 The Austrian Theory of the Business Cycle, that's up for this morning, I use the term a lot capital-based economics as a more substantive title, not that I have anything against Austria, although some of my students don't know where Austria is and others call it Australian economics. So capital-based macroeconomics and that's more substantive. So we're going to look at sustainable and unsustainable growth. Okay, I started out just with the elements of Austrian economics and they're pretty familiar. Production possibilities frontier, the loanable funds market, that's just supply and demand of loans with the interest rate in play and then structure of production, of course, that's hardcore hi-hack and manger and mises too, but without drawing the pictures. Then there's stage-specific labor markets which come along with the structure of production, different parts of the production have different wage levels. And then applications, just two applications, sustainable growth as supported by saving and then unsustainable growth that's triggered by credit expansion. So that's the contrast that we're going for. And we call this the business cycle lecture, but the first part of it, the sustainable growth will probably take more of the time than the business cycle. But once we get through the growth aspect of it, then we can see what happens when you have credit expansion instead of increased savings. Well, you all know Mises and hi-hack and we can dispense with that. Here I want you to realize, as if you didn't already, that Keynes theorizes at a high level of aggregation, so high that he just doesn't get to see the picture of a structure of production. And looking below it says, seeing unemployment and resource idleness as the norm, Keynes called on as counter-cyclical, physical and monetary policies and ultimately for a comprehensive socialization of investment. That's Keynes' swan song in the last chapter of the general theory. Now we've got Friedman here. So Friedman uses even a higher level of aggregation. So what he focuses on is the equation of exchange, Mv equals pq, and the q is a variable that includes both consumption and investment. So you don't see any changes relative to those two things at all. And Friedman says seeing no problems emerging from the market itself. He focuses on the relationship between the government-controlled money supply and the overall price level. Well, of course, hi-hack focuses on the different price levels and the different stages of production as governed by the interest rate. So here we have hi-hack. So capital-based macroeconomics is distinguished by its propitious disaggregation, which brings into view both the problem of intertemporal resource allocation and the potential for a market solution. Hi-hack shows that a coordination of saving and investment decisions could be achieved by market-governed, that's important, market-governed movements in the interest rate. He also recognizes that the aspect of the market economy is especially vulnerable to the manipulation of interest rates by the central bank. So if you get market-governed movements, you don't have any problem with the business cycle. If you have the government at play with interest rates, then you do have a problem. So a lot of my early slides will show the savings part, and then we'll go to the printing part. So here's a production possibilities frontier, sort of a standard thing, consumption on the vertical axis, investment on the horizontal. So under favorable conditions, which means let the market at work and keep the central bank out of the picture. Under favorable conditions, a fully employed market economy allocates resources to both uses making the most of the trade-off. Well, yeah, so we can show that up here in the diagram. The PPF is often used for emphasizing the concept of scarcity. Can't go beyond the frontier, at least not by very much. You can go a little, it turns out, but it causes trouble. So there's an implied trade-off here at expositing theories of capital and interest, economic growth, international trade, a lot of things. But the PPF rarely appears in macroeconomic construction. Well, it appears in mine, it appears in the Austrian view of business cycles. So investment here represents investment, which includes replacement capital. Let's look at that. You can hardly see the lines there. But you have replacement capital, not as much as gross capital. The difference between the replacement and the gross magnitudes constitutes investment, which allows for the expansion of the economy. So you see where the net investment is. So with positive net investment, the economy grows. The PPF shifts outward from year to year, permitting increased levels of both consumption and investment. We'll see how this works. This investment-based outward shifting of the PPF represents a sustainable economic growth because you've got some net investment there. So you can see it grow, you can hear it grow, you know, whatever you want. It looks like that. So four periods of growth are shown with consumption as well as saving and investment increasing each period. That's because there's savings going on, and so the economy grows. The actual rate of expansion of the PPF depends on many factors, first and foremost, the change in saving preferences. Change in saving preferences which provokes a movement along the PPF and affects the rate at which the PPF expands. So it's not that all of a sudden people decide to save. It's more like demographic factors that as those factors change, it may be that overall there are more savings in the economy than before. So suppose people become more thrifty, more future-oriented, they reduce their current consumption and save instead. Okay, again, look at the PPF. Here's what it looks like. Watch the movement along the PPF. There it goes. And so with increased saving and investment, the economy grows at a faster rate. Well, sure, you got savings to work with. You can hear a lot of those growth. Okay, so let's compare the high-growth economy with the original economy. There's one I started with. So with no increase in saving, the economy grows at a modest rate. You see that. And with initial increase in saving, investment increases at the expense of consumption, after which both consumption and investment increases dramatically from period to period. You can see that. Then you can get the comparison, we'll just go across there and you see your higher level. You can easily tell that. So the loanable funds theory was a staple of Keynesian economics. Great Keynesian economics. And that's just the supply and demand of loanable funds. Interest rates on the vertical axis, saving and investment are on the horizontal axis. There's the savings. Okay, demand reflects business community. Willingness to borrow and undertake investment projects. So that's that part of it. So with interest rates serving as a price, loanable funds theory is a straightforward application of the Martialian supply and demand analysis. So here I'm adapting that from the neoclassical view. I does the same thing. So loanable funds theory was closely identified with Dennis Robertson, that's a British economist, contemporary of Keynes and a critic of Keynes's alternative theory, which is the liquidity preference theory of interest. What's the difference between liquidity preference and saving? Saving means saving up for something. That's why people say save up for something. And entrepreneurs will have something ready for them. Liquidity preference means hang on to your money and don't spend any of it. That's what causes problems with Keynesian economics. So there's Dennis Robertson giving him credit for that. On the suggestion of Heron, who was a sympathetic expositor of the Keynesian system, Keynes included in his general theory, on page 180 you should look at that when you're here at some time. A graphical rendition of the loanable funds market. Well Heron told him he needs to put that in. Well he did put it in. So he put it in but only to emphasize he was throwing it out because it interfered with his liquidity preference theory of interest. And worse yet, if you actually look at page 80, you'll see that he fouled up on the whole thing. He has the curves curving the wrong way, doesn't work. And he forgot to label the axles, the axes. That's bad. Look at page 180. Okay, so if people become more future oriented, they increase their saving, causing the interest rate to fall. And thereby encouraging business communities to undertake more investment projects. So watch the saving curve shift right away. There it goes. You might get tired of that. Okay. So with the given technology, the equality of saving investment is prerequisite to genuine, sustainable economic growth. Now the loanable funds market and the PPF tell mutually reinforcing stories. So you can put them together. You've got investment up here and you've got investment down there. And then the things work out together. So the loanable funds market shows how the interest rate brings saving and investment into line with one another. That's right. The PPF shows how the trade off is struck between consumption and investment. The market adjustments in output, prices, wages and other inputs keep the economy functioning on the PPF. So these two elements of capital based macroeconomics show the pattern of movements in consumption, saving and investment and the interest rate that are consistent with the change in inter temporal preferences. So if people start saving, then this thing changes and we can watch that. As before, let people become more future oriented. They save more, which transmits a signal lower interest rate to the business community. So watch the saving induced decrease in interest rate and the corresponding movement along the PPF. Here we go. Now the lower rate of interest establishes a new equilibrium in the loanable funds market and the economy moves along the PPF in the direction of investment and less current consumption. There could be more future consumption because people are saving up and they're going to spend the money. They're not just hoarding. Even the possibility that a market economy could work in this way is at odds with Keynes in theory. Note that more investment is undertaking as consumption falls. Well, sure, I mean just move along the curve and that has to happen. That's the trade off. Now look at Keynes. According to Keynes, however, the reduction in consumer spending would result in excess inventories, which would cause production cutbacks, worker layoffs, and a spiraling down of income and expenditures. The economy would go into recession and the business community would commit less, commit itself less, not more, to investment. In other words, what happens is it goes off the frontier and down inside the frontier. So you get a depression. You get a depression because you really weren't having savings. You were just having liquidity. Now if retail inventories were a representative investment, then Keynes would be right. Here the derived demand effect dominates. Reducing consumer spending means reduced inventory replacement in general, late stage investments move with consumer spending. However, the interest rate effect, and this is what Keynes ignores, he thinks the interest rate just lives a life of its own. Keynes does. The interest rate effect dominates in long-term or early stage investments. A lower interest rate can stimulate industrial construction, for instance, in product development. So to keep track of changes in the general pattern of investment activity, we need to consider the structure of production and the stage-specific labor markets. That's what comes next here, structure of production. You've seen this in an earlier show yesterday or the day before. So capital-based micro disaggregates capital inner-temporally. Consumable output is produced by a sequence of stages of production, the output of one stage feeding into the input of the next. The temporally-defined stages are arrayed graphically from left to right, not from up to down, from the hyacinth. The output of the final stage constituting consumable output. Okay, now there's an early stage. Looks like he knows what he's doing. Late stage investment activity is exemplified by inventory management, well, fine, he doesn't have any consumers, but maybe they'll show up. For pedagogical convenience, the initial capital structure is shown as having five stages. With growth, the number of changes will increase. Although all five stages are in operation during each time period, resources can be tracked through the structure of production over time. Like so. I'm going to skip Henry Ford here, you've seen him before. So together, the sequence of stages form a hyacinth triangle. The summary description of the economy's inner temporal structure of production. In a growing economy, the triangle increases in size, along with the outward expansion of the production possibilities frontier. So let's watch this. So watch the PPF and the structure production expand together. When people choose to save more, they send two seemingly conflicting signals to the market. I say seemingly that's because if you've got Keynesian economics in your head and all you're looking at is investment, whatever that is. So here are the two aspects of it. Decreased consumption dampens the demand for investment goods that are in close temporal proximity with a consumable output. This is the derived demand effect. People aren't demanding as much consumer goods. Well, you don't stock as much of it then. Fine. But here's number two, a reduced interest rates, which went along with an increase in saving, which means lower bearing borrowing costs, stimulates the demand for investment goods that are typically remote from the consumable output. This is a time discount or interest rate effect. So derived demand and time discount are in conflict only if investment is conceived as a simple aggregate as in Keynesian C plus, I plus, G. The capital-based macro capital-enhanced investment is conceived as a structure. Changes in the demand for investment then can add differentially to or subtract differentially from the several stages of production. It can do those at the same time, as we'll see. Keynes theorizing in terms of the aggregate rather than in terms of the structure underlies Hayek's claim, and this is a quote, Mr. Keynes' aggregates conceal the most fundamental mechanisms of change. He didn't have any structure, he just got I for investment. So increased saving resulted in reallocation of resources among the stages of production. The two effects, derived demand and time discount, have their separate and complementary effects on the capital structure. So there's the derived demand effect. I'll skip reading it because I'm short of time here. The time discount effect, and you know what that is. So watch the structure of production respond to an increase in saving. So note you get an emergence of another stage, a sixth stage, but you don't have quite that much consumption going on because people are saving more. So increased saving then has an effect on both the magnitude of the investment aggregate and the temporal pattern of the capital creation. Watch the economy respond to an increase in saving. Like so. And so now we see that that's what works. What doesn't work for Keynes is what I showed you before. It would sink into the inner part of the PPF. The PPF shows that more saving permits more investment. Like so. The Hayekin Triangle shows that capital creation in the late stages such as retail inventories is decreased while capital creation in the early stages, such as product development, is increased. So you get sort of a wrenching like that. The triangle changes in shape. Structure production is given more of a future orientation which is consistent with the savings that made the restructuring possible. That is, people are saving now in order to increase their future spending power. Note the increase in growth. Here we go. I just want you to be awake, I think you are. Now down below I've got a graph that I'll show you that just, well, you'll take a look at it. As tracked by both the PPF and the Hayekin Triangle, consumption has seen to fall as the economy is adapting to a higher growth rate, after which consumption rises more rapidly than before and eventually surpasses the old projected growth rate. When you see that on that side, on the other side like that, it works together. Now watch this line here. I'm showing it pretty dramatic how it drops. It typically doesn't drop that much. In fact, it might not drop at all and just doesn't increase as much. But I make it dramatic. Just so the people in the back row can see what's going on here. Looks like that. You can see what the old projection would have been had they not started saving. Saving implies giving up of some consumption in the near future. You can see that too, where I color it in, I think. That's what you give up. And once you get, you do it in order to enjoy more consumption in the intermediate and far future. That's what it's all about. You save up and then you get something later. Finally, stage-specific labor markets. Although a labor market for each stage could be depicted, it would be kind of hard on this diagram. The pattern of changes. He calls it the wage rate gradient. And I only saw that after I'd done this PowerPoint. And the reason I hadn't seen it before, it wasn't in the 1931 rendition. In 1935, he added a footnote and talked about this wage rate gradient and it shows up in the graph. So there are the labor markets. Now, let's see how this works. Watch the economy respond to an increase in saving. And what you want to watch is the two demand curves because one of them is going to shift one direction and one will shift the other. You know which is which, watch it. All right. So you're not doing a lot of stock of inventory, so demand went down, but you're doing a lot more stuff in the early stage, so demand went up. So the differential shifting of labor demands gives rise to that wage rate gradient. And you can even depict it here, just showing that gradient as between those two and the ones in between as far as that goes. Okay, now, yeah, I'm leaving myself just enough time, I think. Because look what we've shown. We've got loanable funds market. It's working fine, thank you. Production possibilities frontier. We keep it on the frontier. That's great. Structure production. It's not locked in one position. They can move stage-specific markets. That's how that worked. That's just the market at work for you and for me. Okay, so there it is. Now we'll show it all at once. So be sure and see everything. Okay, but watch the economy respond to an increase in saving. Here it goes. And there you have it. Now, I'm going to show that once again just because it took me a long time to make it work that way. Okay, that's the way it works. Now we're going to switch gears dramatically. We know how the markets work. Now we can see how things get fouled up. So this is all about business cycles and it's about the central bank as a central doing what it needs to do, what it thinks it needs to do anyhow. So look at this. This is Steve Hankey. He's at Baltimore, Johns Hopkins. And look what he writes. With interest rates artificially low. See, he's got the Fed in play now. He knows what he's doing. He's got it down. Artificially low consumers reduce something in favor of consumption and entrepreneurs increase the rate of investment spending. And then you have an imbalance between saving and investment. You have an economy on an unsustainable growth path. This in a nutshell is a lesson of the Austrian critique of central banking developed in the 20s and 30s. He's got it. He certainly got it. And I would have written something like that myself but I couldn't have the sternness that he has. So pay attention to him. Look at what Hayek says. This was when I was out at Menlo Park back in the 70s. And Hayek was in residence there. And he did an interview. I wasn't involved in the interview but I got to see what it was about. So look what Hayek says. This is what he said. It was recorded. So the sentence might be a little funny. Booms have always appeared with a great increase in investment. We understand that a large part of which proved to be erroneous, mistaken. That of course suggests a supply of capital that wasn't made apparent which wasn't actually existing. It was made apparent but wasn't actually existing. You get the idea. The whole combination of a stimulus to investment on a large scale, followed by a period of acute scarcity of capital is consistent with the idea that there has been a misdirection due to monetary influences. And that general scheme I still believe is correct. Right. He did essentially the same thing that the previous one did. But this is 1978. Long after he had done business cycle stuff. But even at that point he was still hanging there with that theory. Good for him. So now let's look at credit expansion. This is by the central bank. Increases in the money supply enter the economy through credit markets. The central bank literally lends money into existence. The new money masquerades as saving. That is the supply of loanable funds shifts rightward. But without there being any increase in saving there's just an increase in paper money. That's going to cause problems. So watch the opposing movements of saving and investment as the central bank adds money delta M to the supply side of the market for loanable funds. Oh. This was in the Greenspan years. Okay. So you get more money. This is a different story. Very different story. So you don't get as prime you get as plus delta M. Thank you very much. So responding to the lower interest rates people actually save less and consume more. The result is because it was a supply shift like that. Okay. The result is not a new sustainable equilibrium but rather a disequilibrium that for a time and that's important takes time to see what's going on. Okay. So this is mask by the infusion of loanable funds. So pumping money through credit markets drives a wedge between saving and investment. Just realize all of this is everything's fouled up. Wedges and so on. Investors move down along their demand curves taking advantage of the lower borrowing costs. So you can you can see that. Savers move down along their unshifted savings curve in response to weakened incentive to save. You can see that. Now look at that horizontal piece. What's that? The discrepancy between saving investment is papered over by the newly created money which itself represents no investable resources. So there that you see how it all turns out. So much of Hayek's writing on money is aimed at shifting the focus away from the bedrock relationship between money and the general price level and towards the intertemporal discoordination that is caused by credit expansion. So favorable credit conditions spur on investment activities which suggest a clockwise movement along the PPF in the direction of investment. You can see that. So look at the next paragraph. But income earners are actually saving less and hence consuming more which suggest counterclockwise movements along the PPF in the direction of consumption. As I suggested so because they both can't be there at the same time but that's what they're trying to do. The wedge between saving and investment translates into a tug of war between consumers and investment. So one of them is pushing upwards. That's the consumers. The other one is pushing rightwards. And then we can resolve that into a northeasterly direction where you see a position that's outside the PPF. It can be there or it can be there close to there anyhow but it ain't going to stay. It's going to turn around and go backward. Now let's look at the triangle. The low interest rate consistent with future orientation stimulates investment activities in the early stages but without sufficient resources being freed up elsewhere many of these investment projects will never be completed. So you see they started but they can't complete it because there wasn't really any saving. Compounding the intertemporal discoordination increased consumer demand draws some resources towards the late stages further reducing the prospects completing a new capital structure. You get something like that so you get a warped triangle. It's got a bend in it. It doesn't work. The dynamics of boom and bust entail both over investment and as shown by the PPF diagram and malinvestment an unsustainable lengthening of the high triangle. So there you get over investment and then you get malinvestment. Those are different aspects of the same thing and at the same time you get over consumption that's shown in both graphics. So Mises repeatedly used the phrase malinvestment and over consumption. I have to say though it was Mises that emphasized the over consumption aspect. IAC doesn't even talk about that in prices and production but Mises does. Mises repeatedly used that phrase. So the tug of war that pits consumers against investors pushes the economy beyond the PPF. The low interest rate favors investment and increasingly binding resource constraints keep the economy from reaching the extra PPF point. Now look at the arrow up there. It's headed towards that but then it goes to the right and some people don't realize why it goes to the right. With capital theory there's a lot of complementarity involved and so if you're building a roller coaster you've got the whole thing up and you see there's trouble ahead but you haven't bought the cars yet. Well you go ahead and buy the cars even though just try to reduce the problem. So that's why it turns to the right. The temperately conflicted structure production called dueling triangles eventually turns boom into bust and the economy goes into recession and possibly into deep depression. So like so. Now we've got what Keynes was talking about. He just didn't realize how you get there. We're just about there. Now look at it and see if you can go back there. Wedge between saving and investment. Tug of war between consumers and investors. Dueling triangles. This is an economy out of whack and it's because of the central bank. Okay. Padding the supply of loanable funds with new money drives a wedge between saving and investment. Papering over the difference between saving and investment gives play to a tug of war between consumers and investors. Pitting early stage against late stage distorts the hike and triangle in both directions. This coordination eventually turning boom into bust. And now we can see it. Watch the economy respond to credit contraction. Stay out of the way. That's for thank you. How many can identify the other one? That's Joe the plumber who's giving people a hard time. Okay, we're quitting right there. Thank you.