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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I dont know about Hayeks cycle theory that much but Misesean theory of the cycle is all about bank created funny money and credit.
It has nothing to do with a foreign infusion of investment cash.
The reason the rise in the supply money and credit causes the boom is that the change mimics a change in real savings and time preference while there is none. The only way the amount of credit to increase in free market is the way of savings to increase. If the amount of credit increases regardless of the savings this means the increase is artificial.
If China saves and send its savings to the US as credit this would has no boom effect for the general economy. Because the credit is backed with real savings, and real savings can sustain the capital structure of new investments done with those foreign there wouldn’t be a bust.
Anyways why would anyone think of these booms and busts regarding only to certain geographical locations? If credit from China can cause a boom in the US that means credit from New York can cause a boom in New Jersey and if I give credit to my neighbor that may cause a cycle. This is absurd.
An of course the cycle isn’t about only Central Banks. It is about fractional reserve banking but the CB’s sustain these fractional reserve banks.
But since the whole link between gold and fiat money is broken this point is forgotten.
I have to agree with ktibuk. The effect of foreign investment on developed economies must be miniscule in comparison to the effect of the Central and Fractional Reserve banking systems.
Blaming foreign investment is too easy – looking outward, away from our problems closer to home. Besides which, the effect of foreign investment would be positive if we only accepted gold and silver in payment for shares and commodities. In which case there is a real transfer of wealth to the nation, rather than an inflation of debt-backed currency.
Or am I being obtuse?
I’m confused. So is Bernanke’s glut of savings explanation valid?
Ha! Bernanke seems to want to blame the whole crisis on the idea that banks had too much money lying around and this prompted them to go wild with shaky financial products.
The problem lies not with how much money banks have, but how much they give away. You can’t run into this sort of problem without the fractional reserve system, which is itself facilitated by central banking and the idea of a fiat currency.
And for future reference – nothing Bernanke says is valid.
I’m sorry – in my ranting I didn’t notice that that anonymous post was likely tongue in cheek! Obtuse again!
Another good article! Thanks! Hayek lays the blame where it should be, “the existing credit organizationâ€, or fractional banking. Also, Hayek reminds people that fractinal banking has been around so long it’s unlikely to ever go away.
In addition, the link between the Feds and Chinese is very close. It could be argued that much of China’s savings came from a loose Fed policy which encouraged Americans to buy imported goods from China and give the Chinese their savings which they invested in the US. Monetary policy has a strong effect on trade. In addition, once the inflated US dollars found their way back home, the fractional banking system used them as reserves to further inflate the money supply. In economics, everything is less than six degrees in separation from the Feds.
PS: It would be nice if economists who want to criticize Austrian economics would first learn Austrian economics. Austrians rarely create straw men from mainstream economics, but mainstream economists generally fight straw men of their own creation and call it Austrian.
Bernanke certainly won’t claim to be even part of the problem. They would likely say anything to avoid putting the blame where it belongs.
In a more general sense, any time cash or credit unbacked by real goods is added in, disrupting the connection between savings and borrowing, then malinvestment can occur. But the simple facts are that The Fed and fractional reserve banking are so fundamental and ubiquitous in our current economy that it’s silly to go looking for third parties to blame, or claim that our current circumstances are anything like inevitable in a capitalist system. If the Chinese are going to infuse large amounts of money or credit into the American economy, then it’s important to understand where that money or credit is coming from to see if it will cause malinvestment. After all, the Chinese government isn’t printing U.S. dollars, are they?
ktibuk:”real savings can sustain the capital structure of new investments done with those foreign there wouldn’t be a bust.”
Only in the long term. If there is a temporary increase of savings then the immediate response is not to make the structure of production more roundabout. That is the long term result. In the short term things are much more uncertain.
I think the quote from Hayek contradicts the thrust of Greg’s post. Hayek’s example illustrates how a decrease in savings can lead to an unsustainable boom in an environment of fractional reserve banking. To the extent to which an increase in the supply of loanable funds represents real savings and not newly created paper or electronic media, an increase in global savings cannot possibly explain an unsustainable boom, and the conflict between ABCT and the global-savings-glut hypothesis is not a false dilemma.
Applying Hayek’s reasoning to the global-savings-glut hypothesis, we ought to expect that if anything this would damp the boom phase of the business cycle. Hayek gives the example of a diminution of savings driving the natural rate of interest above the observed market rate. An increase in savings would have the opposite effect: pushing the natural rate down relative to the market rate. This would to some degree counteract the effect of a Fed driven credit expansion that pushes the market rate down relative to the natural rate.
According to Hayek, it would have taken a decrease in savings (precisely the opposite of a global-savings-glut) to drive the natural rate below the market rate and produce an unsustainable boom. In this respect, ABCT is in direct conflict with the idea that an increase in savings could drive an unsustainable boom. The dichotomy between an ABCT Fed/fractional reserve driven boom and the global-savings-glut hypothesis is very real.
Note that Hayek’s alternative root causes must still depend on the “existing credit organization†under which banks are able to supply a greater volume of credit than would be available if they were restricted to the supply of available savings. In the absence of fractional reserve banking as an intermediate cause, changes in savings, expectations, etc. would not cause a gap between the real and market rates of interest, and the subsequent boom-bust cycle, to develop. It is the ability of the banks to operate on a fractional reserve basis that permits the market rate to differ from the natural rate in these cases.
Actually, gold was once the source of an Austrian Business Cycle in Spain. The Spanish imported gold from their (Latin) American colonies, which fueled an artificial boom and led to an bust when the gold dried up that brought down the Spanish Empire.
An substantial increase in the amount of money, even under a commodity standard, will cause an artificial boom and a bust (although, under the free market, that bust will never turn into a Great Depression; government intervention is necessary to cause that).
kitbuk,
“the existing credit organization†described by Hayek refers to Fractinal Reserve Banking. Thus, in our current system, money creation by fractional reserve banking could also be attributed to Central bank/monetary policies since the existence of the Central bank or some other government cartelizing entity is needed in order for fractional reserve banking to exist. The Austrian Business Cycle theory doesn’t rely on the credit created by the central bank.
Rothbard’s explanation of the Austrian Business Cycle clearly attributes the cycle to fractional reserve banking. The central bank is then a detailed practical realization to make the fractional process efficient for the banks. Additional injection of artificial credit by the central bank itself only makes the problem much much worse.
Brad,
Hulsmann would classify the Spanish Empire Inflation as a state caused error cycle. The major difference between Spanish gold mining and mining on the free market is the use of slaves and other acts of state intervention which prevent the application of Rothbard’s analysis of monetary increase via gold mining to that situation. As such, instead of market signals indicating that gold mining would be productive, state decree and intervention lowered the costs to the mine owners and like free coinage, created an unwarranted and unwanted glut in the supply of new money.
I think it would be a mistake to point to this as an example of the failure of the gold standard. The danger to conflate the peaceful coordination of the market with the bungling of the interventionist state is high whenever the actions of the state impede most directly on the money supply. The only alternative market actors have is to discount the current money and select a new medium of exchange. Clearly, this is undertaken only in the most severe cases of governmental bungling.
fundamentalist,
you hit on the most important point that can be made when people blame foreign savings for our woes in the USA. Namely, it is an inflationary process which initially provided these “excess” savings which foreigners later reinvest in the US as a protection against further inflation. If you want to know what is truly “made in the USA,” this is clearly the number one product. I.e. the fundamental cause is inflation in the US. The fact that the return of the inflation is delayed does not counteract the effects that the initial inflation caused, it may merely determine which areas of the economy are most heavily malinvested in. Furthermore, it is impossible to determine how much of that foreign investment represents true savings and how much represents central and fractional reserve bank inflation. The only way to determine this is to let the market recover from the credit binge and discover which enterprises are sound and which were undertaken in the haze of credit inebriation.
I agree with Ktibuk. Why on earth should real savings cause a boom-bust cycle?
The Chinese didn’t increase their savings rate. It has always been high. What probably increased was the dollar amount which that savings rate represented. If the savings rate was 50%, and it stayed the same, then an increase in exports to the US would not increase the savings rate, but it would increase the amount saved.
For the savings to prevent a business cycle, it would have to be American savings, not Chinese. The Chinese got their dollars from US credit expansion which increased imports from China. When they loaned those savings to the US, essentially US credit expansion went overseas and then came back home where through fractional banking it helped increase credit expansion further.
Had the increased savings been American savings, then Americans would consume less and the business cycle probably wouldn’t start, although it gets confusing when you consider that increased savings will artificially inflate credit via fractional banking and the increased credit will be greater by a factor of ten than the increase in savings. My head hurts.
Inquisitor,
Read my previous remark to Kitbuk. Real savings going into a fractional reserve banking system will still generate a boom-bust cycle. That is because the real savings will be used as a reserve to expand credit on top of the that. The expaned credit is not real savings. it is “forced” savings (stolen from others through inflation). If only real savings is used in the system and the reserve requirement is 10%, then you still have about 90% artificial credit created out of thin air by the banks. The Austrian Business Cycle accounts for this scenrio, as properly explained by Murray Rothbard in “Mystery of Banking” and his many other writings.
OK, but that still leaves the focus on the FRB system. I think to blame a glut of savings for this mess misses the point. Good explanation at any rate.
“PS: It would be nice if economists who want to criticize Austrian economics would first learn Austrian economics. Austrians rarely create straw men from mainstream economics, but mainstream economists generally fight straw men of their own creation and call it Austrian.”
Yes, too true.
Stanley & Brad,
The Spanish didn’t just mine gold. They also stole quite a bit of it. That’s a lot cheaper than mining and has nothing to do with market signals.
kitbuk & Inquisitor,
Chinese savings represents the forgoing of natural resource consumption by the Chinese. If the Chinese government, through currency undervaluation, can transfer claims on natural resources from their economy to our economy where no savings has taken place, wouldn’t the resulting distortion of the structure of production in our economy be similar to the effects of credit expansion?
Inquisitor,
It comes down to the important fact exemplified by this quote by hayek:
–Hayek, Pure Theory of Capital p. 394, (see also Huerta de Soto, p.690)
I take this to mean that if any of the monetary increase is used directly to bid up consumer goods, or if any of the profit (for how long? what of the profit to the bank? must it eschew consumption of its profit too?) from the capital goods purchased is consumed, the business cycle will occur. Thus it is not the savings and investment of foreigners which is ultimately to blame, but the inflationary tendencies of the central bank and the fractional reserve banks. We can not expect that the time preferences of economic actors both here and abroad will suddenly decrease to zero as is all but required to offset the artificial stimulation created by the banks. We can expect foreigners to attempt to protect their imported dollars by reinvesting them in the U.S. In doing so the initial effects of the money creation are only postponed, not negated.
It seems as if myopia in economic matters is a prerequisite for becoming a court economist (this is not a slight at Inquisitor, but at Hummel, Cowen et al.).
ktibuk, you don’t get the point. The author’s point is that an increase in savings and investment is multiplied via fractional reserve banking, creating an unsustainable boom. It’s the same cause (credit expansion) but a different mechanism (private counterfeiting instead of socialist counterfeiting).
After reading this piece, I must ask, then, is it not possible for the “malinvestment” of savings to occur by a misdirection of true credit (savings backed) to certain markets?
This would be caused by a CB distorted price system that only get compounded by frb. If the CB embarks on a light to moderate credit expansion (circa 2001-2003), could this be enough to distort the price system by an amount such that when true savings (e.x. Chinese) is committed at that specific time, it becomes “malinvested”? The CB distorted price system acts as a misdirector in which booms and bust appear.
“Chinese savings represents the forgoing of natural resource consumption by the Chinese. If the Chinese government, through currency undervaluation, can transfer claims on natural resources from their economy to our economy where no savings has taken place, wouldn’t the resulting distortion of the structure of production in our economy be similar to the effects of credit expansion?”
It would but the way this is usually phrased is misleading.
noob,
Yes, if certain aspects of the misdirection involve state fostered “illusion”, please see Hulsmann.
What effect does the Yuan being pegged to the dollar have in this debate? Wasn’t it only the the past year or so that they finally de-pegged it? With the Yuan pegged to the dollar, wouldn’t the Yuan have inflated at the same rate as the dollar?
“Must The Central Bank Be The Source Of An “Austrian” Boom And Bust?”
The answer to that question is “no” but I don’t think the article addressed that question. Clearly one can have fractional reserve monetary inflation causing a boom without any central bank. Also any leveraged system will do with or without government intervention. It doesn’t need to be a “bank”. Just so long as there is a mismatch in time frames between lenders and borrowers.
Stock market margin accounts seem problematic in this regard also, as do GSE’s that lend money, Social Security trust funds, and the like. Each can cause cycles of differing lengths.
Wait till everyone who thought there SS money was invested for 30 years discovers it was spent instead. Talk about a mismatch in time frames. It’s the opposite of the fraud commited by fractional reserve. With fractional reserve short term investment (and often non-investment cash flow) is lent long term. With SS a long term investment is used for cash flow. In this case forced savings.
My understanding is that the Japanese are also experencing this kind of backwards fraud. Their intended savings being long term but instead being consumed, by us.
It’s would be a vast simplification of Austrian theory to think this current business cycle was caused by foreign savings invested in US fractional reserve banks. Especially since from my understanding that’s not where most of the foreign money was funneled. Much of that savings bought stocks and bonds. Quite a bit went into these bundled real estate securities at the end.
At least that’s my understanding. I wasn’t aware of any news of foreigners opening lots of savings accounts in our banking system. Correct me if I’m wrong.
Concerning China and Savings Glut, the following three articles by Mike Shedlock may be of interest:
http://globaleconomicanalysis.blogspot.com/2006/12/global-savings-glut-revisited.html
http://globaleconomicanalysis.blogspot.com/2007/09/global-savings-glut-exposed.html
http://globaleconomicanalysis.blogspot.com/2008/06/bernanke-blames-saving-glut-for-housing.html
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