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<font face="Verdana" size="1" color="#002864">http://www.mises.org/fullstory.asp?control=1131</font>
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<font face="Arial" size="2"><font face="Verdana" color="#002864" size="5"><strong>Expectations and Austrian Cycle Theory</strong></font>
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<h1><font size="4">By Frank Shostak</font></h1>
<font size="2">[Posted January 06, 2003]</font>
<font size="2"> in his book, </font><i><font size="2"><a href=) The
Theory of Money and Credit</font><font size="2">, it has been subject
to relentless criticism. </font>
<font size="2">According to the ABCT the artificial lowering of interest
rates by the central bank leads to a misallocation of resources on account of
the fact that businesses undertake various capital projects that prior to the
lowering of interest rates weren't considered as viable. This misallocation of
resources is commonly described as an economic boom. The process, however, is
brought to a halt once businessmen discover that the lowering of interest
rates is not in accordance with consumers' demand for and supply of savings,
i.e., consumers' time preferences. </font>
<font size="2">As a rule businessmen discover their error once the central
bank—that was instrumental in the artificial lowering of interest rates—reverses
its stance, which in turn brings to a halt capital expansion and an economic
bust ensues. It follows then that the artificial lowering of interest rates
sets a trap for businessmen by luring them into unsustainable business
activities that are revealed as such once the central bank tightens its
interest rate stance.</font>
<center>[img]" alt="[image]" style="margin: 5px 0px 5px 0px" /> </center>
<font size="2">Critics of the ABCT maintain that there is no justification
for the notion that businessmen should fall prey again and again to an
artificial lowering of interest rates. Businessmen are likely to learn from
experience, the critics argue, and not fall into the trap produced by an
artificial lowering of interest rates. Consequently, correct expectations will
undo or neutralize the whole process of the boom-bust cycle that is set in
motion by the artificial lowering of interest rates. Hence it is held that the
ABCT is not a serious contender in the explanation of modern business cycle
phenomena. </font>
<font size="2">According to a prominent critic of the ABCT, Gordon Bullock,</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font size="2">One would think that business people might be misled in
the first couple of runs of the Rothbard cycle and not anticipate that the
low interest rate will later be raised. That they would continue to be unable
to figure this out, however, seems unlikely. Normally, Rothbard and other
Austrians argue that entrepreneurs are well informed and make correct
judgments. At the very least, one would assume that a well-informed
businessperson interested in important matters concerned with the business
would read Mises and Rothbard and, hence, anticipate the government action.</font><a title href="http://www.mises.org/fullstory.asp?control=1131#_ftn1" name="_ftnref1"><font size="2">[1]</font></a>
[/i]
<font size="2">Even von Mises himself had conceded that it is possible that
some time in the future businessmen will stop responding to loose monetary
policy thereby preventing the setting in motion of the boom-bust cycle. In his
reply to Lachmann he wrote,</font>
<font size="2">It may be that businessmen will in the future react to
credit expansion in another manner than they did in the past. It may be that
they will avoid using for an expansion of their operations the easy money
available, because they will keep in mind the inevitable end of the boom. Some
signs forebode such a change. But it is too early to make a positive statement.</font><a title href="http://www.mises.org/fullstory.asp?control=1131#_ftn2" name="_ftnref2"><font size="2">[2]</font></a>
<h1><font size="2">Do Expectations Matter? </font></h1>
<font size="2">According to the critics then, if one allows for the
possibility of expectations this could prevent boom-bust cycles. If
businessmen were to anticipate that the artificial lowering of interest rates
is likely to be followed some time in the future by a tighter interest rate
stance, their conduct in response to this anticipation will neutralize the
occurrence of the boom-bust cycle phenomenon. </font>
<font size="2">This way of thinking would be valid if the issue would have
been only the artificial lowering and then lifting of interest rates. If this
was the case then the critics of the ABCT would have a valid point. There is
no doubt that businessmen would have quickly learned to disregard the ups and
downs in interest rates and would have utilised some long-term average of
interest rates in their investment decision process. </font>
<font size="2">The ABCT however, is not about plain variations in interest
rates, but about variations in the monetary policy of the central bank, which
amounts to changes in money supply, and in turn in interest rates. Furthermore,
the key factor that businessmen respond to is changes in market conditions as
reflected by relative changes in demands for various goods and services and
not just interest rates as such. </font>
<font size="2">Here is why.</font>
<font size="2">In a free, unhampered market economy, there will be a
harmonious and sustained change in the pattern of consumption with a rise in
consumers’ real wealth. This harmony, however, gets disrupted when the
central bank pumps money into the economy. This new money is manifested by an
increase in bank demand deposits, which banks make use of in their lending
activities. Now, the expansion in banks' credit, i.e., credit out of"thin
air", begins with a particular individual or a group of individuals—in
other words there are always first receivers of money out of"thin
air".</font>
<font size="2">The first borrowers are the greatest beneficiaries of the
new credit since they are the first receivers of the newly created money out
of"thin air"—their purchasing power has increased. The early
recipients can now purchase a greater amount of goods while the prices of
these goods are still unaffected.</font>
<font size="2">Because the early recipients of money are much wealthier now
than before the monetary injections took place, they are likely to alter their
patterns of consumption. With greater purchasing power at their disposal,
their demand for less essential goods and services expands. The increase in
purchasing power, while boosting the demand for goods and services of the
early recipients of money, also gives rise to demand for goods which, prior to
monetary expansion, would not have been considered at all. </font>
<font size="2">This increase in the purchasing power of the early
recipients of money however, is at the expense of the late receivers or
non-receivers. In short, this increase amounts to a transfer of real funding
from the late recipients of money to the early recipients of newly created
money. The manifestation of this transfer of real funding occurs once the
early recipients bid prices of goods and services up. This means that the late
recipients of money will now have less purchasing power at their disposal, all
other things being equal.</font>
<font size="2">As a result of the loose monetary policy of the central bank,
the composition of goods purchased is now likely to change. A greater
proportion of luxuries in relation to basic goods and services is likely to
emerge. </font>
<font size="2">This change in the pattern of consumption draws the
attention of entrepreneurs—after all, they are in the business of"making
money", implying that to succeed in this endeavour they must obey the
wishes of consumers. </font>
<font size="2">According to Mises, </font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font size="2">"In the capitalist system of society's economic
organization the entrepreneurs determine the course of production. In the
performance of this function they are unconditionally and totally subject to
the sovereignty of the buying public, the consumers."</font><a title href="http://www.mises.org/fullstory.asp?control=1131#_ftn3" name="_ftnref3"><font size="2">[3]</font></a>
[/i]
<font size="2">Consequently, this sets in motion investments in the
infrastructure to accommodate a greater demand for less essential goods so to
speak; i.e., more luxurious goods. </font>
<font size="2">Once loose monetary policy is reversed the transfer of real
funding towards the first recipients of money from the last recipients stops.
This in turn lowers demands for various non-essential goods. All this in turn
undermines various capital goods projects that sprang up on the back of the
previous loose monetary policy and an economic bust emerges.</font>
<font size="2">The question then is: how could correct expectations
regarding the outcome of the loose monetary policy of the central bank prevent
the boom-bust cycle? The job of businessmen is to stay on guard as far as
consumers' demands are concerned. So whenever they observe a growing demand
they react to this. For instance if a builder refuses to act on a growing
demand for houses because he believes that this is on account of loose
monetary policy of the central bank and cannot be sustainable, then he will be
out of business very quickly. To be in the building business means that he
must be in tune with the demand for housing. Likewise any other businessman in
a given field will have to respond to changes in the demand in the
area of his involvement if he wants to stay in this business.</font>
<font size="2">Hence a businessman has only two options—either to be in a
particular business or not to be there at all. Once he has decided to be in a
given business this means that the businessman is likely to respond to changes
in the demand for goods and services in this particular business irrespective
of the underlying causes behind the changes in demand. Failing to
do so will put him out of business very quickly. </font>
<font size="2">Furthermore, knowledge of the ABCT doesn't imply that one
can know the duration of the boom and hence when the bust will emerge. Without
this knowledge however, the only way to neutralize the effect of loose
monetary policy is by not participating in the boom, but this again means
staying out of the business altogether. </font>
<font size="2">In addition to what was said above, the monetary expansion
sets in motion the depletion of the pool of real funding since it gives rise
to consumption that is not supported by production. Consequently, the initial
false boom that is set up by loose money also plants the seeds of its own
demise through the weakening in the pool of real funding. </font>
<h1><font size="2">Boom-bust cycles and the free market</font></h1>
<font size="2">The key to the ABCT is not that monetary pumping sets in
motion the boom-bust cycle as such, but that this cycle is recurrent. Now, in
a free market, without the existence of the central bank, if a particular bank
decides to practice fractional reserve banking, i.e., lending that is not
backed up by money proper then this bank can set in motion a boom-bust cycle. </font>
<font size="2">However, it is doubtful whether the bank could practice this
expansion for too long since it runs the risk of not being able to clear its
checks and thus go belly up. In other words, in the framework of a true free
market, without a central monetary authority, the phenomenon of boom-bust
cycles would have difficulty in arising since the incentive to practice
fractional reserve banking is not very attractive. Hence, contrary
to popular thinking, boom-bust cycles cannot be regarded as part and parcel of
the free-market economy. According to Rothbard,</font>
<font size="2">Banks can only expand comfortably in unison when a Central
Bank exists, essentially a governmental bank, enjoying a monopoly of
government business, and a privileged position imposed by government over the
entire banking system. It is only when central banking got established that
the banks were able to expand for any length of time and the familiar business
cycle got underway in the modern world.</font><a title href="http://www.mises.org/fullstory.asp?control=1131#_ftn4" name="_ftnref4"><font size="2">[4]</font></a>
<font size="2">In short, it is through the systematic intervention of the
central bank that monetary pumping is possible, which in turn gives rise to
recurrent boom-bust cycles. </font>
<h1><font size="2">Conclusions</font></h1>
<font size="2">The Austrian Business Cycle Theory (ABCT) is the only
currently available theory that provides a comprehensive explanation of
the phenomenon of the boom-bust cycle. The validity of the theory remains
despite popular claims that it breaks down once it is assumed that people
learn from the past and are unlikely to commit the same errors again and again.
Furthermore, boom-bust cycles are not part and parcel of a free market economy,
but on the contrary are the outcome of the existence of the central monetary
authority. It is the existence of this authority, which makes it possible for
ongoing monetary injections, which in turn sets in motion the phenomenon of
recurrent boom-bust cycles.</font>
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<font size="2">Frank Shostak is an adjunct scholar of the Mises Institute
and a frequent contributor to Mises.org. Send him </font><font color="#000080" size="2">MAIL</font><font size="2"> and
see his outstanding Mises.org </font><font color="#3571ca" size="2">Daily
Articles Archive</font><font size="2">. Dr. Shostak expresses
gratitude to Michael Ryan for helpful comments during the writing of this
article.</font>
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<div id="ftn1">
<a title href="http://www.mises.org/fullstory.asp?control=1131#_ftnref1" name="_ftn1"><font size="2">[1]</font></a><font size="2"> Gordon
Tullock,"</font><font size="2">Why
the Austrians are wrong about depressions</font><font size="2">", <em>The
Review of Austrian Economics</em>, vol 2, 1987. Also see Ludwig M. Lachmann,
"The role of expectations in economics as a social science", <em>Economica</em>,
February 1943. Also</font><font size="2">,
Salerno's Comment on Tullock</font><font size="2"> and </font><font size="2">Tullock's
reply to Salerno</font><font size="2">. </font>
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<a title href="http://www.mises.org/fullstory.asp?control=1131#_ftnref2" name="_ftn2"><font size="2">[2]</font></a><font size="2"> Ludwig
von Mises,"Elastic expectations and the Austrian Theory of the Trade
Cycle," <em>Economica</em>, August 1943.</font>
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<a title href="http://www.mises.org/fullstory.asp?control=1131#_ftnref3" name="_ftn3"><font size="2">[3]</font></a><font size="2"> Ludwig
von Mises,"</font><font size="2">Profit
and Loss</font><font size="2">," <em>Libertarian Press</em>,
p 108.</font>
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<a title href="http://www.mises.org/fullstory.asp?control=1131#_ftnref4" name="_ftn4"><font size="2">[4]</font></a><font size="2"> Murray
N. Rothbard, </font><font size="2">The
Austrian Theory of the Trade Cycle</font><font size="2"> p. 78-79,
Ludwig von Mises Institute. See also Jorg Guido Hulsmann,"</font><font size="2">Toward
a General Theory of Error Cycles</font><font size="2">", the <em>Quarterly
Journal of Austrian Economics</em>, winter 1998, volume 1, number 4.
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