Saturday, June 27, 2009

Bohm-Bawerk and the Business Cycle

Ludwig von Mises is credited with first formulating the Austrian Theory of the Business Cycle.  But in the following much earlier passage by Eugen von Bohm-Bawerk (who was a great influence on Mises) one can see the theory shadowed forth.

Bohm-Bawerk considers below what would happen if, for some reason, no premium was placed on goods sooner over goods later (time preference), and thereby an absence of interest occurring.  He shows how this situation would be unsustainable.

The possibility of obtaining means of subsistence free of agio would be certain to tempt undertakers into immoderate extension of the production period. If this were to occur only partially and in a few branches of production, naturally the limited stocks of subsistence would leave so much less for the other branches of production; these latter would have to curtail their processes unnaturally; and there would ensue a deficiency in the social provision which would outweigh the increased return got from the favoured branches through the immoderate extension of their processes.  But if the excessive extension were to be introduced all over, the community's stock of subsistence would come to an end sooner than the fruits of processes thus unduly extended could mature; there would be deficiency in provision, want, and distress; famine prices would recall the misdirected natural powers, and put them, with difficulty, to supply provision for the moment. All this could not happen without serious disturbance, expense, and loss.

Now the constant presence of the agio on present goods is like a self-acting drag on the tendency to extend the production period; without checking it all at once it makes it more difficult, and more difficult in proportion to the projected length of the process. Extensions which would be harmful as regards social provision are thus made economically impossible. Moderate extensions over the average process, however, are not absolutely prevented, but are limited to those branches where, from peculiar economic or technical circumstances, the productiveness that goes with the extension of the period is so great that they can bear the progressive burden of the agio. Branches, again, where longer processes are somewhat, but only a little, more productive, are tempted to escape the burden of agio by recurring to periods under the average. Thus, finally, under the influence of the agio, the total fund of subsistence is divided out automatically among the individual branches of production, in such amounts that each branch adopts that length of process which—in the given condition of the fund—is most favourable to the total provision.

Eugen von Bohm-Bawerk, The Positive Theory of Capital, Book VI, Chapter VI, (from The Library of Economics and Liberty)

The theory is almost all here: the immoderate extension of the production period (lengthening of the chain of production), the long-term necessity for savings and investment to be in balance, and the role of the interest rate in keeping that balance.  All Bohm-Bawerk needed do was to extend this analysis of a situation with a complete lack of agio/interest to situations with artificially low agio/interest, and the Austrian Theory of the Business Cycle might have come rushing forth from his pen.

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