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Abstract The causes of the housing boom and the Great Recession which followed were many years

in the making and have become a major topic of discourse amongst economists and policymakers. In my judgment, the Austrian school of economics offers one of the most coherent explanation and prescription for the recent business cycle in the United States of America. It has developed a distinguished framework for theorizing about the macroeconomic relationships underlying the procyclical tendencies of market economies operating under a centrally-directed monetary system. Written first and foremost as an appraisal of the Austrian business cycle theory, this paper explains how the exogenous intervention of central banks can bring about a self-reversing disruption in the coordination and exchange of market participants. In turn, it presents facts and figures in an attempt to show how the boom and subsequent bust in the markets for housing and finance are partly an illustration of such monetary-induced perversities. In sum, these mutually-supportive sections serve as a critique of monetary policy by shedding light on the inherently destabilizing function of central banks in the free market system.

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I. INTRODUCTION The US subprime crisis of 2007 and the Great Recession which ensued were among the worst economic events since the Depression era of the 1930s. It all began in the aftermath of the dotcom bust in 2001, the United States expanded rapidly as the innovations of the financial markets rode piggyback on the easy money policies of the Federal Reserve. The credit-based boom was characterized by a rapid and unregulated growth of securitization which stimulated the creation of risky mortgages that were designed to be refinanced on the presupposition that housing prices would endlessly appreciate. However, when the housing market turned towards its downward trend in Q1 2006, a wave of defaults that extended across a subset of the mortgage market namely, subprime mortgages - triggered the systemic disruptions and failures that were to follow. Despite the assurance of policymakers and economists that these sub-sectoral malinvestments would be contained from spilling over into the real economy, the collapse of two highly-leveraged Bear Stearns-managed hedge funds was identified in Q2 2007.1 From that point onwards, it became apparent that those financial institutions with investments in asset-backed securities whose underlying subprime mortgages were now (finally!) recognized as being speculatively-dubious loans would face significant losses, and not to mention bankruptcy. The unprecedented events of the Great Recession tell a dismal story which accounts for the crude awakening from the widespread delusion of the Roaring 2000s. The failures of financial markets severely undermined confidence in the efficacy of the market system by systemically restraining the supply of loans to the economy. Wall Street underwent a severe correction that bottomed out in March 2009, at which point the S&P 500 Index had fallen from its peak of 1576 to a trough of 666.2 This remarkable 58% plunge in the bellwether index was bound to be mirrored by calamitous falls in the real economy. During the 18-

In June 2007, Bear Stearns injected $3.2 billion worth of collateralized loans to bail out its Structured Credit Fund, and negotiated with banks to loan money for its Structured Credit Enhanced Leveraged Fund. Both hedge funds lost nearly all their value as the crisis worsened in following months. (www.nytimes.com/2007/06/23/business/23bond.htm)
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www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf--p-us-l--

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month period of technical recession from the end of Q4 2007 to Q2 2009, the real Gross Domestic Product decreased at an average annual rate of 2.8%.3 All those industries (i.e. real estate, finance and consumer discretionaries) that had become part of the credit-infused consumption were now subject to dramatic declines. The Great Recession subsequently stamped itself on the American mood by the sheer intensity and duration of unemployment, which rose from a mere 4.6% in 2007 to 10% in 2009.4 Over the years leading up to this considerable contraction, the vast majority of policymakers and economists ignored the market signals and made complacent claims about a new era of the Great Moderation.5 To play on the words of Reinhart and Rogoff, the general euphoria of this economic contention was based on the tenuous belief that this time is different. In particular, it was predicated on the ex ante intuition that the technological advancements of financial markets and the accommodative strategy of the Federal Reserve had dulled the economys sensitivity to volatility and risk. A common view which was thus shared among the upper echelons of the corporate, political and academic strata was that no one saw the coming of this crisis. However, several Austrian economists (see Thornton, 2005; Karlsson, 2004; Schiff, 2006) went against the general mood and made predictions about a housing-led recession well before the masses turned critical in latter part of 2007. With hindsight, FTs Martin Wolf (2010) admitted that mainstream models did a poor job in predicting the crisis and sympathized with the arguments of Austrian economists by pointing out that fractional reserve banking creates unmanageable credit booms and that the resulting malinvestment explains the subsequent financial crash.6 As such, many financial and economic analysts have come to see the virtue of the Austrian school by recognizing that the Federal Reserve may well have sowed the seeds for the Great Recession.
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Bureau of Economic Analysis (BEA), National Income Accounts, Revised Estimates of Gross Domestic Product from 2007 through to date, (www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm) Bureau of Labor Statistics (BLS), Annual Averages of Household Data, Employment Status of the Civilian NonInstitutional Population from 1940 through to date (http://www.bls.gov/cps/cpsaat1.pdf)
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Remarks by Governor Ben Bernanke at the meeting of the Eastern Economic Association, Washington DC, Feb 2004 (http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm) Martin Wolf, 4th April 2010, Does Austrian economics understand financial crises better than other schools of thought? (http://blogs.ft.com/martin-wolf-exchange/2010/04/01/hello-world/)
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This paper will explore the macroeconomic relationships found in the theoretical writings of the Austrian school of economics. Section I introduced the recent cyclical events that form the empirical background to the theoretical analysis of the business cycle. In reviewing the literature, Section II will bring to light the origins and evolution of the Austrian interpretation of the business cycle. In doing so, it will pay particular attention to the pioneering developments of Ludwig Von Mises, Friedrich Hayek and Roger Garrison. Section III will identify the methodology of the Austrians by describing the set of market conditions that permit or hinder the successful coordination of market participants. Subsequently, section IV will explore a multi-faceted model which graphically illustrates the macroeconomic relationships that underpin the Austrian theory. As an investigation of its empirical suitability, section V will make relevant applications of the Austrian theory to the recent boom-bust period in the United States. It presents empirical content to illustrate how the Federal Reserve triggered a business cycle that manifested itself within the interest-sensitive markets of the housing and financial industry. Lastly, section VI will conclude this paper by taking a brief look at ways in which economic theory can empower a correction of economic reform.

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II. LITERATURE REVIEW The central tenet of this Austrian theory is that business cycles stem from the monetary disturbances generated by the exogenous intervention of central banks. Through the money-multiplying process of the fractional reserve system, a credit expansion impinges on the interest rates and triggers conflicting movements in the behaviour of market participants. An artificially lowered interest rate causes the demand for investment to increase without there being an equilibrating rise in consumer saving. In other words, an inconsistency between savings and investment arises because investors take advantage of lower borrowing costs as consumers face a weakened incentive to save. As such, the lower interest rate incentivizes market participants in divergent ways and creates a tug-of-war over capital resources within the structure of production. Producers become more future-oriented and thus increase their investments of capital into longer-term production projects. Meanwhile, the increased demand for current consumption on the part of income-earners draws capital resources towards the shorter-term production of consumer goods. This reduces the availability of capital that is needed to see the longerterm production projects through to completion. As time eventually reveals the temporally conflicted structure of production, the recession merely arises as a corrective adjustment to restore an allocation of capital that reflects greater consistency across market participants. Although this doctrine acquired an Austrian identity following its developments by Ludwig Von Mises in his Theory of Money and Credit (1912), its elementary form was first proposed as the theory of circulation credit by the British Currency School in the nineteenth century. In accordance with the insights of his British predecessors, Mises identifies cyclical fluctuations as an inherent characteristic of the market process within a credit-based economic system. However, he does criticize the Currency School for its inability to account for the critical relationship between interest rates and the money supply of an economy (Mises, 1966). Accordingly, Mises compensates for this deficiency by drawing heavily upon the loanable funds theory of interest from Knut Wicksells Interest and Prices (1898). In particular, he embraces the Wicksellian concept of
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a natural rate of interest that is, the rate of exchange that would naturally prevail if banks functioned purely as intermediaries of voluntary savings. This natural interest rate is understood as being neutral in the sense that it does not cause artificial effects on the level of market prices. In this connection, Mises recognizes how a central bank-induced expansion of the money supply through the credit markets can trigger a deviation of interest rates from their natural levels. These monetary considerations are the foundations from which to explain how the market process gives rise to business cycles. The formulation of the Misesian hypothesis combines these monetary elements with a capital theory which incorporates time as an endogenous variable that shows up in the structure of production. This uniquely Austrian theory of capital is grounded in the early developments of Carl Menger (1871) and its later renditions in Eugen von Bhm-Bawerks Capital and Interest (1889). It analyzes capital by disaggregating it inter-temporally on the assumption that consumer goods are produced by using producer goods in a lengthy sequence of production stages. As such, this capital theory allows for a coupling of short and long run processes of the market system. In his timely analysis of Prices and Production (1935), Friedrich Hayek reinforced this notion of a structure of production by graphically representing how the outputs of one production stage feeds in as inputs to next stage. The sequence of production stages that form the Hayekian Triangle are categorized as the early stages (i.e. mining), middle stages (i.e. manufacturing) and the later stages of production (i.e. retailing). It is important to note that the Hayekian Triangle was originally conceived with reference to a manufacturing economy. However, this initial illustration isnt consistent with the trends of economic development in the United States. As the manufacturing base of the United States declined over the past few decades, the service and information industries have expanded in its place (especially, financial services). Such a structural economic shift in favour of services would thus imply that we focus our empirical attention more so on human capital and financial capital as opposed to physical capital. All things considered, Garrison (p.47, 2001) states that as long as we think in terms of the employment of means, the achievement of ends, and the time element that separates the means and the ends, the Hayekian Triangle remains applicable.
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The most comprehensive graphical framework of the Austrian theory was developed in Roger Garrisons analysis of Time and Money (2001). Garrison designed this model to coherently represent the macroeconomic relationships found in the theoretical writings of Mises and Hayek. It is a dynamic framework that explores the adjustment and coordination mechanisms through which an economy is brought into equilibrium over time. Garrison brings together three graphical elements to represent the market process of a free market economy from an Austrian perspective. Distinctively, he combines the Hayekian Triangle together with the mutually reinforcing mechanisms of the production possibility frontier (PPF) and the loanable-funds market. Whilst using the PPF to explore the trade-off between consumption and investment, he adopts the loanablefunds framework to show that the interest rate clears the credit markets by matching saving with investment. In tandem with the Hayekian Triangle, these core principles simultaneously illustrate how the investment decisions of producers results in a structure of production that is consistent with the saving preferences of consumers. As a corollary to his graphical depiction of a steadystate free market economy, Garrison then demonstrates how the exogenous intervention of central banks can create an inconsistency between the behaviour of market participants and thereby induce a temporally-conflicted structure of production that eventually turns economic boom into bust.

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III. METHODOLOGY Before examining this macroeconomic model in detail, it is important to set out the methodological characteristics that underlie the Austrian understanding of the business cycle. The notion of a spontaneous order can be viewed as the first principle of Austrian economics. It perceives the free market system as an undesigned order which emerges from the individual and independent decisions of market participants (Mises, 1966). It thus solves the coordination problem by making it possible to reason coherently about economic phenomena as interdependent decisions of self-interested individuals. As such, it adheres to Adam Smiths concept of an invisible hand that guides market participants to interact in a mutually compatible manner. In this view, the study of the market process is intimately concerned with the role of institutions in shaping market forces and determining economic outcomes by either facilitating or hindering the coordination and exchange among individuals. Although economic institutions exist largely to assist the ongoing discovery and efficient use of knowledge, the Austrians have emphasized the function of central banking institutions in discoordinating the individual intentions of market participants. The understanding of Austrian economists about how the market process operates is also crucially evident in their theoretical work on the role of the price system. While being determined by the interplay of market activities, Hayek (1935) emphasized that the price system serves to transmit essential information to market participants. It not only registers changes in market conditions but also reflects the reactions and expectations of market participants to these changes. Most importantly, it disseminates intrinsic information to producers about the relative scarcity of resources and the changing valuations and actions of consumers (Cochran, 2004). The price system is thus regarded as being indispensable to economic coordination in that it allows producers to form rational expectations about the ever-changing preferences of consumers. In this connection, the natural interest rate is the key pricing mechanism through which producers coordinate their investments decisions with the saving preferences of consumers. In other words, Garrison (p.440, 1976) wrote that it allows the preferred time pattern of consumption
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activity to be translated into a corresponding time pattern of investment activity. Essentially, the natural interest rate reflects the trade-off between present and future consumption that is inherent in all acts of consumer choice (Mises, 1966). As envisioned by the Austrian theorists, the interest rate will only ever fail to reflect the time preferences of consumers when central banking institutions intervene in the free market system by pumping new money into the credit markets. In response to a resulting fall of the interest rate below its market-determined level, the reaction of producers will depend upon their expectations of the nature of such a price change. Far from relying exclusively upon assumptions of methodological individualism, the Austrian economists adopted elements of subjectivism as fundamental to an explanation of the use and dissemination of knowledge within an economy. Hayek (1948) made an important distinction between a producers ability to understand changes in price signals in contrast to that of an economist. In general terms, he considered that the economic knowledge about the structural workings of an economy should be distinguished from the business knowledge regarding the market conditions within an economy. During periods of monetary expansion, economists and market participants will react to a falling interest rate in different ways depending upon whether or not they expect this change to be attributable to the policy of the central bank. Whilst it is possible for economic theorists to conceptually distinguish between a real price change and a monetary-induced price change, the market participants merely depend upon nominal changes in the interest rate to form their expectations about the underlying economic realities. The Austrians thus recognize that, more often than not, producers dont have the necessary economic knowledge to make corrections for the artificial effects of monetary policies on the pricing system. This assumption of imperfect knowledge is critical in allowing us to understand how central bank intervention can systematically falsify price signals and thereby result in a general cluster of malinvestment in the market process.

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III. THE AUSTRIAN BUSINESS CYCLE THEORY This section explores the diagrammatic model that was developed by Roger Garrison in his timely analysis of Time and Money (2001). To keep things simple, it abstracts from the real diversity of the financial system by considering a private economy that only has one financial market. This assumption of a single financial market is useful in explaining how the financial system coordinates savings and investment. It also serves as a tool to analyze the effect of monetary policy on the consistency between saving behaviour and investment decisions. The loanable funds market is essentially defined as that financial market in which the supply and demand for loans is brought into equilibrium by movements of the interest rate. All savers go to this market to deposit their income and all investors go to this market to take out loans. The supply of loanable funds is money made available for producers to finance investment into capital projects. It reflects consumer willingness to earn interest on that part of total income which is saved and lent out to the banks. Similarly, the demand of loanable funds denotes producer willingness to invest with interest-bearing money that is borrowed against future profits. The market rate of interest is the mechanism through which the saving preferences of consumers are coordinated with the investment decisions of producers. In equilibrium, the condition S = I reveals that saving must equal investment at the natural rate of interest rate (i*). The second component of this macroeconomic framework is the production possibility frontier (PPF). It is used to represent the fundamental trade-off between consumption and investment in a private economy with a given set of capital resources. Otherwise stated, it indicates that resources can only be reallocated towards the production of producer goods at the expense of producing consumer goods, and vice versa. For definitions sake, we assume that producer goods are inputs to production while consumer goods are outputs of production. The horizontal axis measures the magnitude of gross investment (I) and the vertical axis measures the volume of current consumption (C). The point at which the PPF crosses these axes indicates the maximum quantity of producer goods and consumer goods, respectively. The
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slope of the PPF measures the rate at which consumption can be substituted for investment. To be exact, it is equal to the amount of producer goods which can be obtained by foregoing one unit of consumer goods. The slope is thus negative since more investment can only be achieved to the detriment of consumption. Lastly, we must take note that the PPF curve itself represents sustainable combinations of consumption and investment. Assuming full employment of resources would imply that an economy operates at some point along the PPF. Any point inside the PPF is inefficient because the partial employment of resources results in the underproduction of both consumer goods and producer goods. Conversely, any point beyond the PPF is unsustainable because it involves the over-production of these same categories of goods. In this regard, it is only temporarily possible for consumption and investment to move together beyond the production possibility frontier. The next step is to describe the only component that is unique to the macroeconomic theorizing of Austrian economists. In the top-left quadrant of Figure 4.1, the Hayekian Triangle is integrated as a heuristic device that depicts the production structure of an economy as having two dimensions. Not only does it have a value dimension which is expressed in consumption terms, but also a time dimension which is an expression of the time that elapses between the early stages of production and the eventual production of consumer goods. This vertical axis measures the entire value chain from the early stages of production to the late stages of production. Conversely, the horizontal axis of the triangle represents production time by depicting the flow of capital resources through the numerous stages of the production process. Producers operate at different stages of production and make investments that seek to satisfy consumption at different points in the future. Collectively, these investment decisions shape the structure of production and thereby result in a particular level of consumer goods as represented by the point at which the hypotenuse of the triangle hits the vertical axis. For illustrative purposes, let us briefly consider how a change in the time preferences of producers reshapes the structure of production. If, for one reason or another, producers become more future-oriented, capital resources will be allocated towards the more timeconsuming production of producer goods at the expense of the shorter-term production of consumer goods. Graphically speaking, such a process of capital
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restructuring would result in a Hayekian triangle that is characterized by a longer production time on the horizontal axis, a reduced volume of consumer goods on the vertical axis and a shallower hypotenuse. Having separately described the three elementary graphs of the Austrian model, the next step is to identify the interconnections between these different components. Figure 4.1 depicts a fully employed economy in steady-state equilibrium with no growth in living standards. It shows how the supply and demand of loanable funds interacts with the production possibility frontier, whilst simultaneously relating to the structure of production. The loanablefunds market and the PPF are connected through their common measurement of investment (I). Similarly, the aggregate measurement of consumption (C) gives us a simple link between the PPF and the Hayekian Triangle. It is important to recognize the implied connection between the loanable-funds market and the structure of production. That is, the market rate of interest is implicitly reflected by the slope of the Hayekian Triangle. This indicates that the interest rate is the key mechanism through which capital is allocated among the stages of production. For instance, a lower market rate of interest implies a shallower slope since more capital is devoted to the early stages of production, and vice versa. In the steady-state equilibrium, consumers sustain a constant consumption level of C* and save enough to satisfy investment (S* = I*) at the natural rate of interest (i*). There is no net investment since invested capital is merely sufficient to compensate for capital depreciation. Producers operating at different stages of the production make investments to maintain a constant level of output C*. This static model thus coherently relates the different aspects of the market process through which an economy maintains a steadystate equilibrium over time. It can thus be used as a benchmark from which to analyze how cyclical fluctuations may result from a disruption of the tightlyjointed relationships in the market process.

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The Austrian understanding of the business cycle identifies certain institutional settings under which the market process results in a misallocation of capital. It requires us to take monetary considerations into account. Most notably, it focuses on the exogenous effects of monetary expansion by central banking institutions. A policy-induced deviation of interest rates causes the time preferences of market participants to come into conflict. Figure 4.2 shows how the different elements of the market process disjointedly respond to an increase in the money supply by the central banking authorities. New money enters the economy in the form of credit through the loanable-funds market. The supply of loanable funds now comprises both the savings by consumers and the newlycreated money made available by the central bank. This is graphically shown by the outward shift of the supply curve from (S) to (S + M). An increase in the supply of loanable funds causes the interest rate to fall below its natural levels (iB --> i*). As the interest rate falls, consumers decrease their saving to (S) while producers are encouraged to increase their investments to (IB). These conflicting
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dynamics lie in stark contrast to the steady-state dynamics that were previously identified in our benchmark model. In Figure 4.1, savings and investment are always equal to one another. That is to say, a movement in savings will naturally cause investment to make an equilibrating move in the same direction. In Figure 4.2, however, the injection of newly-created money impinges on the natural rate of interest and consequentially drives a wedge between saving and investment by causing them to move in opposite directions.

These conflicting movements in saving and investment can also be identified in the PPF quadrant of Figure 4.2. An artificial fall in the interest rate implies less saving and more consumption in the short run, whilst encouraging more investment into longer-term production projects. Graphically speaking, the market forces which reflect the weaker saving preferences of consumers are pulling north in parallel with the vertical axis. In opposition, the market forces which reflect the increased investment decisions of producers are pulling east
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in parallel with the horizontal axis. Despite them trying to pull the economy in opposite directions, these two set of forces end up merging along a northeastern trajectory outside the PPF. The economy shifts beyond the PPF to indicate the over-production of consumer goods and producer goods. In other words, the mutual incompatibility of saving preferences and investment decisions gives rise to both over-consumption and malinvestment. This unsustainable combination of consumption and investment is also depicted by the two incomplete hypotenuses of the Hayekian Triangle in Figure 4.2. An opposing change in the time preferences of market participants sets in motion two conflicting processes in the structure of production. On the one hand, the lower interest rate discourages consumers to save less and consume more goods in the short run. The steeper hypotenuse indicates that capital is being reallocated from the earlier stages of production towards the latter stages of production. Meanwhile, the availability of cheaper credit incentivizes producers to invest capital into longer-term production projects. The shallower hypotenuse implies reallocation of capital from the later stages of production towards the early stages of production. The broken line at the upper range of this shallower slope indicates that the restructuring of production cant be completed. Hence, a self-reversing process of capital restructuring is set in motion as the conflicting behaviour of market participants creates a tug-of-war over the allocation of capital between the different stages of production. Beyond what is illustrated in Figure 4.2, the tug-of-war between producers and consumers results in resource scarcities that inevitably turns the policyinduced boom into bust. Resource scarcities result from the over-production of both producer goods and consumer goods. The continuing high demand for increasingly scarce resources implies a higher demand for credit which in turn puts upwards pressure on the interest rates. Besides this market pull, interest rates also rise once the injection of newly-created money ceases or the rate of increase is slowed. Producers are forced to revise their investment plans by accounting for these resources scarcities and tighter credit conditions. In doing so, many producers encounter constraints that render their projects less profitable. The consequent liquidation or downsizing of production projects results in a systemic unemployment of capital resources. The boom period of over-production turns into a recession as the economy shifts back towards the
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PPF. Simultaneously, the structure of production reverts back towards achieving compatibility between the saving preferences of consumers and the investment decisions of producers. This self-reversing process of capital restructuring gives way to a downward spiral in both income and expenditures as market participants lose confidence in the economy. Producers and consumers alike become risk averse and exhibit stronger liquidity preferences. Ultimately, this stronger precautionary demand for liquidity bears a crucial role in causing the financial system to suddenly falter or collapse. Thus far, we have explained the artificial boom and eventual bust without any reference to the subjectivism of market participants. Although the Austrian model of the business cycle is constructed to deal with relationships between macroeconomic quantities, it recognizes the strong implications of endogenizing the subjective expectations of individuals. In section III, we identified Hayeks notion of knowledge as representative of the fact that not all producers have enough information about the time preferences of consumers. In solving the coordination problem, we also assumed that the interest rate is a natural mechanism that serves to synchronize the expectations of producers with the behaviour of consumers. Following these assumptions, we may now deepen our explanation of how the market process may be adversely affected by changes in interest rates that result from monetary expansion. The extent to which an artificial fall in the interest rate encourages malinvestment depends critically on how producers perceive this price change. Producers can either wrongly perceive the lower interest rate as to reflect the stronger saving preferences of consumers, or they can correctly perceive it as being the result of monetary policy. By and large, if producers ignorantly expect the former perception to be genuine, monetary expansion will mislead them into behaving as if consumers were more future-oriented than they actually are. Their erroneous expectations about the interest rate encourage them to make investments into more timeconsuming production processes. However, the implied reallocation of capital in favour of a lengthened structure of production has limited scope for completion since consumers are actually less thrifty in their current consumption. In sum, the central bank can thus be said to trigger an ill-fated process of capital restructuring by fooling those market participants who arent informed enough to account for the very nature of a change in the interest rate.
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V. APPLICATION TO THE RECENT BOOM-BUST PERIOD


We have seen that the Austrian theory suggests that business cycles are primarily caused by a fall of interest rates below their natural levels. Although it is difficult to measure such a deviation in practice, some empirical reviews (see Keeler, 2001; Bocutoglu & Ekinci, 2010) intuitively use the federal funds rates as a proxy for market rates whilst using 10-year Treasury security interest rates as roughly equivalent to natural rates of interest. As such, Figure 5.1 and 5.2 respectively illustrate the relationship and spread between the market and natural rates of interest in the US economy during the period of 20012009. Using open market operations following the dotcom bust in 2001, the Federal Reserve bought government securities with the aim of making the effective federal funds rate track a lower target rate. In this way, the effective federal funds rate was radically reduced from a high of 5.98% in Q1 2001 to a low of 1.01% in Q3 2003. The Federal Reserve held the target rate at this historically low level until Q2 2004, before ratcheting it up to 5.24% by Q3 2006. Meanwhile, the 10-year Treasury yields didnt drop or fluctuate nearly as much.

In figure 5.2, the positive bars show the year-long periods in which market interest rates were lower than the natural interest rates, whilst the opposite is true for the negative regions. With the benefit of hindsight, it is reasonable to
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infer that the positive rate spreads (especially from 2002 to 2004) were larger than was justified by the risk and liquidity premiums within financial markets, and thereby paved the way for the malinvestments during the economic boom. Hence, in accordance with the theoretical observations, the Great Recession followed shortly after a nearly half-decennial period during which the market interest rate fell below the natural rate of interest.

According to the predictions of the Austrian theory, a central bank-induced fall in the interest rate incentivizes consumers to save less and spend more on current consumption, while artificially cheap credit entices producers to increase their investments. During the years of loose monetary policy, we empirically notice that the personal savings rate fell from a high of 4.7% in September 2001 to a low of 0.8% in April 2005. And when looking further into the data published by the U.S. Department of Commerce, we observe trends in consumption and investment which correlate to the observations of the theory. Figure 5.2 and 5.3 respectively show aggregate estimates of consumption and investment behaviour in the US economy during the 2000s. It is evidently clear that consumption and investment simultaneously surged during the period in which interest rates deviated from their long-run (or natural) levels. Real gross private investment grew from $1.83 trillion in Q3 2001 to $2.32 trillion in Q1 2006, while real personal consumption expenditures rose from $7.8 trillion to
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$8.98 trillion during the exact same period. As illustrated in the Austrian modeling of the production possibility frontier, a wholly-privatized economy with no central bank can only increase investment to the extent that it is willing to forego current consumption. However, under a centralized monetary system, investment can increase without there being any offsetting decrease in current consumption. Hence, the empirical data presented here seems to fit the theory in the sense that monetary expansion is expected to overthrow the fundamental trade-off between consumption and investment.

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Critics of the Austrian theory often refute its validity on the basis of excluding the possibility that credit might be largely directed towards consumers as opposed to producers. However, such criticism is erroneously founded on an outdated understanding of the theory. Although the old Mises-Hayek model was offered as a specific account of the Great Depression of the 1930s, modern Austrian economists (see Garrison, p.75, 2001) have shown that it can be adjusted to account more generally for the different ways in which credit is injected into the economy - that is, either to producers or consumers. This duality of credit injection accords with the recent boom in which newly-created money was infused through both consumers and producers, but most predominantly the former. In tandem with a variety of legislative programs and government sponsored enterprises, the depth and sophistication of the financial system allowed consumers in all echelons of society to gain easier access to homeownership. Even financially unqualified consumers were encouraged to take on dubiously-attractive capital gains and subprime expected mortgages future requiring no initial current downpayment. Moreover, financial innovations made it possible to transform unrealized incomes into consumption. Financial institutions thus relaxed their lending standards and persuaded consumers to take out credit cards, mortgages, home equity loans, auto loans and so on. In this way, consumers were enticed to use credit to purchase homes and consumer discretionaries that, in many cases, may not have been affordable prior to the artificial fall in the short-term interest rates. The Austrian theory posits that an artificially low interest rate causes producers to lengthen the structure of production by investing capital into longer-term production projects. As indicated by the bubbly behaviour of housing prices, much of the artificially cheap credit offered to consumers and producers was destined for use in the real estate market. While consumers were encouraged to mortgage themselves on an unprecedented scale, billions in development loans were made to producers for residential and commercial construction. This rise in the demand for real estate induced investments of human and physical capital which was consistent with a lengthening structure of production. Human capital resources were drawn away from the late-stage production of goods and services towards the early-stage construction of real
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estate. This capital reallocation is evident from the fact that jobs were being created in far greater abundance in the construction sector relative to services industries. For instance, according to the Nevada Department of Employment, Las Vegas construction jobs increased by 11.1 percent compared to a 4.6 percent rise in the services industries over the year-long period of 2004. Moreover, the boom in real estate demand sent signals for a widening of the early-stage production of raw materials (i.e. lumber, nails, drywall, plastic, and so on). Hence, a lengthening of the production structure was also manifested as an expansion of physical capital-intensive industries relating directly to the infrastructural production of real estate. Bearing in mind that the production activities of the United States have become increasingly financial in nature, the favourable impact of artificially cheap credit on the future-orientedness of producers was also noticeable in the interest-sensitive markets of the financial industry. First and foremost, lower interest rates reduced the yield that commercial banks made on their shortterm issuance of loanable funds. Unsatisfied with low short-term yields, these banks became increasingly tolerant of risk and thus increased their long-term investments of financial capital by providing higher-yielding loans with long maturities. Most notably, these financial producers drastically increased their provision of longer-term amortizing mortgages and real estate development loans. According to the Federal Deposit Insurance Corporation, credit loans directed towards the real estate market more than tripled from $1.43 trillion in 1999 to $4.5 trillion in 2009. Similarly, lower interest rates incentivized private equity producers to increase their capital investments by borrowing short to carry out leveraged buyouts (LBOs) with the use of longer-term financing. As leveraged buyouts grew from $24.6 billion 2000 to $356.7 billion in 2007, the average Debt/EBITDA ratio (i.e. the number of years needed to pay off debt) went up from 4 in 2001 to 5.5 in 2006. Indeed, the increase in the size and leverage involved in many of these LBOs would have been unthinkable had the interest rates not been lowered for so long by the Federal Reserve.

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As was previously noted in section III, the Austrian theorists value the price system as an effective means of communicating information about underlying economic realities to market participants. In this regard, a higher price can often signal a rise in the consumer demand and thereby induce a search on the part of producers to increase the supply of the good in question. However, in the context of monetary expansion, producers may be far removed from the nature of such a price change because they dont have the necessary economic knowledge to differentiate between what is real and what is central bankinduced. Producers can thus be misled by monetary disturbances into reacting with erroneous expectations about nominal price changes. In application, such perverse practices is evident from the very fact that market participants formed their expectations on the false pretence that real estate prices would perpetually increase in the foreseeable future. By failing to recognize that housing inflation was being artificially fuelled by the procyclical policies of the central bank, market participants saw no end to the ever-rising prices in the real estate market. In the first instance, the rise of housing prices was brought about by credit-infused consumption for present use. But speculators were soon to follow as they took advantage of cheap credit to buy real estate for the sole purpose of making profits from their expectations of ongoing price appreciation. These speculative investments pushed real estate values even further above that warranted by present use. Although this speculation spread throughout the economy, it was most pronounced in Las Vegas and Southern Florida. However, when then housing market took a downward turn as of 2006, it became increasingly evident that a false expectation of profitability had led to a euphoria of unjustified momentum investing in the real estate market. As the Federal Reserve gradually increased the federal funds target rate during 20042006 to stave off inflation, higher credit costs caused the rate of increase of new investment within the housing and mortgage markets to slow down. The resulting fall in housing prices and reduced availability of cheap credit subsequently triggered troublesome effects within the subprime mortgage market. Many investments of financial capital within this market turned out to be unprofitable as low-end homebuyers found themselves incapable of paying back their loans at increasing adjustable mortgage rates. Although they may not have seemed systemically contagious at first, the problems of insolvency
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within this subset of the mortgage market eventually rippled through the economy and brought forth a housing-led bust of unprecedented proportions. As the Austrian theory of the business cycle dictates, the Great Recession set in to purge malinvestments from the preceding boom by redirecting misallocated capital resources away from the industries that had become part of the creditinfused real estate binge. In this regard, there is no better evidence of malinvested physical capital projects than the empty and half-completed homes, shopping centers, hotels and office buildings that were abandoned in various parts of the United States. Similarly, the misallocation of human capital was reflected most markedly by the mass unemployment of construction workers. According to employment data released by the Bureau of Labor Statistics, total construction payroll employment dropped by 2.1 million in the period of 20062010. In residential construction alone, unemployment grew by 1.3 million during this same period. Since real estate became such a key component of financial activities during the economic boom, job losses in the financial industry loosely mirrored the above-mentioned trend in construction employment. The financial sector lost 5.9 percent of its jobs since the between Q4 2007 and Q2 2009 most of which occurred in the credit intermediation subsector. Ultimately, the reallocation of human capital resources was manifested as the laid off workforces of the financial and real-estate related industries were forced to look for jobs elsewhere. And as the massive devaluation of real estate prices brought to light the malinvestments of financial capital, bank failures triggered a reallocation of financial resources from inefficient banks to better managed institutions most evidently from the acquisitions of the Bear Stearns and Washington Mutual by JPMorgan Chase.

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VI. CONCLUSION Having come to the end of this analysis, it is customary to make a few remarks about its contributions to the post-crisis debate on economic policy. A meaningful response to the crisis requires a comprehensive understanding of its nature. In the Austrian view, the Great Recession was not a failure of free market capitalism as such, but primarily the result of the hyperactive intervention on the part of the Federal Reserve. However, while the artificially low interest rate may have been a root cause, it is far from the only factor to have impinged on the complex story of the housing boom. Amongst other things, a full explanation would involve housing-related legislation, government sponsored enterprises in the secondary mortgage market, rating agencies, financial deregulation and the global savings glut. Although the Federal Reserve was not entirely to blame for the housing boom, it is reasonable to conclude that it was a chief contributor. In retrospect, there is much evidence to suggest that the low interest rates may have been at odds with the natural rate of interest. Given the very fact that yields on short-term securities barely reflected the immense risks underlying financial markets during the boom period, the Federal Reserve has confirmed its ability to target a federal funds rate that is consistent with bubble-prone economic growth. Both theory and evidence seem to suggest that a greater degree of economic stability is to be achieved by ruling out the targeting of interest rates by the Federal Reserve. Instead, the determination of interest rates should be restored to the province of the marketplace. Only in this market-determined manner will interest rates tend towards their natural levels and thereby allow the plans of producers to better conform to the economic realities of consumers. In achievement of this aim, the Austrian school postulates the need to follow through with the institutional reforming of the monetary system. Notably, Austrian economists (see Mises, 1978; Hayek, 1976; Garrison, 1996) advocate the decentralization of money as the de facto prescription for the moderation of the business cycles. As an alternative, these theorists propose that governments reinstate a monetary arrangement in which the convertibility of money is maintained in terms of one or more commodity goods - the simplest example being a privatized gold standard. Mainstream economists have long
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frowned upon such a proposition on the grounds that there are high resource costs and supply-side disturbances related to a commodity standard. However, in view of the accuracy of Austrian economists in predicting and explaining the recent recession, a reconsideration of the market-based monetary system deserves greater merit than it has received to date. At the very least, the Austrian understanding of the procyclical perils of centralization ought to foster a greater appreciation of the countercyclical qualities of decentralization. Although this policy solution seems counter to historical trends in monetary development, the case for a decentralized monetary system parallels that of markets in general. The virtue of monetary decentralization is that the invisible hand mechanisms of the market would allow the money supply to respond naturally to changes in demand. It thus prevents the money supply from being repeatedly expanded in surplus of demand by the whims and excesses of central banking officials. With no lender of last resort, financial institutions would be free to fail and would thus have to restrain themselves from imprudent lending by paying more diligent attention to the risks underlying their loans. Moreover, uninsured depositors would put pressure on banks to meet their obligations by carefully monitoring the health of their balance sheets. Such vigilant and disciplinary behaviour at both ends of the market would temper speculative excesses within the financial industry. And without fractional reserve banking, financial institutions would not be dangerously over-leveraged since each would be required by law to hold 100 percent commodity reserves against their notes and demand deposits. Hence, the broader lesson in all this is one that gives us a greater appreciation for the full privatization of money in solving the business cycle problem in the United States. With no centralized intrusion on the part of the Federal Reserve, there can be no monetary disturbance that periodically nullifies the coordinative forces of the invisible hand with procyclical consequences. However, given the state of public opinion and scope for political opportunism in present times, it seems as though we have a while to wait before the mainstream come to recognize that the all-knowing central bankers cannot outdo or even match the performance of the market as an automatic stabilizer of the macroeconomy.

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VII. BIBLIOGRAPHY Bocutoglu & Ekinci (2010) Austrian Business Cycle Theory and Global Financial Crisis, Published for the Turkish Economic Association Conference Cochran, John P. (2004) Capital, Monetary Calculation, and the Trade Cycle The Journal of Austrian Economics, Volume VII, pages 1725 Fleckenstein, William A. (2008) Greenspans Bubbles: the Age of Ignorance at the Federal Reserve, Printed by McGraw Hill Publishers, New York Garrison, Roger W. (1986) The Hayekian Trade Cycle Theory: A Reappraisal Cato Journal of Economics, Volume VI, No.2 Garrison, Roger W. (1996) Central Banking, Free Banking, and Financial Crises, The Review of Austrian Economics Vol. 9, No. 2, pages 109-127 Garrison, Roger W. (2001) Time and Money: The Macroeconomics of Capital Structure, Printed by Routledge Publishers Garrison, Roger W. (2008) Interest-Rate Targeting During the Great Moderation: A Reappraisal, Working paper published for Cato Institutes 26th Annual Monetary Conference on the 19th November 2008 in Washington, D.C. Haberler, Gottfried (1986) Reflections on Hayekian Business Cycle Theory, Cato Journal, Volume VI, No.2 Hayek, Friedrich A. (1935) Prices and Production, Second Edition, New York, Printed by Augustus Kelly Publishers Hayek, Friedrich A. (1945) The Use of Knowledge in Society, Published in the American Economic Review, Volume XXXV, No. 4, pages 519-530 Hayek, Friedrich A. (1948) Individualism and Economic Order, Published by the University of Chicago Press. Hayek, Friedrich A. (1976) Choice of Currency: A Way to Stop Inflation, Published by the Institute of Economic Affairs Hoffman & Schnabel (2009) A Vicious Cycle of Manias, Crashes and Asymmetric Policy Responses, University of Leipzig, MPRA Paper No. 18532

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Karlsson, S. (2005), America's Unsustainable Boom, Ludwig von Mises Institute, Mises Daily Article, http://mises.org/story/1670 Keeler, James B. (2001) Empirical Evidence on the Austrian Business Cycle Theory Published by the Review of Austrian Economics, pages 331351 Keynes, John M. (1936) General Theory on Employment, Interest and Money, Printed by Palgrave Macmillan Publishers Mises, Ludwig V. (1912) The Theory of Money and Credit, Translated from German by H. Batson, New version published in 1971 by Irvington-on-Hudson Mises, Ludwig V. (1966) Human Action: A Treatise on Economics, Translated from German by Bettina Greaves, Published by Henry Regnery Company Mises, Ludwig V. (1978) The Causes of Economic Crisis: On the Manipulation of Money and Credit, Translated by Bettina Greaves, Published by Liberty Funds Rothbard, Murray N. (1970) Man, Economy and State: A Treatise On Economic Principles Second Edition, Published by the Ludwig Von Mises Institute Schiff, Peter D. (2006) Crash Proof: How to Profit from the Coming Economic Collapse, Published by John Wiley & Sons, New Jersey Taylor, Thomas C. (1980) An Introduction to Austrian Economics, Published by the Cato Institute of Economics. Thornton, M. (2004), Housing: Too Good to be True, Ludwig von Mises Institute Mises Daily Article, http://mises.org/story/1533. Wicksell, Knut (1898) Interest and Prices: a Study of the Causes Regulating the Value of Money, Translated from Swedish by Richard Kahn, New version printed in 1962 by Augustus Kelley Publishers Verick & Islam (2010) The Great Recession of 2008-2009: Causes,

Consequences and Policy Responses Discussion Paper No. 4934, Published by the Institute for the Study of Labor (IZA).

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