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Why Business Cycle Theory Matters

Mises Daily: Wednesday, November 24, 2004 by


The recent announcement that Edward C. Prescott and Finn Kydland had received the 2004 Nobel Prize in economics has put business cycle theory front-and-center again in economic discussion.

Whether or not one agrees with all of what Prescott and Kydland have said—and Austrian economists do not—does not cloud the larger importance of this subject and why it is important to understand the nature of business cycles.

In my graduate economics class for MBA students, I frequently employ case studies that look at business failures and mistakes. More often than not, a statement like "at the same time, a deep recession further clouded Company X’s business fortunes" or something like that.

I find such statements to be rather interesting; the downside of the business cycle is treated in the same way that one would view a hurricane or an earthquake: a simple force of nature. A business that is hit hard during a recession is not unlike a business whose building is flattened by a tornado.

Such a view is short-sighted, of course; Austrians—and especially Austrians—are quite aware that there is a huge difference between a company that suffers losses because of a violent storm and one that loses money during a downturn in the business cycle. Most important, storms and earthquakes are a force of nature that no person can control; business cycles, on the other hand, are the sole creation of people.

Austrians see the business cycle first and foremost as occurring because of monetary decisions made by central bankers and others in policy-making capacities, as opposed to the introduction of new technologies, which is the central theme of Prescott and Kydland. In other words, business cycles, as Murray Rothbard pointed out in America’s Great Depression, have the common thread of monetary inflation, which leads to capital malinvestment, and ultimately culminates in the boom and bust routines that we have come to know so well.

Business cycles are usually treated as though they were unavoidable natural phenomena; what is even worse is that the Keynesian paradigm, which still dominates the college textbooks, promotes the dangerous fiction that economic booms are the result of "good" (read that inflationary) monetary policies or "wise" fiscal policies of government expansion, and that cyclical downturns occur because government is not spending (or printing) enough money.

The former view—that business cycles are unavoidable natural occurrences—assumes that individuals and business firms have no way of predicting what will happen (in general) during the boom/bust cycle, or have no way to protect their assets even if they recognize the problem. The latter view—the Keynesian perspective—is even worse.

As I work through the various case studies in which bad business decisions were exacerbated by overall economic downturns, I ask whether or not the knowledge of an Austrian view of business cycles would be useful for business decision makers. I assume that it is useful for those in government who make decisions on taxation, spending, and monetary policies, although one doubts that even good theory would induce politicians and bureaucrats to change their ways.

The larger issue here is whether or not business owners would benefit from the ABCT. For example, in an earlier article on the criminal indictment of Ken Lay, I wrote: "It is too bad that Lay, a Ph.D. economist, did not have training in the Austrian Business Cycle Theory, as he might have recognized the unstable conditions of the boom—conditions that mistakenly were called the "New Economy."

Yet, I ask, would such knowledge have mattered?  Would Lay and his underlings have followed a different set of actions had they understood the nature of the boom as Rothbard and Ludwig von Mises understood it?  For that matter, what about the investors who were trying to ride the crest of the dot.com wave?  Would they have looked elsewhere instead of that sector in order to unload some of their cash?

These are not idle questions. In his criticism of the ABCT, Gordon Tullock argues that it is a weak theory because it assumes that business owners are "fooled" on numerous occasions into putting money where the capital investments cannot be sustained. Indeed, if one accepts the theories of Rational Expectations that people are not fooled by government policies, then the ABCT is not plausible.

However, Tullock’s point—as seemingly strong as it might be—also ignores the existence of financial bubbles. (I strongly doubt that Tullock, a first-rate thinker, is going to deny that bubbles occur, but he simply looks elsewhere for an explanation of their existence.) 

All criticisms aside, we are left with a simple fact: during boom times, people do place investments into lines of production that are not sustainable, and during the bust the malinvestments are laid bare. Furthermore, no one, not even Paul Krugman, is claiming that reflation by the Federal Reserve System could bring back the go-go business conditions that existed at the height of the boom.

(Krugman, as well as his editorial colleagues at the New York Times,not to mention some of the presidential candidates, are trying to push the snake oil that we had a recession because of the modest tax cuts pushed through by the Bush Administration a couple of years ago.

More specifically, they are claiming that the business recovery—if we can call it that—is not as robust as it should be because of the tax cuts, and that tax increases would bring back prosperity. Once upon a time, Keynesian "theology" [a most appropriate term, I believe] held that tax cuts could not do such a thing. Apparently, Krugman, a diehard Keynesian, either is trying to rewrite the doctrines of the Church of Keynes or is trying to suck up to the tax-and-spend politicians in hopes of U.S. Secretary of the Treasury some day.)

There is an inherent problem in this notion that private business owners would benefit from knowledge of the ABCT. Unless everyone is convinced that the boom is headed for a sure bust, the person who decides to act cautiously in the face of a boom is going to face enormous pressures from investors and others to engage in the same practices that others are following—and making large returns, however pyrrhic they may be in reality. Would Wall Street have endorsed more guarded actions by Enron that surely would have kept its stock prices down, at least in the short run?

Given that situation, knowledge of the ABCT remains socially useful and should be aggressively pursued both by policy makers and by individual investors and business owners and managers. First, prudence demonstrated during a boom by business managers likely will mean that the firm will not be hopelessly extended when the bust occurs—which was Enron’s terrible fate.

To put it another way, Enron did not have to become the Case Study of the Century; energy trading is a good and profitable exercise and there is no reason that this company had to go down the road to destruction. Perhaps an understanding of the ABCT by its principal decision makers could have brought about different results (and different addresses by those former employees who either have been imprisoned or are facing prison for their financial and accounting shenanigans). Not everyone has to act like sheep.

Second, the ABCT clearly points out that business cycles are not inevitable in and of themselves. Once central banks embark on an aggressive program of monetary expansion, the stage is set for an inevitable boom and bust. However, there is no reason that monetary authorities have to engage in such policies in the first place.

A free market economy in which participants enjoy free prices, private property, and (very) limited interference from government is going to result in the improvement of economic conditions no matter what the external situation might be. Furthermore, free markets do not need a "boost"—and especially a monetary "injection"—from the state to operate more "efficiently" and fairly. As the ABCT so clearly tells us, attempts by government to give markets "a helping hand" ultimately create boom-and-bust cycles, which turn that "helping hand" into a closed fist.

Would be that all business owners and investors knew and understood the ABCT. (Yes, I know that Alan Greenspan knows the theory—and, apparently, it has not done him any good.)  Would it prevent government from acting in the way that it does?  Perhaps not. However, the ABCT tells us this truth most clearly and plainly: the emperor has no clothes. That bit of wisdom always is worth knowing.


William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive. Comment on the blog.