Anatomy of a Real Recovery

Austrian Business Cycle Theory (ABCT) has been criticised for 1) misrepresenting the true nature of the boom and reasons for the bust, and 2) for not offering constructive solutions to generate a recovery.

Point 1 is the subject of much debate and has been covered extensively in the academic literature and indeed defended and explained in this blog. ABCT as advanced in various guises by Mises, Hayek, Rothbard, Hutt, Lachman, Hazlitt, Heurta de Soto, Hoppe, Hulsman, Salerno, Bagus (to name some of the major Austrian scholarly contributors) is a stylised theory, essentially, of widespread business error and market distortion resulting from price controls (centrally planned interest rates) and/or state-sanctioned fraud (money printing and bank credit expansion usually under a state-enforced currency monoply).

Since mass error and the effects of monetary central planning and institutionalised monetary fraud are fundamentally complex, ABCT does not, and certainly should not, claim clear and perfect knowledge of cyclical cause and effect, severity and timing. In the real world, where nothing is conveniently held equal, it is highly implausible that every business cycle will conform to neat, stylised propositions. While the core of ABCT is constructed off a base of sound logic (Praxeology), in the practical nuts and bolts of economic analysis understanding business cycles is a mix of theory and history. Often theoretical truths are obscured by other forces that don’t render them wrong, only not easily visible.

We’ve pointed this out in this blog before where technological advances during an artificial credit expansion may render society’s subsistence fund more sustainable than it otherwise would have been, allowing projects to be completed that would otherwise have become unfunded. This is another way of saying that real savings can rise during a credit expansion for an unrelated reason, which can validate investment decisions and reserve consumer purchasing power for the future.

More complexity dwells here. Credit expansion still creates inflationary distortion in markets which can foster mass error. That higher saving may validate investment decisions does not mean those are the right investment decisions. This is particularly true if credit was channeled to politically favoured industries and compounded if private savings and investment channels are highly regulated and distorted as in many advanced economies.

The point is, business cycles are complex, but their essence is mass systemic error bought about regulatory or legal distortions, particularly in the monetary system.

It is true, as per criticism number 2, that Austrians have been light on describing how to recover after the bust, short of saying, “let the market sort it out.” While perhaps strictly correct, it doesn’t win the School much currency in the political malaise after a bust. Arguably though the shunning of the government fix will tend to relegate the Austrian remedy to the trash heap as politicians seek to “never waste a crisis.”

Yet the “let the market sort it out” quip does also gloss over the microeconomics of recovery. In the Keynesian version of events companies are folding and “animal spirits” are flagging, and there seems to be no way for the microeconomic process of recovery to start other than by some “exogenous” jolt of demand stimulus by the government to calm the nerves and get capitalists to soldier on, make stuff, and hire staff. This is the vicious-spiral-into-the-7th-circle-of-hell theory so defining of Keynesian prognoses. It’s also an easy version of events for people to swallow because its basic, plays on fear, and targets a quick fix, despite it being folly to its core.

The Austrian version of events was always less sexy and more, well, realist. Unnecessary lines of production need to be liquidated and sold to those capitalists who have funds to deploy in the recession. ‘Sunk’ capital that cannot be reallocated in such a way must be forgone and go to waste – a real loss of wealth.

Paul Cwik argues that the Austrian story needs to pay far more attention to the post-bust recovery and the microeconomic business process of what drives economic restoration. In his July 2008 paper in the QJAE, “Austrian Business Cycle Theory: A Corporate Finance Point of View”, Cwik states that:

 The main emphasis of the ABCT has been on the theory of the upper-turning point-the artificial expansion of credit, the manipulation of interest rates, the malinvestments committed by entrepreneurs and then the credit crunch and/or real resource crunch.

But, Cwik argues, what’s needed is a greater emphasis and demonstration of,

…how a company can take a failing component from another business and tum it into a viable operation via the liquidation process.

Cwik goes on to show in the paper,

how the Austrian theory can make superior recommendations for policies (through the usage of the liquidation process) to help stimulate economic recovery.

Here are Cwik’s concluding implications:

The second implication is that the analysis (explaining how fixed capital equipment has to be sold-off at reduced prices in order to transform the malinvesments into legitimate capital equipment) does not seem to explain the duration of the recession phase. There are two stumbling blocks that tend to reduce the smooth transition of the fixed capital into productive structures. The first is that capital is not an amorphous mass, a homogeneous blob of “K.” Capital goods have differing degrees of specificity, complementarity and substitutability. It is not simply a question of lowering the price and then plugging the machine into another production process. The project in the example illustrated above was self-contained, but in the real world, such projects are rare. Typically, a firm’s projects need to be integrated into other existing firms. Austrians have long argued that merely investing capital does not lead to economic growth, but correctly arranged capital structures guided by the market process are the mechanism for growth. Rearranging prices is simply not enough to pull an economy out of a recession. Some of the more specific capital may have to be thrown away-scrapped-if no other firm could make a profit from it. A liberalization of merger and acquisition laws could improve the situation. Furthermore, the elimination of other obstacles found in bankruptcy laws could help expedite the transfer of malinvestments into productive ventures.

The third implication (and also second stumbling block) is that savings are needed in order to facilitate this transformation process. In order for the second firm to purchase the capital equipment from the first firm, the purchaser will need the funds to complete the transaction. Newly created credit will only start the boom/bust cycle again. Increasing real savings (a reduction in consumer goods in favor of investment goods) expedites the transformation process. This observation means that in order to stimulate an economy, savings need to be increased. A government interested in helping an economy out of a recession has to then do the following: first, not interfere with the price adjustment process; second, not reinflate the money supply; and finally, try to increase the amount of savings in the country. It could do this through liberalizing its laws to allow for increased savings to flow in from abroad and it could also cut taxes on domestic savers. By increasing the amount of savings, the amount of malinvestments that could be transformed into profitable investments increases. Increasing the amount of savings available for investment can shorten the duration of a recession.

This is a short but highly insightful paper that gives excellent nuance to ABCT and the market’s recovery process. The full article is here (pdf).


About Russell Lamberti

Russell Lamberti is a regular contributor to Mises SA. He is Chief Strategist at ETM Analytics, an Austrian-influenced economic research firm based in Johannesburg. Although he wrties about many topics, you'll most often find him slaying patent and copyright law and exposing the biggest bubble in history: fractional reserve banking.
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