11. The Theory of the Cycle and Idle Resources: Their Role in the Initial Stages of the Boom

Critics of the Austrian theory of the business cycle often argue that the theory is based on the assumption of the full employment of resources, and that therefore the existence of idle resources means credit expansion would not necessarily give rise to their widespread malinvestment. However this criticism is completely unfounded. As Ludwig M. Lachmann has insightfully revealed, the Austrian theory of the business cycle does not start from the assumption of full employment. On the contrary, from the time Mises began formulating the theory of the cycle, in 1928, he started from the premise that at any time a very significant volume of resources could be idle.³⁹ In fact Mises demonstrated from the beginning that the unemployment of resources was not only compatible with the theory he had developed, but was actually one of its essential elements. In market processes in which entrepreneurs undertake plans that involve the production of heterogeneous and complementary capital goods, errors are continually committed and due to “bottlenecks,” not all productive factors and resources are fully employed. Thus the necessity of a flexible market conducive to the exercise of entrepreneurship, which tends to reveal existing maladjustments and restore coordination in a never-ending process. Indeed the theory explains how bank credit expansion interrupts and complicates the coordinating process by which existing maladjustments are remedied.⁴⁰

The theory of the business cycle teaches precisely that credit expansion unbacked by an increase in real saving will encourage the malinvestment of productive resources even when there is a significant volume of idle resources, specifically, unemployed labor. In other words, contrary to opinions expressed by many critics of the theory, full employment is not a prerequisite of the microeconomic distortions of credit expansion. When credit expansion takes place, economic projects which are not actually profitable appear so, regardless of whether they are carried out with resources that were unemployed prior to their commencement. The only effect is that the nominal price of the original means of production may not rise as much as it would if full employment existed beforehand. Nevertheless the other factors which give rise to malinvestment and a spontaneous reversal, in the form of a crisis and recession, of the errors committed eventually appear, regardless of whether the errors have been committed with originally-unemployed resources.

An artificial boom based on bank credit expansion which reallocates previously-unemployed original means of production merely interrupts the process of readjustment of those factors, a process not yet complete. Consequently a new layer of widespread malinvestment of resources overlaps a previous layer which has yet to be completely liquidated and reabsorbed by the market.

Another possible effect of the use of previously-idle resources is the following: apart from the fact that their price does not increase as rapidly in absolute terms, they may make a short-term slowdown in the production of consumer goods and services unnecessary. Nonetheless a poor allocation of resources still takes place, since resources are invested in unprofitable projects, and the effects of the cycle eventually appear when the monetary income of the previously-unemployed original means of production begins to be spent on consumer goods and services. The relative prices of these goods and services rise more rapidly than the prices of products from the stages furthest from consumption, thus diminishing real relative wages and setting off the “Ricardo Effect” and the other effects which lead to crisis and recession. In any case credit expansion will always, from the outset, cause a more-than-proportional increase in the relative price of products from the stages furthest from consumption. This rise stems from the new monetary demand credit generates for these goods and from the artificial reduction in the interest rate, which makes such projects more attractive. This results in a lengthening of the productive structure, a change which cannot be maintained in the long run and which is completely independent of whether previously-idle resources have been used in some of such projects.

Therefore the common argument that the theory developed by Mises, Hayek, and the Austrian School rests on the existence of a full employment of resources is fallacious. Even if we suppose high unemployment exists, the credit expansion process invariably leads to a recession.⁴¹