Freedom Daily,” August 1997.)

In 1898, Wicksell published Interest and Prices. He adapted Böhm-Bawerk’s theory of capital and time-consuming processes of production and took it a step further. Wicksell explained that in actual markets, goods do not trade directly one for the other. Rather, money serves as the intermediary in all transactions, including the transfer of savings to potential borrowers and investors. Individuals save in the form of money income not spent on consumption. They then leave their money savings on deposit with banks, which serve as the financial intermediaries in the market’s intertemporal transactions.

Banks pool the money savings of numerous people and lend those savings to credit-worthy borrowers at the rates of interest that come to prevail in the market and that balance the supply of the savings with the investment demand for it. The borrowers then use the money savings to enter the market and demand the use of resources, capital, and labor by offering money prices for their purchase and hire. Thus, the decrease in the money demand and the lower prices for consumer goods due to savings — and the increased demand and the higher money prices for producer goods due to investment borrowing — act as the market’s method to shift and reallocate resources and labor from consumption purposes to capital-using production purposes.

But Wicksell pointed out that precisely because money served as the intermediary link in connecting savings decisions with investment decisions, there could result a peculiar and perverse imbalance in the savings-investment process. Suppose that the savings in the society was just sufficient to sustain the undertaking and completion of periods of production of one year in length. Now suppose that the government monetary authority in that society were to increase the amount of money available to the banks for lending purposes. To attract borrowers to take the additional lendable funds out of the market, the banks would lower the rates of interest at which they offered to lend to borrowers.

The lower market rates of interest due to the monetary expansion would raise the present value of investment projects with longer time-horizons until their completion. Now suppose that borrowers were consequently to undertake investment projects that involved a period of production of two years in length. Because of their increased money demands for resources and labor for two-year investment projects, some of the factors of production would be drawn away from one-year investment projects. As a result, at the end of the first year, fewer consumer goods would be available for sale to consumers. With fewer consumer goods on the market at the end of the first year, the prices of consumer goods would rise and consumers would have to cut back their purchases of consumer goods in the face of the higher prices. Consumers, Wicksell said, would be forced to save, i.e., they would have to consume less in the present and wait until the second year had passed and the two-year investment projects had been completed to have any greater supply of goods to buy and consume.

At the same time, the greater supply of money offered for resources and goods on the market would be tending to increase their prices and, as a consequence, the society would experience a general price inflation during this process. If the government monetary authority were to repeat its increase of the money supply time — period after time — period, there would be set in motion what Wicksell called an unending “cumulative process” of rising prices.

In his book The Theory of Money and Credit (1912, 2nd ed., 1924), Ludwig von Mises accepted the general outline of Wicksell’s analysis of the effect of a monetary expansion on production and prices. But he took Wicksell’s idea further and demonstrated the process by which a monetary expansion of this type eventually created an “economic crisis” and generated the sequence of events known as the “business cycle.”

Mises distinguished between two types of credit offered on the market: “commodity credit” and “circulation credit.” Mises’s student and early follower in applying the Austrian theory of the business cycle, Fritz Machlup, called these two types of credit “transfer credit” and “created credit.” And it is this latter terminology that we will use because it more clearly designates the distinction that Mises was trying to make.

If there were no increase in the money supply, then any money savings out of income would represent a real transfer of market control over resources and labor from income-earners to potential investors. Savers will have lent a quantity of real resources represented by the monetary value of those real resources in investment activities instead of using them more directly and immediately in the manufacture of consumer goods. This “transfer credit” of real resources for investment purposes would be returned to savers when the money loans were paid off with the agreed-upon interest. The returned sum of money would then have the capacity to purchase a greater quantity of real goods and services for consumption purposes. And the investment projects undertaken with the transfer credit would have time horizons consistent with the available savings and the period over which the loans were made.

However, the government monetary authority has the capacity to disrupt this fairly tight fit between savings and investment that is kept in balance by the market-determined rates of interest. Through its ability to expand the money supply, the monetary authority has the power to create credit for lending purposes. The “created credit” is indistinguishable from transfer credit for purposes of market transactions. It represents additional units of the medium of exchange that are interchangeable with all other units of money offered on the market in trade for various goods and services. And thus those units are just as readily accepted in market transactions as the units of the money supply in existence before the monetary expansion.

Yet, Mises argued, there is this important difference: there is no compensating decrease in consumer demand for goods, services, and resources that normally follows from a decision to save more than previously, to counterbalance the increased demand for the use of resources and labor by investment borrowers who have taken the created credit offered to them on the loan market.

At this point, Mises applied his theory of the non-neutrality of money to explain the sequence of events that were likely to logically now follow. (See, “Monetary Central Planning and the State-Part VI,” Freedom Daily, June 1997.) With the newly created credit, the investment borrowers would bid resources and labor away from the production of consumer goods and investment projects with shorter time-horizons to begin the undertaking of investment projects with lengthier periods of production. To attract resources and labor into the more time-consuming investment activities, investment borrowers would have to bid up the prices of the required factors of production so as to draw them away from their alternative uses in the economy. The newly created credit now passes to those factors of production as higher money incomes. They become the “second-round” recipients of the newly created money. Unless those factors of production were to undergo a change in their time preferences, and therefore in their willingness to save, their real demand for consumer goods would be the same as it was before the increase in the money supply. They would, therefore, increase their money demand for finished goods and services in the same proportion out of income as before.

As a result, the prices for consumer goods would start to rise as well. But because of the reallocation of resources away from consumer goods production, the quantities of such goods available on the market are smaller than before, which intensifies the rise in the prices of consumer goods. As the factors of production expend their higher money incomes on desired consumer goods, the sellers and producers of those goods become the “third round” recipients of the newly created money. Producers of consumer goods now increase their demand for the same scarce factors of production to draw them back into the consumer goods sectors of the economy and into investment projects with shorter time-horizons to more quickly try to satisfy the greater money demand for consumer goods. The factors of production drawn back into activities closer to the final consumer stage of production become the “fourth-round” recipients of the newly created money.

Those who initially had taken the created credit off the loan market now find it increasingly difficult to continue with and complete some of their longer-term investment products in the face of the rising costs of continuing to employ the required quantities of factors of production that are moving back to the consumer goods sectors of the economy. A “crisis” begins to emerge as growing numbers of these longer-term investment projects cannot be financially continued. The demand for more additional lendable funds from banks to continue projects that were begun, pushes market rates of interest up, creating an even greater crisis in the investment sectors of the economy. The expansionary or “boom” phase of the business cycle now turns into the contractionary or “depression” phase of the cycle, as a growing number of the lengthier investment projects collapse, are left incomplete, and result in a malinvestment of capital in economically unsustainable lengthier processes of production.

The only way some of those investment activities could be temporarily saved would be for the government monetary authority once again to increase the money supply in the form of more created credit. But that would merely set the same process in motion again with the same inevitable result further down the road. And if the monetary authority were to try to prevent this inevitable result through greater and greater increases in the money supply, the end result would be a higher and higher rate of price inflation that would threaten the destruction and collapse of the society’s monetary system.

Mises’s conclusion from his analysis was that the causes of the business cycle in modern society are not to be found in some fundamental flaw in the market economy. Rather its basic cause is to be found in government manipulation and mismanagement of money and credit.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).