Keynesian Vs. Austrian approach to the business cycle theory - Dissertation Économique

The business cycle is a theory to which it is believed that an economy goes through different and separate phrases of economic expansion and contraction. Two economists renowned for observing and explaining about the business cycle are Keynes and Hayek. Although both economists explain the business cycle their views on the causes and effects of the business cycle differ greatly. Keynes believed that government intervention within markets is ideal for the economy. Contrary to this, Hayek and the Austrians believe the general consensus behind the bust of an economy is due to the central bank of a nation lowering its interest rates. This illusion provides a false sense of confidence for entrepreneurs, as the resources of what they think are available is a mismatch to what resources are actually available. Austrians believe this system is unsustainable. The act of lowering interest rates is not necessarily bad, it is how the central bank that does it which is the main point of contention. Many economists believe that lowering interest rates by pumping more money into the economy is an artificial way of recovering an economy, and thus does not address the actual issues of an economic boom and bust.

The source of economic growth is to trade. In addition to trade and consumption, consumers must also be aware of saving and investing their resources. The more resources that are spent on consumption and less on savings, the fewer resources there will be left for investment and ultimately future economic growth (Mahoney). In order for an economy to increase its quality and quantity of resources, people most forego consumption and instead save and invest. This has proven to be challenging as everyone has different time preferences; The majority of people’s time preference is that they want the shortest possible time preference meaning that they want the shortest possible duration of attaining their desires, thus foregoing the future and instead more intent on focusing on the present.

An example of time preference would be the story of Robinson Crusoe, a fictional novel depicting a sailor stranded on an island by himself . On this island there are edible berries for him to collect to satisfy his own hunger. Crusoe is often used as an explanation about time preference as he has the choice of choosing between the lowest or highest time preference; If he chooses the lowest time preference he forgoes current consumption of berries

and saving them for later (Rothbard). During this time he invents a tool that will enable him to collect more berries at a more efficient rate. By investing his time and saving berries for later consumption, Crusoe is able to collect a larger quantity of berries thus gaining more in the long run (Rothbard). The idea of a Robinson Crusoe economy is to entice consumers to save and invest in order to gain greater quantity and quality yields of production.

The reason as to why the business cycle draws many criticisms is due to the artificial improvement in the economy. As more money is pumped into the economy, money supply increases but also inflation occurs. This stimulus into the economy creates an illusion that there appears to be more than there really is. This artificial solution is unsustainable. Hayek also criticizes the fractional reserve banking system, he states that this system is a fraud and is unsustainable. If an individual makes a deposit to the bank one would assume that he is able to withdraw the full amount at any time. In reality this is not the case with the fractional reserve banking, banks hold a fraction of the deposit and the remainder is loaned out. The reason as to why many Austrians disapprove of this banking system as it provides banks with the means to increase their wealth but leaving those that have made deposits to the bank vulnerable to losing their wealth.

There are numerous times in which banks have defaulted as a result of this system the most recent significant event would have to be the 2008 housing market crash in the United States. During this time banks would give out loans to practically anyone even those with bad credit scores. Many people were too caught up with the low interest resulting in many taking out loans from banks. This reckless lending by the banks resulting in many being unable to pay their mortgages due to their bad credit resulting in some financial institutions defaulting. Banks are not supported by any actual funding instead funded through fiat money which in actuality has no real value when compared to the gold standard. Central banks and government have been bestowed upon tremendous power as they are the ones that determine the worth of the paper money currency. Austrians are against this and are in support of there being a gold standard however in reality this is not the case. Since money is no longer backed by a gold standard, this enables the government to produce as much paper money as they need.

Solutions that are proposed and supported by the Austrians is the establishment of the gold standard instead of the current monetary funding is by fiat money which has no real value. The belief is that the gold standard will be more stable and more unlikely to fluctuate when compared to fiat money. This stability gives more confidence for entrepreneurs and investors. In addition to confidence in investing the exchange rate and purchasing power of a currency that is backed by fiat money quickly depreciates. This quick depreciation leads to over indebtedness to which results in people being unable to pay off their debts.

Some objections towards the Austrians theory of the business cycle, Richard Wagner states that “the Austrian theory assumes that entrepreneurs are foolish and do act rationally in forming expectations” (Callahan, 223). Essentially Wagner’s argument is that he believes that the Austrian theory is very presumptive as he questions whether or not Austrians believed that entrepreneurs and businesses never learn from their mistakes.

A prime example of the business cycle going through the boom and bust phases is the current situation that most economies are now facing. An article written by the CBC reported that central banks around the world are slashing and significantly lowering their interest rates in an attempt to help keep the economy afloat and still help stimulate consumer spending (Evans). The belief is that by lowering the interest rates at a substantially low rate, it would entice people to spend and invest their money. However as a result of banks significantly lowering interest rates many economies around the world may face a recession. Despite their best efforts, consumers however are unlikely to increase their consumption as the impact of the virus has left many businesses closed and many employers laying off their employees.

There are also ethical decisions relating to the economy and the pandemic. Governments are left with the tough decision of deciding between maintaining economic activity and the health of the people. Many economies around the world are attempting to juggle both by not shutting down all businesses or by attempting to restart the economy as soon as possible. Some industries may never recover in certain countries; customers may have gone to foreign suppliers or gone bankrupt. Long term damage may be there. Some economists are even predicting that the effects of the global pandemic may have long lasting effects citing similarities between the late 1920s great depression. This point is highly debated in the Keynesian perspective: the cause of the great depression was a result of aggregate demand contracting rather than expanding. Contrastingly Austrians believed that the bust of the great depression was related to bad investment as a result of the illusion that the increase of money supply had created.

In conclusion the business cycle and money is volatile due to the introduction of fiat money and government intervention. The volatility which leads to a bust in the business cycle is due to the governing intervening on interest rates my pumping money leading to an increase in the money supply, this action creates an illusion of there being more than there really is resulting in investors and consumers investing in bad projects. The Austrians believed that the boom within an economy is a result of individuals saving their money and wealth and investing it wisely when the economy is stable. Although there are clear differences in perspective between Keynesians and Austrians, both ideologies share a common goal of wanting there to be a stable and prosperous economy.

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