This video, The Austrian Theory of the Business Cycle | Roger W. Garrison, from the Von Mises University does a good job of explaining the Austrian Business Cycle Theory (ABCT). The key point is that increasing the rate of savings (capital) results in increased economic growth in the future. The theory was worked out by Von Mises and Hayek. The foundation of the theory is very similar to classical economics, which held that economic growth was the result of increases in capital. The video has a number of charts and graphs to make it look more scientific, however no empirical evidence is provided to support the theory. Other work may provide empirical evidence, but I know of counter evidence as well.
This article will first discuss ABCT of recessions and some small errors in the theory. Then I will show that ABCT is incorrect about what causes economic growth and its failure to explain economic history, particularly the Industrial Revolution.
Austrians are always focused on showing that Keynes economic theories are wrong, and they are certainly right about this. Austrians argue that there is a trade between investment and consumption, which they call the sustainable Production Possibilities Frontier. Keynesian theory would say there is no difference between consumption and investment. Certainly there is a trade between investment and consumption. The Keynesians somehow argue that by eating your seed corn you will be wealthier. However, a minor problem with ABCT is that it equates savings with investment. The two are not necessarily the same.
ABCT then states that recessions are caused by Central Banks (the Federal Reserve in the US) arbitrarily lowering interest rates below the market rate, which causes mal-investment and reduces the saving rate. Unless we narrowly define saving as putting money in a bank, savers have a number of choices which are not directly affected by interest rates. For instance, savers can put their money in stocks or corporate bonds. The return on stocks and corporate bonds is more related to the success of the underlying company than the interest rate set by the Central Bank, so the disincentive to save is not a strong as suggested by the ABCT. The second question is why does this cause mal-investment but increased saving does not. In both cases the investment intermediary is a commercial bank. Now if we were talking about direct government spending then the case is clear. In that case the government is not subject to the market. However, commercial banks are subject to the market. If interest rates are lower because of additional savings or because the Central Bank set them lower does not change their loan approval process. In addition, the ABCT completely ignores tax and regulatory policy. Are Austrians really saying that recessions can only be caused by Central Banks setting interest rates too low? Why not too high? This is why Austrians are obsessed with what Central Banks are doing and seem somewhat oblivious to other issues.
These are not my real complaints with the ABCT however. My real complaints are 1) recessions happened before there were Central Banks and 2) economic growth is not caused by increases in capital. Central Banks are a fairly new creation and fractional reserve banks did not exist in the world until around 1650s. The United States did not have a Central Bank until 1913, but there were recessions before that in the US. There were certainly recessions in the world before there were banks, including one huge one called the Dark Ages. ABCT fails to explain the source of all recessions, including the recession of 2001.
ABCT is also wrong on what causes economic growth. Robert Solow did an econometric study of the US economy to determine how much of the growth was due to increases in labor, how much was due to increases in capital, and how much was due to increasing levels of technology. According to Wikipedia
[This] technique has been applied to virtually every economy in the world and a common finding is that observed levels of economic growth cannot be explained simply by changes in the stock of capital in the economy or population and labor force growth rates. Hence, technological progress plays a key role in the economic growth of nations, or the lack of it. http://en.wikipedia.org/wiki/Growth_accounting
Robert Solow won the Nobel Prize in economics for this work. (This is not an endorsement of everything Solow says)
I would change the bolded part to state that the only way to obtain real per capita increases in wealth is through increasing levels of technology. This becomes more apparent if you look over longer timeframes. If we had the same technology as our ancestors in 1600, even with today’s total capital, would we be any wealthier than our ancestors? We would not live longer, we would not be able to produce any faster, the only difference might be that we had more savings to fall back on or disseminate existing technologies. However there was very little technological change at the time, so the increase in technological dissemination would have been small. As a result, we would be essentially no wealthier than our ancestors. Our standard of living is defined by our level of technology. I discuss this in much more detail in my upcoming book, “Source of Economic Growth.”
Note that the ABCT does not account for technological change. As a result, the theory should hold up in a technologically static world. However, this is totally inconsistent with economic history. The Industrial Revolution started in Great Britain and the United States. There is no evidence that these countries had larger savings or capital stocks than say France or China or Holland or Japan. The Industrial Revolution was really a perpetual invention machine, driven by inventions not by capital. The source of all wealth is the human mind. The application of the human mind to problems of survival is called inventing, which is how we increase our technological level.
Austrian Business Cycle Theory does not hold up under scrutiny. Austrians have misidentified the source of economic growth and have a defective model for what causes recessions. Naturally they prescribe the wrong medicine. Austrian Economics is not pro-capitalism, it is not consistent with the enlightenment, reason, and science, which I have described in other posts.
PS: I mentioned above that the Austrians misdiagnosed the recession of 2001. They love to say that Greenspan created a bubble economy, which implies that in fact there was no real economic growth in the late 1990s. The narrative that Greenspan created a credit bubble by holding interest rates too low does not fit the facts. The economic growth of the late 1990s was built on new technologies that have made our life immeasurably better. Real incomes and industrial production rose significantly in the late 1990s. In addition, the effective Fed funds rate in the late 1990s was between 5.5 and 6.5%, which looks tight by today’s standards. The Federal Reserve’s balance sheet was stable. There was an inverted yield curve in 2000, which happened as Greenspan was increasing interest rates. The commodities index was falling slightly in 1999 and rose slightly in 2000. M1 was essentially flat in the late 1990s and M2 was growing slowly. The evidence is overwhelming that the recession of 2001 was not caused by Federal Reserve “printing” too much money. In fact the evidence points to the idea that Greenspan was too restrictive and caused an inverted yield curve in his desire to cause the stock market to cool off, which caused the recession. It is true that the stock market had gotten ahead of earnings, but recent experiments in economics show this is a common with new investors and is not necessarily the result of easy credit.