One of the surprisingly popular theories as to why the recession occurred is known as the Austrian Business Cycle Theory (ABCT), which argues that not only is the government not the solution to the recession, but in fact, it is also the cause. It claims that the recession was caused by the government artificially lowering the interest rates and distorting the economy leading to a recession. As you can imagine this theory is very popular among libertarians eager for an excuse to absolve the market of blame for the crash. It is promoted by Ron Paul and Peter Schiff who claim to have predicted the Financial Crash (and the next one too). It is also completely wrong and dangerously so.
The Austrian Business Cycle Theory gets its name from the fact that many of its original advocators were Austrian, though it is now an American ideology. It argues that when the central bank artificially lowers interest rates this causes banks to over-lend. Investments seem cheaper and therefore plans that wouldn’t have otherwise been made go ahead, creating malinvestment. The expansion of credit leads to inflation and a distortion of the economy. In particular there is an unsustainable investment in production such as the building of new factories. Eventually, the unsustainable bubble bursts and the investments have to be abandoned and the economy allowed to re-adjust. During this period the economy is in recession and workers are unemployed as they re-adjust to more sustainable plans. Crucially, unlike other theories, recessions are viewed as a necessary healing time that the economy must go through, any attempt to shorten them only delays the recovery and makes the problem worse.
The ABCT is commonly explained using the metaphor of a hangover. This turns an economic lesson into a Greek morality tale of hubris. It argues that cutting interest rates is like cutting the price of alcohol with the result that people drink too much. Eventually people run out of drink and wake up with a terrible hangover the next day. As painful as it is, it must be endured both as part of sobering up and as punishment for getting too drunk. Keynesian policies advocated by Paul Krugman (to supporters of the ABCT Krugman is the eternal enemy) are the equivalent of hair-of-the-dog, that is to say, trying to avoid a hangover by continuing to drink (launching a fiscal stimulus or keeping interest rates low). This only makes the damage worse in the long run and delays the necessary recovery. In the Austrian view you must swallow your medicine and cleanse your system.
Natural Rate Of Interest
Crucial to the ABCT is the notion of a “natural rate of interest” that is, how much it would cost to borrow if it wasn’t for government interference. Austrians view central bank control over the interest rates as a price control over a commodity that should be left to the market (though interestingly, they predict over-demand rather than under-supply as the problem). They argue that banks are a business just like any other, if they want to attract savers they will raise their interest rates and if they want to attract borrowers they will lower the interest rate. Between these two pressures banks will find an equilibrium that exactly suits the state of the economy. However, any diversion from this point by the government will distort the economy.
The natural rate of interest is so crucial to the ABCT that it cannot function without it. Which is why it is a shame that it is not true. The problem is that banks are nothing like other businesses (as anyone who has been following the papers over the last few years can surmise). When deciding how much money to save, ordinary people do not consider the interest rate they will receive or compare the rates of various businesses. The decision to save has more to do with how much is left over of your wages after paying bills as well as the temperament of the individual. Cautious people save regardless of interest rate and reckless people care even less. Likewise when borrowing money, the flexibility on part of the bank is valued more than the interest rate (for example Anglo Irish Bank was popular because developers knew they could receive money even though the interest rate was higher).
There is a further problem as the ABCT assumes there is only one natural rate of interest in the economy. However, there is no reason to think this is the case (unless there is only one commodity in the economy or it is a barter economy, which believe it or not, is what the original proponents assumed). Rather there would be one rate for houses, another for cars, another hotel construction etc. This point was even conceded by Fredrick Hayek himself who acknowledged that there is no one natural rate of interest. Without one natural rate of interest, you can’t claim the government is forcing rates too low and therefore the theory crumbles. That one of the main Austrian theorists admitted this shows how bad a problem it is.
Predicting The Crash
It is claimed that the ABCT is such a good explanation of recessions that Austrian economists both predicted the Great Depression and the Financial Crash of 2008. Unfortunately these claims fail to live up to expectations. Hayek studied the economy and market as part of his job at the Austrian Institute For Business Cycle Research where he also wrote monthly bulletins. At the end of 1928 he wrote that “The credit situation is to be described as awkward and difficult, but not as dangerous.” Here he expresses some uneasiness, but hardly a prophecy. However, his case loses all credibility when reading the bulletin of October 26th, 1929 (two days before deepest drops). Hayek writes that “However, at present there is no reason to expect a sudden crash of the New York stock exchange. However, it is not impossible that the end of the absolutely amazing price increases has arrived, and [that] the [price] level should slowly crumble. The credit possibilities/conditions are, at any rate, currently very great, and therefore it appears assured that an outright crisis-like destruction of the present high [sc. price] level should not be feared.” This is the equivalent of someone claiming in September 2008 that the economy was not going to crash and at worse would suffer a soft landing. The evidence for Mises is even scantier and needs less discussion (suffice to say there is no evidence to support the claim he did).
Some Austrian economists did predict the 2008 crash, but this is an example of being right for the wrong reasons. There is no mention in ABCT of asset bubbles, excessive debt levels, lack of regulation, bad debts, stock market crashes or basically any of the features of the 2008 Financial Crash. Low interest rates certainly did contribute to inflating the boom, but they are a small piece of the picture, not the core. The notion that Austrian economists predicted the crisis is not on its head by a footnote by one of their own. After outlining the ABCT as above, Murray Rothbard drops a bombshell that discredits Austrian claims. He writes that “To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur. (Rothbard 2004 :995–996).” In other words the ABCT predicts a bubble and burst only if businesses receive most of the lending. If consumers do, then there will not be a bubble. As the boom through the 2000s was driven by consumer borrowing (mainly to buy property) the ABCT falls flat on its face.
It is strange to hear Austrian economists who otherwise worship the market as perfect, superior to all other institutions and incapable of failure, claim that only four years of below average interest rates will almost destroy capitalism. Is the economy that brittle and that unable to adapt, that a not significant change causes it to buckle and snap? The market which otherwise is praised as the ultimate form of efficiency becomes a wildly unstable machine swinging from drought to flood with every change of interest rate. The problem for ABCT is that history disagrees. There have been periods of low interest rates without causing asset bubbles or major recessions resulting. Interest rates are merely another cost for a business and a minor one at that. Do bubbles result from all reductions in business costs? If wages temporarily decline will that lead to an unsustainable bubble? The Federal Reserve began raising interest rates as early as 2005, yet rather than dampening the boom (if interest rates were the main driver) it kept roaring on. There is a marking lack of correlation between interest rates and economic activity, making ABCT a theory without a basis.
Why Aren’t We In A Bubble Now?
The final nail in the coffin of the ABCT comes from the fact that although interest rates are at an all time low at the moment, there is no bubble or boom; to the contrary the economy is stagnating. Proponents of the ABCT claim this should lead to another bubble and many have embarrassed themselves by the failure of this prediction. It must be concluded that interest rates are not the driving force of booms. Furthermore, the massive money printing of Quantitative Easing has not lead to the mass hyperinflation as warned or another bubble, the reality has been more of a damp squib. This is especially important as Austrians seem to believe that Keynesian economics amounts to nothing more than wildly printing money, despite the fact that the idea behind QE was promoted if not created by conservative darling, Milton Friedman.
Let The Fire Burn
It’s best to think of the ABCT response to recessions as if your house caught on fire but the government decided not to send fire fighters. After all, it is the people’s own fault they weren’t watching the cooker and if everyone knew the government would put out their fires no matter what, well then everyone would take up smoking and throw cigarette ash around like confetti. No, the fire should be let burn as interference would only make things worse and the fire will naturally die out. Now this is technically true, just as all recessions do end even if the government doesn’t intervene, but left to itself far more damage is done. Refusing to fight recessions is like refusing to fight fires; the problem will last longer and spread to otherwise safe places. We may not like the cost of a fire service or that it will lead to government agents in our house, but when your house is on fire special exceptions must be made.
So that is why ABCT is wrong. It greatly exaggerates the importance of interest rates and completely misunderstands the causes and solutions to recessions. The evidence does not support it and instead shows many examples of times when changes in the interest rates did not have the extreme results predicted. Its refusal to fight recessions is not only wildly incorrect, but positively dangerous. Even conservative icon Milton Friedman declared that “I think the Austrian business-cycle theory has done the world a great deal of harm.” In making the government the scapegoat for recessions they blind themselves to the solution. There just isn’t the evidence to support the ABCT and were governments to ever fall under its sway, then disaster would result.