Explanation of the Austrian Business Cycle: Part 1

This was originally published at NetRight Nation here.

Lately in the news, we have seen varying explanations of the credit crisis. Some people blame the lenders, some the consumers, some the government, and some all three. Congressman Ron Paul along with many economists have argued that it was the central bank that messed up the financial markets, which is usually called the “Austrian Business Cycle Theory.” First, you are probably wondering why it is called “Austrian.” This is because of the school of economics it is derived of. In Ludwig Von Mises’ Human Action, he explains this business cycle theory, which will shed light on the current situation. Even those who do not usually subscribe to the Austrian school of thought have mentioned Austrian-like explanations for the current situation. For example, famed author of “The End of Poverty,” Jeffery Sachs recently came out saying “To a large extent, the US crisis was actually made by the Fed, helped by the wishful thinking of the Bush administration.[1]” I agree with Sachs on the first part of his statement, however I do not think that even the Bush administration could “wishfully think” us into a recession.

Most people remember the housing boom that swept the nation and drove our economy. President Bush even ran in 2004 on the platform that more people now have owned their own home in American than ever. The first step of the Austrian business cycle is that the central bank, in this case the Federal Reserve (Fed), expands credit. They can do this by adjusting the reserve rate, the federal funds rate or making open-market operations. If we look back around June of 2001, we can see that the Fed lowered the federal funds rate to 3.75%, which was a .25 percent cut. The short-term interest rates at this time had fallen 2.75 points since the beginning of the year[2]. It was also being reported that consumer confidence was being raised and the housing sector continued to climb with these falling interest rates. New home sales at that time were up 8.8% from a year before that.[3] This then completes the second part of the Austrian business cycle, which is that firms, in this case the housing sector for the most part, borrows more for long-term project. This is because they believe that the lower interest rate is because of the consumers saving more money, which means long term spending preferences. The third stage of the Austrian business cycle is that capital and labor are bid away from short-term projects to move to these longer-term projects, as seen in stage two. One thing that was found to be interesting is during this move towards housing investments we saw car interest rates cut to zero and created a mini-boom in the car industry that was contributed to the growth of GDP at the beginning of the year 2002[4]. As I mentioned consumers’ confidence was on a continual rise and this completes the fourth stage of the Austrian business cycle, which is labor will spend money on current consumption and in turn will raise short-term profits. The housing market is continuing to rise with the low interest rates from 2001-2002. According to The Economist, the housing boom was and is bigger than the stock market bubble of the late 1990s and they believe it could be the biggest bubble in history.[5] Since 2001, over two-fifths off all the private sector jobs where in the housing industry[6]. This includes the construction, real estate and mortgage broking areas. It is also important to note that in other countries, they are feeling the effect of a failed housing market bubble. Japan has kept interests rates low while their housing prices fall constantly. Prices there have fallen for 14 years in a row and by 40% since the early 1990’s[7]. Germany has seen the same thing and both of these economies have been plague with lower consumer confidence. This is more proof that, in the reverse, consumer confidence will grow with a boom from an interest rate created boom in the economy. The next stage is when the pain begins.

[1] “Comment is Free” http://commentisfree.guardian.co.uk/jeffrey_sachs/2008/03/the_roots_of_crisis.html

[2]“Another shot from Dr Feelgood; Monetary policy; Greenspan cuts rates again” The Economist (US) (June 30,2001)

[3] See footnote 5.

[4] “Saying that America’s prospects for economic recovery have improved, the Fed left interest rates unchanged at 1.75%.” The Economist (US) (Feb 2,2002)

[5] “In come the waves – The global housing boom.” The Economist (US) (June 18,2005)

[6] See footnote 8.

[7] See footnote 8.



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3 CommentsLeave a comment

  1. […] Read the rest of this great post here […]

  2. […] she basically claims the Austrian Business Cycle as the winner. You can find an explanation here and here from me: “The particular asset varied from one boom to another. But the basic […]

  3. […] First, if you haven’t you should read my posts on the Austrian Business Cycle here and here. My very first discussion of recessions can be found here. I can only repeat myself so […]

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