Kelvin Teo
New Asia Republic invites you to our inaugural economics lecture on the Austrian Business Cycle at the Singapore Management University which will be held on 19 August 2011 from 730pm to 830pm.
The 2008 Financial Crisis is back to haunt us.
Martin Wolf, the Chief economics commentator at Financial Times, devoted a blog commentary on Austrian economics where he opined that economists working in the Austrian tradition were more nearly right than everyone else from other schools of economic thought when it came to predicting the 2008 Financial crisis. Friedrich Hayek, a economic Nobel Laureate luminary within the Austrian ranks was believed to have predicted the Great Depression, and in recent times, economists from the school proved to be spot on in their prediction of the recent financial crisis. As a result, this led to a surge of interest in the Austrian thought, in particular, the concept of boom and bust cycles, formally known as the Austrian Business Cycle theory (ABCT).
The ABCT is a major contribution by the Austrian school, which attempts to explain boom and bust cycles within an economy. What brings about the boom part of the cycle? The most common explanation by Austrian economists is credit expansion by the banking system. How does credit expansion or put more specifically creation of money occur? Suppose the central bank has a sum of $10,000. The bank keeps a certain percentage of this sum of money, say 10% as cash reserves. Thus, it will have a cash reserve of $1000, and the other $9000 will be loaned out and deposited into a member bank. The member bank will keep 10% as cash reserves and loan out $8100 which will be loaned to another private bank. This private bank will keep 10% of the $8100 as cash reserves and loan out $7290 to another bank. Thus, this process of storing a fraction of deposits as cash reserves and loaning out the rest goes on. The total money supply is the summation of deposits ($10,000 + $9000 + $8100 + …. and so on). Such a practice of not retaining deposits in their entirety in the expansion of money supply is known as fractional-reserve banking. Put simply, this credit expansion is simply the central bank lending to members banks, with the latter lending part of the deposits to private banks and so on which increases the money supply.
What results in the boom phase of the cycle? Economists Anthony M Carilli and Gregory M Dempster published an insightful piece entitled “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma” in the journal, The Review of Austrian Economics, describing a situation in which banks increase their lending and with entrepreneurs or businessmen taking up the loans. In a situation where savings, and therefore, saving deposits in banks have not increased (i.e. no increase in saving), the wise move for the bank is not to increase lending. To increase lending will be to increase liquidity risk, a situation where banks have reduced cash reserves and are unlikely to meet demands for deposits withdrawal. However, the decision on whether or not lend is also motivated by bankers’ desire to gain profits from borrowers who pay interests on their loan. Each bank realises that if it does not increase lending, it will lose potential customers (borrowers) to other banks.
From there, there are two possible courses for banks to take – 1) cooperate or form an agreement with each other not to increase loans 2) Do not cooperate and maximise profit by increasing loans. And at the end of the day, it will be the profit maximising motive of banks that see them issuing more loans. This is an example of Prisoner’s dilemma, where two or more actors choose not to cooperate when cooperation is in their best interests.
The next question is why are entrepreneurs or owners of firms willing to take out loans from banks? As it is, loans are needed to fund projects with the goal of increasing profits. Investments in such projects will allow firms to gain a competitive edge over their rivals. However, multiple firms would have thought of this move of taking out loans from banks to invest in projects, each hoping to gain an edge over its rivals.
What leads to the bust phase of the cycle? With increased lending by banks and entrepreneurs happy to take up loans to fund their investment into projects, there will come a time when the realisation has hit home that such projects are not profitable after all. As a result, such projects are left abandoned. This is the bust phase of the cycle. Entrepreneurs are limited by their ability to predict future patterns of consumer demand or more cost-efficient approach of satisfying demand at the time of initial investment. This phenomenon is known as malinvestment.
The next question is what should be the appropriate response during the bust phase of the cycle, which is better known to us as a financial crisis. It is easier perhaps to start with the “don’ts”. An important “don’t” for governments to realise is don’t hand out grants or bail out firms in distress. For instance, if a firm is making a $3000 loss, a grant of $3000 will help it to break even, but the fundamental question is whether the grant represents efficient use of resources. The second issue is that grants and bail-outs would create a moral hazard situation – firms guilty of malinvestment or have made poor investment decisions would end up with the assumption that they would be bailed out for wrong moves they have made, and will continue to malinvest or make poor investment decisions.
The problem with such grants and bail-outs is that they do not address the crux of the issue, that the loss making firms are not making efficient use of capital and the best correction will be liquidation that allows inefficient uses of capital to be passed into more efficient uses. Bailing these firms out will only delay the inevitable. When the grants or bail out package dries up, liquidation is an eventuality. However, in the event that the government does not intervene with grants or bail outs, firms have a number of options to limit their losses – costs cutting and liquidation of investments in projects or simply liquidating malinvestments.
Now, what is a very important “do” in coping with a financial crisis or bust phase? It is simply tax cuts, in the form of business tax cuts and individual tax cuts. Recall, the example of the firm who has made a loss of $3000. With a tax cut of $3000, the firm will break even. In combination with cost cutting measures, which is a prudent move made by firms in response to a bust, the firms will become profitable again. Cost cutting measures will include salary cuts and liquidation, the latter of which results in unemployment, thus, individual tax cuts across the board will help the workers cope with the crisis. Though liquidation will result in eventual unemployment, it is also a process that frees up resources utilised inefficiently that can be put into efficient use. This is part of the economic recovery process.
It must also be pointed out that it is taxes that fund grants or bail out packages. If we think about the whole scheme of how things work, it will be the business taxes and individual taxes, paid by firms and the population that will form the grants and bail out packages. It isn’t a good idea to begin with to tax everyone else to fund businesses or firms that are not making efficient use of capital, simply put, resources are diverted in the form of taxes from other areas to firms who are not using them efficiently. With tax cuts, however, the eventuality that government spending will decrease (because government spending, including that on grant and bail out packages is funded by taxes).
The combination of tax cuts, non-interference in the economy (through grants and bail out packages) and reduced government spending has worked before. When faced with a severe recession in the 1920s and an unemployment rate looming at an ominous 12%, President Warren G Harding reduced taxes and government spending. That move pulled the entire country out of recession in 6 months, and is considered the quickest and most successful efforts in dealing with a financial crisis in US history.
In a financial crisis, it is not unusual for people to turn to the government for solutions. The solution ironically is not for the government to do much, except to cut taxes and reduce spending eventually. In not intervening with the economy, the economic ecosystem is allowed to readjust itself, with the freeing up of resources otherwise utilised inefficiently to areas where they can be used efficiently. This is known as a laissez-faire approach.
—
Photo courtesy of MyEyeSees, Flickr Commons
That’s is why I don’t think we can sustain TH/GIC.
Their return rates are so low.
If positive.
It is better for them to close shop