List of figures
List of abbreviations
1 Introduction
2 The Austrian Theory of the Business Cycle
2.1 Capital-based macroeconomics
2.1.1 The market for loanable funds
2.1.2 The production possibilities frontier (PPF)
2.1.3 Stages of production
2.1.4 Capital-based macroeconomics model
2.2 The Business Cycle
2.2.1 Monetary expansion, the market for loanable funds and the PPF
2.2.2 Artificial interest-rates and the structure of production
2.2.3 Boom and Bust
3 The Subprime Crisis and the Austrian Theory
3.1 Monetary policy and regulation before and during the crisis
3.2 Application of the theory
3.3 Evaluation of the Subprime crisis
4 Conclusion
Bibliography
The role of central banks and monetary policy in modern economies is a highly controversial topic. This paper attempts to show the relationship between monetary policy and the development of economic crisis, especially the recent Subprime Crisis in the USA. For this purpose the first part of the paper examines the Austrian theory of the business cycle and its illustration, the capital-based macroeconomics model. According to the Austrian theory artificially low interest-rates are responsible for misallocations of resources within the intertemporal capital structure and, consequently, reoccurring fluctuations within the economic system.
The second part of the paper applies the Austrian theory of the business cycle to the Subprime Crisis and investigates the role of the Federal Reserve System for the development of the crisis.
Ultimately, this paper states that expansionary monetary policy and flawed government regulations were the cause for unbalanced changes in the American structure of production and the recession.
Figure 2.1: The market for loanable funds (or investable resources)
Figure 2.2: Change of intertemporal preference
Figure 2.3: Gross investment and growth (contraction, stationary, expansion)
Figure 2.4: "Hayekian Triangle"
Figure 2. 5: The structure of production (continous-input/ point-output)
Figure 2.6: Effect of falling time preference on stages of production (saving-induced capital restructuring)
Figure 2.7: The macroeconomics of capital structure
Figure 2.8: Saving-induced capital restructuring with future economic growth
Figure 2.9: Monetary expansion in the market for loanable funds
Figure 2.10: The PPF and expansionary monetary policy
Figure 2.11: Policy-induced capital restructuring
Figure 2.12: Boom and bust (policy-induced intertemporal disequilibrium)
Figure 3.1: M2; year-on-year growth-rate
Figure 3.2: Federal Funds Rate
Figure 3.3: Federal Funds Rate and Inflation Target
Figure 3. 4: Gross Domestic Product; year-on-year growth-rate
Figure 3.5: S&P/ Case-Shiller U.S. National Home Price Index
Figure 3.6: Employment in different sectors: year-on-year growth-rate
illustration not visible in this excerpt
From 2007 to 2009 large financial institutions broke down all over the world. Big investment banks like Lehmann Brothers went bankrupt or needed to be saved. This was the result of the housing bubble and the Subprime Crisis in the USA. (See WHITE 2008, pp. 7-8)
Before the crisis the Federal Reserve (FED) pursued a policy of low interest-rates and “easy money”, a strategy also currently conducted by the FED and the European Central Bank (ECB). Is expansionary monetary policy really able to effectively counter economic crisis and create sustainable prosperity for society?
In the first half of the 20th century the Austrian economist Ludwig von Mises and his scholar Friedrich August von Hayek developed a business cycle theory. Their work is based on the English currency school, the Swedish economist Knut Wicksell as well as their predecessors Carl Menger and Eugen von Böhm-Bawerk. According to the Austrian theory of the business cycle low interest-rate policies are responsible for misallocations of resources and reoccurring fluctuations within the economy. (See HAYEK 2008b; See MISES 1980)
In this paper I try to illustrate the main features of the theory, how it can be used to explain the Subprime Crisis and how the current situation can be analysed within the framework of the theory.
I will use the capital-based macroeconomics model of the contemporary economist Roger Garrison to illustrate the essential characteristics of the theory. (See GARRISON 2006)
With this paper I attempt to provide the reader with basic knowledge about the Austrian theory of the business cycle and the capital-based macroeconomics model. The first part explains the three basic components of capital-based macroeconomics: the market for loanable funds, the production possibilities frontier and the structure of production and their interaction with each other. Furthermore, I investigate a change in the time preference of a society. In the next section I analyse the effects of an expansionary monetary policy and an artificially low interest-rate on the individual parts of the model as well as on the model as a whole. Accordingly, this section tries to explain the Austrian theory of boom and bust. The final part of the paper examines the Subprime Crisis. First of all, I take a look at the government regulations and the monetary policy before and during the crisis. Next, I try to apply the Austrian framework to the Subprime Crisis. Last, I evaluate the crisis as well as the applicability of the Austrian theory of the business cycle.
The first part of the capital-based macroeconomics model is the market for loanable funds. On this market the interest-rate coordinates demand and supply. The supply of loanable funds represents that part of the income not spent on consumption goods, but generating interest. Demand shows the readiness of businesses to borrow this income to produce future consumption goods. (See GARRISON 2006, pp. 36-37)
illustration not visible in this excerpt
Figure 2.1: The market for loanable funds (or investable resources)
Own figure based on GARRISON 2006, p. 37
According to GARRISON (2006, pp. 36-40) the market for “loanable funds” can also be referred to as the market for “investable resources”. In other words savings (S) are present goods not used for consumption purposes, but instead for investment in capital goods to enable a higher degree of consumption at some point in the future. Investment (I) is not investment in financial tools, but investment in real physical production goods, which “[…] provide their owner the expectation of being advanced toward the final goal of consumption, a goal which provides the raison d’être for the whole productive enterprise.” (ROTHBARD 2009, p. 378)
As stated by GARRISON (2006, p. 39) the intersection of supply and demand establishes the equilibrium interest-rate (i_eq). This interest-rate balances saving (S) and investment (I).
According to MISES (2012, pp. 481-482, p. 521) the equilibrium interest-rate changes, just as the degree of time preference of a society varies. Time preference is a category of human action. It is explained by the fact that present goods have a higher subjective value than future goods of the same kind. Because of that the price of current goods is higher than the price of corresponding future goods. The difference is the interest-rate.
Time Preference declines as a society becomes wealthier and therefore more able to satisfy its most urgent present wants. As a result, it is possible to save up remaining consumption goods to engage in longer production processes. The interest-rate falls as well. (See MISES 2012, p. 487, p. 521)
illustration not visible in this excerpt
Figure 2.2: Change of intertemporal preference
Own figure based on GARRISON 2006, p. 62
Capital-based macroeconomics can also illustrate a change in time preference of a society.
In figure 2.2 the intertemporal preference of the people becomes more future oriented. People become thriftier. They consume less present goods to be able to consume more at a future point in time. It the model this translates into a shift of the supply curve to the right (S → S’) and a falling interest-rate (i_eq→ 〖i'〗_eq). (See GARRISON 2006, pp. 61-61)
A change in intertemporal preferences is not the only sustainable way an economy can grow within the framework of capital based macroeconomics, but it is essential in order to understand the effects of expansionary monetary policy. (See GARRISON 2006, p. 67)
The second component of capital-based macroeconomics is the production possibilities frontier (PPF). In basic economic textbooks the PPF usually describes a trade-off between two goods to illustrate the concepts of scarcity and efficiency. Points on the PPF are efficient, but points below are inefficient. Points above the PPF are not feasible with the current amount of resources. (See MANKIW; TAYLOR 2008, pp. 30-31)
In capital-based macroeconomics GARRISON (2006, pp. 41-42, p. 46) uses the PPF to highlight the trade-off between consumption goods (C) and capital goods. Gross investment (I) per year represents the produced amount of capital goods in that year. For a purely private economy points on the PPF show sustainable combinations of consumption and investment. All available resources are employed. Points below the PPF show inefficient combinations with unemployed resources.
illustration not visible in this excerpt
Figure 2.3: Gross investment and growth (contraction, stationary, expansion)
Own figure based on GARRISON 2006, p.43
In figure 2.3 the stationary economy marks the point, where the gross investment is only sufficient to compensate for depreciation. There is no growth. Growth is only achieved, when net investment is bigger than zero. This is the case in all points on the PPF lying south-east of the no-growth point illustrated by the expansionary economy in figure 2.3. Combinations of gross investment and consumption lying on the north-west of the no growth-point signify capital consumption and economic contraction. It is also possible for combinations of consumption and investment to lie above the PPF. This scenario, however, can only be temporarily and is not sustainable. (See GARRISON 2006, pp.41-42, p.45)
As stated by GARRISON (2006, p. 43) the PPF will change if we introduce a mixed economy. The outline of the PPF depends on the tax system and on the way government spends its money. This will not bother me in this paper, because I investigate the effects of monetary rather than fiscal policy.
The last element of the capital-based macroeconomics model is the intertemporal structure of production. This part is exclusive to the Austrian approach to macroeconomics. (See GARRISON 2006, p. 45)
illustration not visible in this excerpt
Figure 2.4: "Hayekian Triangle"
Own figure based on HAYEK 2008b, p. 228
Goods are divided into goods of the first order and goods of higher orders. First order goods are consumption goods, that is, goods that satisfy human wants directly. Higher order goods, on the other hand, are goods that are further away from the direct satisfaction of human needs. They are production goods. They need a certain amount of additional resources until they can fulfil the final purpose of consumption. Goods of the first order attain their value from the direct satisfaction of human wants. Goods of higher orders acquire value, because we use them, ultimately, to produce goods of the first order. They satisfy human needs indirectly. The transformation of goods of higher order into goods of first order is time-consuming. (See MENGER 2007, pp. 56-58, p. 63, p. 67)
Figure 2.4 illustrates the transformation of goods of higher order into final consumption goods. The process involves the application of additional original means of production, that is, labour and natural resources at every new stage of production. The hypotenuse of the triangle expresses the addition of their value. The vertical axis shows the progression of time during several stages of production. The bottom represents the value of the final consumer good. In conclusion, the area of the triangle indicates the total quantity of intermediate products that must exist at any point in time to guarantee a steady output of consumption goods. This implies that the figure has two interpretations: It shows the structure of production for a certain product at any given stage and also indicates the processes of production occurring simultaneously. Goods can be found in different stages of production depending on their current use. (See HAYEK 2008b, pp. 228-229; See MULLIGAN 2002, p. 19)
illustration not visible in this excerpt
Figure 2. 5: The structure of production (continous-input/ point-output)
Own figure based on GARRISON 2006, p. 47
In capital-based macroeconomics GARRISON (2006, pp. 46-49) adopts Hayek’s construction of the structure of production and turns it by 90 degree to match the rest of the model.
He uses a continuous-input/ point-output-conception, that is, consumption goods are consumed immediately even though some consumption goods are durable and not consumed in an instant. This, however, does not diminish the explanatory power of the model, because the focus of the model lies on the structure of production rather than the structure of consumption. The simple triangular shape does not aim to get rid of the complexities of capital structure, but puts them aside to explain intertemporal equilibria and disequilibria.
In contrast to other macroeconomic models the capital-based macroeconomics model puts its emphasis on the time dimension of the production process. It illustrates the intertemporal allocation of resources throughout the production process. (See GARRISON 2006, 46-49)
illustration not visible in this excerpt
Figure 2.6: Effect of falling time preference on stages of production (saving-induced capital restructuring)
Own figure based on GARRISON 2006, p. 62
According to BÖHM-BAWERK (1930, pp. 17-19) the goal of satisfaction of human needs can be achieved by short production processes or more roundabout, that is, longer processes. More roundabout processes require more time and eventually more stages of production, but have the advantage that “[…] a greater product can be got with equal labour, or the same product with less labour.“ (BÖHM-BAWERK 1930, pp. 19)
In capital-based macroeconomics a falling time preference leads to a more roundabout production process. The slope of the hypotenuse flattens as the interest-rate declines. This signifies a higher demand at early stages of production and a lower demand at later ones. Businessmen draw resources away from consumption into investment. They expect a stronger demand for consumption goods in the future as a result of increased saving now. (See GARRISON 2006, p. 63; See HAYEK 2008b, p. 233, p. 239)
We cannot see the growth effects of the more roundabout production process solely by looking at the structure of production model. (See GARRISON 2006, p. 64)
FILLIEULE (2007) presents a more formal approach to the capital structure.
The loanable funds market, the PPF and the structure of production figure form the capital-based macroeconomics model. The common investment-axes connect the market for loanable funds and the production possibilities frontier. PPF and structure of production link up through their shared consumption-axes. Indirectly, the slope of the structure of production diagram represents the equilibrium interest-rate in the loanable funds market. The compatibility of those three diagrams signifies that the equilibrium interest-rate is the natural rate of interest, the rate that is determined by supply and demand if capital goods are traded directly instead of money. (See GARRISON 2006, pp. 50-51; See WICKSELL 2013, p.188)
illustration not visible in this excerpt
Figure 2.7: The macroeconomics of capital structure
Own figure based on GARRISON 2006, p. 50
Figure 2.7 shows the entire capital-based macroeconomics model for a private economy. All resources are employed. Net-investment is zero. Savings are just enough to avoid capital consumption. There is no economic growth. This state represents Mises’s “evenly rotating economy” (See GARRISON 2006, p. 51; See MISES 2012, pp. 245-249)
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Figure 2.8: Saving-induced capital restructuring with future economic growth
Own figure based on GARRISON 2006, p. 54, and p. 62
According to GARRISON (2006, pp. 61-64) in capital-based macroeconomics a decreasing time preference leads to a fall in the equilibrium rate of interest. The supply curve in the loanable funds market shifts to the right. People save more and consume less. As a result, entrepreneurs withdraw resources from late stages of production and redirect them into early stages. The capital structure of the economy becomes more roundabout. This capital restructuring leads to a stimulation of the growth-rate in the future. Economic growth-rates will be higher than before the change in time preference.
Unlike conventional macroeconomic models there are no explicit considerations about the general price level and labour markets in the capital-based macroeconomics model. There are different labour market segments implicit in the structure of production. When the interest-rate falls, demand for labour in early stages will increase and demand in late stages will decrease. The model is independent from changes in the general price level. The primary concern lies in changes in relative prices between consumption goods and capital goods. (See GARRISON 2006, p. 53)
Again, for a mixed economy the observations vary depending on taxes and government spending. (See GARRISON 2006, p. 50)
SKOUSEN (2007) provides another model for Austrian macroeconomics. RAVIER (2011) reviews the model and starts his investigations at an unemployment-equilibrium.
According to HAYEK (2012, pp. 140-141) business cycles, that is, reoccurring fluctuations in economic activity have a monetary origin. A discrepancy between the artificial money interest-rate and the equilibrium rate is the source of unbalanced changes in the structure of production and, consequently, for the development of business cycles.
illustration not visible in this excerpt
Figure 2.9: Monetary expansion in the market for loanable funds
Own figure based on GARRISON 2006, p. 69
In the model a rightward movement of the supply curve in the loanable funds market indicates expansionary monetary policy by central banks or other monetary authorities. The specific tools of the central banks do not matter. They are just different ways of creating additional money or credit. The new supply curve (S+ dMc) contains saving (S) as well as the additional money supply by central banks in the form of extra credit (dMc). The new, artificial interest-rate (i’) is lower than the equilibrium interest-rate (i_eq). (See GARRISON 2006, pp. 67-69)
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