The Mirage of Prosperity: Inflation, Deflation and the Business Cycle
This article is adapted with permission from a Twitter thread by @craigduddyecon. Comment on it here!
In the modern era, our generations have been plagued with a groaning instability. Every few years there is a new boom, a new inflation that eventually reverses itself and reduces the living standards of people among all kinds of nations. Yet, our politicians seem helpless to stop it. Here is why our system seems so unstable, and how we can put an end to it.
The Austrian Business Cycle Theory is an idea which explains why we have business cycles. These are distinct from economic progress, or recessions. Rather, business cycles are intrinsically related to unsustainable booms where the price quickly comes calling.
Originally, the outline of this theory was developed by influential economists, such as Bohm-Bawerk, Ludwig von Mises, Knut Wicksell and noble prize winner Fredrich Hayek. It was a break from the theories of either under, or overconsumption theories. Instead, the Austrian Business Cycle Theory makes the case that through manipulations in the money supply and interest rates, central commercial banking systems become proxies to fuelling unsustainable booms which will eventually reduce consumer living standard. There are a few central tools which we need to understand business cycles:
The first is Austrian Capital Theory. Put simply, the Austrian School views capital through the lens of plans rather than objects. Capital is the types of goods we produce in order to assist in producing other goods. For instance, a conveyor belt is helpful to produce more of other goods. These goods are all different, and may be put into many kinds of plans. Many economists treat this as a simple ‘factor’ of income, but this misses the whole point. If we treat a truck the same as a computer software, our analysis will suffer the consequences!
A second component we need to understand is interest rates and time preferences. The role of interest rates in the modern economy is to coordinate the preferences of consumers and producers over time. It is an economic law that people prefer things sooner rather than later, but what does this mean for cycles? If individuals have a lower time preference, then they relatively are more willing to sacrifice present consumption in the interest of future consumption. If individuals have a high time preference, they are far less likely to postpone consumption in the present.
The interest rate is a signal of this ‘price of time’ and there is two kinds. First, there is the natural rate of interest which can be considered the ‘equilibrium’ rate of interest. Second, there is the market rate of interest which is made up by commercial and central banks. A business cycle will occur when the market rate of interest—due to the behaviour of central and commercial banks—pushes it below the natural rate and therefore fuels unsustainable projects.
Finally, we have to understand the role of economic calculation, and prices. Entrepreneurs base their plans and decisions of both what and when to produce on market signals. Production takes place over time, and they must have the income to complete projects before sale. If the signal is false, plans fail! If these prices signals are artificially altered by the interest rate, then their ability to rationally calculate is also compromised. This is why we see many entrepreneurs all make the same mistake at the same time. It is not faulty judgement, but faulty signals.
Now that we have the analytical tools to understand how to analyse business cycles, what are the dynamics we should look out for? First, the spiral begins by inflating the economy. The central bank may purchase securities in open market operations by creating money themselves. Through banking operations, the money supply can be expanded and lower the rate of interest. It becomes more profitable for longer kinds of projects to take place, as entrepreneurs can now get loans cheaper to buy the machines and goods they need.
For example, if the market interest rate falls it will be more profitable for entrepreneurs to build big plants than before. If real savings haven’t been freed up for these projects, this becomes a problem. More people try to use more resources, and yet the same amount exist! Eventually, enough entrepreneurs all engage in the same mistake as each other and bid up the price of resources. When it becomes obvious that no one has enough income to keep production going, eventually many projects will be let go or liquidated, wasting massive resources.
After the bust rears its head, the temptation is always with policy makers and politicians to attain popularity by promised spending, public programmes and recovery. Yet, this can only make the issue worse. If even more money is printed, we are doomed to repeat the same mistakes. Rather, the Austrian vision of recovery is one in which we learn from our past mistakes. Central authorities (as they exist) do not do nothing, but they also do not create the same problems all over again. Hayek’s suggestion was that the central banks should expand the money supply just enough to stabilise spending, and prevent a secondary deflation.
This theory has mounds of historical support, where we can see rising asset prices, malinvestments and continuous crisis cycles. For some examples, see the Great Depression, the Dot-Com Bubble and the 2008 Financial Crisis.
A world in which all our policies are eventually doomed to reverse on themselves cannot be considered proper economic policy, and yet it is said there is only Keynesians in a recession as politicians keep power through promises kept by spending, and a little more spending. If we wish to create a stable economic system, we must look to the root cause of the entire crisis. A virus is not destroyed by pain relief, but by targeting the virus itself. That means pursuing monetary equilibrium. Not inflation, nor deflation will be the cure to our ills.
This piece solely expresses the opinions of the author, and not necessarily the Classical Liberal Caucus as a whole.
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