Friday, April 23, 2010

Redux: What is ABCT in a Nutshell?

In a nutshell the Austrian Business Cycle Theory (ABCT) is an explanation of the causes of economic boom and bust cycles that are born of interventions by the monetary authority in credit markets. The monetary authority sets interest rates below their market value, thus causing the money supply to increase. This inflationary increase in the supply of loanable funds encourages banks to begin making loans on an increased scale. This causes credit to expand as rates are lowered beyond where they were perceived by market actors prior to the intervention. Furthermore this expansion pushes credit beyond the limits of loanable funds that are held in savings.
Subsequent to this a distortion occurs in the structure of production and prices. This distortion in turn sends false price signals to market actors who will participate in an artificial boom, unless they realize that credit is being pushed beyond the amount of loanable funds available. Entrepreneurs begin to invest in capital projects that had not been profitable prior to the expansion of credit. Prices begin to rise in the capital and stock markets, and a wide array of market participants react accordingly. Eventually these increases will be seen in retail and consumer prices.
During the boom firms will begin to show accounting profits. Unbeknownst to investors and entrepreneurs, these profits are artificially higher than their real values. This signal will increase the demand for capital and lengthen its structure, and drive investors and entrepreneurs to continue to invest with artificial credit. Increases in demand will occur first in the earlier stages of production, the capital goods sector, and then in the late stages, the retail and consumption stages. As demand increases, capital projects that were being undertaken prior to the boom will be abandoned for new ventures that appear to be profitable to entrepreneurs and investors.
Due the increased demand labor markets will experience an expansion as more employees are thought to be needed. New hires will occur across the stages of production.  The increase in the demand for labor will first occur in the early stages, and then the later stages. Unemployment will decrease significantly, and workers will apply parts of their income to capitalize on the promise of the boom.
Eventually the credit expansion slows or stops. Market participants will come to realize that they have received bad signals and information, and that there is no backing to the credit that caused the artificial boom. Realizing that they have acted on false information, their investments during the boom are in fact malinvestments. These malinvestments will need to be cleared from the market place. This process can be severe but also short, assuming there are no further interventions from the monetary or fiscal authorities.
If further intervention occurs, malinvestments will be prevented from clearing the market. Further intervention by monetary and fiscal authorities can extend the life of the bust beyond what it could have been had there been no interference. The bust can result in recession, panic, credit crunch, and depression. One possibility of further intervention is that the monetary authorities can continue to inflate and expand credit. This will be an attempt to perpetuate the life of the boom, or to begin a recovery. An action such as this might induce banks to continue to lend and entrepreneurs to make malinvestments. But the reality will be that nothing has changed. The recovery boom is also built on faulty price signals, and will not be sustainable. This will create a new crop of malinvestments that will need to be cleared out of the markets.
Upon the realization that their investments are in fact malinvestments, entrepreneurs and investors will seek to get rid of them. They will begin to see significant losses in their profits and revenues. These entrepreneurs will cease channeling funds to projects that appeared to be profitable in the boom. In turn they will attempt to seek out assets with real value. As the demand for loanable funds decreases borrowers will look to pay off their loans as fast as possible. This decrease in demand will begin to have a profound effect on the banks that made the faulty loans. As this process continues banking losses will begin to increase significantly. They may also experience solvency issues due to the fact that they will not have real assets to back up the expansion of credit.
The bust will start to have considerable impact on the market participants who sought to take advantage of the boom. Entrepreneurs, investors, and workers alike will begin to feel the damaging effects of the bust, which can be sudden and severe. The entrepreneurs that accumulated heavy losses during the bust will look to reduce as many costs as possible. One of the most probable places to begin to roll back costs is the labor markets. Layoffs and cuts will occur in the early stages of production, that is, the capital goods sectors. Eventually this will occur in the late stages of production, specifically in the retail and consumer markets. Unemployment will increase, and there will be a credit crunch!
The ABCT is easy to explain with layman’s analogies. The analogy that seems most appropriate, and is my own personal favorite, is the hangover. Imagine you are a college student who is about to hit the town on a Friday night with your school buddies. You start drinking by sharing a six-pack in your room or apartment to loosen up. You gather up your cash, slap on some Old Spice, and hit a keg party. The beer in the kegs is cheap, but cold (easy money). You put three bucks in the contribution jar, and fill and refill your plastic cups as much as possible. Now you have a nice buzz, and the party is on (the boom)! As time goes by, the keg begins to get light, and it is replaced. Then that one is consumed and begins to float. You and your buddies are not quite ready to hang it up, so it is off to the bars! You are low on cash but you have your credit card. You try to hit as many as you can, and connect with as many people as you can. It is turning out to be one hell of a night!
Eventually, your buddy comes up with the brilliant idea that you should supplement your beer binging with kamikaze shots. They taste smooth, and you get another round. You slam them and roar chants as you high five and scream “That’s what I’m talking about!” You are on fire, spinning, and begin to slur, but you are holding on. The bar closes and the bouncers clear the joint, but you and your friends are not done yet. It is now time for afterbars, but not before you stop at the local greasy spoon to fill up on the burgers and fries you think you need. As you make your way to afterbars, a buddy stops to vomit in the parking lot. He regains his bearing, and you drag him to the house for afterbars (attempting to extend the boom). Beer and liquor await you there (stimulus), but at this point you are stammering, stuttering, and stupid drunk (malinvestments becoming apparent)! You are wasted, to use the parlance of our times. You make it through about twenty minutes of “The Godfather” and you pass out on the couch (the bust sets in).
You wake up hours later with a headache that feels like an elephant stepping on your head. The light fills the room, and you are blinded by this unwelcome intrusion to your seeking of relief. You make your way over the passed out people to the bathroom, and unload your “malinvestments.” You think to go to the fridge and grab beer and start drinking again, because that is what worked on spring break in Panama City Beach. But you don’t. You let your “market clear.” It hurts, but it ends quicker than if you had continued to drink. Your “market clears” and you are back on your feet with a little ibuprofen and a lot of water!

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