Friday, July 1, 2011

A Brief Summary of Austrian Bubble Theory

Several months ago--perhaps even a couple of years, now--I came across a simple, but incredibly insightful, explanation for the business cycle--the booms and busts that we've come to accept as a way of life.  I cannot remember precisely where I read it first, but it was likely in the book Human Action, by Ludwig von Mises.  I would like to take a moment to summarize this theory, because I'll be using it in future posts.

To understand why we have "booms" and "busts", we first need to understand that societies advance technologically by saving for the future.  If I were on a desert island, for example, I might have to spend most of my time fishing, just to get enough to eat--but if I dried a little bit of fish each day, I can save enough up to take a week off from fishing to make a net, which I could use to more quickly catch fish, and then have more free time to pursue other activities.  Step by step, then, my standard of living increases.

Now, I don't live on an island, so I don't necessarily have to save up money in order to take this step.  I could find someone willing to loan me their savings.  Of course, I take a bit of risk in doing so, because if things fall through, I have to pay things back despite losing everything, and I won't be able to save as much money for the next major project; on the other hand, I might also succeed, and be ready to fund the next project!  And, if debt can be used to push the boundaries of our standard of living, then it's obvious that, if we could make debt easier to obtain, we'll push those boundaries even faster, right?

It is this last step--making debt easier to acquire--that we start pumping up economic bubbles.  If I'm interested in building a factory, for example, and I don't have enough savings, I'll look at the loans and say, "hey, at this interest rate, I'll be able to afford it!"  Unfortunately, everyone else looking to expand their operations are making to same conclusions, and so they are taking out loans as well.  This leads to inflation, and so the loans don't cover the costs--in which case, I'll have to ask myself "Should I get another loan, or should I cut my losses and give up on my factory?" and, at some point, I'm going to realize it's time to cut my losses, and I'll have to leave my factory half-built.  The economic bubble bursts when a large number of people reach this conclusion.

Sadly, when this happens, we don't go back to the level we started before the bubble burst:  we're actually worse off.  Savings have been expended, and we have to pay off loans.  Workers have to be re-trained.  Factories are empty; they may even need to be converted, or perhaps torn down.  Unemployment is going to be higher while we shuffle everything around.

Admittedly, I am not an economist.  If you pointed me to a given bubble pop, I would not be able to identify all the factors that lead to it--at least, not without some research first.  It should be kept in mind, though, that throughout the history of America, politicians almost always thought we "need" artificially low interest rates; thus, this potential cause for disaster is always humming away in the background.

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