All About the Business Cycle

“For over a century, different opinions have formed about the causes of economic “booms and busts,” an apparent cycle of financial activity. The Austrian and Keynesian schools of thought completely disagree on this matter, and the pertinent solutions. Who is right—and why?”

By David Behrens

     Financial crises have rocked the foundations of international monetary policy for over a century, and with instability looming large in today’s markets, economic decisions will have to be made. In times like this, it’s important for the public to understand the anatomy of the business cycle. Two major schools of thought have dominated Business Cycle Theory since the early 20th century: The Keynesian school, which asserts that stimulus can spark economic growth, and the Austrian school, which describes how artificially low interest rates create the illusion of a boom, followed by an inevitable bust.

     John Maynard Keynes, particularly in his most famous work, The General Theory of Employment, Interest and Money, established many fiscal and monetary precedents which contributed to the development of modern macroeconomics. Keynes believed that the fluctuations of employment caused by those of investment, in a cyclical manner, had a roundabout effect of diminishing the marginal propensity to consume. Furthermore, he believed that this would decrease aggregate demand and that decreases in aggregate demand would limit productive capacities. To put these ideas in context, Keynes thought that the inherent instability of an economy would cause uncertainties, leading consumers to consume less and producers to produce less. When this happens, Keynes’ solution was to boost aggregate demand in order to spark activity in sectors that created capital, thus relieving the glut in production by simulating a jolt in consumption. It is consequently crucial to recognize the composition of aggregate demand, which is made up of consumption, investment, government spending and net exports. Keynes’s prescription to boost aggregate demand by increasing government spending was based off the level of control that the government could wield over government spending versus a more complex variable like consumption. This plan was eventually welcomed by many politicians in the later years of the Great Depression.

     The Austrian School of economic thought is stylistically very different from the London, or Keynesian school. Championed by economists such as Friedrich Hayek and Ludwig von Mises, it relies on a rationalist methodology known as Praxeology. The Austrian Business Cycle theory correlates the “booms” experienced by an economy with a “bust” that follows. Their theory is that the problems caused by ordinary fluctuations of capital are exacerbated by the policies of central banks. Typically, the Austrian School lays out the following scenario:

     Central banks, in the hopes of encouraging consumption, mandate that interest rates be kept below a certain point. For this to have any effect, that point must be lower than the uninhibited market would have roughly placed it. Therefore, banks across the country, endowed with currency from the central bank, issue cheap credit—people are able to get loans more easily than they otherwise would. The problem with this is that the market, made up of countless independently-acting individuals, always determines a rate of interest that will come closest to satisfying everyone’s needs. The central bank, made up of a small handful of elites, does not intend to have this same effect and fundamentally can’t reproduce the same market result. The consequence of cheap credit is that it incentivizes people to take out loans to the point where the loaned funds are not all eventually accounted for. People will use their new capital to undertake projects that they ordinarily wouldn’t (a recent example of this is the housing boom around the turn of the 21st century). The return on all of this investment is not as high as it needs to be for banks to account for all of their loans, so the banks need to claim they have more money, as interest rates rise. This aforementioned sequence of events comprises the process of inflation. Depreciated currency ends up taking up the slack caused by the interest rates being too low. In addition, people are incentivized by low interest rates to spend when they may ordinarily save, thus distorting the natural signals of supply and demand for money in an economy. Those who decide to save their money are harmed by the inflation caused by the business cycle because their savings become less valuable.

     The distinction between these two theories is important because it has continued to challenge policymakers in all parts of the world. Today, the United States Federal Reserve faces consistent uncertainty over whether or not to raise interest rates, as investors such as George Soros have begun to predict a financial crash. Central banks such as that of Venezuela have had a difficult time determining the value of their currencies, resulting in uncertainty for consumers and producers responding to price signals. No matter which side is more adhered to today, there is comfort in the magnanimous volume of empirical evidence that the future will provide, particularly with the aftereffects of both Brexit and the next U.S. election. Analysis awaits us as today and tomorrow’s economic points of interest arise.

References
Keynes, J. (1936). The General Theory of Employment, Interest and Money.
Mises, L. v. (1949). Human Action. Yale University Press.
Rothbard, M. (1962). Man, Economy and State.