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Must The Central Bank Be The Source Of An "Austrian" Boom And Bust?

12/01/2008

Many economists seem to think that the Austrian Theory of the Business Cycle is an explanatory projected circumscribed by its dependence on the identification of lose money created by a central bank as the necessary explanans for the boom and bust cycle.  But this is not Hayek’s view, and a careful reading of Hayek makes is clear that Hayek considered other sources of the misdirection of capital through the time structure of production as equally valid generators of the artificial boom / inevitable bust pattern of the trade cycle.  In Hayek’s view, the mere fact of the elasticity of the supply of credit in the private banking system makes it possible and likely that spikes in the supply of investment cash can set in motion expansions of credit that are unsustainable across the time structure of production and consumption.  Misperceived price signals in the credit system are quickly embodied in real goods — such as capital goods — becoming systematic distortions of the system of relative prices across the structure of production and consumption.

To put this in contemporary terms, a spike in investment cash from China and other Asian countries could set in motion a much more massive credit expansion by Western financial institutions far beyond anything warranted by this infusion of fresh investment capital, setting in motion unsustainable distortions across the time structure of production and consumption as described by the Austrian theory of the artificial boom and inevitable bust.

Hayek’s rejection of lose monetary policy by a central bank as the necessary and exclusive explanans of the Austrian trade cycle theory can be found in Lecture IV of Hayek’s Monetary Theory and The Trade Cycle.  Find there also Hayek’s example of an artificial boom / inevitable bust cycle generated by private commercial banks rather than by a central bank.

From Hayek’s perspective then, Jeffrey Rogers Hummel, Tyler Cowen and other economists are offering up a false dilemma when they suggest that an Austrian account of the current boom and bust must stand against an explanation of recent events which appeals to a spike in investment cash from China and other Asian countries as a central cause of the current boom and bust.  They are wrong to suggest that an Austrian explanation of the current boom and bust cycle must necessarily invoke monetary policy on the part of the Federal Reserve in its explanation, and they are wrong that an Austrian explanation cannot invoke the spike in investment cash from Asian as a trigger for a credit induced over-expansion which creates unsustainable distortions across the time structure of production and consumption.  A sound Austrian explanation might invoke the Asian investment spike alone, or it might invoke both the investment spike and Fed policy.  Or it might invoke Fed policy alone.  Theory doesn’t rule in or out these alternatives, historical investigation and explanatory plausibility does.

Click in the extended section for quotes setting out the false alternative imagined by Hummel and Cowen, as well as a brief section from Hayek in which Hayek clearly rejects the identification of the Austrian theory solely with explanations that make essential appeal to central bank policy.Here is an example from Jeffrey Rogers Hummel making the mistake of identifying Austrian boom/bust theory with central bank policy explanations, and holding out Austrian theory as an explanatory rival to any account which invokes investment cash from
China:

For those who are skeptical of explanations relying on irrational asset bubbles or pervasive market failure, there are three primary alternatives: (1) monetary expansion under Greenspan generating a self-reversing boom as in Austrian business cycle theory or something similar; (2) government-induced moral hazard from some combination of subsidized risky mortgages, implicit government guarantees, leaking deposit insurance, and the infamous “Greenspan put,” which promised to use monetary policy to prevent any collapse of asset prices and bailout institutions too big to fail; or (3) a savings-glut coming from abroad, particularly China, that then started to recede.

And here’s an example of Tyler Cowen doing the same thing

I don’t side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash.  I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.

Finally, here’s a brief section where Hayek rejects the identification of the Austrian theory with an explanation appealing exclusively to central bank policy:

The fact that [action by the Central Bank] is not an inherent necessity of the monetary starting point is however shown by the undoubtedly endogenous nature of the various older trade cycle theories, such as that of Wicksell. But since this suffers from other deficiencies, which have already been indicated, the question of whether the exogenous character of modern theories is or is not an inherent necessity of their nature remains an open one. It seems to me that this classification of monetary trade cycle theory depends exclusively on the fact that a single especially striking case is treated as the normal, while in fact it is quite unnecessary to adduce interference on the part of the banks in order to bring about a situation of alternating boom and crisis. By disregarding those divergencies between the natural and money rate of interest that arise automatically in the course of economic development, and by emphasizing those caused by an artificial lowering of the money rate, the monetary theory of the trade cycle deprives itself of one of its strongest arguments; namely, the fact that the process it describes must always recur under the existing credit organization, and that it thus represents a tendency inherent in the economic system, and is in the fullest sense of the word an endogenous theory.

It is an apparently unimportant difference in exposition that leads one to this view that the monetary theory can lay claim to an endogenous position. The situation in which the money rate of interest is below the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the “natural rate” (at which the demand for and the supply of savings are equal) above its previous level; while the banks refrain from raising their rate of interest to a proportionate extent, but continue to lend at the previous rate, and thus enable a greater demand for loans to be satisfied than would be possible by the exclusive use of the available supply of savings. The decisive significance of the case quoted is not, in my view, due to the fact that it is probably the commonest in practice, but to the fact that it must inevitably recur under the existing credit organization.

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