Since I first highlighted the decline in the bank lending growth rate here on Seeking Alpha in January, I have written two articles during the last week (here and here) attempting to explain the economic significance of this recent development. With the growth in bank credit granted for commercial and industrial purposes the biggest culprit of this decline, pulling down the growth rate of the money supply with it, this is a timely opportunity to address the essence of the so-called "Austrian" Theory of The Business Cycle.
The roots of the Austrian theory of the business cycle can be traced back centuries. Our focus here will, however, be the theory as initially put forth by Ludwig von Mises and further developed by Friedrich Hayek and others.
Over the years, this theory has been referred to by many names. In his 1912 book, The Theory of Money and Credit, Mises coined it the "trade-cycle theory," a doctrine he stated "is called the monetary or circulation credit theory, sometimes also the Austrian theory" (Mises, 1953, p. 423). I will here refer to it as the Austrian Theory of the Business Cycle or Austrian Business Cycle Theory, as either one is how the theory is commonly referred to these days. The latter name also readily allows us to shorten it to ABCT, an easy to remember acronym.
Though many non-Austrian school economists and non-Austrians have made important contributions to the theory, the Austrian part of the name originates in the fact that it was economists from the Austrian school, most notably Mises, and later Hayek and others, who first developed a coherent theory of the business cycle.
As the name implies, the Austrian theory of the business cycle seeks to identify and explain the underlying fundamental causes of what is commonly referred to as the business cycle, i.e., broad-based expansions and contractions of economic activities in an economy. Instead of merely identifying and explaining symptoms of the business cycle, as have become not only commonplace, but often the only way these days, in my opinion, any sound economic theory traces the problem all the way back to its root causes. As Greaves once explained, "... science trace cause and effect by going back and back and back until one cannot go back any further" (Greaves, 1973, p. 76). And that is exactly what the ABCT does: it goes all the way back to the very reason overconsumption and malinvestments can take place at all in the first place and continue for some time. Most importantly, the theory also explains why both must one day come to an end.
The elasticity of the money supply (a currency with the ability to increase in volume based on demand) lies at the very heart of the Austrian theory of the business cycle for one simple reason: there would be no broad-based and large-scale business cycles without it. Consequently, if the money supply was largely inelastic, there simply would be no need for a theory of the business cycle at all, as there would be no cycle to explain. Unfortunately, the reality is that we have lived with an elastic money supply to varying degrees for a very long time, and most unfortunately, we will likely have to live with it for the foreseeable future. That's why a sound theory of the business cycle was an asset for anyone in its possession during the last century, just as it will be now and in the future.
Under existing monetary systems, someone will always receive the new money first and be in a position to spend it before others because, as Hayek puts it, "The influx of the additional money into the system always takes place at some particular point" (Hayek, 1935, p.5). Who this someone is largely depends on by what process the monetary inflation takes place at that particular time, e.g., banks issuing business or consumer loans, or banks and the central bank financing government deficits. The reality is, of course, that additional money is constantly being injected into the economy through many avenues. For example, mortgage lending is the dominant way banks extend credit to individuals in many countries, as this is encouraged, and often financially supported, by governments. Real estate prices and goods and services associated with real estate are therefore prime beneficiaries of an increased money supply.
Changes in relative prices brought about by inflation are important for the Austrian theory of the business cycle, as such changes will alter the distribution of productive resources, at least for a while. As individual prices and their interrelationships, rather than the general level of prices as such, act as signals for market participants, more will be produced of those goods and services whose prices are now relatively higher (as the prospects for profits increase) and less will be produced of those goods and services that now fetch a relatively lower price (prospects for profits decrease). That is to say, changes in relative prices prompt changes in the structure of production. Furthermore, as the general level of prices may continue growing at a rate deemed "stable" even if relative prices are changing significantly (Hayek, 1935, p. 28), it follows that changes in relative prices are more important than the rate of change in the general level of prices. (Hayek, 1935, p. 158).1 As Hayek also describes, any change in the quantity of money must always influence relative prices, whether or not it actually influences the level of prices (Hayek, 1935, p. 28). This, of course, is why central banks' dual mandate (stable price inflation and financial/economic stability) is a recipe for economic regression.
As the credit expansion process continues, the stock of consumer goods available is gradually depleted, as the supply is yet to increase or yet to increase sufficiently to offset the higher demand brought about by the higher total salaries in the producer goods sector. When this process continues, prices of consumer goods will eventually rise faster than prices for producer goods, as the economy was not sufficiently rich in the first place to undertake both a lengthening of the production process and an increase in production of consumer goods. The purchasing power granted to the producers who lengthened the production process was, as a result, simply diverted from other sectors of the economy. Moreover, this diversion of resources, set in motion by an increase in the money supply, was done against the will of the market. That is to say, the diversion of resources on a grand scale to the producer goods industry would not have happened if the money supply were inelastic, as interest rates would rise sharply (to equate the supply of, and the demand for, loanable funds), effectively putting an end to the boom. A shortage of consumer goods manifests itself in the economy, and the now relatively higher prices and profit increases for consumer goods bring about pressure toward a reduction or outright abandonment of investments in many of the new projects that were undertaken. This pressure can be postponed through yet higher doses of credit granted to the producer goods industries.
No further injection of credit and money can repair the damages done to the economy; all it can ever accomplish is to postpone the adjustment process and make the inevitable downturn even worse. This is the case as further credit injections only serve to further disturb the preferred consumption-savings ratio, which has already been pushed out of balance. What is needed, instead, is an increased rate of savings instead of yet more consumption and further depletion of scarce resources. The savings that were depleted during the artificial boom phase now need to be replenished in order to allow the economy to prosper in a sustainable fashion going forward. The faster this is allowed to happen, the shorter the downturn will be.
The Austrian theory of the business cycle was developed at a time when banks lent money into existence mainly to businesses. Specifically, though Mises recognised that the lower interest rates caused by credit expansion attracted all producers who could use the borrowed funds (Mises, 2006), the ABCT focuses on what happens when business use these funds to lengthen the production period (Mises, 1953, pp. 360-361).
At the core of the theory lies the idea that artificial booms and very real busts are brought about by a misdirection in production, i.e., malinvestments. Hayek explained that this can only occur "... when the pricing process is itself disturbed..." (Hayek, 1933, pp. 84-85). The theory therefore seeks to get to the bottom of what factors can possibly disturb the "pricing process" and how these disturbances then create the business cycle. The creation of new money is normally undertaken by banks by way of creating new deposits (money) through lending. As, especially at the time when the theory was developed, bank lending was usually done in the form of lending to businesses as mentioned above, the theory focuses on what happens when businesses lengthen the production processes with the newly created purchasing power they receive from the banks.
It would be of no economic significance if changes in the money supply affected all prices equally and at the same time (Hayek, 1935, p. 5). As prices in the real world are never affected equally nor at the same time whenever the money supply changes, a theory of the business cycle needs to incorporate this fact in its analysis. Where and how the new money enters the market are therefore of importance when it comes to understanding how money supply changes affect the economy.
In general, on what the new money is first spent, how the recipients of the money from the first receivers spend or invest their money and so forth, in addition to the size and speed of the new money influx determine how prices and the economy are affected. But these different processes have one thing in common independent of how the new money filters through the economy, and that is:
... that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of the others and the whole structure of relative prices therefore very different from what the pure theorist describes as an equilibrium position (Ebeling, 1996, pp. 97-98).
Prices are, therefore, never affected to the same extent and at the same time whenever the supply of money brings about changes in the structure of prices (e.g. see Mises, 2008, p. 409).
The Austrian theory of the business cycle deals with the particular situation where banks grant credit to businesses via the loan market (Mises, 2008, p. 568) and in this way inflate the money supply. According to Garrison, the Austrian theory of the business cycle (Ebeling, 1996, p. 112):
... emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not.
When banks expand credit, and with it new money and the supply of loanable funds, market interest rates are pushed below the level they would have been absent an expansion of credit and money. This lowering of the interest rate increases economic activity, as credit is now more plentiful than before, and as it can be attained at a lower cost. Entrepreneurs act accordingly as if actual savings have increased, though they have not. That is, entrepreneurs invest more than savings have provided for, and they do so in a lengthening of the production structure (since the shorter production methods are already exhausted). This increase in investments pushes the prices of producer goods up and an artificial boom ensues, reflecting the extent of the credit expansion and the additional investments such credit expansion brings forth.
Many ventures that previously would have been unprofitable are now found profitable given the cheaper and more readily available credit offered by banks. Especially ventures with projected cash inflows longer into the future will benefit, as they are more sensitive to changes in discount rates. More projects are, as a result, started than otherwise would have been the case, including more projects with expected payoffs longer into the future. The prices of consumer goods will increase as well, albeit at a slower pace than for producer goods, as both salaries and the number of people working in the producer goods industries increase. At least a part of this increase in total salaries will be spent on consumer goods. The supply of consumer goods, however, has not yet increased, as it takes time for the longer production processes that were initiated to finally start producing consumer goods (which is the ultimate purpose of all production). It is this mismatch between supply and demand for consumer goods that pushes consumer goods prices up.
If the credit expansion were ended quickly, the economic distortions would be smaller. However, once started, credit expansion tends to continue, as banks are able to create credit in excess of any limit set by their own assets and customer deposits. The price (inflation) premium component of the market interest rate will rise, but it does not rise sufficiently to end the credit expansion, as it will lag the rate of increase in new credit granted. Furthermore, the upward movement of the bank credit cycle sets in with full force, as fractional reserve banking allows banks to create credit, and with it, new money based on customer deposits received which were originally created out of thin air by other banks.
But the credit expansion cannot continue indefinitely. Once people come to expect continued price increases, panic will set in, jeopardising the whole monetary system as the value of the currency rapidly declines. Mises refers to this as the "crack-up boom," as everybody becomes "... anxious to swap his money against "real" goods, no matter he needs them or not, no matter how much money he has to pay for them" (Mises, 2008, p. 425).
Banks, and especially central banks, will however usually put in place measures to end or greatly reduce credit expansion before the onset of such a general panic. A bust in the producer goods industries dependent on further cheap credit, but which now face higher costs of borrowing, sets in and resources move away from producer goods to consumer goods in an effort to re-establish the preferred consumption-savings ratio of market participants. Interest rates rise, as people's degree of preference for the present over the future has increased (time preference increases).
The many who gained from the cheap credit and investment boom will now suffer; the unemployment rate in the affected industries will rise, and a portion of the investments will be lost as it becomes apparent they were, in fact, malinvestments. During the process, resources were squandered and the economy as a whole is worse off a result. The economy now needs to be "repaired" and adapt to the new situation brought about by the wasting of resources (losses) the credit expansion orchestrated - a course which requires decreased consumption and increased savings.
Mises, The Theory of Money & Credit, 1953
Greaves, Percy L., Understanding the Dollar Crisis, 1973
Mises, The Causes of the Economic Crisis And Other Essays Before and After the Great Depression, 2006
Hayek F. A., Monetary Theory and The Trade Cycle, 1933
Hayek F. A., Prices and Production, 2nd ed., 1935
Ebeling, Hayek, Mises, Rothbard, Haberler, & Garrison, The Austrian Theory of the Trade Cycle and other essays, 1996
Mises, Human Action, A Treatise on Economics, 2008
1. Hayek explains that "... general price changes are no essential feature of a monetary theory of the Trade Cycle; they are not only unessential, but they would be completely irrelevant if only they were completely "general" - that is, if they affected all prices at the same time and in the same proportion" (Hayek, 1933, p. 123).
He later explained that "There can also be no doubt that, in connection with these secondary monetary complication ["…the effects of the further monetary changes which may, and perhaps even probably will, but need not, be induced by this first change"], general price movements, apart from the changes in relative prices, will be of the greatest importance, and that anything which stops or reverses the general price movement may lead to induced monetary changes, the effect of which on the demand for consumers' goods, and producers' goods, may be stronger than the initial change in the quantity of money" (Hayek, 1935, p. 158).
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