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Understanding the Austrian Theory of the Business Cycle

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Tags Booms and BustsBusiness Cycles

06/01/1986Mark Skousen

The Free Market 4, no. 6 (June 1986)

 

One of the highlights of my professional career occurred recently when I had the opportunity to talk with Professor F. A. Hayek at his vacation home in the Austrian Alps. It was an unforgettable experience. Since the death of Ludwig von Mises in 1973, Professor Hayek has been the acknowledged dean of the "Austrian" school of economics, which teaches individualism, laissez-faire economics, and the gold standard. He is now 86 years old, but sharp and alert, and still working hard on a number of projects.

Professor Hayek is the oldest living member of the Austrian school, which began in Vienna with Carl Menger in the 1870s, and continued with Eugen Bohm-Bawerk, Ludwig von Mises, and Murray N.Rothbard, among others. In 1974, Professor Hayek won the Nobel Prize in Economics for his work on the Mises-Hayek theory of the business cycle.

Of all the many contributions of the "Austrians," their theory of the business cycle is one of the most valuable. Economists and Wall Street analysts have known for decades that the markets are highly volatile. There is a business cycle in national output, interest rates, and inflation, creating bull and bear markets in stocks, bonds, gold, and so on. And Austrian theory is the only satisfactory explanation of this business cycle.

The first thing to understand is that the principal source of economic disruption and the business cycle is irresponsible government policy. The business cycle, inflation, and high nominal interest rates are not caused by the free market, but by government's monetary and fiscal policies.

Without government intervention, the free market economy would reflect:

  1.  Stable interest rates, probably in the 2%–3% range, as in the 1950s.
  2. No inflation. In fact, historically, average prices have tended to decline slightly with a free market and gold standard.
  3.  Low unemployment. No minimum wage laws and forced collective bargaining, which keep wages artificially high during a recession.
  4.  High savings rate. Contrary to standard Keynesian doctrine, high personal savings rates are good for economic growth.
  5.  Economic growth without recessions or depressions.

But as long as government is ubiquitous, and controls the supply of money, it will appear that "capitalism" is inherently unstable, as the Marxists say. Only the wise student of history and economic science knows that government policy, not the free market, is responsible for economic instability.

The key to understanding the economic cycle is what the Austrians call the "structure of production." Unlike the Keynesians and Monetarists, the Austrians look at the economy not as a whole, but as a collection of individual parts—not "macroeconomics," but "microeconomics."

The easiest way to understand the "structure of production" is to see how the economy exists at a single moment, as if a snapshot were taken. If the whole economy were suddenly frozen, what would you see? You would see some products and services completed, such as cars coming off the assembly line ready to sell to consumers. Other products would be half finished, and still others would be just starting production.

In other words, there is an order to the production of goods and services in an economy. The "higher" order or stages of production are "capital goods," which include tools, machinery, raw materials, trucks, and other goods necessary to produce final consumer goods, which include automobiles, food, clothing, and so on.

This distinction is very important in understanding the inflationary boom~bust cycle. As the Austrians point out, the central bank (the Federal Reserve) expands the money supply in a way that affects certain industries more than others. Historically, because the Fed expands the money supply primarily through the credit markets, the capital-goods investor has been more affected than the consumer-goods market.

There are essentially four. states to the business cycle:

First, the inflationary boom. The Fed expands the money supply by purchasing Treasury securities from banks. Profits in capital-intensive industries tend to rise, and because the stock market is highly capital-intensive, the stock market goes through a bull market. However, at the later stages of the inflationary boom, consumer prices start catching up, the stock market loses its luster, and the bull market ends. Also, at the end of the inflationary cycle, gold and silver and other inflation hedges move up sharply.

Second, the credit crunch. Once consumer prices start rising sharply, and interest rates start edging up, the Fed usually puts on the brakes and causes a credit crunch. Interest rates rise rapidly as capital industries scramble for funds to escape bankruptcy.

Third, recession. Production of capital goods falls more sharply than consumer goods. Gross National Product declines, and stocks continue to fall. Interest rates start dropping as demand for credit declines. Prices for commodities and capital goods tend to fall more sharply than consumer goods, which sometimes continue to rise ("inflationary recession").

Fourth, economic recovery. The recession in capital goods ends as the economy returns to stability.

The Austrians are the only school with satisfactory answers to two questions facing economics today: 1) how it is possible to have low inflation in the face of double-digit increases in the money supply, and 2) inflationary recession.

The "low-inflation" environment continues, despite 10% annual increases in the money supply, because of the previous "malinvestments" in the capital goods industries. When companies are on their backs, it requires a greater increase in credit than the previous cycle to achieve a return to previous levels of economic prosperity. After the economy has gone through a major recession and the inflationary psychology has been broken, the government must expand the money supply at a higher rate than the previous cycle in order to achieve the same level of economic activity and price inflation. Note, however, that under President Reagan, the money supply has grown at the same rate as under President Carter, but not more—therefore, we would expect, under Austrian theory, the inflation rate to fall below the double-digit rates of the 1970s. Indeed it has.

I believe the money supply must expand at a 15% to 20% annual rate in order to rekindle double-digit price inflation this time around. So far it hasn't happened, although lately M1 has been growing at a 14% rate. At some point, of course, price inflation will catch up, but it's too early to tell when this will happen.

During the inflationary stage of the business cycle, production and prices for capital goods and raw commodities tend to rise much more than for final consumer goods. Only at the later stages of the inflationary boom do consumer goods (as measured by the Consumer Price Index) begin to rise.

Look, for example, at the production of automobiles. During an inflationary boom, the price of iron, steel, aluminum, and other producer goods used in building cars may increase substantially, perhaps doubling in value. But the price of an automobile in the showroom may increase only 5% to 10%.

During a recession, just the opposite occurs. Prices for producers' goods and raw commodities drop sharply, compared to consumer goods. In the case of cars, steel may fall sharply in price. Meanwhile, the price of finished cars may fall only slightly, or, as has occurred recently, continue to rise.

Thus, consumer goods always tend to rise in a recession relative to capital goods. If you look at the statistics of any recession, you'll note that the raw commodities price index and the wholesale price index fell by a greater amount than consumer prices. Consumer prices also tended to fall, but not by the same amount. In other words, consumer prices rose in relation to wholesale and commodity prices.

The relationship still holds even today during a recession, except that now in absolute terms, consumer prices are rising instead of falling. This is because the magnitude of monetary inflation is much greater than in past cycles. So, relative to capital goods, all recessions are "inflationary recessions." It's just that such a relationship didn't become obvious until the Consumer Price Index continued to rise in the 1973–1975 recession and the 1980–1981 recession.

If you want to learn more about this aspect of Austrian economics, I recommend the following books, all available from the Institute: What Has Government Done to Our Money?, by Murray N. Rothbard ($3), America's Great Depression also by Rothbard ($18), An Introduction to Austrian Economics by Thomas C. Taylor ($3), and The Austrian Theory of the Trade Cycle by Ludwig von Mises and others ($3); shipping charge: $2.25 with each order.

All show that the only way that we can escape from the business cycle is through the establishment of sound money (i.e., a gold standard and no central bank) and the free market. If we are ever able to do so, the Austrian school of economics will deserve the credit.

Cite This Article

Skousen, Mark. "Understanding the Austrian Theory of the Business Cycle." The Free Market 4, no. 6 (June 1986): 1, 4–6.

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