Only Austrian Theory Can Explain and Expose Booms and Bubbles

What causes economic booms, busts and bubbles? It’s clear from their continuing and unexpected appearance every few years that mainstream economists still have no idea.
    Next week however, beginning September 18, Mark Thornton will teach a new online Mises Academy course on Bubbles, Booms, and Busts: outlining two mainstream “business cycle” theories (Keynesian, and so-called “Real Business Cycle”) whose practitioners failed to see the latest crash coming, and the Austrian theory of booms and busts—many of whose practitioners did.
    To gain a better idea of some of the topics addressed in his course, Dr. Thornton recently answered questions from the Mises Institute’s writers about the conflicting theories of how bubbles form and busts result.

Mises Institute: While elected officials and various pundits are clear that they believe the Keynesians can solve the current crisis, do the Keynesians have a theory that explains what caused the crisis in the first place?

Mark Thornton: Keynesian business cycle theories are based on the idea that cycles are caused by changes in aggregate demand. This theory, however, provides no purely economic cause for business cycles. The instigator or cause in Keynesian theory is a psychological factor that is driven by so-called “animal spirits.” Small changes in entrepreneurs’ optimism and pessimism affect their investment decisions and can spread and snowball out of control causing sharp increases and decreases in aggregate demand, profits, and employment.
    The general solution for these problems within the Keynesian framework is for aggregate demand to be decreased or increased by the public sector as a substitute for the private sector. The primary means to increase public sector aggregate demand is to increase government spending financed by borrowing rather than taxes.
    The problem with Keynesian business cycle theory is that cycles just happen or are brought about by random exogenous¹ factors. With the Housing Bubble, people just went out and built too many houses and then realized they made a mistake. At that point, the animal spirits of depression took over the economy and in particular the housing and banking sectors went into a tailspin. The Keynesian explanation for the Housing Bubble crisis is correct] to this extent only]: that expectations were psychologically impacted in a positive way during the bubble and in a negative manner after the crash and therefore do play a part in the narrative describing the cycle.

MI: Many Austrian economists have presented Austrian business cycle theory as the answer to the shortcomings of Keynesian theory. Are there other theories, and do they help explain the bust?

MT: One other such theory is known as “real business cycle theory.” According to real business cycle (RBC) theory the overall economy is influenced positively and negatively by “technological shocks” such as new technology, bad weather and disease shocks, oil price spikes, and new environmental or labour regulations. RBC theory holds that markets clear and that government should not respond to short-term fluctuations, but should concentrate on long-term improvements in public goods.
    RBC theory does a good job of describing both the housing bubble and subsequent collapse. For example, in RBC theory, the housing bubble is explained by things such as the expansion of the Community Reinvestment Act in the late 1990s, increased tax advantage for residential real estate, and new developments in the “technology” of financing residential housing, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO).
    The RBC theory also does a good job of anticipating the aftermath of the housing crisis. The “shock” to the financial industry would increase the intensity of the crash and the massive Keynesian-style responses to the crisis represent the opposite of what RBC theory recommends. Specifically, the theory recommends the smallest possible response when it comes to monetary and fiscal policy.
    Unfortunately, while RBC theory can provide a pretty good explanation in hindsight, the types of real changes that it relies on are difficult to model and hard to know in advance. Therefore, while it is “real,” it does not really help us understand reality. However, its policy implications for an economic downturn are correct, which is essentially to do nothing and let markets clear.

MI: But aren’t things like psychology and government regulations important in economic growth and decline?

MT: It would be difficult to deny the psychological changes in people and markets that occur over the business cycle. In a true boom economy everyone is making money and they are often making more than they ever expected. Wealth, income, and wages grow at a very fast pace. Skyrocketing asset values encourage conspicuous consumption. Likewise, after boom turns to bust people first tend to deny that there has been any fundamental change in the economy.
    However, these psychological experiences should be viewed as effects rather than causes.
    It also would be difficult to deny that real changes and shocks occur over the business cycle, particularly during the boom. Most booms or bubbles are in fact linked to new technologies and specific industries and products. The Housing Bubble was linked to “subprime” and related financial innovations. The “tech” or dot.com bubble of the late 1990s, the Japanese Bubble of the 1980s, the Booming 60s and the Roaring 20s all expanded on the basis of new technologies in terms of products as well as production, distribution, and management processes.

MI: But the Austrian position doesn’t rely on these explanations?

MT: The Austrian business cycle (ABC) theory asks the question “why?” What is the ultimate cause of this cyclical process described by these approaches to understanding business cycles?
    To answer this question, Austrians look at prices. The “price” that is most important at the macroeconomic level is the interest rate, whether it is the interest rate on loans, interest as the return to capital, or the natural interest rate based on time preferences in the overall economy. In a pure market economy the loan rate of interest would follow the natural rate of interest. Austrian economists have developed a theory of interest that explains the natural rate of interest as being based on social time preference.
    The problem of the business cycle arises when the loan rate of interest diverges from the natural rate of interest. While this divergence could happen in a free banking system, the major divergence occurs under central bank regimes when large reductions of the interest rate are executed by injecting money into the banking system over a long period of time. A larger volume of loans is thereby made possible. The lower interest rate increases investment and consumption and reduces savings. These changes in the economy provide the conditions for a boom in the economy. If the new funds are funnelled into a specific sector of the economy, a bubble could result.
    So the central bank is the ultimate cause of the business cycle. Its actions first cause such things as heightened optimism and technological innovations during the boom that ultimately end up being malinvestments, damaged expectations, and depression in the bust.

MI: So ABC theory helps economists spot a bubble?

MT: Back in 2004, I wrote an article that shows that by using the ABC theory, Austrian economists were able to observe the economy of the early 2000s and detect signs of the existence of a housing bubble where others could not. And Walter Block has showed that numerous Austrian economists and “Austrian” financial analysts published warnings of a housing bubble. The vast majority of mainstream and government economists saw no major problems in the economy at this time. In fact, as we came closer to the bubble collapsing, there were more denials of a housing bubble and more claims of the emergence of a new paradigm.
    In fact, Austrian economists have a long record of spotting bubbles in the economy. For example, I pointed out here that Mises, Hayek, and other Austrian economists were aware that the 1920s were a period of unsustainable boom conditions and financial imbalances, whereas [Milton Friedman’s precursor] Irving Fisher had declared a permanently high plateau and continued to deny the problem throughout the stock market’s historic collapse. I also found that Hazlitt, Mises, and Rothbard were writing and speaking out against the U.S. government’s economic policy and the dangers to the dollar during the late 1960s, while Keynesian economists such as Arthur Okun, the chairman of the President’s Council of Advisors declared the business cycle had been defeated. What was ahead was the demise of Bretton Woods and the stagflation of the 1970s.

Register for Mark Thornton’s Mises Academy course on Bubbles, Booms, and Busts here.

Mark Thornton is a senior resident fellow at the Ludwig von Mises Institute in Auburn, Alabama, and is the book review editor for the Quarterly Journal of Austrian Economics. He is the author of The Economics of Prohibition, co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War, and the editor of The Quotable Mises,The Bastiat Collection, and An Essay on Economic Theory.

1. “Exogenous” is an economists’ word for “we didn’t see it coming.”