Austrian Business Cycle Theory 2

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Some advocates of the Austrian Business Cycle Theory trace the passage of new money through the economy. The new money enters the economy at a certain place, and those receiving it spend it. And so on. As the money passes through the economy, it distorts relative prices. Since relative prices provide signals and incentives to adjust production, the passage of the new money through the economy distorts production as well. These distortions of production are malinvestments.

If the point of this argument is that changes in the quantity of money are not likely to be neutral–to impact all prices in proportion–the argument has some value. However, excessive focus on the new money is an error. Suppose the new money has a different color. For example, all existing money is green, and the new money is red. Is it really correct that the distortions in the economy can be identified with the transactions undertaken with the red money and all of those transactions handled with green money reflect some kind of undistorted market?

In my view, such a position is so wrong as to be wrongheaded.

While the initial point of entry into the economy is important, after that, changes in prices impact the patterns of demands–the way that “old” money is spent. It is the various direct and indirect effects of changes in demand that are relevant.

Suppose households refrain from spending $10 billion on restaurant meals and instead purchase bonds. The bonds are sold by firms who use the proceeds to purchase $10 billion of drill presses.

The central bank creates $5 billion of new(red) money and lends it to the firms to purchase drill presses. The increase in the supply of loans immediately results in a surplus of loans. The central bank, and the bond buyers compete to find borrowers, resulting in a lower market interest rate. The central bank lends newly created money into existence at a lower interest rate. The prices of the bonds the households buy are higher, and the yields lower.

Because of the lower interest rate, firms can profitably use more drill presses. The demand for drill presses rises. It would be possible that households would continue to refrain from purchasing restaurant meals and continue to purchase $10 billion worth of bonds. When added to the $5 billion lent by the central bank, that will be a total of $15 billion spent on drill presses. In that scenario, $10 billion of old (green) money is spent on drill presses like before, and $5 billion of additional new (red) money is spent on drill presses as well.

However, the lower interest rate that households receive from bonds reduces their incentive to buy them. Suppose they purchase $2 billion fewer bonds and instead purchase restaurant meals. The households spend $2 billion additional old (or green) money on restaurant meals. They spend only $8 billion of old (green) money on bonds, which is received by firms to purchase drill presses. So the firms spend $2 billion less old (green) money on drill presses. Of course, the central bank is lending $5 billion new (red) money to firms to purchase drill presses. So the firms spend $8 billion old (green) money on drill presses. They spend $5 billion new (red) money on drill presses, for a total expenditure on drill presses of $13 billion. The increase in expenditure on drill press machines is $3 billion.

Clearly, $2 billion of the $5 billion of new (red) money is spent on drill presses that would have been purchased even if the central bank hadn’t lent anything. Of course, they would have been purchased with old (green) money. At most, $3 billion of the new (red) money is used to purchase drill presses that are only purchased because of the central bank’s loans.

However, even this is not necessarily true. Suppose there are several established firms that regularly purchase drill presses. They buy $10 billion worth. The central bank, lends those firms $5 billion. Every drill press that is purchased with the new (red) money would have been purchased even if the central bank had done nothing. The firms sell only $5 billion of bonds to fund the other $5 billion of drill presses. The households who would have purchased the other $5 billion of bonds must either purchase restaurant meals or else lend to someone else. Since they are willing to accept lower interest rates, some new, start-up firms enter the industry and sell $3 billion worth of bonds and purchase $3 billion worth of drill presses. The additional drill presses are all purchased with old (green) money.

So, in this scenario, the central bank creates $ 5 billion in new (red) money. All of it is spent on drill presses that would have been purchased anyway. However, the distortion of interest rates does have an effect. While $5 billion of old (green) money continues to be spent on drill presses exactly as it would have been spent, $2 billion of old (green) money is spent on additional restaurant meals, and $3 billion of old (green) money is spend on additional drill presses. In this scenario, all of the increase in demand created by the central bank involves the expenditure of old (green) money.

While in this scenario, more of the increase in demand was on drill presses ($3 billion) and less on restaurant meals ($2 billion,) it would be possible that the situation is reversed. Suppose the demand for restaurant meals and the supply of bonds is very interest elastic. On the other hand, the demand for drill presses by the start-up firms is not very interest elastic. It would be possible that all of the $5 billion of new (red) money is lent to firms that would have purchased drill presses anyway. They sell $5 billion of bonds and still purchase the other $5 billion of drill presses with old (green) money coming from the households. And the households use $3 billion of old (green) money to purchase restaurant meals that they would not have bought if they had instead been using that income to purchase bonds. And they purchase $2 billion of bonds using old (green) money from the startups, who are purchasing $2 billion of drill presses using that old (green) money.

The new (red) money was spent on drill press machines, but the distortion in demand involves entirely the pattern of expenditure of old (green) money. And the greatest distortion is in a segment of the economy, restaurant meals, different from where the red money is spent.

I am not arguing that only in these special cases where none of the new (red) money is spent on the particular goods that represent the malinvestmen does tracing the new money become pointless. I think the most plausible scenario for the drill presses would be that some new money is spent on drill presses that are only profitable because of the lower interest rate. And some old money would be spent on those particular drill presses too. My point, however, is that the color of the money is irrelevant.

While the initial point of entry is important, after that, there is no point in looking at what happens to the new money. And, everyone who understands this and is using language about what happens to the new money, stop! It is rather the new patterns of demand that might have various secondary and tertiary effects.

Because of the influence of the Austrian theory on free market oriented laymen, there is a significant group of people who are liable to get confused. And further, they will pontificate about what the Austrian theory means to still other people in a confused fashion. So let’s avoid the confusion.