11. Modern Business Cycle Theories in Light of the ABCT

11

Philipp Bagus

---

Modern Business Cycle Theories in Light of the ABCT

Introduction

It was been one hundred years that Ludwig von Mises (1912) gave the world the first exposition of what has now come to be known as the Austrian business cycle theory (ABCT). Due to the recent financial and economic crisis dubbed as the Great Recession new interest in the ABCT from the media and the Internet has arisen (Masse 2008; Lawson 2008; Becker 2008). In this article we will evaluate alternative modern business cycles theories in the light of the already one hundred year old theory of Mises. After reviewing Mises’s contribution we will compare the similarities and dissimilarities to modern business cycle theories and criticize them in the light of ABCT. We will then ask if these theories can enrich Mises’s ABCT and modernize it.

The Austrian Business Cycle Theory

Ludwig von Mises (1912) initially set out ABCT in his book The Theory of Money and Credit. ABCT was later elaborated by Mises (1928, 1998) himself, Friedrich A. von Hayek (1929, 1931) and Murray N. Rothbard (2000). More recently, Jörg Guido Hülsmann (1998), Roger W. Garrison (2001) and Jesús Huerta de Soto (2009) have enriched ABCT with new details. In 1912 Mises did not start from scratch either but built on three main theoretical blocks combining them into something innovative and new.

First, Mises built on the Currency School which found the root of economic crisis in excessive credit expansion. The Currency School explained that when in a classical gold standard world banks of one country expand credits more than the banks of another country, there results an external drain of gold reserves in the country of higher credit expansion and consequently a recession (Mises 1953, p. 365). The Currency School remains, however, for Mises only a starting point. He considered its account unsatisfactory for several reasons. Mises points out that not only an internationally unequal credit expansion, but also a coordinated credit expansion (countries expanding credit at the same rhythm) triggers an artificial boom. Moreover, the Currency School analysis remains superficial as it does not explain the microeconomic discoordination caused by credit expansion.

As a second ingredient, Mises takes Wicksell’s distinction between the money rate of interest and the natural rate of interest. He agrees with Wicksell that a divergence between the two leads to a natural reaction of the market (Mises 1953, p. 355). But Mises disagrees on the correction mechanism. Wicksell regarded banks raising interest rates in response to a falling reserve ratio in the wake of price inflation as the main correction mechanism.

The third and essential building block that Mises adds in is Böhm-Bawerkian capital theory, which allows him to describe the intertemporal distortions of the capital structure caused by credit expansion. Mises (1953, p. 360) cites Böhm-Bawerk when making reference to the subsistence fund; i.e., the fund that is necessary to sustain the factors of production during the productive process. The natural rate of interest indicates the sustainable length of the structure of production as determined by the subsistence fund.

Equipped with Böhm-Bawerkian capital theory Mises sets out the question of his research which had been only unsatisfactorily answered by Wicksell:

We are conducting our investigation in order to . . . disclose the consequences that arise from the divergence (which we have shown possible) between the money rate and the natural rate of interest. (Mises 1953, p. 359)[1]

Mises himself is surprised that this question has not been dealt with more extensively before:

It is a striking thing that this problem, which even at the first glance cannot fail to appear extremely interesting, and which moreover under more detailed examination proves to be one of the greatest importance for comprehension of many of the processes of modern economic life, has until now hardly been dealt seriously at all. (Mises 1953, p. 360)

When banks lower the money interest rate by credit expansion (the production of additional fiduciary media), “below the natural rate of interest as established by the play of the forces operating in the market, then entrepreneurs are enabled and obliged to enter upon longer processes of production.” Mises (1953, pp. 360–61). In this context, Mises defines the natural rate of interest as “[t]hat ratio between the prices of goods of the first order and of goods of higher orders which is determined by the state of the capital market” (p. 364).

Due to the reduction of the money interest rate new and more roundabout production processes are started. However, this lengthening of the structure of production will not be sustainable due to an insufficient amount of real savings. The subsistence fund will be used up before the additional projects are completed (Mises 1953, p. 361). A sustainable lengthening of the structure of production requires prior saving and an increase in the means of the subsistence fund (or reduced consumption during the longer production period). If savings do not increase—and they are likely to fall due to the lower interest rate that reduces the incentive to save—the new projects are bound to fail.

The recession comes as a correction of the distortions that “bank intervention” (p. 362) has caused in the loan market. Mises regards credit expansion or the production of fiduciary media as a violation of the free interaction in the market. The cause of the business cycle cannot be found in the free market but rather in the intervention of a privileged banking system.

Mises explains the onset of the recession with the depletion of the subsistence fund. When the subsistence fund comes to an end, consumer good prices will increase relative to producer good prices. The interest rate, i.e., the spread between buying and selling prices, will increase again. In addition, the interest rate will also increase because a premium for price inflation is factored in.

Mises makes also clear that banks cannot prevent the bust by lowering monetary interest rates (1953, p. 363). Banks can via credit expansion only postpone the recession. The recession will set in irredeemably. The boundary set by real savings for the length of the production processes simply cannot be changed by the production of fiduciary media. After the bust society will be poorer. As capital goods are specific, some invested capital will be irredeemably lost or has to be used uneconomically.

In The Theory of Money and Credit Mises developed an endogenous monetary business cycle theory. The causes of the boom bust cycle are inherent in the institutional setup of the banking system: The “gratuitous nature of credit . . . is the chief problem in the theory of banking” (Mises 1953, p. 352). Mises’s analysis employs a developed capital theory, relies on the importance of time for production, and is based throughout on individual human action. Its reality and richness contrasts with the theories we are to examine in the following.[2]

Modern business cycle theories

Monetarist Business Cycle Theories: Expectations-augmented Phillips Curve and Friedman’s Plucking Model

Milton Friedman augmented the traditional Phillips curve analysis—that finds an inverse relationship between price inflation and unemployment—with adaptive expectations (Friedman 1968). Workers suffer a monetary illusion when prices start to rise offering more labor. However, sooner or later workers discover that prices rise faster than nominal wages and adapt their expectations negotiating for wages that permit them to maintain their purchasing power. Thus, in the long run the inverse relationship between inflation and unemployment breaks down. In a scenario of adaptive expectations, monetary authorities can only exploit in the long run the supposed tradeoff between inflation and unemployment when they continuously surprise workers with higher than expected inflation rates (Cagan 1956).

The inverse relation between inflation and unemployment is indeed consistent with ABCT. Credit expansion unbacked by real savings causes an artificial boom that reduces previously existing unemployment. The boom turns into bust and unemployment increases—not so much because workers start to anticipate inflation—but rather because malinvestments are liquidated. If credit expansion is continued at the moment of the bust, a reduction of unemployment will get ever more difficult. High price inflation and unemployment are the result.

In 1993 Friedman developed an alternative monetarist approach namely his “plucking model.” Starting from an empirical analysis of the second half of the twentieth century Friedman argues that economic growth rates remained below an upper boundary and tended toward it. In the plucking model an exogenous shock reduces economic growth below its potential provoking a recession. Exogenous shocks are caused by a monetary contraction or the failure to increase the money supply in response to an increase in the demand for money. The excess demand for money and price rigidities causes a recession.

The main problem of the plucking model is that it does not allow for artificial booms. Economic fluctuations are only negative deviations from and returns to the long term economic growth path. These fluctuations are caused by errors in monetary policy. The plucking model goes in hand with Friedman’s interpretation of the Great Depression. Friedman does not think that the artificial boom in the 1920s played an important role to explain the Great Depression. In his view the Great Depression was caused by a failure of the Federal Reserve who permitted a monetary contraction.

As for a more fundamental critique, Friedman just supposes an exogenous shock but does not ask if the structure of production is sustainable. He focuses on the monetary contraction, but does not discuss if the supply of money had been artificially inflated before. He fails to see that even though credit contraction coincides with the recession it is not its cause. The recession is caused by the artificial expansion of credit that led to an unsustainable structure of production. Friedman’s analysis neglects the effects of credit expansion on the structure of production completely. Unsustainable growth is ruled out in the plucking model by definition.

Friedman fails to understand the concept of unsustainable growth because he sees no connection between money and the real economy. Friedman, such as Keynes, believes in the short-term Phillips curve mechanism, namely that inflation can, at least temporarily, reduce unemployment. For him this reduction of unemployment is the only effect of inflation. For monetarists and Keynesians the interest rate and the money supply are merely monetary phenomena manipulable by the banking system without causing adjustments in the structure of production or the real economy.

Equilibrium Business Cycle Theory

The equilibrium business cycle theory is the business cycle theory of new classical macroeconomics. It assumes rational expectations, continuous market clearing and maximizing behavior of a representative agent. In a common metaphor the representative agent lives on an island knowing local prices but ignoring the global price level. When his local selling price starts rising, the agent will rationally increase his output as he does not know if he is dealing with a real increase in his relative prices or if just the general price level increases. When he finds out that the change implied only a nominal increase in prices, he will reduce his output again. As a consequence of unanticipated increases in the money supply we can then see fluctuations of real variables (Lucas (1975), Lucas (1977), and Snowson, Vane, and Wynarczyk (1994, pp. 188–235).

There are two main similarities of EBCT and ABCT. Both are monetary business cycle theories (Arena 1994, p. 214) and in both there are difficulties in interpreting price signals, as they do not contain all relevant information (Garrison 1991). Due to these similarities sometimes it is even maintained that EBCT is the intellectual heir of ABCT (Bordo 1986, p. 457). Lucas (1977, p. 8) himself regards Hayek as his intellectual ancestor and Laidler (1983, p. 72) regards Lucas, Barro, Sargent and Wallace as Neo-Austrians. However, historically EBCT evolved from monetarism and the formalization of Milton Friedman’s claim that the long term Phillips curve is vertical (Zijp 1993, p. 146).

More importantly, the theoretical differences between EBCT and ABCT are profound.

First, prices are distorted for different reasons in the respective theories (Clark and Keeler 1990, p. 210). In the ABCT it is the institutional setup of the banking system that distorts the interest rates as new fiduciary media are introduced through the credit market. In the EBCT an unanticipated money supply shock distorts output prices. While ECBT focuses on the general price level, ABCT focuses on relative prices of different order goods and especially interest rates as a coordinator of the structure of production. While Lucas develops a theory of overinvestment, Mises develops a theory of malinvestments.

Second, in the EBCT there prevails at all time an equilibrium as the proper name indicates. As such, bankruptcies and unemployment in a recession do not appear as an entrepreneurial error but rather as planned. The ABCT makes emphasis of an intertemporal disequilibrium caused by the distortion of the interest rate. The distortion of the interest rates induces entrepreneurs to commit investment errors that are corrected in a recession. The resulting unemployment had not been planned for.

Third, the EBCT claims that anticipated changes in monetary policy will not affect real variables. Money is neutral (Snowdon, Vane, and Wynarczyk 1994, p. 197) Yet, for Austrian theory and ABCT in particular money is never neutral (Mises 1998, pp. 413–16). It always leads to redistribution and affects the structure of production at the specific places it is injected (Garrison 1989).

A related question is if better information of entrepreneurs about credit expansion and its effects could cushion its effects. Mises (1998, p. 791) argues that entrepreneurs may in the future anticipate the effects of credit expansion and avoid using the easy credit. But would the Austrian business cycle disappear with rational expectations? For that to be the case, as Huerta de Soto (2009, pp. 423 and 535–42) argues all economic agents would have to agree that ABCT is the correct theory, and exactly know how much money is injected and where in the economy it is injected. They would have to have all the relevant information. And even if they had this information, the future would remain uncertain. Thus, economic agents would be tempted to participate in the boom trying to withdraw from the corresponding investment projects before the recession sets in (Garrison 1989). But they could not know how long the boom would last.

In an additional argument, Hülsmann (1998) asserts that there may exist a general illusion in the economy that the reduction of interest rates through monetary means would be beneficial to the economy. The illusion allows for the error cycle called ABCT.

Real Business Cycle Theory

RBCT evolved from new classical macroeconomics. Likewise it assumes continuous market clearing, a representative agent and in addition perfect information. According to RBCT money does not cause cycle fluctuations but there are only adjustments to real shocks such as technological progress. For instance, temporary technological innovation causes an increase in real wages which spurs employment. In contrast, technological progress interpreted as permanent reduces the supply of labor due to a wealth effect (Snowdon, Vane, and Wynarczyk 1994, pp. 248 and 281). Fluctuations are just optimizing reactions to market changes.

Similar to ABCT, the policy implication of RBCT (and of EBCT) is to flexibilize factor markets. In general RBCT has even less in common with ABCT than EBCT as monetary changes have no influence on the fluctuations of RBCT. Most importantly, RBCT neglects the interest rate as the price coordinating present and future behavior, i.e., consumption and investment plans.

The fluctuations stipulated by RBCT may or may not exist depending on the reaction of individuals to shocks such as technological progress. Individuals may react differently to these kinds of shocks. Of course, technological progress leads to adjustments in the structure of production. However, these fluctuations have no cyclical form of boom and bust. Some industries producing the old technology contract, others expand. In strict terms, RBCT is no cycle theory.

New Keynesian Business Cycle Theory

New Keynesian Business Cycle theory (NKBCT) focuses on rigidities in the price system.[3] Monetary shocks but also technological shocks can affect real variables due to nominal rigidities. These price rigidities may result from uncompetitive markets, menu costs or wage rigidities (caused by long term contracts, efficiency wages or insider-outsider problematic).[4] Similar to ABCT money in NKBCT is not neutral. As another similarity price rigidities may play a role in ABCT, namely in the context of a secondary depression. If factor markets, especially labor markets, are inflexible the recession will be prolonged. The readjustment of the structure of production is inhibited by these institutional price rigidities.

In contrast to NKBCT price rigidities are not the cause of the boom in ABCT. The boom is caused by credit expansion. Price rigidities caused by privileged labor unions, unemployment benefits, subsidies or labor market regulation merely delay the recovery. The rigidities’ origin is found in government interventions and not in the free market as by the New Keynesian theory.

Financial Instability Hypothesis

The financial instability hypothesis developed by Post-keynesian Hyman Minsky (1974, 1992) also received renewed attention in the wake of the recent financial crisis.[5]

According to Minsky’s descriptive hypothesis, during economic booms the accumulation of debts by economic agents makes the financial system ever more vulnerable. At some point the over-indebted financial structure falls apart. Overindebted borrowers have to sell their assets at the “Minsky moment.” Liquidity dries up, asset prices collapse and the recession starts.

In his analysis Minsky distinguishes three types of borrowers (Shostak 2007). First, hedge borrowers pay interest and principal of their loans from their cash flows. Second, speculative borrowers pay interest but not principal from their cash flows, and as such, have to continuously roll over the principal of the loan. Third, Ponzi borrowers are not able to pay neither interest nor the original loan. These borrowers of the ultimate phase of the boom rely on the appreciation of the assets which they bought in order to use them as collateral to refinance themselves and/or lower interest rates.

An important similarity to the ABCT is that the cause of the business cycle is monetary: credit expansions (accompanied by financial innovations). Minsky’s theory is also an endogenous theory. Bubbles are seen endogenous to financial markets. ABCT acknowledges an increase in the fragility of the financial system as the credit expansion continues. However, here the similarities end. For Minsky the capitalist system itself is unstable. However, while ABCT is also an endogenous theory of the business cycle, the cause is not to be found in the free market. Rather, fractional reserve banking and the production of fiduciary media cause the business cycle and as a side effect make the financial system ever more unstable. In other words, the financial instability is only the consequence of the underlying real causes such as the distortion of the structure of production. It is not credit or money per se that cause the crisis but the lack of real savings, when fiduciary media finance new investment projects. While Minsky recognizes a financial instability, he does not well explain why agents over-indebt themselves and why the crisis does not only affect the financial sector but also the real economy. He explains the bust—the financial break down—but not the boom of the real economy. He also fails to explain how the financial system ever re-stabilizes.

In contrast to Minsky’s view, the problem is not credit (or its corollary debt) per se. Commodity credit—loans backed by real savings—is unproblematic. The problem is circulating credit—loans not backed by real savings. The main reason for Minsky’s shortcomings is the lack of a developed capital theory that would allow him to analyze the effect of the manipulation of the interest rate on the real structure of production.

Common Problems in Modern Business Cycle Theory

Beside the already mentioned specific problems in the above modern cycle theories, they have in common some more fundamental problems.

First, their analysis is too aggregated. Modern business cycle theories try to find relations between macroeconomic aggregates. The focus on the aggregates hides the view on the real underlying microeconomic discoordination problems that ABCT does explain. One usually fails to notice the microeconomic adjustment problems trying to find relationships between aggregates such as aggregate demand, aggregate supply, the general price level and the money supply. In particular, the analysis of the effect of the rate of interest on the structure of production is prevented by the level of aggregation in modern business cycle theories.

Second, and related to the first point, in contrast to ABCT modern business cycle theories lack an elaborate intertemporal capital theory integrated with monetary theory. EBCT, for instance, follows Clark and Knight in the idea that capital is a homogenous and self-renewing fund.[6] The main shortcoming of modern cycle theories is that they neglect that production takes time. Not all investment projects are viable if people are not willing to wait for their completion but want to increase consumption earlier. The interest rate coordinates these saving and investment preferences. Due to the lack of a genuine capital theory, the discussed business cycle theories have a blind spot for intertemporal distortions in the structure of production caused by the production of fiduciary media.

Third, methodological differences set ABCT apart from modern business cycle theories. EBCT, or RBCT uses an representative maximizing agent, mathematical equilibrium models and homogenous capital. Minsky, Friedman and New Keynesians make very restrictive assumptions on human action. Minskian investors are prone to become over-indebted. Friedman’s workers adjust their expectations but do not anticipate policy changes. New Keynesians economic agents do not adopt or renegotiate prices in the wake of shocks.

In contrast, ABCT is based on individual human interaction. Individual entrepreneurs provided with fiduciary media at artificially low interest rates tend to engage in specific and rather long investment processes. These projects will turn out to be unsustainable as there is a lack of real resources. Individual consumption and saving behavior is not in line with entrepreneurial investment plans. The mathematical corset of EBCT, RBCT, NKBCT, monetarist business cycle theories make these theories both unrealistic and inflexible. The realism of the ABCT allows for a theoretical richness and makes is flexible for additions as the institutional environment changes.

Fourth, there is a lack of realism in modern business cycle theories.[7] These theories just explain changes in the general output due to (perceived) changes in general profitability. Moreover, these changes do not explain long enduring booms. Thus, EBCT diagnoses an overinvestment. NKBCT also points to a general increase or fall in business activity due to price stickiness. Modern theories can explain a general boom and a general bust of economic activity. But they cannot explain changes within the structure of production. In the boom phase more capital intensive sectors have higher growth rates than consumer good related sectors, while in the recession the consumer sector fares relatively well in comparison to sectors far away from consumption. The change in relative profitability of different stages of the structure of production and the consequent adaption of the structure of production is only explained by ABCT. Only ABCT explains unemployment through the reallocation of resources that then may be prolonged by institutional rigidities. The level of aggregation prohibits modern business cycle theories to explain these phenomena we observe in reality. Changes in the general price level that many modern business cycle theories focus on, do not account for the severe restructuring occurring during the business cycle.

Is ABCT Still Up to Date?

As we have seen the similarities between ABCT and modern business cycle theories are only superficial while the differences abound and are profound. Modern business cycle theories have more in common with each other than with ABCT due to methodological differences.

Some ideas of ABCT reappear in modern business cycle theories but in a distorted way due to a too aggregate approach. EBCT, for instance, hinges on monetary illusion. Mises (1998, pp. 546–47) also mentions the possibility of a monetary illusion regarding entrepreneurs. Indeed, there may be an accounting illusion for entrepreneurs who think that their real profits have increased and do not realize that the increase in accounting profits is only due to price inflation. The inflationary generated “wealth effect” leads to capital consumption. For Mises this is only a possible but not necessary feature of the cycle. These accounting profits lead to an increase in consumption thereby increasing the discoordination of the structure of production.

The idea of price rigidities appearing in NKBCT has also been addressed by Austrian economists in context of the recovery in the form of institutional rigidities. Government interference with factor markets may prolong considerably the recession (Huerta de Soto 2009). After the boom factors of production are allocated at places where consumers do not want them to be. Consumers have more urgent desires. Consequently, factors of production must be re-shifted. Government regulations delay this adjustment process by causing institutional price rigidities.

Moreover, the idea that psychology may play a role in business cycles can also be easily fit in into ABCT. As mentioned, Mises himself uses the accounting profit illusion. Huerta de Soto speaks of an optimism with very harmful effects that develops during the boom due to wealth effects. Economic agents start to believe that they can get rich without saving through credit expansion. A phenomenon called herding behavior and asset price bubble may develop in turn (Bagus 2007, 2008b). Thus, some insights from behavioral finance are compatible with ABCT and may be enriching to a historical analysis of business cycles. In contrast to the traditional Keynesian approach (animal spirits), however, it is not exogenous changes in psychology that causes the business cycle. Euphoria and optimism are just possible ingredients that develop during a credit expansion. The cause of the boom is the credit expansion that feeds the euphoria which otherwise would most likely die out very quickly.

In short: In modern business cycle theories there are no new ideas that are good, and what is acceptable in modern business cycle theories has been better expressed and incorporated into ABCT.

Non-surprisingly, even though being the oldest of the mentioned cycle theories, the influence of ABCT has been rising recently as market commentators have used it to explain the crisis of 2008. Due to its realism and methodological approach ABCT is in one sense the youngest cycle theory as it is most flexible and can explain most recent events.

Its realism also allows ABCT to incorporate additions and updates to institutional changes. For instance, political business cycles are easy to incorporate. According to Nordhaus (1975, p. 185) politicians try to stimulate monetary growth in order to generate a boom that helps them to be reelected. When politicians can influence monetary institutions, such as the central bank, the possibility of an artificial boom increases before elections.

An update of ABCT is to incorporate the institution of investment banks that during the last decades increasingly engaged in excessive maturity mismatching (Bagus 2010; Bagus and Howden 2010). While U.S. investment banks cannot expand credit (they do not accept demand deposits), they borrowed short term on whole sale financial markets at low interest rates and invested long term at higher interest rates.

The risk of this behavior was already pointed out by Mises in 1912 (1953, p. 263, citing Knies [1876, p. 242]):

For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, “The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.” Only thus can the danger of insolvency be avoided.

While Mises refers to the golden rule of matched maturities as a common sense rule to reduce risks, he does not apply this insight to his own ABCT and intertemporally discoordination. However, this application is a small step (Bagus 2010). When people save to increase their consumption in six months, their savings can only be used sustainably in investment projects that yield additional consumer goods in six month time. When a bank lends the monetary savings for projects that yield additional consumer goods only in 10 years time, there is a distortion in the structure of production. There is an artificial lengthening of the structure of production that is not sustainable, because people do not save enough; or more precisely not long enough. The practice of maturity mismatching which has been very pronounced during the last cycle and exacerbated the amount of malinvestments would be reduced in a free market due to its entailing risky nature pointed out by Mises. However, banks will excessively engage in this behavior when there is a government to bail them out, or a central bank that will rediscount their illiquid long term investments in times of emergency. In a world of fractional reserves and continuous credit expansion, maturity mismatching also becomes less risky. As the money supply is almost continuously increasing it is easier to find someone to roll-over the short term debts invested long term. In recent times, maturity mismatching has amplified the traditional ABCT developed first by Ludwig von Mises 100 years ago. Mises remarks almost hint at this extension.

It comes as no surprise that excessive maturity mismatching is easy to add to the existing theory, because ABCT has always been based on realism. In this sense, it is the most modern of all business cycle theories.

References

Alonso Neira, Miguel A., Philipp Bagus, and Juan Ramón Rallo Julián. 2011. “Teorías del ciclo economic: principales contribuciones y análisis a la luz de las aportaciones de la escuela austriaca de economía.” In Tendencia y nuevos desarrollos de la teoría económica, ICE, January, February, No. 858.

Arena, Richard. 1994. “Hayek and modern business cycle theory.” In Economics of F.A. Hayek: Vol. 1 Money and Business Cycle. Marina Colonna and Harold Hagemann, eds. Brookfield, Vt.: Edward Elgar. Pp. 203–17.

Bagus, Philipp. 2007. “Asset Prices—An Austrian Perspective.” Procesos de Mercado: Revista Europea de Economía Política 4, no. 2: 57–93.

——. 2008a. Österreichische Konjunkturtheorie aus heutiger Sicht. Munich: Grin Verlag.

——. 2008b. “Monetary Policy as bad medicine: The volatile relationship between business cycles and asset prices.” Review of Austrian Economics 21, no. 4: 283–300.

——. 2010. “Austrian Business Cycle Theory: Are 100 Percent Reserves Sufficient to Prevent a Business Cycle?” Libertarian Papers 2, no. 2.

Bagus, Philipp, and David Howden. 2010. “The Term Structure of Savings, The Yield Curve, and Maturity Mismatching.” Quarterly Journal of Austrian Economics 13, no. 3: 64–85.

Becker, Gary. 2008. “Depressions Cause a Lot More Pain than Benefits.” The Becker-Posner Blog. http://www.becker-posner-blog.com/archives/2008/11/depressions_cau.html#c097726

Bordo, Michael D. 1986. “Austrian Influence on Business Cycle Theory.” Cato Journal 6, no. 2: 455–59.

Cagan, Phillip. 1956. “The Monetary Dynamics of Hyperinflation.” In Studies in the Quantity Theory of Money. Milton Friedman, ed. Chicago: University of Chicago Press.

Clark, James, and James Keeler. 1990. “Misconceptions about Austrian Business Cycle Theory: A Comment.” The Review of Austrian Economics 4: 208–11.

Friedman, Milton. 1968. “The Role of Monetary Policy: Presidential Address to AEA.” American Economic Review 58: 4–17.

——. 1993. “The ‘Plucking Model’ of Business Fluctuations Revisited.” Economic Inquiry 31, no. 2: 171–77.

Garrison, Roger W. 1989. “The Austrian Theory of the Business Cycle in the Light of Modern Macroeconomics.” The Review of Austrian Economics 3: 3–30.

——. 1991. “New Classical and Old Austrian Economics: Equilibrium Business Cycle Theory in Perspective.” The Review of Austrian Economics 5, no. 1: 91–103.

——. 2001. Time and Money: The Macroeconomics of Capital Structure. London: Routledge.

Hayek, F.A. von. 1929. Geldtheorie und Konjunkturtheorie. Vienna: Gustav Fischer.

——. 1931. Prices and Production. London: Routledge.

Huerta de Soto, Jesús. 2000. La Escuela Austríaca, Mercado y Creatividad Empresarial. Madrid: Editorial Síntesis.

——. 2009. Money, Bank Credit, and Economic Cycles. Auburn, Ala.: Ludwig von Mises Institute.

Hülsmann, Jörg Guido. 1998. “Toward a General Theory of Error Cycles.” Quarterly Journal of Austrian Economics 1, no. 4: 1–23.

——. 2007. Mises: The Last Knight of Liberalism. Auburn, Ala.: Ludwig von Mises Institute.

Knies, Karl. 1876. Geld und Kredit, Vol. II. Berlin: Weidmannsche Buchhandlung.

Knight, Frank H. 1935. “Comment.” The Journal of Political Economy 43, no. 5 (October): 625–27.

Laidler, David. 1983. Monetarist Perspective. Linotron Times: The Camelot Press.

Lawson, Dominic. 2008. “It all went wrong when we left the gold standard.” The Independent. 14th October. http://www.independent.co.uk

Lucas, Robert E., Jr. 1975. “An Equilibrium Model of the Business Cycle.” Journal of Political Economy 83, no. 6: 1113–44.

——. 1977. “Understanding Business Cycles.” In Stabilization of the Domestic and International Economy. Karl Brunner, Allan H. Meltzer, eds. Vol. 5. Amsterdam, New York, Oxford: North-Holland Publishing. Pp. 7–29.

Maanen, Peter van. 2004. “Monetarist Business Cycle Theories: A Critique.” Working Paper. Auburn, Ala.: Ludwig von Mises Institute.

Machlup, Fritz. 1935. “Professor Knight and the ‘Period of Production.’ ” The Journal of Political Economy 43, no. 5 (October): 577–624.

Masse, Martin. 2008. “Credit does not grow on trees.” Financial Post. October 22nd. http://network.nationalpost.com/np/blogs/fpcomment/archive/2008 /10/22/credit-does-not-grow-on-trees.aspx

Minsky, Hyman. 1974. “The Modelling of Financial Instability: An introduction.” Modelling and Simulation 5, no. 1: 267–72.

——. 1992. “The Financial Instability Hypothesis.” The Jerome Levy Economics Institute Working Paper No. 74.

Mises, Ludwig von. 1912. Die Theorie des Geldes und der Umlaufsmittel. Leipzig: Duncker und Humblodt.

——. 1928. Geldwertstabilisierung und Konjunkturpolitik. Vienna: Gustav Fischer.

——. 1953. The Theory of Money and Credit. New Haven, Conn.: Yale University Press.

——. 1998. Human Action. Scholar’s Edition. Auburn, Ala.: Ludwig von Mises Institute.

Nordhaus, William D. 1975. “The Political Business Cycle.” Review of Economic Studies 42, no. 130: 169–90.

Rothbard, Murray N. 2000. America’s Great Depression. Auburn, Ala.: Ludwig von Mises Institute.

Prychitko, David L. 2010. “Competing explanations of the Minsky moment: The financial instability hypothesis in light of Austrian theory.” The Review of Austrian Economics 23, no. 3: 199–221.

Shostak, Frank. 2007. “Does the Current Financial Crisis Vindicate the Economics of Hyman Minsky?” Ludwig von Mises Institute, http://mises.org/story/2787

Snowdon, Brian, Vane, Howard, and Wynarczyk, Peter. 1994. A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought. Brookfield, Vt.: Edward Elgar.

Warburton, Clark. 1966. “The Monetary Disequilibrium Hypothesis.” In Depression, Inflation, and Monetary Policies: Selected Papers: 1945–53. John Hopkins University Press, Baltimore. Pp. 25–35.

Yeager, Leland. 1997. “The Significance of Monetary Disequilibrium.” In The Fluttering Veil. Indianapolis: Liberty Fund. Pp. 217–51.

Zijp, Rudy van. 1993. Austrian and New Classical Business Cycle Theories, A comparative study through the method of rational reconstruction. Brookfield, Vt.: Edward Elgar.

---

Philipp Bagus is an associate professor of economics at Universidad Rey Juan Carlos, Madrid.

[1] As Hülsmann (2007, p. 781) notes there is no natural rate of interest in the sense of an interest rate prevailing in a barter economy. Money is not just a veil over a barter economy, but it affects all economic variables. One cannot, therefore, compare the natural and money interest rates. Mises, himself, in his book Nationalökonomie established a new indicator for artificial low interest rates. The benchmark is no longer the interest rate of a barter economy but the monetary interest rate in the absence of credit expansion.

[2] For comparisons of ABCT with other business cycle theories see also Garrison (1989), Bagus (2008a) and Alonso, Bagus and Rallo (2011). Maanen (2004) criticizes monetarist business cycle theories in detail.

[3] Monetary disequilibrium theorists hold a similar theory in which price stickiness leads to fluctuations (Warburton 1966, or Yeager 1997). The reasons for necessary price adjustments are in contrast to NKBCT merely monetary. As price adjustments are sluggish, quantity adjustments follow upon monetary changes. Monetary disequilibrium theory may, therefore, be regarded as a subset of NKBCT.

[4] For an account of NKBCT see Snowdon, Vane, and Wynarczyk (1994, pp. 292–318).

[5] For a recent Austrian assessment of Minsky’s financial instability hypothesis see Prychitko (2010).

[6] For the differences between Austrian capital theory and the capital theory of Clark and Knight see Huerta de Soto (2000, pp. 91–96), Machlup (1935), and Knight (1935).

[7] As Roger Garrison (1989, 12) puts it: “Austrian theory has empirical content that is absent from rival theories.” ABCT explains why more capital intensive industries suffer more in a recession. It takes into account that new money is introduced through credit markets, while in rival theories it just reaches individual cash balances. ABCT emphasize the different stages of production and the absence of complete vertical integration. With complete vertical integration it would be impossible for individual entrepreneurs to profit from different profit rates at the distinct stages.