Transcript | 6. lecture: The Austrian School of Business Cycles - University for modern Slovakia

What is with the crises? Are they the inevitable part of market economy or could they be avoided under certain circumstances? May governments by implementing reasonable policies prevent crises or may only partially eliminate their consequences? Right at the beginning, I will mention a very surprising opinion. The Austrian School does not believe in the effectiveness of state intervention in the market, it believes that crises could be avoided if the government were to implement correct policies, while on the other hand, the Keynesian School believes that there is a need for regulation by the state and that the state cannot prevent crises.

What is the background or the Austrian School? The most important representatives of the Austrian School are Ludwig von Mises and Friedrich August Hayek. Hayek based his theory of business cycles from 1974 on the works of Mises, for which he won a Nobel Prize in Economics. Hayek and Mises argue that the real cause of crises is always the manipulation of the value and volume of money on market, thus the policy of central banks along with the fractional reserve banking system of commercial banks.

Ludwig von Mises wrote in his book Human Action issued in 1949, I quote: "The wavelike movement effecting the economic system, the recurrence of periods of boom which are followed by periods of depression is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

So the central category of the business cycles theory is the interest rate. The interest rate actually means the value and cost of money. All prices in the market economy should in principle be determined by the market, i.e. supply and demand. And in principle they are, except of one, the most important one, the price of money. This price is determined by a state institution, namely the central bank. This is the core problem according to the Austrian School. It considers the central bank to be an institution that non-systematically interferes with the value of money and determines the value of money instead of the market, and thus de facto, it is acting as a planning commission that does not plan the amount of concrete, electricity or cars to be produced, but rather plans the actual value of money.

Why is it, according to the Austrian School, so important? We will explain it on two examples. How would it be if the value of money (interest rate) were to be determined by the market (supply and demand) and how it is in the current system, where the central bank determines the interest rate?

The first scenario. Supply and demand determine the value of money. If people save more, banks lend more; the value of money (interest rate) goes down. Lower interest rate offers more capital to implement long-term, capital-intensive projects that at higher interest rates would not be paid off. New factories are built or existing ones are expanded, future production capacity is being increased. This corresponds well with the fact that people save more, thus save for higher future consumption. In other words, lower current consumption leads to higher future consumption. Under these conditions, there is neither short-term nor long-term market imbalance. Later, if people begin to save less, money supply will decrease, interest rates will increase and the investments in long-term, capital-intensive project will also decrease. However, a sufficient production capacity has already been created that is able to increase the production and supply of consumer goods in order to meet the increased demand generated by lower savings rates and higher consumption. Thus, supply and demand for money determine the structure of investment, production and consumption, which is a key in maintaining the relationship between savings and investments.

However, in the real economy, it works differently, because the central bank determines the interest rate, thus determining the value of money. Frequently, the central bank wants to stimulate economic growth, so it begins to lower the value of money. Already, in the earlier lectures, we mentioned that the Fed did this in its effort to boost the economy after the dot-com bubble in 2000.

So what happens in the economy? People do not increase their savings, they do not defer their consumption, yet the interest rate is still low and companies venture into long-term, capital-intensive projects, since the low interest rate gives them a false signal. More is invested that it would be under normal circumstances, there is an artificial boom inflating the bubble. It is invested in projects that would not be implemented under normal circumstances, which creates long-term unsustainable situation. It is unsustainable because people do not have enough savings to increase the future consumption and to meet the future production capacities that were created during this artificial boom. The bubble thus arises mainly due to an artificial reduction in the value of money, which leads to too many investments and too high consumption. The basic relationship between savings and investment is undermined. The economy is expanding simultaneously in two opposing directions, creating an erroneous allocation of resources into projects that are unsustainable in the long run. Manipulation of interest rates means that the entrepreneurs are not able to evaluate the risks of investment; the credit expansion and low value of money give them false signal of low risk and high return on investment. Mises compares it to the site manager who builds a house and believes that he has more bricks that he actually has.

From the abovementioned, it is clear that there is a fundamentally different view on the crisis from the Austrian and Keynesian schools. The Austrian School does not consider the crisis to be the problem but rather a consequence of the problem, which is the artificial boom that precedes it, which has monetary reasons. The crisis is only a cleansing process, which re-establishes the equilibrium that was disrupted by the artificial boom and bubble inflation. It is not just a theoretical dispute, it is essential in terms of what policies to implement during crises.

The Keynesian School promotes massive interventions, including the continuation of credit expansion, while the Austrian School asserts the opposite; it is up to the markets to clean themselves up as soon as possible. Hayek, in his critical response to the government policy during the Great Depression, aptly said: Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end...."

 Despite the fact that Mises and Hayek wrote the words quoted in this lecture in the first half of last century, they were almost prophetically fulfilled in the first great crisis of the new millennium. And I fear that they will continue to fulfil.