This presentation starts by looking at how the market process works: coordination through prices and profits. The two alternative theories of the business cycle are introduced: - The non-Austrian theories, which blame the cycle on the free market and call for government to take control. - And the Austrian Theory of the Business Cycle (ABCT), which blames the cycle on government manipulation of interest rates. The boom, bust and recession stages of the ABCT are analyzed in detail. It is concluded that government actions only prolong recessions and make them more severe. And the business cycle would not occur with interest rates determined on a free market.

1. Austrian Business Cycle Theory by Graham Wright (http://managainstthestate.blogspot.com/)

2. The Austrian Business Cycle Theory (ABCT) was developed by Ludwig Von Mises and his student F.A. Hayek in the 1920’s and 1930’s. INTRODUCTION Ludwig Von Mises (1881-1973) F.A. Hayek (1899-1992)

3. Agenda “Before we can meaningfully ask what might go wrong, we should first understand how things could ever go right.” “How Things Go Right”: Prices and Production Austrians and Keynesians on Business Cycles Austrian Theory of the Boom and the Bust In a recession, what can government do to help?

4. In a free market, production is coordinated to make best use of resources, in terms of consumer desires and values. PRICES AND PRODUCTION On a free market, prices are formed by supply and demand. Production is coordinated by entrepreneurs seeking profits and responding to profit and loss signals. There is no need for a ‘central planner’. The profit-loss mechanism of the market ensures that: Entrepreneurs best satisfying consumer demands (using resources efficiently) are rewarded and survive, and Entrepreneurs failing to satisfying consumer demands (wasting resources) are punished with losses and bankruptcy. When the price of a product is manipulated by governments… the market becomes uncoordinated and resources are wasted / misallocated / malinvested from the consumers’ point of view.

5. The market process is entrepreneurs and investors responding to profit and loss signals. (1) PRICES AND PRODUCTION More production needed Demand > Supply Prices Increase Profits Increase Production Increases Existing firms increase production of that product, and new firms enter the market. Entrepreneurs increase prices to try to maximise profits The structure of production is rearranged to increase production

6. The market process is entrepreneurs and investors responding to profit and loss signals. (2) PRICES AND PRODUCTION Less production needed; resources are needed elsewhere Supply > Demand Prices Decrease Profits Decrease Production Decreases Existing firms decrease production of that product, and some firms go bankrupt. Competition impels entrepreneurs to decrease prices to try to maximise profits The structure of production is rearranged to decrease production

7. Agenda “How Things Go Right”: Prices and Production Austrians and Keynesians on Business Cycles Austrian Theory of the Boom and the Bust In a recession, what can government do to help?

8. So why are economies plagued by recurrent business cycles? AUSTRIANS AND KEYNESIANS The business cycle is a fundamental feature of a market economy, caused ultimately by human ‘animal spirits’. Governments can lessen the effect of the business cycle through fiscal/monetary policy. Keynesians The business cycle is caused by governments artificially lowering interest rates. Governments interventions worsen recessions. With a free market interest rate, the business cycle simply would not occur. Austrians

9. AUSTRIANS AND KEYNESIANS “Fear The Boom and Bust” - A Hayek vs. Keynes Rap Anthem ( http://www.youtube.com/watch?v=d0nERTFo-Sk )

10. Agenda “How Things Go Right”: Prices and Production Austrians and Keynesians on Business Cycles Austrian Theory of the Boom and the Bust In a recession, what can government do to help?

11. The interest rate is a reflection of time-preferences BOOM-BUST CYCLE High time-preferences High interest rates High spending, low saving Low time-preferences Low interest rates Low spending, high saving The interest rate is the price of borrowing money. Like all prices, in a free market, the interest rate is determined by supply and demand. The supply of money to be loaned (savings) and the demand for loans. The free market interest rate is therefore a reflection of the time-preferences of the individuals in society; that is, how highly people value current consumption over saving that will allow them future consumption. Interest rates coordinate the time-structure of production. That is, the profitability of short-term versus long-term production projects.

12. Government manipulation of the interest necessarily results in a malinvestment boom BOOM-BUST CYCLE When a central bank inflates the money supply the interest rate price signal is distorted. This causes the time-structure of production to become distorted. With an interest rate lower than the free market rate due to government manipulation, the amount of savings appears to be higher than it really is. It appears as though people are saving for the future, when in fact they want to consume now. Entrepreneurs are misled into starting more and different, especially long-term production projects, believing they will be profitable. There is an “artificial” boom, especially in capital goods industries: housing, construction, mining, manufacturing, etc. This boom is a result of malinvestments of resources in unsustainable projects. While the boom continues, the malinvestments are unseen; they appear to be profitable businesses. The bigger and longer the boom, the more malinvestments occur.

13. Resources are scarce, so inevitably, there will be a bust, at which time the malinvestments become apparent: bursting price bubbles, job cuts, foreclosures and bankruptcies. BOOM-BUST CYCLE

14. Agenda “How Things Go Right”: Prices and Production Austrians and Keynesians on Business Cycles Austrian Theory of the Boom and the Bust In a recession, what can government do to help?

15. In a recession, Keynesians recommend that even more money is printed; politicians are happy to take this advice BOOM-BUST CYCLE

16. BOOM-BUST CYCLE The recession is the recovery period; the “hangover” following the binge of the artificial boom The inevitable recession is the market process of adjusting the structure of production back to satisfying consumers’ real time-preferences. Bankruptcies, defaults and unemployment increase as the malinvestments are liquidated. This frees up the land, labor and capital to be put to use satisfying real consumer demand. The recession-recovery can only be slowed down and made more severe by government interference, since the market process requires free market prices. Bailouts Stimulus Packages Nationalizations More Regulations Low Interest Rates Lower Taxes Less Regulation Eliminate Price Controls Stop Inflating!

17. BOOM-BUST CYCLE Money creation cannot go on forever; a “permanent boom” is impossible Further money creation – attempting to keep interest rates low – may delay the bust, but it will only create even more malinvestments, which will cause a bigger bust in the future. Hyperinflation is when the money supply is increased so much (in an attempt to delay a bust) that the value of the money rapidly decreases, until it is almost worthless.

19. This created a large artificial boom, resulting in an inevitable bust in 1920.

21. This created a large artificial boom, resulting in an inevitable bust in 1929.

23. For free education, visit The Ludwig von Mises Institute, the intellectual home of the Austrian School, at mises.org