1.1. changes in relative prices and the subsequent

1.1. The Austrian Business Cycle Theory

The Austrian School is
a school of economic thought emerged in Vienna in the second half of the 19th
century, through the outstanding work of its founder, Carl Menger. The Austrian
School, which still exists today1,
has gone through several stages of development and is best known for its
liberal views, its opposition to socialism, its disapproval of mathematical and
statistical methods in economic analysis, and last, but not least, its monetary
business cycle theory.   

According to monetary
business cycle theories, the root cause of all macroeconomic imbalances is authorities’
monetary misconduct in the allocation of resources, which leads to fluctuations
in real economic activity and to depressions. Monetary theories investigate the
effects of changes in relative prices and the subsequent adjustments in real variables
caused by monetary disruptions. In this endeavor, they do not attempt to
analyze the evolution of macroeconomic aggregates, which mask the changes in
relative prices. The first monetary model of the business cycle was developed
by the Austrian economist Ludwig von Mises and was further developed thoroughly
by Friedrich von Hayek.

In effect, the first
economist who analyzed fluctuations in the economy was Richard Cantillon and he
can even be said to have laid the foundations of Austrian business cycle
theory. Cantillon developed the seeds of Austrian business cycle theory on
prices and production in Hayek’s manner, and Hayek himself acclaimed
Cantillon’s important contributions and insights. Rothbard
(1995, p. 357) also found that Cantillon provided the first glimpse of
Austrian business cycle theory. During Cantillon’s time, the institutions of
the modern capitalist economy were fully developed and the first major business
cycles occurred. According to his view, the origin of imbalances in the economy
was improper handling of the money supply by economic authorities. In the
liberal spirit, the economist showed that the money supply and other monetary
variables, such as the interest rate, are relatively stable in their natural
state and don’t need regulation by governments. Interventions by central banks
and monetary interference by governments lead to instability and harmful
dysfunctions in the economy. Essentially, Cantillon showed that aggregate consumption
and output were distorted and the functioning of the economy was ultimately impaired
when money and interest were manipulated by government. His theory provides
both the methodological insights for studying business cycles and a feasible
explanation of the business cycle (government intervention) that has
subsequently been developed and refined by David Ricardo and the Currency
School, Knut Wicksell, Ludvig von Mises, Fr. Hayek. More recently, the same
approach is used by the modern Austrian School, as well as the New Classical

The Austrian monetary
model asserts that business cycles are triggered by an excessive increase of
credit in the economy, which affects the real variables like output and
employment. This excess credit leads to untenable investments initiated by
antreprenerus, which will naturally be liquidated during the recession, when
credit contracts drastically. In the Austrian model of the cycle, the artificial
expansion phase of the cycle is a deviation from normal economic activity,
while the crisis is the natural path towards a new equilibrium. In his famous
work on business cycles, Mises (1912) showed that artificial shifts in the
interest rate by monetary authorities impact visibly on the structure of
capital in the economy. According to Mises, if interest rates are artificially
low, the volume of credits will expand, generating a boost in economic
activity. Businesses will expand, because this policy of cheap money makes even
some unsuccessful investment projects seem very appealing to entrepreneurs. As the
volume of credit increases in the economy, prices begin to surge, and
entrepreneurs ultimately find they can no longer sustain the investment
projects they started, due to a shortage of funds. However, as long as the
volume of credit continues to expand, investors will keep on borrowing money to
further finance their investments and continue their activities.

More specifically, according
to Austrian theory, the expansion in the initial phase of the business cycle is
triggered by an increase in the volume of credits in the economy. This is
generally signaled by a decrease in the interest rate – below the level that
would prevail in the absence of monetary fluctuations – and a subsequent
increase in prices. This credit expansion may be provoked either through the
Central Bank’s intervention, or through the fractionary reserve system and is
due to the artificially low interest rate. No matter the cause, the rising
volume of credits generates an improvement in business activity. Investors find
themselves in the possession of large amounts of money that they can place in
various assets in the investment process. At the same time, from the investor’s
perspective, the lower interest rate increases the overall profitability of
investments and enhances credit even further. Because the additional credit
reaches the producers/investors first, they can bid higher prices for the
assets they need in the production process. Consequently, the first visible
effect will be a relative price increase of all the goods involved in
production, i.e. a relative price
increase of intermediate goods, as compared to final consumption goods. As the
price of intermediate goods rises, the profitability of investments will tend
to slow down. At this point, if the expansion of credit does not accelerate,
the increase in intermediate prices will catch up with final goods prices,
generating a drastic decline in investment profitability. The crisis will set
in at the point where producers can no longer sell their output at existing
prices. To sell their output, they will be forced to reduce the prices, at the
cost of great losses. If, at this time, the money supply upsurges again, the
producers will be given a short break, but the crash is inevitable. The ratio
between intermediate goods prices and final goods prices must adjust in such a
manner, that the overall profitability declines to its initial or natural
level, consistent with the natural rate of interest.

Had the investment process
been sustained by a real increase in saving, the new investments could be accommodated
by the existing resources in the economy and the new production structure could
be maintained. But the business expansion is only determined by the expansion
of credit. This is because credit expansion increases the money supply,
generating the so-called „fiat money”, which have no correpondent in real
economic activity. It is just new money, artificially created through credit
and the fractionary reserve system. Soon, the newly created money will spread
throughout the whole economy, from the borrowing entrepreneurs to the factors
of production through wages, rents, interests. But because people’s time preferences
have not changed, they will spend their higher incomes according to the initial
consumption-investment ratio, prior to the expansion phase. In this way, demand
will shift back to the industries closest to final consumption. Capital goods
industries will acknowledge their investments have been unsustained, as
resources are being directed to sectors which are closer to final consumers. Accordingly,
much of these investments will have to be liquidated. The entrepreneurs have
been misled into investing in goods with longer production structures, which
are usually further from final consummation.

Thus, according to
Austrian business cycle theory, through a policy of easy money, public
authorities induce the appearance of profitable investments and reduced risk among
economic agents. Consequently, hazardous agents will engage into business
activities, which will generate more credit expansion, as long as the interest
rates remain low. While, in the short run these policies may encourage business
activity, they will generate unfeasible investments in the economy over the
long term, that is, investments which would be unprofitable at normal interest
rates. Credit growth engenders excess investments and consumption, which are
not consistent with the individuals’ time preferences and the availability of
resources. Hayek’s contribution consists in developing the theory that monetary
injections can impact systematically on the inter-temporal evolution of prices,
leading to the so-called intertemporal discoordination.

In explaining
economic crises and depressions, Austrian economists (Mises 1949, 1953; Hayek
1933, 1939; Rothbard 1963, 1969) focus on errors made by participants in the
market. Their aim is to explain the recurrence of the phenomenon we call
crisis. Roger Garrison states that ”

In Hayek’s
view, economic problems are, without exception, coordination problems. Effective
synchronization of economic activities means the compatibility of plans among
market participants. If the buyer’s plan matches the seller’s plan at the
moment of the exchange, then both participants will be satisfied with the
results and gains of the exchange. Profit indicates the matching of plans.
Under uncertainty, people base their decisions on judgment and anticipations.
Correct judgments will bring profits to entrepreneurs, whereas, wrong judgments
will incur losses. In Hayek’s system, errors are associated with knowledge
problems. Poor judgment and anticipation leads to mismatching of producers’
plans, coordination failure and dysfunctions in the economy (Hayek, 1937).

According to Hayek’s
theory, the decrease in the interest rate may be caused either by changes in
the time preferences of consumers, or by authorities’ flawed monetary policy.
If the change is preference-induced, then changes in prices will modify the
production structure according to the new consumer preferences. If, on the
other hand, the change is policy-induced, then economic agents will receive
false signals from the market, resulting in a mis-allocation of available
resources among the production phases. Since the interest rate is artificially reduced
during the boom, firms will put their money primarily into physical capital. Because
business is booming, the production process can take more time to produce the
same amount of real output. Due to incomplete information, market will signal
that the additional resources be engaged in the early stages of production. This
is all the worse, because it will take more time and financial resources to
complete the production process. At one point, investors will find that they
cannot complete the production process. This is because more investment
projects have been initiated than can possibly be sustained by the real economy
and the ensuing resource scarcities will eventually generate the bust.

At the same
time, however, the lower interest rate means that consumers increase their
consumption and decrease saving. The injection of credit in the economy
provides more funds both for investment in early-stage, higher-order
production, and in later-stage, lower-order production at the same time. The
effect of the low interest rate is an economy where real consumable output
takes longer to produce, while consumers are less willing to wait for their
needs to be satisfied. This production structure is unsustainable, and
eventually will result in the abandonment of many entrepreneurial plans, of
much installed capital and of goods in early production stages, as well as in
high labor unemployment, even if the interest rate is kept low. Both producers’
and consumers’ entrepreneurial plans are disrupted because they were grounded
on a lower interest rate and a longer production

The bigger and longer the
credit expansion, the longer the expansion phase. The boom will be complete when
credit growth begins to slow down, below the level required by the market and
the initial ratio between consumption and investments is restored. The longer
the boom, the worse the errors of producers’ plans and the longer the ensuing
depression phase. 

Thus, the recession is merely
a process through which the economy adjusts to the errors and malinvestments of
the expansion phase and reorganises according to consumer preferences. The
adjustment phase consists of the rapid liquidation of erroneous investments. Some
of these investments will be abandoned completely, while others will continue in
part.2 The underlying principle will be the efficient use of
the existing capital stock. The recession is nothing more than a cleansing
process for the economy, which restores the optimum level of efficiency. This is
the necessary and natural path towards normal economic activity, after the distortions
created in the expansion phase.  


For a short while
during the two world wars, the Austrian business cycle theory dominated the
academic environment, but it was soon to be eliminated by the Keynesian theory,
despite its theoretical and practical utility3.
Its major flaw was the Austrian’s theory lack of a remedy to the onset and
progress of the crisis. In the Austrians’ vision, the best remedy for the
crisis was its prevention. Once the crisis has set in, we can only let the
economy liquidate the mal-investments and return to its natural, sustainable
production level. At the opposite end, Keynes’ theory provided not only an explanation,
but, most importantly, a cure to the crisis, through government anti-cyclical


1 In other
parts of the world, primarily the United States of America

Rothbard, M, America’s Great Depression, pag 12-13

3 Even today, the Austrian theory
of the business cycle provides the most feasible explanation for the Great
Depression of 1929-1933 in the United States of America