Monday, December 24, 2012

A Very Discount Christmas Special: Mises and Hayek are Dead

Austrian economics dominates online amateur economics blogging and commentary. Their views go largely unchallenged because most people who read their stuff agree with it or have better things to do than worry about it. Yes, I have nothing better to do on Christmas Eve than try to start a war with libertarians.

This is actually a rather charming picture and makes the
headline seem morbid and untactful.
The Austrian business cycle theory posits that the business cylce is caused by the monetary authority. So far, so good. As I understand it, the theory is based around the analysis of the so called "boom and bust cycle," with booms preceding and causing the inevitable bust. The monetary authority increases the money supply which in short-order causes an increase in prices (inflation) and a fall in real interest rates. These artificially low interest rates are below the equilibrium real interest rate that would prevail in an "unmanipulated" market, and remain so for an extended period. Firms borrow funds at these interest rates and use the loans to invest in capital projects, which because they are financed at low interest rates are low-quality projects. Later, at some unspecified point in time, real interest rates are revised upward to their equilibrium value and the investment projects, which were undertaken to the point where their rates of return equalled the previous, low, interest rate, are now unprofitable. A recession ensues as firms cancel their "malinvestments," banks write off bad loans made with the initial increased money stock, and workers and capital are reallocated away from investment, which was made excessive, and toward consumption or other sectors. 

To Review:

1. Money Supply Increases 2. Interest Rates Fall 3. Firms Borrow and Make "Malinvestments" 4. Rates Rise Again 4. Malinvestments are liquidated 5. A Reallocative Recession Ensues 6. Rinse Repeat

This all sounds reasonable enough; but as we'll see in part 2, there are fatal flaws that need to be addressed.

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