Our series into Capitalism continues. In this, our purpose is in no small degree to wean you Libertarians of an Austrian bent away from Austrian economics and toward Alexander Hamilton’s superior vision of economics, Robber Baron Capitalism.
We now take aim at that pillar of Austrian economics, the Austrian theory of the business cycle, knock it down to size, and replace it with an explanatory model that builds on what you have learned in Part I.
We also expand on why in Part I we emphasized national policy makers should view their economy from the prism of sectors.
The Austrian take on the business cycle is an interesting, but ultimately unsatisfactory, explanation of boom and bust. At most, their theory explains why fractional reserve banking can in some cases reinforce poor economic decision making.
But, as you will see, its explanatory power falls short in other important areas.
Especially compared to the theory we now introduce to you.
Alexander Hamilton’s Theory of the Business Cycle – In Hamiltonian theory economic boom and bust cycles are driven by changes in consumer demand for a type, or types, of goods and/or services. These cycles are usually concentrated in specific economic sectors in both the upswing and downswing phases.
In Hamiltonian theory, economic activity is usually born from a type of customer demand.
In the value signalling triangle of consumer, producer, and economic environment, the consumer signals what type of demand they have to producers.
The producer interprets these customer value signals.
If the producer believes satisfying the customer’s demand is valuable enough to the producer within the producer’s business environment, the producer adjusts its operations and allocates resources towards satisfying demand.
As mentioned in Part I of our series, the act of satisfying particular types of demand in one sector requires the producer to establish processes and allocate resources that differ in type and kind from those used in other sectors:
Types of customer demand leads to the creation of different sectors because different types of consumer demand frequently require producers to design different types of processes in order satisfy different demands: The medical industry exists to satisfy medical needs; the financial sector exists to satisfy financial needs, the housing sector exists to satisfy housing needs. Each of these sectors have developed substantially different types of medical, financial, and housing processes to satisfy the demand in their respective sectors.
Because satisfying different types of desires requires different types of business processes, different sectors ultimately allocate different types of resources in their business operations that are often not needed in other sectors: Medical processes are allocated medical resources, financial processes are allocated financial resources, housing processes are allocated housing resources.
Because what consumers, producers, and the economic environment signal as valuable is constantly changing, producers must continuously reallocate resources and fine tune business operations to align with changes in demand and environment.
This reallocation of resources and process tuning by the producer never ceases.
Because time is required for producers to adjust to new value signals, there is always a time lag between the moment when value is signaled by the customer and the environment and when the producer can act on this new information.
Just as trains moving at top speed cannot stop on a dime, businesses cannot reallocate on a dime during a boom or downturn because it takes time to alter the course of their planned business operations.
In mathematical terms, how quickly and efficiently reallocation is performed is a function of how liquid a producer’s assets are and how quickly a producer can redirect other resources (land, labor, material…) dedicated to an old business action to new business actions. Sometimes resources in an old business action can be reallocated to new purposes. But usually at least some resources cannot be reallocated because they are not recoverable from the old business action.
Economic booms are usually concentrated within a particular sector that experiences a large upswing in consumer demand relative to demand in other sectors.
When a sector booms because of increasing demand, producers in that sector reallocate more and more resources and operations towards satisfying this increasingly valuable demand.
Sectors – such as raw material suppliers, financial services, marketing, staffing agencies, etc… – that are downstream or complementary to the producers in boom sectors also devote more of their resources and operations towards the boom sector.
The more demand there is and the more resources are allocated to the boom sector, the more sector momentum a sector has within a national economy.
Sector momentum naturally cascades through the rest of the economic system during rapid expansion.
Sector momentum also naturally cascades throughout the economy when previously booming sectors turn to bust.
Downturns occur whenever demand for a good or service, for whatever reason, reaches diminishing utility to the consumer. As utility is reached, demand falls below what producers projected demand would be. When demand misses expectations, producers must decide how to reallocate resources, if resources should be sold off, or if the producer can remain in business.
To Hamiltonians, economic downturns are inherently unavoidable. Over time, demand projections must consistently overshoot or undershoot because there are too many random and non-quantifiable factors for the producer to know in advance when and exactly to what degree a booming sector will see demand taper off.
Indeed, economic value itself is inherently non-quantifiable.
Because projections almost always miss their targets (when projections are precisely met, it is normally a fortunate statistical accident that is not repeated in future projections) some misallocation (malinvestment) of resources is inevitable. Especially when a bust starts.
After a boom, a high proportion of resources are lost because the demand they were meant to satisfy is less than anticipated. Operations at this point were near completion and had assumed robust demand. In mathematical terms, reallocation is easiest to perform when the old business action is at its earliest stage, hardest when the old action was closer to completion before cancellation.
For cancelled activities, a business actor may be able to rollback some resources invested in the cancelled activity to other activities, but some capital is usually not recoverable.
Economic recovery happens, and the boom cycle reestablishes itself, when a new demand emerges that is valuable for producer’s to serve.
Growth in Capitalistic economies is ultimately superior to Socialist economies because producers in Capitalism are ultimately reflecting the true desires signaled by the customer. Because customer desires are best reflected in Capitalism, Capitalistic systems ultimately enjoy lasting benefits in processes after economic boom and bust cycles have ended. The internet bubble and the industrial expansion of the 1920s all had positive impacts that long survived their respective crashes.
We note here that our theory holding that demand is the true driver controlling boom & bust is similar to Schumpeter’s theory that technological innovation drives market cycles. We generalize Schumpeter’s point to argue that demand of any kind – whether driven by demand for technology, cultural preferences, or any other customer motivation – is the key explanatory factor.
The traditional Austrian counter to Schumpeter is to argue fractional reserve banking causes boom and bust because central banks hold interest rates at artificially low levels. These low interest rates then encourage malinvestment in technological innovation, such as malinvestment in the green energy sector.
The Austrian argument against Schumpeter is weak because low interest rates are not by themselves sufficient to determine what specific technology investors decide to malinvest in. The number of possible investments in technology are essentially infinite, but not all of these possibilities attract malinvestment when interest rates are excessively low.
In the case of green energy malinvestment, Austrian theory does not explain why the green energy sector was favored over traditional energy sectors. The easy credit directed towards green energy would have been just as easily directed towards more profitable oil and gas companies.
Hamiltonian theory explains why. In Hamiltonian Capitalism investor actions are primarily explained by demand.
From a Hamiltonian viewpoint (as well as Schumpeter’s), malinvestment in green energy is the result of Liberal governments distorting normal consumer demand for energy towards politically favored green energy. Under normal market signalling conditions, “green” energy would not have enjoyed so much investment because that sector has not technologically matured to the point where it can substitute for classic energy industries.
Progressives substituting their perception of value for the customer’s normal preferences is the real culprit, not fractional reserve banking.
The Limits of Austrian Market Cycle Theory
As for the remedy to boom and bust so often proposed by Austrian economists, the gold standard, this too must be rejected as a cure.
It is at best just another economic tradeoff with disadvantages that do not obviously outweigh the flaws in fractional reserve banking.
The first error in Austrian affection for the gold standard is that the price of gold itself carries no inherent information about what interest rates should be.
Value, and associated prices, are inherently subjective for all goods and services. Gold is no different. The price of gold at any given moment reflects the preferences of its many customers. Those preferences include customers who value it in industrial applications and those who value it for aesthetic reasons. Neither gold’s industrial uses nor its aesthetic appeal hold advice about what a “correct” interest rate is.
Second, interest rates are also not quantifiable as “correct” or “wrong” because what qualifies as correct varies from the preferences of each individual economic actor. A very cash rich business such as Apple can tolerate much higher interest rates than a cash poor startup.
If interest rates are subjective, and the price of gold is like all other prices subjective, gold cannot indicate a “correct” interest rate of any kind. If there is no correct interest rate, a gold standard is not inherently better than fractional reserve banking.
No matter how interest rates are set, a given rate at a given point of time will always be too high and too low in the opinion of many economic actors.
What Austrians have misidentified as a flaw in fractional reserve banking is actually a side effect of Progressive economic policy.
Interest rates have been kept artificially low because economic growth across the West has been artificially suppressed by Progressive economics. Progressive policy, and any kind of Socialist economics, depresses economic growth because the network of value signalling between the consumer, producer, and economic environment is distorted by Leftist interference in the economy – usually by Liberals substituting their own subjective value preferences for the natural preferences of the consumer.
To compensate for lower growth, Progressive central bankers set interest rates low to make borrowing cheaper for business operations. This strategy reaches diminishing returns because low interest rates cannot compensate for the distortion of consumer demand signals.
Under Capitalism, interest rates would be less politicized (and therefore higher) because economic growth would be consistently higher. Hence, there would be no need for a gold standard to hold interest rates at traditionally healthier levels.
The Policy Implications of Hamiltonian Theory of the Business Cycle
For Capitalists, Hamiltonian analysis brings important implications for policy.
If the government cannot eliminate bust cycles for the reasons already discussed, then government policy should be to nurture the business environment in preparation for new demand to emerge and lead the next upswing in the economy.
This environmental nurturing should include creating a favorable environment for as many economic sectors to prosper so that dependence on one booming sector – a sector that must eventually experience a decline – is minimized. If one growth sector fails, others will be able to make up at least partially for this missing growth. This diversification in economic portfolios will alleviate risk from becoming too dependent on one sector of expansion.
The government should treat its overall economy like a basket of investments that, because of compound growth, increases over time despite periodic downturns. Occasional downturns should not alter long term economic strategy.