An Attack on the Austrian Business Cycle Theory

In my most recent post, I briefly explained what the Austrian Business Theory is. In this post, I will try to make some arguments against the Austrian Business Cycle Theory. The theory, in short, says that when the central bank extends the bank credit at an artificially low interest rate, this credit feeds a boom in the production sector, And once businesses realize that the higher demand wasn’t relative rather overall caused by an expansionary policy, they try to re-adjust their capital. This re-adjustment process is, according to the ABCT, a recession.

Now, let’s try to argue against one of the main assumptions on which the ABCT built on.

The first assumption or definition that was taken to build the foundation of the theory by Ludwig Von Mises is the notion of a natural rate of interest. The natural rate of interest, a defined by Swedish economist Knut WIcksell, is the rate that would balance the amount of capital demanded by the borrowers and the amount of capital saved by the savers in the economy. In other words, it is a market equilibrium price for the capital. F.A.Hayek explains the notion in Prices and Production (1935):

“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.”

The ABCT says that when the government or the central bank intervenes the market and controls the interest rate, the economy is distorted by this artificial interest rate.

However, the notion of the natural rate of interest could be attacked in a following way. This notion assumes that an equilibrium interest rate could be dictated by the market itself. If we want to see this natural rate of interest, we have to assume that savers and borrowers perfectly maximize the profit that can be made from the capital saved or borrowed. That perfect maximization, however, doesn’t take a place in real world. When savers decide how much money to save for future, their decision depends on not only the prevailing interest rate but also how much money they have in their saving account or for how much time period they are saving etc. For the borrowers, they also don’t react perfectly to the change in the interest rate. They might consider uncertainty in the economy or conditions on their borrowing. For these and many other factors that influence their saving and borrowing decisions, the definition of a natural rate of interest loses its assumption.

Therefore, from the very beginning of its story, which takes the notion of a natural rate of interest when it talks about how the central bank lowers the interest rate below a natural rate of interest, the Austrian explanation of business cycles is attacked by the other schools.

 

 

6 thoughts on “An Attack on the Austrian Business Cycle Theory

  1. jhchamot

    I agree with your counter-argument about the ABCT. However, we should remember that most economic theories have assumptions like these (maximization, information, rationality, etc.). So I guess the question is how unrealistic this assumption is compared to most other assumptions made in business cycles theories (or any economic theories).

    1. enjar Post author

      I agree. To me, an importance of studying theories is to learn cause and effect relationship of economic phenomena that economists came up before our time. Each theory can be argued by the others, but we still should study all most of them if not all of them.

  2. lippmanb

    I agree as well. Economic theory does not always work in practice like models may suggest. I think another good question is how this compares to other countries around the world.

    1. enjar Post author

      That will be a good research topic! I have been looking at some researches which showed that there weren’t that much empirical evidence to support the ABCT.

  3. dslavin

    I liked your concise summary of the ABCT in the beginning of the post, it gave the blog post an organized structure. One of the things I would venture to argue is that there still exists some sort of natural rate of interest even given the distortions you mentioned. It may be more difficult to measure because of these distortions, but I do think that if you look at consumers and savers on a macro level, they tend to make financial decisions similarly. Thus, I think that if we looked at a natural band of interest rates instead of a single interest rate in order to account for the distortions, the ABCT may still hold up when the government sets the interest rate artificially low, so low that it goes past the lower bound of the band.

    1. enjar Post author

      That is another good point to do research more. I think that equilibrium band of price, in general, exists for most goods in the economy. I will try to look up more on this and post more

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