Disclaimer: This is bound to be a clumsy attempt at explaining the Austrian theory of business cycles. For a much better explanation please listen to the April 13, 2009 and January 5, 2009 episodes of Econtalk, or watch the famous Hayek vs. Keynes music video.
The Austrian theory of business cycles stresses the role of interest rates in valuing alternative investment options. As an example I'll use an investment option that many people consider at some point: going to college. Pursuing a degree, whether it be an associates, bachelors, masters, or any other, is an investment in one's own human capital. Like any investment one must consider the costs and the expected returns. A change in costs affects decision making. Lower costs mean future returns don't need to be as high, while higher costs mean future returns must increase to compensate.
Imagine that an election takes place and a new congress and president are elected. The newly elected politicians decide that more bridges are needed. In order to achieve this they create a new fund to provide scholarships, grants, and low interest loans to students pursuing a degree in structural engineering. This makes it less burdensome to pay tuition fees. Yay, interest rates have gone down! Education is more affordable! This leads more people to enroll in a structural engineering degree program than otherwise would have. These students eventually graduate and enter the job market. The aforementioned bridge loving politicians have decided to allocate more money to transport infrastructure, and recent graduates enter a favorable job market. As one might expect, this encourages even more people to pursue a structural engineering degree, adding the existing incentive created by lower interest rates. Many bridges are built, and many engineers are trained. Unfortunately, there comes a time when more bridges are unnecessary. We're all bridged out, one might say. What to do with all of those bridge-building structural engineers? They are no longer needed, and many lose their jobs. Furthermore, the tools and machinery they used to use are no longer utilized. Their staff is let go. There are surplus stocks of rebar and concrete laying around. This loss of jobs and misuse of resources happened because distorted interest rates caused too many people to pursue a degree in structural engineering. School was too cheap. The interest rate signal was wrong. If the interest rate had been higher, fewer people would have opted to enroll in structural engineering programs, and therefore fewer engineers would be produced.
Wait, many are quick to say, we need to put those bridge building engineers back to work! That's the solution! The problem is that we don't need more bridges. We've got plenty, thanks. Paying them to make more won't help, it just pushes more resources to an already unnecessary use. Austrian theory points out that a correction must be made. The engineers, their staff, the machinery, and the supplies need to be put to different uses. This transition will not be painless. Many bridge builders will face hard times. This is very sad. This highly regrettable situation does not mean, however, that pouring more money into bridges is a solution. The Austrian theory is that the structural engineers need to find another application for their skills, an entrepreneur must figure out a use for old rebar and concrete, and so on. This adjustment is the only real way to recover from malinvestment due to distorted interest rates.
Distorted interest rates lead to changes in investment decisions. Those investment decisions eventually prove to be poor choices. The resources allocated to those investments must be reallocated to other uses. This transition is the bad times in the business cycle. When interest rates have adjusted and resources are better allocated in response, we see the good times in the cycle. Refusing to accept the consequences of misallocation, either by further distorting interest rates or propping up wasteful uses, merely compounds the problem and delays the inevitable.
The Austrian theory of business cycles stresses the role of interest rates in valuing alternative investment options. As an example I'll use an investment option that many people consider at some point: going to college. Pursuing a degree, whether it be an associates, bachelors, masters, or any other, is an investment in one's own human capital. Like any investment one must consider the costs and the expected returns. A change in costs affects decision making. Lower costs mean future returns don't need to be as high, while higher costs mean future returns must increase to compensate.
Imagine that an election takes place and a new congress and president are elected. The newly elected politicians decide that more bridges are needed. In order to achieve this they create a new fund to provide scholarships, grants, and low interest loans to students pursuing a degree in structural engineering. This makes it less burdensome to pay tuition fees. Yay, interest rates have gone down! Education is more affordable! This leads more people to enroll in a structural engineering degree program than otherwise would have. These students eventually graduate and enter the job market. The aforementioned bridge loving politicians have decided to allocate more money to transport infrastructure, and recent graduates enter a favorable job market. As one might expect, this encourages even more people to pursue a structural engineering degree, adding the existing incentive created by lower interest rates. Many bridges are built, and many engineers are trained. Unfortunately, there comes a time when more bridges are unnecessary. We're all bridged out, one might say. What to do with all of those bridge-building structural engineers? They are no longer needed, and many lose their jobs. Furthermore, the tools and machinery they used to use are no longer utilized. Their staff is let go. There are surplus stocks of rebar and concrete laying around. This loss of jobs and misuse of resources happened because distorted interest rates caused too many people to pursue a degree in structural engineering. School was too cheap. The interest rate signal was wrong. If the interest rate had been higher, fewer people would have opted to enroll in structural engineering programs, and therefore fewer engineers would be produced.
Wait, many are quick to say, we need to put those bridge building engineers back to work! That's the solution! The problem is that we don't need more bridges. We've got plenty, thanks. Paying them to make more won't help, it just pushes more resources to an already unnecessary use. Austrian theory points out that a correction must be made. The engineers, their staff, the machinery, and the supplies need to be put to different uses. This transition will not be painless. Many bridge builders will face hard times. This is very sad. This highly regrettable situation does not mean, however, that pouring more money into bridges is a solution. The Austrian theory is that the structural engineers need to find another application for their skills, an entrepreneur must figure out a use for old rebar and concrete, and so on. This adjustment is the only real way to recover from malinvestment due to distorted interest rates.
Distorted interest rates lead to changes in investment decisions. Those investment decisions eventually prove to be poor choices. The resources allocated to those investments must be reallocated to other uses. This transition is the bad times in the business cycle. When interest rates have adjusted and resources are better allocated in response, we see the good times in the cycle. Refusing to accept the consequences of misallocation, either by further distorting interest rates or propping up wasteful uses, merely compounds the problem and delays the inevitable.
No comments:
Post a Comment