Tuesday, May 12, 2009

My Take on the ABCT (Simple Version)


Below is my take on the Austrian Business Cycle Theory.


1. Money Supply Increase causes a general

2. Credit Supply Increase, which causes a general

3. Interest Rate Decrease, which causes a general

4. Longer Term Investment Increase, which causes a general

5. (a) Demand for Labor Increase and (b) Demand for Capital Goods Increase, which cause a general

6. (a) Wage Rate Increase and (b) Capital Goods Price Increase, the first of which causes a general

7. Credit Demand Increase, which causes a general

8. Interest Rate Increase, which, along with 5(b), causes a general

9. Longer Term Investment Decrease back to normal

There is nothing inherently circular about this progressive response to artificial 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

1-2. 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.

2-3. 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.

3-4. The lower the interest rate, the more viable are longer term projects funded by investment borrowing.

4-5. Longer term production processes generally require more labor and goods than shorter term production processes.

5-6. 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.

6-7. 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, with Hayekian triangles, and Bohm-Bawerkian insights into what the interest rate represents.  I in no way doubt the veracity of these analyses, but too often the concrete human motivations and actions that actually embody the turn from boom to bust was left out.  Even when those concrete motivations and actions were present, 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 the recent 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.

7-8. This increased demand for credit then raises the interest rate, which causes, along with the increased capital goods prices (6b),...

8-9. the long-term projects from stage 4 to no longer be profitable.  Boom gives way to bust.

Regarding the 6-7 analysis, I 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 thought processes with you, my fellow travelers, who are also trying to teach themselves economics (and political philosophy, history, etc.) as best they can.

I would very much like to hear any comments and corrections you would like to offer.

Related Posts

My Take on the ABCT (Complex Version)

My Take on the ABCT: Objections Considered


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