For the man on the street the multiple stock market crashes in March were an unforeseen circumstance caused by the Coronavirus Pandemic, disrupting an otherwise strong economy. For the Austrian Economists, the reality was no surprise, and neither were the other major recessions of the 20th century. Before the Great Depression, Austrian economist Ludwig Von Mises developed the most complete and logically consistent explanation of the boom and bust cycle, now known as Austrian Business Cycle Theory.
Only Austrian Business Cycle Theory is built on foundations of correct theories of capital, interest, saving, and investment. It correctly analyses the problem of fiduciary media, inflation and deflation. Most importantly, the approach recognizes the irrefutable law of time preference, the distortions to which form the reality of business cycles. Based on the a priori deductions of Austrian Business Cycle Theory, unless 2+2 =5, the collapse of the housing market was inevitable in 2008 and a further downturn is inevitable now.
In a free and unhampered market, individuals are secure in their property rights to make the trade off to consume or to save, and capital goods have undisturbed market prices indicating their supply and demand. A medium of exchange is originated in the voluntary market in the form of commodity money. Given free banking, banks are free to enter and exit the market and cannot issue further banknotes than their real reserves due to the threat of redemption of these notes by competing banks. In the market economy, the real rate of interest is determined by the time preferences of individuals acting in the market, and gross interest rates reflect real interest rates in the supply and demand for credit.
With an individual and their given income, they are faced with the trade off between immediate consumption or saving. The trade off is between enjoyment in the present of the current income, or the enjoyment of increased resources at a period in the future. The cost of saving for the future is a decrease of consumption in the present, while the cost of consumption is the forgoing of the opportunity for increased wealth in the future. The ratio between consumption and saving formed in the market is time preference.
Real time preference formed by subjective valuations form real, or origionary, interest. Monetary interest rates reflect real interest rates and serve as a market price for credit. The law of time preference is that equal goods are more valuable in the present than in the future. In other words, waiting time is disutility. 100 dollars on demand now is more valuable than 100 dollars in one year. Therefore a price premium is demanded with the return of the money. With 5 percent interest, 100 dollars is worth 105 dollars in one year.
Saving is a prerequisite for the issuing of credit. A loan cannot be granted without money that is unused, or set aside in the present for the given amount plus interest in the future. When banks issue increased credit, it indicates a greater supply of loanable funds, and lowers the market interest rate. A lower market interest rate indicates an abundance of saved resources and capital. Under this condition, the projects taken on by entrepreneurs are sustainable for the given economy and realizable. A higher interest rate would indicate the scarcity of loanable funds, or saved resources. There is not a great enough supply of capital goods to take on the projects that would exist under lower interest rates.
To coordinate the possibility of projects in an economy, the market interest rate serves as a price signal to entrepreneurs. Capital investment varies in its remoteness from the present. The building of an oil rig is more remote than an oil refinery. One is further in time from the final consumer good than the other. Greater credit is needed for capital investment projects that begin to produce goods at more remote periods in the future. Therefore, only lower interest rates are an indicator for entrepreneurs to embark on these projects. Higher interest rates indicate the resources for less remote projects. Not only does the interest rate indicate to the entrepreneur when society has the available capital for ambitious time-sensitive projects, it coordinates with the demands of a society that saves. When saving takes place, it is an indication that the saver prefers increased wealth in the future over current resources in the present. The investment projects that coordinate with the interest rate meet this demand.
Then the central bank intervenes in the economy, changing conditions that would otherwise exist in an unhampered market.
Regardless of real saving, the central banking system is able to artificially expand credit, increasing its supply with fiduciary media. Fractional reserve banking issues fiduciary media by granting fraudulent loans that are not backed by real reserves. This process is only made possible en masse by control and cartelization of banks under the central bank. When the credit expansion takes place, the market interest rate is artificially lowered below the real interest rate.
When this happens, entrepreneurs take the price signals as if real resources are available for more ambitious and remote investments. Business costs are decreased with the lower price of credit and an artificial boom ensues. In appearance, great investment projects are begun, and employment increases to near full employment. With capital in higher demand without a real increase in their supply, the price of capital goods increases, as well as wages and consumer prices. Furthermore the constant supply of fiduciary media increases the money supply and inflates stock market prices, creating the illusion of a bull market.
During this period, riskier behavior by speculators is encouraged by the constant bull market and easy conditions for greater credit. Government, businesses, and households are discouraged from real saving and often spiral into debt. Long running artidicial booms may increase the number of zombie companies, like in 2020. Although the market appears to be in strong condition, these conditions have a limited number of endings, and they are all downturns.
Ludwig Von Mises writes a near perfect analogy for the business cycle in Human Action, with a hypothetical bricklayer building a house. In a free market, real savings would reflect the supply of capital goods available for the construction of the house, and the remoteness from present use. Increased saving would translate to a blueprint for a larger house that takes longer to build, versus less saving and a smaller house that is finished sooner. If the real conditions are of the latter, but credit is inflated to give false impressions to the investor, a larger house will be attempted when real resources are not actually available for the project, and its profitability is not realizable.
Towards the end of a boom, its effects will be revealed in the emerging debt and inflation of certain prices. The central bank, first, could continue to flood the market with credit as long as possible. This would result eventually in the hyperinflation of consumer prices and what Mises called, the crack-up boom. Individuals would lose confidence in US dollar, and “fly into real values”, forcing the economy to contract, and the malinvestments to liquidate. The more likely case is that credit is tightened before mounting inflation, and the malinvestments are liquidated. When this happens, unsustainable and unprofitable projects, that appeared realizable under the artificial conditions of credit expansion, are revealed to be malinvestments. These projects can only be liquidated. The stock market, wages, and other artificially high prices deflate and unemployment grows high for a time. What happens in what we know as the recession, is formerly distorted conditions caused by central bank intervention, are becoming realigned to the real conditions of the market. The economy can only return to normal conditions through a downturn after the boom.
Austrian Business Cycle Theory is an a priori deduction that can only be denied by ignoring basic axioms of the economy. The greatest error by other schools of economic thought, that impair them from realizing the correct view of business cycles is the ignorance of time and time preference in the economy. The direct cause of malinvestment in an artificial boom is the distortion of the price in an economy that economizes and allocates resources through time. To refute Austrian Business Cycle Theory, or ABC Theory, we would have to deny the law of time preference, deny the implications of time preference based on real saving. Furthermore, we would have to deny the implications of interest as a price signal for entrepreneurs, deny the formation of the rate of interest in a free market, and possibly many more laws of economics.