The Austrian Business Cycle Theory, Foreign Exchange And Business Cycles

The Financial Crisis of 2008 brought attention, once more, to the problem of business cycles. There are different approaches to study the phenomenon of business cycles. Some of them rest on shocks to the real economy (i.e. productivity of government spending); this is the area of Real Business Cycle Theory (RBC). Other theories rely on monetary shocks that, through an effect on foreign exchange rates, can distort the import/export industries, the financial markets, and finally drive the economy into a crisis. In the opinion of some, however, this is not enough to understand the Financial Crisis of 2008.

William White (2009, p. 16), for instance, argues that:

In short, this crisis provides evidence that the simplifying assumptions on which much of modern macroeconomics is based were not useful in explaining real-world development.

Ricardo Caballero (2010, pp. 85-86) sustains the following:

What does concern me about my discipline, however, is that its current core –by which I mainly mean the so-called dynamic stochastic general equilibrium approach­‒ has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. […] On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crisis, and by doing so it leaves us overly exposed to the new and unexpected.

These are two samples of what seems to be a common position in the discipline: business cycle theories fall short in their effort to explain the extent of the crisis. This may not be enough to say that business cycle theories are wrong, but certainly something seems to be missing. In this context, the Mises-Hayek insight on the problem of business cycle seem to be a candidate to at least complement, if not substitute on some relevant margins, how we think about business cycle problems. This has been considered by some (‘non-Austrian’) economists. Diamond and Rajan (2009, p. 33), for instance, working on a model inspired by the Mises-Hayek insights conclude that:

Our model suggests that the crisis of 2007-2009 may not be unrelated to the actions of the Federal Reserve earlier in the decade, not only in convincing the market that the interest rates would remain low for a sustained period following the dot-com bust because of its fears of deflation, but also in promising to intervene to pick up the pieces in case of an asset price collapse ‒ the so-called Greenspan put.

Axel Leijonhufvud (2009, p. 742) considers that:

Operating an interest targeting regime keying on the consumer price index (CPI), the Fed was lured into keeping interest rates far too low for far too long. The result was inflation of asset prices combined with general deterioration of credit quality […]. This, of course, does not make a Keynesian story. Rather, it is a variation on the Austrian overinvestment (or malinvestment) theme.

It seems, as Oppers (2002, p. 10) says, that the “wholesale rejection of Austrian ideas in the post-war went too far, […] it may be that Austrian factors become more important with the changes in the international financial system in the past twenty years […]. In such an environment, herd behavior and bubbles could encourage malinvestment similar to that envisaged by Hayek.” But the financial crisis was an international phenomenon, not a country isolated problem. It is, then, important to take into consideration that countries have their own fiat currencies. This raises the problem of the foreign exchange relationship between each currency.

If all central banks behave optimally, then one should not expect to deal with big distortions. But the fact that there is one currency per country means that each central bank needs to react to the monetary policy of the other central banks. In this context, foreign exchange stability has become a prime concern of central banks, especially in small and emerging economies where the economy and the government finances are sensitive to the import/export industries. For this reason, avoiding competitive devaluations is one of the main concerns of international monetary policy and institutions like the International Monetary Fund.

But foreign exchange stability does not do away with the problem that the above references suggest one should expect from the Mises-Hayek insights. In other words, foreign exchange stability is not enough to achieve economic stability; other concerns need to be taken into consideration. If a big central bank follows a monetary poliy that is too loose for too long, and the central banks in the periphery decide to maintain foreign exchange stability, then their central banks will be forced to accommodate the expansionary policy. The deviation of one major central bank becomes the deviation of all central banks. Foreign exchange stability is kept at the cost of interest rate disequilibrium. But it is precisely the importance of the interest rate equilibrium where the Mises-Hayek insights fall strong. It is no coincidence that John B. Taylor (2009, p. finds that “housing booms were largest where the deviations from the [Taylor] rule were largest.” Andreas Hoffmann (2010) also finds that the countries in Central and Eastern Europe were also carried to an unsustainable boom when the European Central Bank decided to follow the Federal Reserve’s easy monetary policy.

There seems to be a distance between the Financial Crisis of 2008 and what business cycle models can explain. That distance needs to be bridged with some special components, especially the reaction of the capital structure to movements in interest rates and monetary policy. To the extent that the market process is about the way the capital structure is adjusted, this should be a key aspect of monetary policy and business cycle theories. A sound monetary policy is not so much about foreign exchange or price level stability as should be about interest rate equilibrium. If the later is achieved, the formers follow; but the other way around can easily take us off track, displaying no clear symptom of the growing problems for the monetary policy, just as was the case with the Financial Crisis of 2008.

Caballero, R. J. (2010). Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome. Journal of Economic Perspectives, 24(4), 85-102.

Diamond, D. W., & Rajan, R. G. (2009). Illiquidity and Interest Rate Policy. Cambridge. NBER Working Papers 15197.

Hoffmann, A. (2010). An Overninvestment Cycle in Central and Eastern Europe? Metroeconomica, 61(4), 711-734.

Leijonhufvud, A. (2009). Out of the Corridor: Keynes and the Crisis. Cambridge Journal of Economics, 33(4), 741-757.

Oppers, S. E. (2002). The Austrian Theory of Business Cycles: Old Lessons for Modern Economic Policy? IMF Working Papers 02/2.

Taylor, J. B. (2009). Getting Off Track. Stanford: Hoover Institute Press.

White, W. (2009). Modern Macroeconomics Is on the Wrong Track. Finance & Development, December, 15-18.

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