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The Austrian School of
Fall Term, 2014
Austrian School I
• Austrian Economics mainly a theory of business cycles
• Centered around patterns of interest rates and
• Two types of interest rates
• The natural rate of interest – reflecting return on
• The market rate which reflects the borrowing costs of
funds charged by the banks
• When the market rate is below the natural rate
companies borrow to invest and the economy expands
• In opposite case investment is reduced and the
economy contracts
• Drawing on this mechanism the Austrian School
emphasizes bank credit’s role in the business cycle
Austrian School II
Austrian Mechanisms:
• Low interest rates stimulate borrowing from banking
• The expansion of credit induces an expansion of money
through the banking system
• This in turn leads to an unsustainable credit-fueled
investment boom in which “artificially stimulated”
borrowing seeks out diminishing investment opportunities
• Boom results in widespread overinvestment causing capital
resources to be misallocated into areas which would not
attract investment if the credit supply remained stable
• Expansion turns into a bust when credit creation cannot be
sustained – either increase in market rate or a fall in natural
• A “credit crunch” sets in – money supply suddenly and
sharply contracts when markets finally clear
• Causes resources to be reallocated back to more efficient 3
Austrian School III
• Austrian Business Cycle
Austrian School IV
Austrians often referred to as “Liquidationists”
Best way back to recovery is to
• liquidate the bad investments out of the system and
• start fresh with capital better allocated
In 1930s Austrian mechanism did not work because extreme risk
aversion kept the market rate above the natural rate even after
Roosevelt, by putting banking system on sound footing through
guaranteeing bank deposits – liquidity situation improved and
credit began expanding
• Economy began expanding in 1934 due to credit expansion, not fiscal
• Recovery in 1934 more Austrian than Keynesian.
• Economy tanked in 1934 when monetary and later fiscal support was
Austrians right about role of credit and recovery in 1930s, but
wrong in not recognizing need for confidence-building economic
Austrian School V
• 1930s Credit Impulse
Austrian School VI
• Austrian critique of current crisis:
• Major Factor: The belief that even in a world of
uncertainty economic and financial outcomes could be
• Assumptions of rational expectations and efficient
financial markets
• Led to overconfidence in ability of policy makers, firms and
individuals to successfully plan for the future despite uncertainty
-- “unknown unknowns”
• At macro level rational expectations and efficient market theory
became the rationale for inflation targeting by major banks
• Replaced monetary targeting of the early 1980s
• Economy expected to grow in a steady state if only
central bank ensured stable and low rates of inflation
• Policy mainly implemented by Alan Greenspan at the
U.S. Federal Reserve
Austrian School VII
• The new approach to Federal Reserve policy had
several ramifications:
• Under-regulation of financial markets – assumed that
when individuals had rational expectations and
markets were efficient – no need to worry about asset
markets or regulate financial markets
• Development of highly leveraged financial products
and risk management
• Financial participants saw only “known unknowns”
that could be quantified with probability theory – felt
there was little need for contingencies for the truly
unforeseen – the “unknown unknowns”
• Seemed appropriate to raise leverage to the extreme
• Feeling of being in control with good foresight laid the
ground for the extremely high leverage built into
financial products and balance sheets of firms.
Austrian School VIII
• Lessons the Austrians drawn from the crisis
• Clear markets are not highly rational with perfect foresight
• There are elements of irrationality and inefficiencies in the behavior
of people and markets
• As a result outcomes can not be planned with a high degree of
• This reality leads to conclude:
• Idea that more regulation of markets will provide stability is
incorrect – in a world of uncertainty can only best tentatively plan
for the future – use trial and error or a flexible approach
• In a world of unknown unknowns firms and investors need larger
buffers to cope with the unforeseen – more equity and less
• In a world where markets are not always liquid but can freeze up –
need greater reserves of liquidity
• Need to accept the reality that we can not fine tune the business