What cause booms and busts? Introduction to the Austrian Business Cycle Theory

February 6th, 2007

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What causes the business cycle of booms and busts? According to popular belief, the business cycle is due to the collective mood of the consumers, which drives investments and spending. That is why Wall Street is so fixated on the readings of consumer confidence. Central banks, on the other hand, hope that by adjusting a lever called the ?interest rates?, fluctuations of the economic cycle can be smoothed through the resulting influence on investments and spending. Hence, it may seem that the Fed?s policy of ultra-loose monetary policy (of exceptionally low interest rates) several years ago not only prevented a recession, but created further economic growth.

But according to the Austrian School of thought, the control of interest rates is the very action that creates the business cycle. Thus, the Fed did not avert a recession several years ago. Instead, they merely defer it. Worse still, the extent of the coming recession is proportional to the excess of the prior artificially induced boom. By deferring a necessary recession and engineering a synthetic economic boom, the Fed is setting the stage of an even more severe recession down the track.

Before we introduce the Austrian Business Cycle Theory, let us ask a thought-provoking question: If we generally let market forces set the price of things (e.g. stocks, consumer goods, bonds, real estates, etc), then why is it that the price of money (interest rates) should not be chosen by the market? Does the central bank know better than the market to set the ?right? price of money?

Now, here comes the introduction to the Austrian Business Cycle Theory to explain the phenomena of booms and busts. For this, we will use a metaphor from this book, Economics for Real People:

Imagine that you are a bus driver, at the edge of a desert, about to take a busload of passengers across it. You have left all gas stations behind. Your destination is a town on the other side of the wasteland before you. You are faced with a trade-off: the faster you try to reach the town, the less the passengers can use the air-conditioning to alleviate the desert heat. Both higher speeds and higher air-conditioning settings will use up the gas more quickly. And since, in our luxurious bus, each passenger has his own temperature control for his seat, you, the driver, cannot control the total amount of air conditioning used on the trip.

In order to make your decision, you look at your fuel gauge and determine how much gas you have. You tell the passengers that they must now make a trade-off between comfort on the way and speed travelled, as the more air-conditioning they choose to use; the faster the bus will consume fuel. Then you collect statements from the passengers on what temperature they will keep their seat. You perform some calculations on mileage, speed, and fuel consumption, and pick the fastest speed at which you can travel, given the amount of gas you have and the passengers? statements about their use of the air-conditioning.

The passengers had to decide whether to cross the desert in greater comfort but arrive later at their final destination, or in less comfort but with an earlier arrival. The science of economics has little to say about the combination that they picked, other than that it seemed preferable to them at that moment of choice.

However, also imagine that, before you began your calculations, someone had sneaked up to the bus and replaced the passengers? real choices with a fake set that chose a higher temperature, in other words, one that makes it seem they will use less fuel than they really will. You will make your choice on travel speed as if the passengers will tolerate an average temperature of, say, 80 degrees, whereas in reality they will demand to have the bus cooled to an average of 70 degrees. Obviously, your calculations will prove to be incorrect, and the trip will not come out as you had planned. The trip will begin with you driving as if you have more resources available than you really do. It will end with you phoning for help, when the sputtering of your engine reveals the deception.

Stay tuned for the explanation of this metaphor!

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