WorldSys: Austrian Home Study Course, Week 30

READINGS: “The Austrian Theory of the Trade Cycle and Other Essays” by Mises et al., Chapter 8 of Thomas Taylor’s “Introduction to Austrian Economics”, Chapter 13 of Gene Callahan’s “Economics For Real People”

1 Is the business cycle a natural feature of the market economy?

No, it is a result of credit expansions from financial institutions. There would be swings and retractions in a regular economy, of course, but not ones of such intensity and duration as are present in a mixed or socialist economy.

2 What is the natural rate of interest?

The rate of interest set by the market, in the absence of meddling by the central bank. Put another way (and quoting Roger Garrison) “[t]he natural rate of interest is the rate that equates saving and investment.”

3 What is the connection between central banking and the business cycle?

The Austrian Theory of the Business Cycle stipulates that it is just the central bank’s expansion of credit which drives the business cycle in the first place. Holding down interest rates and increasing the money supply encourages people to open businesses which are only profitable on paper — with easy credit and prices set to rising by an ever-inflating money supply.

4 How does the Federal Reserve lower market interest rates?

Flooding the market with new cash, which makes more money available for loans and thereby lowers the per-loan interest rate.

5 Why are low interest rates politically popular?

They’re an immensely easy sell — all you have to do is make it sound like you’re giving more businesses the power to expand and create jobs and the working-class members of your constituency will love you for it.

6 How does an artificially lowered interest rate affect the structure of production?

Investments, expansions, projects, and enterprises which are not actually feasible suddenly look more feasible because it is easy to get credit (a loan) to undertake them. Over time this means that more and more unsustainable businesses are funded, gradually bringing the structure of production into a more fragile and unworkable configuration.

7 What is the boom period?

The exuberant period in which easy credit and an expanding money supply cause people to spend more than they would opening businesses and starting new ventures. Everyone is feeling optimistic.

8 Can the boom be maintained indefinitely?

No. All that is occurring is that an expansion of credit is leading people to attempt ventures which would not look profitable or even possible under stable, sound economic conditions. Since the boom period is giving rise to a structure of production and a series of entrepreneurial bets which cannot all physically be realized it is unsustainable by definition.

9 In what sense is the “bust” good for the economy?

It liquidates bad investments and unsustainable ventures, freeing up those resources for better uses elsewhere.

During the boom period people are incentivized to open businesses they normally wouldn’t because interest rates are artificially low, and to remain in business when they aren’t profitable because an artificial rise in prices makes them look more successful than they actually are.

When it becomes clear that this isn’t going to end well the bust is the equivalent of a brush fire, clearing out the thickets, fertilizing the soil, and making space for new, healthier growth.

This is painful, of course, and we shouldn’t make light of people’s failures. But this self-corrective mechanism is a necessary component of a functioning economy.

While all this is happening people start cutting back, eventually building new capital stores to be invested in enterprises that better conform to the consumer’s pattern of wants.

10 Should the government use the printing press to stimulate the economy if there is widespread unemployment?

Using the printing press to spur anything — unemployment, investment, what have you — reliably leads to mal-investments and distortions in the capital structure as business people work off faulty market signals and fund ventures which only look profitable in the light of low interest rates and rising prices.

So if the Federal Reserve curbs unemployment by inflating credit and allowing a whole bunch of new businesses to open up which shall only last as long as new money is being printed, what’s going to happen when the chickens come home to roost and the contraction begins?

11 What is capital consumption?

The use of capital without replacing it during the boom period.

12 Why do entrepreneurs make bad investments during the boom period? Doesn’t the market weed out those who make poor forecasts?

It does when it’s allowed to function properly, but this can take time. If inflationary practices have systematically distorted almost the entire economy then making sensible economic forecasts becomes extremely difficult, no matter how smart and careful an entrepreneur is.

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