Austrian business cycle theory and recent irrationality
October 4, 2008 – 10:09 am by JohnI am not even an amateur economist yet, much less a real economist, but I think I understand the basics of the Austrian business cycle theory (ABCT). As you know, I think it explains the boom–bust cycle of our economies pretty well (but maybe that’s because the libertarian economists I know of promote it). I also understand some of its shortcomings and the objections to it. For instance, one of ABCT’s shortcomings is that, while it asserts that consumer spending decreases during a recession because of the contraction of the money supply (deflation), it doesn’t explain why the deflation should occur. It seems like it’d be easy to come up with some pretty plausible explanation, but I haven’t read much into this, and, again, I’m not a real economist…
A major objection to ABCT, from other libertarians, most notably Bryan Caplan, is that the Austrians blame the imprudent boom on a cluster of bad investment/lending decisions by businessmen and bankers all across the economy, which are permitted and even encouraged by artificially low interest rates, and this widespread irrationality makes no sense because, one, Austrians extol the forecasting abilities of entrepreneurs everywhere else, and, two, they should be able to restrain themselves knowing that the Fed is artificially inflating the supply of credit and money.
Well, this pretty solid layman’s answer to Caplan notwithstanding, I just wanted to make this observation: Doesn’t the massive clusterfuck that the banking industry has given to themselves and the American/world economy (with the help of the Fed) provide some pretty solid empirical evidence that smart, rich, educated people—insiders, who know as well as anyone how this machine works—can make a long series of short-sighted decisions, and that this will hurt both them and the economy at large? And that thousands of these people made their imprudent investing/lending decisions all around the same time?
Or, even if the banksters actually did know better and knew the easy credit was going to hurt a lot of people, they didn’t actually think they themselves would be harmed by the malinvestments; they knew the Fed would bail them out or do something else to reward them for their bad policies. In that case, doesn’t this episode still show that the moral hazard of counting on the Fed to bail them out makes the Austrians right about the central bank encouraging bad decisions and unwise investments? Because regardless of whether the banksters and businessmen “knew” they were making bad decisions (i.e., if Caplan is right, there wasn’t a cluster of widespread stupidity), the fact that our Statist economic structure was guaranteed to bail most of them out and reward them for their bad decisions means that this part of ABCT is still right: intervention by the central bank encourages malinvestments that cannot turn a profit—a boom that must necessarily end in a bust.
(Or maybe I’m lumping banksters and entrepreneurs into the same group, “Fed-encouraged bad-decision-makers,” and neither Austrians nor Caplan do this. Because banksters do the lending and entrepreneurs make the investments, and perhaps the banksters were the only ones who profited from this sorry situation, so I have moved no closer to an explanation of why otherwise-prudent entrepreneurs made so many bad decisions.)
By the way, what does Caplan propose as an explanation for the boom–bust cycle of economies? What is the CBCT?
Any thoughts are welcome…