Saturday, May 16, 2009

My Take on the ABCT (Complex Version)

Business Cycle Stages

1. Money Supply Increase causes a general

2. (a) Credit Supply Increase and an ongoing (b) Purchasing Power of Money Decrease.  2(a) causes a general

3. Interest Rate Decrease, which causes a general

4. (a) Longer Term Investment Increase, and, aided by 2(b), a (b) Sharp Demand for Particular Assets Increase. 4(a) causes a general

5. (a) Demand for Factors of Production Increase.  4(b) causes a (b) Sharp Particular Asset Price Increase.  5(a) causes a general

6. (a) Wage Rate Increase and (b) Capital Goods & Land Price Increase.  6(a) causes a general

7. Credit Demand Increase, which causes a general

8. Interest Rate Increase, which, along with 6(a) and (b), causes a general

9. (a) Longer Term Investment Decrease back to normal, and along with the completion of 2(b), a (b) Sharp Demand for Particular Assets Decrease,  all of which which cause a general

10. (a) Wage Rates Decrease, a (b) Capital Goods & Land Price Decrease and a(c) Sharp Particular Asset Price Decrease all back to the normal level (although adjusted for the new level of the money supply).

The above describes a finite expansion of the money supply.  There is nothing inherently circular about this progressive response to artificial money and credit expansion.  The theory might even be called the Austrian Business Blip Theory (ABBT) were it not for the government's recurrent interventions into the markets for money and credit.

Causal Explanations

1 to 2(a). The money supply increase in the present system is in the form of bank money.  This bank money is made available as new and additional credit.

1 to 2(b).  The new and additional money is progressively distributed throughout society, bidding up prices as it goes along, and thereby progressively reducing the purchasing power of any given currency amount. 

2(a) to 3. The interest rate is the price of credit.  Increases in supply cause decreases in price.  Therefore, a general increase in the supply of credit will cause a general decrease in interest rates.


3 to 4(a). The lower the interest rate, the more viable are longer term projects funded by investment borrowing.


2(b) and 3 to 4(b).  Because the currency unit gets a smaller return (the low interest rate), and is also losing purchasing power (higher prices), it becomes less attractive as a means of saving than certain other asset classes (like houses).  Here's my attempt to grapple with asset bubble theory:

In any given market condition, there will generally be one asset which is optimal for longer-term saving, due to a good level of and balance between purchasing power storage and liquidity; also there will be one asset optimal for shorter-term saving due to the same considerations, but leaning more toward liquidity.  Of course, nothing says people must have only two such categories.  Savers may have a diverse spectrum of savings desired for their various balances between purchasing power storage and liquidity.  And often, the optimal asset for several different categories will be the same: the common currency.

If the currency is being devalued at a certain small rate, it might then become less attractive as a means of extremely long-term saving than some other asset class, which has a lower rate of real depreciation than other asset classes.  Then if the currency is devalued faster, it might then become less attractive as a means of mid-term savings than that same asset class.  And if it is devalued faster still, it might become less attractive as a means of short-term savings than that asset class.

So in an asset bubble, over-and-above the appreciation due to monetary expansion, there is a premium given to certain assets by virtue of their role, not just as a good, but as a store of purchasing power.  Certain assets are better stores of purchasing power than others.  Savers realize this and buy up those assets, increasing the prices of those assets and thereby sending the market a signal regarding the superior money-ish (in terms of storing purchasing power) qualities of that particular class of asset to other savers, who also pile in.  Thus whatever is seen as a superior means of saving will have its value spiral upwards, due to the tremendous demand brought about by all of society replacing money with it for a certain portion of their savings.


4(a) to 5. Longer term production processes generally require more labor and goods than shorter term production processes.

5 to 6. Wage rates are the price of labor.  Increases in demand cause increases in price.  Therefore, a general increase in the demand for labor will cause a general increase in wage rates.  Also, an increase in demand for capital goods will cause an increase in the prices of capital goods.

6(a) to 7. This is my own either new or independently formulated contribution.  I've been avidly reading works and listening to lectures to try to understand the ABCT.  It was tough at first, partially because I was trying to foist up price inflation as the dominant element in my understanding of it.  It only started making sense when I let that drop and read and listened more carefully; this led me to realize that what the theory was chiefly concerned with was not price inflation but artificial credit expansion and its temporary effect on the interest rate.

Then it all started to click, but still only incompletely.  In expositions of the theory, the explanation of the boom phase generally made sense to me, but things would always get muddy concerning how the boom became a bust.  Often the explanation would focus on why the bust was, according to capital theory, inevitable, as demonstrated by Hayekian triangles, and Bohm-Bawerkian insights into what the interest rate represents.  I in no way doubt the veracity of these analyses, but I couldn't see the concrete human motivations and actions that actually embody the turn from boom to bust.  Even when those concrete motivations and actions were mentioned, the causal links didn't quite make sense to me.  For example, I would often read that workers, after getting their raises in stage 6, would (a.) go out and spend their additional money, and that would bring their savings and consumption back to their normal ratio according to their time preference and that this led to (b.) not enough savings being available to see all the long term projects in stage 4 to their completion.  But in everything I've read or listened to, it's never been explained (at least for my understanding) exactly how (a.) leads to (b.).  Again, I in no way doubted that it does happen; it seems theoretically necessary.  But how?

Then, motivated by a recent Mises Forums post asking for a concise explanation of the ABCT, I started trying to construct the above step-by-step explication.  I tried to make it as clear and direct as possible.  But, I kept getting stuck at stage 7.  I kept asking myself, "what is the bridge from 6 to 8?"  Then I thought, "stage 8 is just the opposite of stage 3.  Just as an increase in the supply of credit brought about lower interest rates, higher interest rates must come about from either a decrease in the supply of credit or an increase in the demand for credit."  Then it finally hit me: the savings-to-consumption ratio is indeed essentially what determines the interest rate, but not immediately so.  The concrete human action that embodies the reestablishment of the normal savings--to-consumption ratio is more borrowing.  People generally have an income-to-debt ratio they're comfortable with, according to their time preference.  If they get a raise, they don't suddenly become more thrifty than before; so they borrow more, generally in proportion to the increase in their wages.  Regarding this, know I could very well be wrong, or I could be right and silly at the same time, if that was what ABCT scholars were saying all along, and I was just dull to it.  In any case, I thought I'd share my thoughts on this.

7 to 8. This increased demand for credit then raises interest rates.

8 and 5(b) to 9(a). The higher interest rates, along with the increased factors of production prices (6),  cause the long-term projects from stage 4 to no longer be viable.  Boom gives way to bust, as businesses rush to reallocate resources away from the non-viable longer term ventures to viable shorter-term ventures.

8 and the completion of 2(b) to 9(b).  An increase in the money supply must be finite (or at least abbreviated), or else hyperinflation will result.  Any finite increase in the money supply will cause a finite increase in prices.  The new money will progressively bid up prices, but eventually the new money will reach all sectors, and then prices will stop generally rising.  Thus, the money will stop losing purchasing power (and actually start gaining purchasing power, as money naturally does in a market), while the particular assets that had replaced money as a means of saving start to depreciate (as real assets tend to).  These changes, along with the increase in the rate of interest, reestablish money's attractiveness as a means of saving.

9(a) to 10(a) and (b).  Businesses reallocate resources back to shorter-term production processes, reducing demand for factors of production.  This decrease in demand causes a decrease in the prices of factors of production, although to a higher level than before the monetary expansion.

9(b) to 10(c).  Savers flock out of the asset classes they had flocked into, and back into money.  This drop in demand causes the prices of those assets to plummet.

Related Posts

My Take on the ABCT (Simple Version)

My Take on the ABCT: Objections Considered

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