Beruflich Dokumente
Kultur Dokumente
La Calidad Acadmica,
un Compromiso Institucional
Zelmanovitz, Leonidas
(2011). The Austrian
Business Cycle Theory and
the recent nancial crisis
Criterio Libre, 9 (15),
23-58
ISSN 1900-0642
The Austrian Business Cycle Theory and the recent financial crisis
ABSTRACT
The argument presented in this paper is based on the recognition that the
Austrian Business Cycle Theory is outdated in its description of how the effects
of monetary phenomena are transmitted to the real sector and produce
business cycles. In the paper it is argued that there are epistemological
limitations for successfully preventing inflationary credit expansions by
the adoption of Inflation Targeting policies and that the adoption of such
policies is the cause of the economic boom that ended in 2007. It is also
described in the paper how monetary contraction happened, starting in
September 2008; and that is offered as an explanation for the beginning
of the downturn. Finally, it is argued in the paper that once started the
downturn a prudential response by the monetary authorities, one that
would mimic the reactions of the competing money suppliers in a free
market would have been, is the proper course of action under the current
monetary arrangements.
KEY WORDS:
Austrian school of economics, economic cycle, financial crisis.
JEL CLASSIFICATION:
B25, E44, E65.
**
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The paper is product of research for Line Money Market research of the Program of Liberty
Fund Conference.
Ph. D. in applied economics, Universidad Rey Juan Carlos, Madrid, Spain; magster in
Austrian economy, Universidad Rey Juan Carlos, Madri; licensed in Law, Universidad
Federal, Porto Alegre, Brazil; Liberty Fund Fellow, Indianapolis, USA. lzelmanovitz@
libertyfund.org.
Criterio Libre N 15
Bogot (Colombia)
Julio-Diciembre
2011
Pp. 23-58
ISSN 1900-0642
Universidad Libre
Leonidas Zelmanovitz
RESUMEN
LA TEORA AUSTRACA DEL CICLO ECONMICO Y LA RECIENTE CRISIS FINANCIERA
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The Austrian Business Cycle Theory and the recent financial crisis
RSUM
LA THORIE AUTRICHIENNE DU CYCLE DAFFAIRES ET DE LA RCENTE CRISE FINANCIRE
1. INTRODUCTION
The narrative of the Austrian Business Cycle Theory (ABCT for short) is well
known. Departing from the assumptions that money is not neutral and
financial flows are a mere mirror of what is happening in the real economy,
the Austrian theorists argue that every time that there is an expansion of
credit in the economy above the actual availability of saved resources, two
things happen. First is the Cantillion effect, which refers to the fact that since
some agents in the economy get the new money first, they spend it first,
and therefore the burdens and benefits of inflationary credit expansion are
uneven in the economy. Second, the availability of new money reduces the
actual interest rate below its notional previous natural level, inducing the
economic agents in general to engage in investments made viable due to
a lesser cost of capital; they start to invest specially in more time-consuming,
capital-intensive forms of production that will demand real resources above
the actual available resources in the economy.
For some time, in the upturn of the cycle, the economy will experience overconsumption and over-investment, with the economic agents guided by
distorted relative prices (cause and consequence of the way in which the
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Leonidas Zelmanovitz
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The Austrian Business Cycle Theory and the recent financial crisis
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Part of the arguments and evidence presented here were previously discussed: (a) in a working paper on the demand for
money presented at the Austrian Scholars Conference 2010 at the Mises Institute in Auburn, Alabama and later published in
the Journal Criterio Libre, year 8, #13, Bogot (Colombia), edition Julio-Diciembre 2010; (b) in a working paper on inflation
targeting presented at the III International Conference: Austrian Economics in the XXI Century, in Rosario, Argentina, and
published by the Journal RIIM of Eseade, Argentina; and (c) in my dissertation on the philosophy of money for the Doctorate
in Applied Economics at Universidad Rey Juan Carlos in Spain.
Perhaps the most influential academic paper proposing an inflation target as the central criterion for monetary policy is John B.
Taylors Discretion Vs. Policy Rules in Practice (Taylor, 1993). Its main credit, however, is that it endorsed what at that time
became common practice among central banks. Bernanke et al. (2001), first published in 1999, is also widely quoted in
academic discussions about inflation targeting for the collection of data supporting the claim for inflation target effectiveness.
Proposals for targeting monetary policy on a broad price index were already deemed old by Professor Yeager in a 1983
paper (Yeager, 1983: p. 308), and rightly so, since, as this chapter argues, their root may be found in the monetary policy
of the 1920s. Specifically, the similitude between the 1920s and the 1990s was already perceived, according to Professor
Barry Eichengreen, who wrote that observers see parallels, in other words, between the new economy of the 1990s
and the new age of the 1920s (Eichengreen, 2002: p. 9).
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The Austrian Business Cycle Theory and the recent financial crisis
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Leonidas Zelmanovitz
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The Austrian Business Cycle Theory and the recent financial crisis
4
5
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Leonidas Zelmanovitz
Incidentally, the time lag may be considered as yet another epistemological objection to inflation targeting, since it is only
after the monetary disturbances are perceived by the price index that monetary authorities will have the information that some
corrective action is necessary.
Professor Bagus emphasizes the fact that the exact knowledge assumed to exist in order to practice inflation-targeting policies
is actually nonexistent when he states that error estimates are not provided in econometrics because there is not a precise
way of calculating them (Bagus, 2010: p. 28).
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The Austrian Business Cycle Theory and the recent financial crisis
Table 1. Consumer Price Indexes selected developed countries 1970-20078: (percentage changes
based on national price indexes published by each country)*
Year
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
USA
Canada
5.9
3.3
4.2
2.9
3.3
4.9
6.3
7.6
11.0
10.9
9.1
10.7
5.8
7.6
6.5
8.0
7.6
9.0
11.3
9.1
13.5
10.2
10.4
12.4
4.0
10.7
5.3
5.9
4.4
4.4
3.5
4.0
1.9
4.2
3.7
4.4
4.1
4.0
4.8
5.0
5.4
4.8
4.2
5.6
3.0
1.5
3.0
1.8
2.6
0.2
2.8
2.2
3.0
1.5
2.3
1.7
1.6
1.0
2.2
1.8
3.3
2.7
2.8
2.5
1.6
2.2
2.3
2.8
2.7
1.8
3.4
2.2
3.2
2.0
2.8
2.2
Japan
7.6
6.4
4.8
11.7
23.2
11.7
9.4
8.2
4.2
3.7
7.8
4.9
2.8
1.9
2.3
2.0
0.6
0.1
0.7
2.3
3.1
3.3
1.7
1.2
0.7
-0.1
0.1
1.9
0.6
-0.3
-0.8
-0.7
-0.9
-0.3
0.0
-0.3
0.3
0.0
France
5.9
5.5
6.2
7.3
13.7
11.8
9.6
9.4
9.0
10.8
13.0
13.3
12.0
9.5
7.7
5.8
2.5
3.3
2.7
3.5
3.4
3.2
2.4
2.1
1.7
1.8
2.0
1.2
0.7
0.5
1.7
1.7
1.9
2.1
2.1
1.8
1.6
1.5
Germany
3.4
5.2
5.5
7.0
7.0
5.9
4.3
3.7
2.7
4.1
5.5
6.3
5.3
3.3
2.4
2.1
-0.1
0.2
1.3
2.8
2.7
3.5
5.1
4.5
2.7
1.8
1.4
1.9
1.0
0.6
1.4
1.9
1.5
1.0
1.7
1.5
1.6
2.3
Italy
Sweden
5.0
7.0
4.9
7.4
5.7
6.0
10.8
6.7
19.1
9.9
17.1
9.8
16.7
10.3
18.5
11.4
12.0
10.0
14.8
7.2
21.3
13.7
19.5
12.1
16.5
8.6
14.6
8.9
10.9
8.0
9.1
7.4
5.8
4.2
4.8
4.2
5.1
5.8
6.3
6.4
6.5
10.5
6.3
9.3
5.3
2.3
4.6
4.7
4.1
2.2
5.3
2.5
4.0
0.5
2.0
0.7
2.0
-0.3
1.7
0.5
2.5
0.9
2.7
2.4
2.5
2.2
2.7
1.9
2.2
0.4
2.0
0.5
2.1
1.4
1.8
2.2
Swiss
3.6
6.6
6.7
8.8
9.8
6.7
1.7
1.3
1.1
3.7
4.0
6.5
5.7
3.0
2.9
3.5
0.8
1.4
1.9
3.1
5.4
5.9
4.0
3.3
0.9
1.8
0.8
0.5
0.0
0.9
1.5
1.0
0.6
0.6
0.8
1.1
1.1
0.7
UK
6.4
9.5
7.1
9.2
16.0
24.3
16.7
15.8
8.6
12.6
16.9
12.2
8.5
5.2
4.5
5.2
3.6
4.1
4.6
5.9
8.2
6.8
4,7
3.0
2.4
3.5
2.4
3.1
3.4
1.5
3.0
1.8
1.7
2.9
3.0
2.8
3.2
4.3
*The data has not been adjusted for comparability. National differences exist.
Sources: United States Bureau of Labor Statistics (www.bls.gov/fls/flscpian.pdf), International Monetary Fund, (www.imf.org/
external/pubs/ft/weo/2000/02/data/index.htm).
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The countries shown on the table were selected because they are representative of modern Western societies as a result of the
size of their economies and their leadership in institutional developments. These percentage changes are based on national
price indexes as published by each country.
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The Austrian Business Cycle Theory and the recent financial crisis
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Leonidas Zelmanovitz
The United States is one of those countries where, to this day, inflation targets are not formally adopted; nevertheless,
American monetary policy is guided primarily with a focus on the inflation rate. In Mr. Alan Greenspans memoirs he defends
keeping the Fed Funds rate unchanged in 1994; he argues that it was the first time since the 1960s that the inflation rate had
been under a three percent rate per year for three consecutive years. About the monetary policy in 1996, in the seventh year
of the most consistent bull market in record, he argues that the Fed has no explicit mandate under the law to try to contain a
stock market bubble and that it was established that price stability is central to long-term economic growth. In December
of that year, the famous concept of irrational exuberance was offered during a speech at the American Enterprise Institutes
annual dinner, yet there was no change to the inflationary easy credit policy since the consumer price indexes did not show
any impact from that policy (Greenspan 2007: 178).
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The Austrian Business Cycle Theory and the recent financial crisis
10
11
38
Every society has in any given moment a structure of production composed by the sum of buildings, equipments, inventories,
and individuals engaged in productive activities. They operate in a given cycle of production, shorter for industrialized goods
of consumption, longer for agricultural goods, perhaps even longer for capital goods. Every structure of production requires
a certain liquidity expressed by a quantity of medium of exchange available in order to operate the economic transactions.
This quantity of medium of exchange can be available because the economic agents themselves have enough capital to do
their transactions or it can be made available through credit. But the fact is that, at any given moment, the economic agents
require neither more nor less money than is necessary to make their transactions. This can be considered the optimum
amount of money, and this optimum varies all the time with the variation of the circumstances. A necessity of increasing
inventories or expanding productive capacity through the introduction of new technology or fixed assets may demand
increases in the optimum amount of money; on the other hand, better management techniques and lean production process
may liberate resources and imply a reduction of the money demanded by that society at that moment. This understanding is
a generalization of the Needs of Trade Doctrine advocated by the members of the Banking School in the debates on
monetary policy in the middle of the nineteenth century in Britain. Although their arguments were in favor of allowing the local
banks to have some elasticity on the issuance of bank-notes in different regions of Great Britain at different times during the
year in order to accommodate the needs of trade (White, 1995: 123), their arguments may be accepted as a general
principle about money, given the stiffness of price and contracts, since in those circumstances the adjustment cannot be done
as easily by price changes.
The reflux mechanism operates under a gold reserve system in which bank notes are cleared among different and competing
issuing banks, as in the case of Scotland during the second half of the nineteenth century. A more aggressive bank would
have systematically negative balances at the daily clearing and would be forced to give reserves to the more conservative
ones, inducing the aggressive bank to scale back and start to operate at the same level of exposure as the other banks.
However, this mechanism is not a guarantee against a general expansion of the banks leverage, as pointed out by J.R.
McCulloch and quoted by Professor Lawrence White (1995: 103).
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Leonidas Zelmanovitz
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Contrariwise, limiting
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The Austrian Business Cycle Theory and the recent financial crisis
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3.
13
Obviously, it is not any quantity of base money that will be absorbed by the money-holders; it is not any quantity of credit
money that could be generated by the banking system leveraging the available amount of base money without significant
and considerably fast impact on the purchasing power of money. But, to the extent that the initial circumstances permit,
substantial amounts of financial claims over and above the increase in real savings can be created under the current monetary
arrangements almost everywhere until it starts to compromise the purchasing power of money and the credibility of the
banking system.
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The Austrian Business Cycle Theory and the recent financial crisis
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15
16
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For the purposes of this work, when a monopoly of the money supply is referred to, a monopoly created by law is what is
meant and not a natural monopoly in the supply of money that may arise spontaneously under a competitive framework.
For a discussion on money as a capital good, see Barnett and Block (2005).
The GAMOE definition of money was first developed by Carl Menger, it assumes that money is a spontaneous social
institution, that it is developed in society in order to facilitate economic transactions and therefore to allow and enhance the
division of labor by diminishing the transaction costs of bartering. It is important to note, in accepting the GAMOE definition
of money that the other two main functions of money i.e., its capacity to be used as a unit of account and as a store of
valueare derived from its central attribute.
If the GAMOE definition of money is accepted, money becomes anything that comes to be generally accepted as a medium
of exchange. So, not only commodity money, but also fiat money, bank deposits available on demand, and credit instruments
with extremely high liberative power may be considered money under this definition. In fact, the distinction between money
and quasi-money becomes somewhat blurred. That is so because, given some circumstances, some financial instruments may
lose or acquire liquidity even to a degree of becoming money, while a fiat currency may totally lose the confidence of the
money holders and cease to be considered money. As written by Professor Leland Yeager in his book The Fluttering Veil,
At some point, apparently, the shading or drift from the properties of close near moneys toward those of money become a
jump from a difference in degree to a difference in kind (Yeager, 1997: 109).
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The Austrian Business Cycle Theory and the recent financial crisis
As confirmed by empirical
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The Austrian Business Cycle Theory and the recent financial crisis
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Fiat justitia ruat caelum is a legal phrase in Latin that may be translated as Do justice and let the sky fall. The maxim signifies
the belief that justice must be realized regardless of consequences. It can have a positive and a negative connotation. In the
case of judging the proper course of action for the monetary authorities to adopt in case of a higher demand for money due
to an increase in the uncertainty in middle of an economic crisis, first it must be understood whether it is a case that admits
a prudential response.
Professor Rothbard in Man, the State and the Economy describes the liquidationist point of view against the prudential
response suggested above: It may well be true that the deflationary process will overshoot the free-market equilibrium point
and raise price differentials and the interest rate above it. But if so, no harm will be done, since a credit contraction can
create no malinvestments and therefore does not generate another boom-bust cycle (Rothbard, 2009: p. 1006). As it is
argued in this chapter, there are other harms to be considered aside from the generation of another cycle.
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Leonidas Zelmanovitz
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22
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The Austrian Business Cycle Theory and the recent financial crisis
Figure 2. True Money Supply (TMS) vs. MZM Money Stock vs. M2 Money Stock
Cont. nota 22
in a forced liquidation of those assets. Those will be the alternatives every time that there is an explicit or implicit warranty
of the financial institutions that the investors in money market mutual funds have a debt claim against the banks and not an
equity position. This work is not the place to discuss the policies followed by the Fed during the recent financial crisis, but in
evaluation the course of action followed, one must keep in mind the understanding that if the investors in money market mutual
funds had had the perception that the principal of their investments had been at risk, the flight to liquidity would have been
much greater than what it actually was (with catastrophic and unpredictable consequences for the entire financial system).
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Professor George Selgin in the introduction to Leland Yeagers Fluttering Veil argues that it is not only in a mixed economy
that a downward rigidity in prices is to be found. He argues that it is a consequence of a network externality; that each
seller has an incentive to wait for others to go first in making desirable adjustments (Yeager, 1997: XVI).
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The Austrian Business Cycle Theory and the recent financial crisis
A MATTER OF PRINCIPLES
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In order to evaluate to what extent a financial crisis may or may not justify extraordinary measures, it seems relevant here to
keep in mind Ayn Rands definition of emergency:
An emergency is an unchosen, unexpected event, limited in time that creates condition under which human survival is
impossible. In an emergency situation, mens primary goal is to combat the disaster, escape the danger and restore
normal conditions. By normal conditions I mean metaphysically normal, normal in the nature of things, and appropriate
to human existence. By its nature, an emergency situation is temporary the principle that one should help men in an
emergency cannot be extended to regard all human suffering as an emergency and to turn the misfortune of some into a
first mortgage on the lives of others (Rand, 1963: p. 55).
Professor Robert Higgs describes in chapter eight, The Great Depression: An Emergency More Serious than War, the ways
in which an artificial crisis was created by President Franklin Delano Roosevelt soon after his inauguration in March 1933
(claiming dubious powers given by the Trading with the Enemy Act of 1917) by proclaiming a banking holiday (Higgs,
1987: p. 170). Abuses such as that and others carried on by Roosevelt under the New Deal such as the seizure of gold
and the devaluation of the gold content of the United States dollar were largely avoided during the recent financial crisis.
Obviously the monetary constitution of the United States is not the same today as it was at the time of the founding. In 1913
with the establishment of the Fed, a major change, one may say a constitutional change (if not formally, at least de facto)
was introduced. At the end of World War I, under the new monetary regime, a first important change was introduced when
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Leonidas Zelmanovitz
Cont. note 26
27
It seems to be beyond
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28
It is disputable whether Bagehot in his book was making an apology for central banking or, on the contrary, was actually
calling attention to the real underpinning of British financial markets (trust) and the inherent fragility of the fractional reserve
system in place.
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Most of the monetary expansion done in the immediate aftermath of the Lehman debacle was done by crediting the deposit
accounts of financial institutions with the central bank; those deposit accounts are part of the monetary base and therefore of
the money supply.
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REFERENCES
Aristotle (1941). The Nicomachean Ethics,
in The Basic Works of Aristotle, edited by
Richard McKeon, thirty-fifth printing, New
York: Random House.
Bagus, Philipp (2010). Morgensterns Forgotten
Contribution: A Stab to the Heart of Modern
Economics to be published in the American
Journal for Sociology and Economics.
Barnett II, William and Walter Block (2004).
On the Optimum Quantity of Money, in The
Quarterly Journal of Austrian Economics, Vol.
Number 1, Spring Edition.
Barnett II, William and Walter Block (2005).
Money: Capital Good, Consumers Good
or (Media of) Exchange Good?, in The
Review of Austrian Economics, Vol. 18,
Number 2.
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