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The Austrian Theory
of the Trade Cycle and Other Essays
Answering questions about the Austrian School
By Jason Kauppinen
Business cycles affect the lives of all people; from the entrepreneur to the average citizen. Naturally these cycles are the subject of a great deal of study by economists. For instance, the disciples of Keynesian theory contend that insufficient consumer demand is the cause of bust periods in the trade cycle. Consequently they tout government manipulation of consumer spending as a cure. The Monetarists, however, see bust periods as a failure of central bank policy to provide enough liquidity. In response, they advocate government manipulation of the money supply through a central banking system. Both of these schools of thought however, are unable to adequately answer the simple question that Murray N. Rothbard asks within his essay "Economic Depressions: Their Cause and Cure".
"...the market economy has a built-in natural selection mechanism for good entrepreneurs, this means that, generally, we would expect not many business firms to be making losses. And, in fact, if we look around at the economy on an average day or year, we will find that losses are not very widespread. But, in that case, the odd fact that needs explaining is this: How is it that, periodically, in times of the onset of recessions and especially in steep depressions, the business world suddenly experiences a massive cluster of severe losses? A moment arrives when business firms, previously highly astute entrepreneurs in their ability to make profits and avoid losses, suddenly and dismayingly find themselves, almost all of them, suffering severe and unaccountable losses?" (Rothbard, pg 64)
These questions are answered by the Austrian Theory of the Trade Cycle; a theory fully outlined by the book The Austrian Theory of the Trade Cycle and Other Essays. This slim paperback contains the aforementioned essay by Murray N. Rothbard, as well as essays from Ludwig von Mises, Gottfried Haberler, and Friedrich A. Hayek. Roger W. Garrison also contributes an introduction and a summary. The trade cycle theory that these five writers support is profoundly different from both Keynesian and Monetarist theory.
Gottfreid Haberler's essay, "Money and the Business Cycle" is a step by step explanation of the Austrian Trade Cycle Theory. The Austrian theory contends that the boom-bust cycles of modern economies are actually caused by centralized government run banking systems. These act as a catalyst for the creation of ultimately unprofitable projects by private banks.
Haberler explains how the allocation of capital is central to the Austrian theory. He contrasts the Austrian's view of capital as something that is added to and also changed over time in reaction to different business conditions with the Keynesian view of capital as a fixed, monolithic, unalterable stock. He then details how the theory is used to explain how a government manipulated interest rate distorts the flow of capital and causes both the boom and the bust portions of the trade cycle. Finally he explains what role a bust period plays in attempting to correct a government induced distortion of the capital structure.
Ludwig von Mises' essay "The 'Austrian' Theory of the Trade Cycle" begins by outlining the theory's origins. It is based in part on the English "Currency School" but improves upon its two major defects. The first error is that it omits the role of current accounts in monetary expansion. The second is its narrow focus on credit expansion within one country only. Austrian school authors such as Mises and Hayek modified and expanded the theory to cover the case of central banks in multiple countries engaging in monetary manipulation simultaneously. Mises then shows how the Austrian theory can be used to explain the origins of the economic difficulties that Germany experienced in the 1920's and 1930's. He concludes his essay with a brief examination of bank policy options during depressions.
Friedrich Hayek titles his essay with a rhetorical flourish: "Can we still avoid Inflation?". He proceeds to cover the first the well-known destructive effect of inflation among borrowers and lenders as well as its lesser-known effect of distorting the capital structure of an economy. Hayek also shows how the Keynes' idea of uniform inflation was nonsensical, and how public policy based upon it must be ultimately destructive.
Roger W. Garrison's introduction presents a broad overview of the development
of the Austrian trade cycle theory. Of particular interest is his observation
that the Austrian theory was typically included in economics texts until
the 1930s. It then lost prominence in the wake of the "Keynesian
Revolution" that occurred after the publication of Keynes' General
Theory of Employment Interest and Money. Garrison maintains that Keynes'
theory overtook the Austrian trade cycle theory because Keynes' theory
was both simplistic enough for policy makers to understand, and attractive
enough to follow. In his words: "An easy-to-follow recipe for managing
the economy won out over a difficult-to-follow theory that explains why
such management is counterproductive." Garrison's summary shows how
the Austrian trade cycle theory can be explained using graphed aggregates.
These abstractions are only useful in showing, in a very simplified way,
how the theory operates. In the real world, the expansion and later contraction
would first occur in the capital goods areas and then proceed through
the economy from there.
This is Jason Kauppinen's first contribution to Enter Stage Right.
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