Section [ ]. Austrian Business Cycle Theory
In light of the problems with other potential explanations discussed in the preceding section, a theory is needed which would formulate a mechanism through which economic crises are caused by the economy becoming temporarily less capable of producing enough of what consumers actually want in a genuine way. One promising candidate is the Austrian Business Cycle Theory (ABCT).
In this paper, I will attempt to apply to the US Great Depression and the period preceding it in which its causes should be sought the version of ABCT formulated in more detail elsewhere .
The version of ABCT in question tries to assign a definite meaning to the rather vague intuition that the unsustainable boom preceding the bust and economic decline consists in an unjustified lengthening of the economy’s temporal production structure in comparison to the time structure of consumer demands. The proposed answer is to put into the focus the micro-level elements of such deviations – the excessively long investment projects.
The latter projects are excessively long because they divert certain types of resources (the “contested goods”) away from competing projects (the “closer-to-production projects”) which would have resulted in the production of final consumer goods earlier, and whose product would have been in keeping with the consumer demands. There does not need to be an absolute difference in duration among these two clusters of projects; just that by the time the excessively long projects are launched they must be further than the closer-to-production projects from resulting in the production of final consumer goods.
The excessively long projects may manage to divert the contested goods from the closer-to-production projects because the credit expansion may temporarily provide them with funds for investment at interest rates which makes them more profitable than they were before with nothing else changed. In contrast to this scenario, an increase in the amount of investable funds through increased savings would first have led to decreases in the prices of some consumer goods and then, in turn, in some of the inputs used to produce them. This would serve as a signal which of the previously unprofitable projects have become more profitable and would motivate entrepreneurs to seek credit financing for exactly such projects. Overall, this would tend to channel the savings-based additional credit into non-distorting applications.
In the ABCT scenario, the originators of the excessively long projects are capable of securing the supply of part of the contested goods needed for their undertakings at prices which do not properly reflect the fact that the demand for these goods for the relevant period has significantly increased compared to the expectations based on the past realities. This leads to the excessively long projects becoming illusorily more profitable than they actually are. The economic realities reestablish themselves when the originators of the closer-to-production projects discover that they are suddenly in competition with the excessively long projects for the contested goods, and that they are not able to secure the full supply of the needed contested goods at the current prices. The shortage of the relevant final consumer goods leads to the increasing prices which, in turn, allows the originators of the closer-to-production projects to bid up the prices of the contested goods. This frustrates the calculations on which the excessively long projects are based and creates cost overruns which may be fatal for them.
The economy-wide problems arise from the resultant malinvestments because part of economy’s capital goods are trapped in the troubled excessively long projects and it takes time and resources to reallocate it. The time factor does not just concern mere physical reallocation, the new uses for the capital need to be discovered by entrepreneurs who also need to secure funding for the reallocating projects.