Tuesday, August 5, 2014

Austrian Business Cycle Theory and the Significance of Different Monetary Regimes

The most popular version of the Austrian Business Cycle Theory [ABCT] attempts to explain economic booms and busts as a function of central bank intervention into the economy (For the sake of conciseness, I omit endogenous ABCT). The central bank is said to expand the money stock, creating an unsustainable boom that distorts the relative prices of goods and arbitrarily lengthens the structure of production (Hayek 19311933; Rothbard 1963;Garrison 1999). The lengthening occurs without an increased willingness of agents to increase savings, and thereby lower the interest rate endogenously. As a result, consumption does not fall to make way for an increase in goods produced with capital and time and capital intensive techniques. As the new money makes its way from capital intensive processes into the hands of laborers, the consumer and producer goods industries bid up the price of inputs. Eventually, the new, more capital intensive forms of production prove to be unprofitable, at which point the boom turns to bust and resources are reallocated to reflect the actual time preferences of consumers.

Two factors of enormous significance weigh on the ABCT. First, analysis typically occurs within a closed economy (Hummel 1979, 50-51). Booms and busts within a single country are assumed to be a function of the largess of the domestic central bank. Second, analysis occurs within the international gold standard.  The nature of the gold standard fostered gold outflows from a nation when the central bank increased the base money stock without a concomitant increase in the nation’s gold stock. In order to stop the outflow, the central bank needed to either devalue the currency or contract the base money stock. Devaluation increased the domestic price of gold. Contraction restored the balance of exchange rates that previously existed. Underlying the entire analysis is the usual ceteris paribus condition, meaning that all other central banks are assumed to hold policy constant.

When the international nature of the gold standard is considered – and it is nothing short of a travesty that Austrians have for so long failed to account for the international nature of the international gold standard in the model – business cycles can be caused by more than just changes in the domestic money stock (Hummel 1979, 50-51; Barnett and Block 2008, 90). If a foreign central bank contracts its stock of base money, the contraction will attract gold to that country. This results in a rise in the interest rate that will attract investment, and a fall in prices that will attract commerce. The increase in gold for the foreign country is equivalent to a loss of gold for another. 

Now consider a situation where central bank “A” first expands its money stock, only to contract it in order to stem gold outflows. The home nation of central bank “A” might appropriately experience an ABCT-type boom and bust, but what about other countries on the gold standard? If other central banks only act passively – i.e., do not change their reserve ratios – then their nations’ money stocks will also expand. When central bank “A” finally contracts its money stock, the reverse occurs. As gold flows out from the other nations, those central banks contract their base money stocks in order to maintain their reserve ratios. Thus, the actions of a single central bank – if that bank is large enough – might result in an international boom and bust. Keep in mind that, even in a world where all but nation “A” are on 100% reserve standards, action by central bank “A” will lead to the same result.

Note that it is the gold standard itself that necessitates the boom and bust cycle. In a world of floating exchange rates, monetary expansion in one nation will, all else equal, diminish the value of that nation’s currency relative to other. Unlike under the gold standard, where an increase a nation’s domestic money stock encourages gold to leave that nation, under floating exchange rates the same action will lead to an increase in exports. The nation that expanded its money stock might experience a boom as foreigners buy cheaper goods. The boom is self-contained, only affecting other nations inasmuch as they can purchase cheaper goods from the nation that devalued and inasmuch as they alter patterns of productions as a result of the new stream of goods. There is no strong impulse that drives a boom in these countries, with the caveat that the purchase of goods from country “A” will increase demand for currency from country “A”, and symmetrically, decrease demand for other currencies. I doubt, however, that this effect would be large enough to stimulate a substantial boom in other countries. In this case, monetary expansion by central bank “A” will not lead to a similar increase in demand internationally as the responsiveness of floating exchange rates mitigate, though not perfectly, the central bank’s impact on the real economy in each country.

Given the above analysis, I feel justified in concluding that until ABCT has accounted for the significance of different types of monetary regimes, its applicability to the modern world will remain inhibited.

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