Is the Austrian Trade Cycle Theory an Overproduction Theory?
The overproduction theory of the trade cycle holds that the boom of a trade cycle is a period of overproduction. Firms have produced more goods than consumers are willing to buy. So firms reduce prices and production. As firms cut back on production, they lay off workers. This explains both the falling prices and rising unemployment that corresponds to the bust period of the cycle. The initial overproduction may be explained by excessive optimism by either consumers or producers or by an overstimulation of the economy by excessive bank credit. Excessive bank credit may be promoted by a liberal central bank policy.
The Austrian theory of the cycle differs substantially from the overproduction theory. First, it rejects the idea that excessive optimism by itself can cause the boom. The boom must be caused by an excessive expansion of bank credit. This expansion occurs as the result of an unexpected increase in the quantity of money, which enters through the loan markets. In short, banks reduce the rates of interest on loans, inducing firms to borrow the money. The result is not overproduction or overinvestment. Instead the Austrian theory calls it malinvestment. The term malinvestment signifies that the problem is not that too many goods are produced. It is rather that the goods produced are substantially different from the ones that consumers demand. The problem is that the low interest rates mislead firms into thinking that consumers have increased their demands for goods that take long periods to produce. Firms are encouraged to produce goods that take long times to produce but consumers do not want to buy as many of those goods as the firms produce. Thus, the firms embark on longer range investment plans than can be realized, given the true state of consumer demand. Large construction projects which will take twenty or thirty years to pay off are examples.
Another way to think about the effects of the monetary expansion and lower interest rates is to recognize that they distort the prices of the factors of production. The lower interest rates reduce the cost of long-term investments relative to short-term investments in the eyes of the entrepreneurs who own firms. However, these entrepreneurs are misled. The interest rates provide false signals of profitability. If it weren't for the particular way in which the new and unexpected money enters the economy, the entrepreneurs would only make the ordinary type of entrepreneurial errors. They would make some mistakes in their interpretation of consumer demands and production possibilities, but the mistakes would not be systematic.
Because the Austrian theory depends on entrepreneurial errors, if the entrepreneurs knew that the lower interest rates were artificial, they could avoid their losses. There would be no trade cycle. For the cycle to occur, the increase in money must be unexpected.
The bust comes when entrepreneurs finally get the message that the demand for the goods produced with the long term projects is not high enough to justify completing them. At that point the desire for money profit motivates them to give up on the malinvestments and to readjust to the reality of consumer demand. At this point, the long-term project firms lay off workers.
A banking system can complicate this adjustment process by increase the quantity of money still more. But it cannot stop it, since it cannot continually fool the entrepreneurs.
The Austrian theory is described in the following books:
Hayek, F. A. (1933) The Monetary Theory of the Trade Cycle. London: J. Cape.
von Mises, Ludwig (1966). Human Action: A Treatise on Economics. Chicago: Henry Regnery Company, chapter 538
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J. Patrick Gunning
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U.S. Coast Guard Academy
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