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[This article is excerpted from chapter 13 of Mr. Callahan's book, Economics for Real People.]

In the economies of most modern industrial nations, a central bank manages the nation's money supply and attempts to control the level of interest rates, at least to some extent. (In the United States, that central bank is called the Federal Reserve. Since it is the most powerful and famous central bank in the world, we will focus our discussion on "the Fed.") Various rationales have been put forward for central bank interference in the market: to supply sufficient currency and credit to "meet the needs of commerce," to ensure a "stable value" for the currency, to "fight inflation," to smooth out fluctuations in the economy, and so on.

In light of our discussion of money and credit so far, those reasons are suspicious. We have seen that prices can adjust to whatever amount of currency is in the economy. Certainly, the adjustment process takes time and has associated costs. Therefore, we'd prefer gradual to rapid change, giving us more time to adjust. The need to dig up gold from the ground in order to create money acted as a regulator on the growth of the money supply during the period of the gold standard. That regulator led to a century-long period of remarkably low volatility in prices. Being able to create new money almost at will, as central banks can, obviously makes it easier to create rapid changes in the money supply. The various hyperinflations that have occurred in the last century, under fiat money regimes, attest to that fact.

Similarly, we have every reason to believe that the best mechanism for matching the businesses' perceived credit needs with the available savings is the interest rate market. What really matters to a business is that it can acquire the goods, the knowledge, and the services it needs to complete its plans during their progress toward producing consumer goods. The cash a business borrows is important only as a means to help acquire those factors of production. If the real factors are not available, because people have not saved a sufficient amount out of current and past production to bring them into existence, then neither increasing the amount of dollars in circulation nor artificially lowering the interest rate will magically bring them forth from the void.

And we have already covered the reason that the search for a stable currency is hopeless: valuation is an aspect of human action, and there are no constant numerical values in human action. Every freely chosen value implies the possibility of a change in valuation. And, far from fighting inflation, the Fed is the main cause of it.

In this chapter, we will examine the final reason listed above, "smoothing out fluctuations in the economy," in some depth. Over the course of the chapter we will see that the central bank tends to be the creator, and not the dissipater, of economic fluctuations. When it is putting on the brakes and deflating a bubble, it was usually the one that inflated the bubble in the first place.

Out of Gas

Image that you are a bus driver, at the edge of a desert, about to take a busload of passengers across it. You have left all gas stations behind. Your destination is a town on the other side of the wasteland before you. You are faced with a trade-off: the faster you try to reach the town, the less the passengers can use the air-conditioning to alleviate the desert heat. Both higher speeds and higher air-conditioning settings will use up the gas more quickly. And since, in our luxurious bus, each passenger has his own temperature control for his seat, you, the driver, cannot control the total amount of air conditioning used on the trip.

In order to make your decision, you look at your fuel gauge and determine how much gas you have. You tell the passengers that they must now make a trade-off between comfort on the way and speed traveled, as the more air-conditioning they choose to use, the faster the bus will consume fuel. Then you collect statements from the passengers on what temperature they will keep their seat. You perform some calculations on mileage, speed, and fuel consumption, and pick the fastest speed at which you can travel, given the amount of gas you have and the passengers' statements about their use of the air-conditioning.

The passengers had to decide whether to cross the desert in greater comfort but arrive later at their final destination, or in less comfort but with an earlier arrival. The science of economics has little to say about the combination that they picked, other than that it seemed preferable to them at that moment of choice.

However, also imagine that, before you began your calculations, someone had sneaked up to the bus and replaced the passengers' real choices with a fake set that chose a higher temperature, in other words, one that makes it seem they will use less fuel than they really will. You will make your choice on travel speed as if the passengers will tolerate an average temperature of, say, 80 degrees, whereas in reality they will demand to have the bus cooled to an average of 70 degrees.

Obviously, your calculations will prove to be incorrect, and the trip will not come out as you had planned. The trip will begin with you driving as if you have more resources available than you really do. It will end with you phoning for help, when the sputtering of your engine reveals the deception.

"Far from fighting inflation, the Fed is the main cause of it."

I offer the above as a metaphor for the Austrian business cycle theory (ABCT), which explains why most modern economies tend to swing through boom times and recessions. You, the driver, represent the entrepreneurs. The gas is the sum of the resources available in the economy. The trip across the desert is some period of production. The passengers represent the consumers. Their choice on how much to use the air conditioning is analogous to how much consumers want to consume now at the expense of saving for the future (i.e., their time preference). The speed of the bus is the amount of investment spending the entrepreneurs will undertake. The ultimate destination is the satisfaction of as many of the consumers' wishes as possible. And it is the central bank — for instance, the Federal Reserve — that has sneaked up and tampered with the consumers' choices.

What the central bank tampers with is the market's reading of the consumers' average time preference, which is the rate of originary interest. Consumers' time preferences tell us how much capital will become available through consumer saving, or, in our metaphor, through cutting back on the air-conditioning.

When the central bank artificially lowers the rate of interest — we hear on the news that the Fed has cut rates to "stimulate the economy" — entrepreneurs make their plans as if consumers were willing to delay consumption and save more than they really are. As the bus driver, you act as if the passengers are willing to endure the heat enough for you to drive 70 miles per hour. In reality, they will force the bus to consume gas so rapidly that you should have planned to drive only 55. Your attempt to cross the desert will fail, leaving you out of gas.

Of course, the real economy does not simply come to a halt. At some point in the trip, it becomes apparent that the bus is using fuel too rapidly. The Fed, expressing a concern about "overheating," will raise rates. The entrepreneurs will slow way down so that the bus does not simply die — they lay off employees, cancel investment projects, and reduce spending in other ways. The economy, after the boom at the start of the trip, has fallen into a recession.

Our metaphor also allows us to differentiate between a "soft landing," a "hard landing," and a full crash. The further the bus has gone before the discrepancy between the market interest rate and consumers' real time preference is accounted for, the "harder" a landing the economy will undergo. If the entrepreneurs discover the error early (or the central bank cuts short the expansion quickly), the bus may only have to slow to 50 miles per hour to complete the trip. If the credit expansion is continued for a long time the bus may wind up having to coast down hills with the engine off — and we have a fullscale depression, or crash.

As we saw in earlier chapters, interest rates reflect consumers' time preference because it is what borrowers must pay lenders, in order to persuade the lenders to delay their own consumption. If I have $100, I could spend it today on a nice dinner with my wife. Or, I could lend it out for a year, at the end of which I could spend it on a somewhat nicer dinner.

Exactly how much nicer a dinner I must expect to receive before I will lend the money is an expression of my preference for current consumption over future consumption. If I demand a rate of interest of at least 5%, that means that a $105 dinner next year is marginally more valuable to me than a $100 dinner this year. On the other hand, if my friend Rob demands 10-percent interest, he is demanding a $110 dinner. He values current consumption compared to future consumption more highly than I do.

The net result of all lenders and borrowers expressing their time preference by offering and bidding on loans is the market rate of interest. In any real interest-rate market, that rate will include, besides originary interest, added interest to account for inflation (or subtracted interest to account for deflation), as well as a risk premium to account for the chance that the venture or person that the money has been lent to will go belly-up.

The rate of interest tells entrepreneurs whether a particular investment is worth making or not. In an unhampered market, without inflation or deflation, that rate would be approximately equivalent to what is termed, in finance, the risk-free rate of interest. Since entrepreneurs can earn that return on their money simply by buying high-grade bonds, they will not undertake capital projects if they estimate that their return will be lower than the risk-free rate of interest. In terms of our analogy, it makes no sense to plan to travel 70 miles per hour on our trip if the consumers are only willing to turn off the AC (put off current consumption) enough for us to travel 55 miles per hour. For any project that returns less than the riskfree rate of interest, the consumers are indicating that they would, in fact, prefer that the resources necessary be used for current consumption rather than being invested in that project.

The Fed Starts A Party

Let's look briefly at the recent Internet boom-and-bust as an example of using the Austrian theory to explain an episode in economic history.

It's been said that the Fed's job is to take away the punch bowl once the party gets going. The aphorism doesn't mention that it was usually the Fed that had filled it in the first place. ABCT has sometimes derisively been referred to as a "hangover theory." In fact, the metaphor is fairly apt. The Fed gets the party ginned up on cheap credit, then has to cut everyone off before disaster strikes.

MZM (money of zero maturity, one of a number of money supply measures) increased at a rate of less than 2.5% between 1993 and 1995. But over the next three years it shot up at an annualized rate of over 10%, rising during the last half of 1998 at a binge rate of almost 15%.

Sean Corrigan, a principal in Capital Insight, a British-based financial consultancy, details in "Norman, Strong, and Greenspan," the consequences of the expansion that came in

autumn 1998, when the world economy, still racked by the problems of the Asian credit bust over the preceding year, then had to cope with the Russian default and the implosion of the mighty Long-Term Capital Management.

Corrigan continues:

Over the next eighteen months, the Fed added $55 billion to its portfolio of Treasuries and swelled repos held from $6.5 billion to $22 billion…. [T]his translated into a combined money market mutual fund and commercial bank asset increase of $870 billion to the market peak, of $1.2 trillion to the industrial production peak, and of $1.8 trillion to date [August 2001] — twice the level of real GDP added in the same interval.

The party was in full swing. The Fed had kept the good times rolling by cutting the federal funds rate a whole percentage point between June 1998 and January 1999. The rate on 30-year Treasuries dropped from a high of over 7% to a low of 5%.

Stock markets soared. The NASDAQ composite went from just over 1,000 to over 5,000 between 1996 and 2000, rising over 80% in 1999 alone. With abundant credit being freely served to Internet start-ups, hordes of corporate managers, who had seemed married to their stodgy blue-chip companies, suddenly were romancing some sexy dot-coms that had just joined the party.

Meanwhile consumer spending stayed strong — with very low (sometimes negative) savings rates. Growth was not being fueled by real investment, which would require the putting aside of current consumption to save for the future, but by the monetary printing press.

Buoyed by the stellar stock market returns, consumers built massive additions to their houses and took trips they otherwise would not have taken. Real estate, especially in the "dotcom areas" such as Silicon Valley, soared in price.

As so often happens at bacchanalia, when the party entered the wee hours, it became apparent that too many guys had planned on taking the same girl home. There were too few resources available for all of their plans to succeed.

"The rate of interest tells entrepreneurs whether a particular investment is worth making or not."

The most crucial — and most general — unavailable factor was a continuing flow of investment funds. (Of course, a continual supply of such funds by the Fed would only extend the boom and worsen the ensuing crash.) There also turned out to be shortages of programmers, network engineers, technical managers, and other factors of production. Internet startups, which had planned to operate at a loss for years by raising capital, found that not only was there less investment money available than they had hoped, but the cost of staying in business had gone up as well!

The business plans for many of the start-ups involved negative cash flows for the first ten or fifteen years, while they "built market share." To keep the atmosphere festive, they needed the host to keep filling the punch bowl.

However, the Fed knows that such a boom cannot be sustained indefinitely without eventual price inflation. Ultimately, if credit expansion continues, it will lead to the crack-up boom, where the economy enters into a period of runaway inflation. Fears of inflation led to Federal Reserve tightening in late 1999, which helped bring MZM growth back into the single digits (8.5% for the 1999–2000 period). As the punch bowl emptied, the hangover — and the dot-com bloodbath — began. According to research from Webmergers.com, at least 582 Internet companies closed their doors between May 2000 and July of 2001. The plunge in share price of many of those that remained alive was gut wrenching. For example, shares of Beyond.com, split adjusted, went from $619 to 79¢. The NASDAQ retraced two years of gains in a little over a year. Unemployment shot upward, and the economy slipped into a recession.

In the fall of 2001, Enron exploded in the largest corporate bankruptcy in US history. It appears, at the time of writing, that some at Enron were at least morally and perhaps criminally culpable in the meltdown. But Enron's rise took place during a period of free-flowing credit, and it crashed once the last call was made. Ponzi schemes, too, thrive when credit is easy.

Another prominent explanation for booms and busts, one that has been applied to the Internet craze, might be called "mania theory." Investors become entranced by some particular investment — tulip bulbs, French colonial trading ventures, Florida real estate, the "nifty fifty" stocks, or Internet companies — and begin a self-perpetuating process of bidding more for the asset, seeing its price rise, bidding even more, and so on. Like a manic-depressive who can only maintain his manic phase so long before crashing, eventually people begin to have doubts about the mania, and it all blows up.

Commenting on the psychology of the theory is beyond the scope of this book. Nevertheless, we can say that there is nothing in the mania theory that contradicts the Austrian account. They look at the same phenomenon from the vantage point of two different sciences: social psychology and economics.

"ABCT has sometimes derisively been referred to as a "hangover theory." In fact, the metaphor is fairly apt."

They may, in fact, prove to be complementary. The Austrian theory offers a coherent explanation of the onset of the mania — a credit expansion — and the onset of the depression — the cessation of the expansion. After all, the mere fact that people are excited about the Internet cannot create a speculative bubble by itself. The funds to speculate with must come from somewhere, and the Austrian theory identifies just where. On the other hand, the mania theory might help explain the reason that booms often do seem to be channeled into certain faddish investments.

Boom, Bust, and the Structure of Capital

The Austrian Theory is concerned primarily with malinvestment, not with overinvestment. Entrepreneurs have spent time and resources on projects that they cannot actually complete and that they would not have undertaken if there had been an accurate reading available of consumers' time preference. As Mises put it in Human Action,

a further expansion of production is possible only if the amount of capital goods is increased by additional saving, i.e., by surpluses produced and not consumed. The characteristic mark of the credit expansion boom is that such additional capital goods have not been made available.

Differentiating overinvestment from malinvestment is only possible because of the key Austrian insight that capital has structure, which we examined in Chapter 8. Many entrepreneurial plans count on complementary capital goods being available sometime in the future. For example, as I launch my e-commerce business, my plan may have a step such as: "Six months after start-up: hire 100 web programmers at $100,000 each annually." But in the intervening months the boom is proceeding. Other companies are flush with cash from the credit expansion as well. As we all begin to hire our programming staffs, it turns out that web programmers are not available in the quantity and at the price we thought they would be. Any company that can't afford to put its plan on hold must bid more for those services.

The new credit tends to flow first into the higher-order capital goods — things like business plans, new buildings, new plants, and so on. It is later, when those goods require complementary goods to continue production on their road toward consumer goods, that the transitory nature of the boom becomes apparent. If real saving had occurred, there would have been a much better chance of the complementary goods being available. Take our example of my e-commerce business: If enough people had been setting aside enough time to learn web programming (a form of saving), then perhaps there would have been enough web programmers available for both my plans and those of my competitors to succeed.

Yet another metaphor for the process by which the Fed "manages" the economy would be that of a hyperactive pediatrician, who never feels that the children under his care are growing at the "right" rate.

The body grows by a process we do not consciously control, based, in ways we only partly comprehend, on genetic makeup, nutrition, rest, exercise, and so on. Each cell responds to its own local conditions, and the net result of all of these responses is the body's overall rate of growth. Similarly, each individual in the economy makes local decisions based on his unique circumstances, the net of which is the overall state of the economy. By using this analogy I do not mean to contend that the economy is "really" some sort of organism, only that the process of economic growth is in some ways similar to that of organic growth.

"The Austrian Theory is concerned primarily with malinvestment, not with overinvestment."

The Fed, the pediatrician of our analogy, feels it can improve on its patient's natural state. It doesn't alter any of the real inputs to the process, such as the number or nature of capital goods available, or the willingness to save. Instead, it fidgets with the economy's "hormonal levels" by adjusting the interest rate. When it makes credit easy, the economy's apparent growth speeds up. In fact, what has occurred is that certain visible manifestations of growth have accelerated, while other, equally necessary but less visible growth processes have suffered as a result. Without the necessary "nutrients" being present, the "growth" is not built on a solid foundation.

The "bones" weaken and cannot support the body. The central bank, fearing a collapse, then tries to reduce the rate of growth through tightening credit. That in no way undoes the damage done during the period of credit expansion, but, rather, adds a new set of distortions to those already present.

Of course, once the central bank has engaged in credit expansion, it is foolish to blame it for reining in the boom. The only alternative is eventual economic collapse in the crack-up boom: hyperinflation and the breakdown of the indirect exchange economy.

The proponents of Austrian business cycle theory do not hold that credit expansion unsupported by savings is the only way an economy can come upon hard times, or that, even when ABCT does apply, that it accounts for all of the hardships experienced in a downturn. For instance, although many Austrian theorists contend that the path to the Great Depression was paved by expansionist central bank policy in the 1920s, they generally acknowledge that ABCT does not fully account for the depths of the crash.

For instance, in the United States, both the Hoover and Roosevelt administrations disastrously attempted to hold post-crash prices, especially wages, at pre-crash levels. That halted the adjustment process of the bust in its tracks and created the mass unemployment that made the Great Depression so notorious. (W.H. Hutt did extensive work on this aspect of busts.) Milton Friedman feels that Fed blunders led to a collapse of the money supply. Austrians acknowledge that further Fed errors would exacerbate the downturn. And at the same time the stock market crashed, the system of international division of labor, made possible by the free trade policies of the late nineteenth century, was collapsing in an international trade war among the increasingly interventionist states of the 1930s. (The infamous Smoot-Hawley tariff was the main American salvo in that war.)

Nor is the Austrian business cycle theory deterministic, in that it does not claim to reveal beforehand precisely where the distortions resulting from an artificially low interest rate will appear. The story we have given here is a typical one, but not the only one possible. When the government sets the price of eggs too low, we cannot say exactly where distortions will appear, but we can say it is likely they will. Piero Sraffa objected to ABCT as stated by Hayek: Why, he asked, couldn't relative wealth changes from the rate cut drive marginal time preferences down to exactly where the central bank had set the rate? Well, we suppose, they could. So could the wealth changes from price-fixing in the egg market just happen to set supply and demand equal. But it would be pure chance and would happen very rarely.

But What About Expectations?

As Economist Richard E. Wagner of George Mason University says, in a paper published in the Review of Austrian Economics, "Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff": "the primary criticism that has been advanced against Austrian cycle theory … is that the Austrian theory assumes that entrepreneurs are foolish in that they do not act rationally in forming expectations."

Wagner goes on to point out that "a variety of occupations and businesses have arisen that specialize in forecasting the timing and extent of all kinds of governmental actions, including those of the central bank." Presumably, entrepreneurs now have better information with which to form their expectations.

The idea of rational expectations entered into economic theory chiefly through the work of Robert Lucas. Justin Fox, in a Fortune magazine article entitled "What in the World Happened to Economics?" explains Lucas's theory as follows:

He argued that if people are rational … they can form rational expectations of predictable future events. So if the government gets in the habit of boosting spending or increasing the money supply every time the economy appears headed for a downturn, everybody will eventually learn that and adjust their behavior accordingly…. But the deductive logic of Lucas and other "new classical" economists led them to the stark conclusion that government monetary and fiscal policy should have no effect on the real economy.

As Austrian theory posits central banking as the primary cause of the cycle of booms and busts that have characterized modern market economies, it is easy to see why a wholesale acceptance of rational expectations theory entails a rejection of Austrian business cycle theory. For instance, Gordon Tullock, in his article "Why the Austrians Are Wrong about Depressions," says:

The second nit has to do with [Austrian's] apparent belief that business people never learn. One would think that business people might be misled in the first couple of runs of the [Austrian] cycle and not anticipate that the low interest rate will later be raised. That they would continue unable to figure this out, however, seems unlikely.

What can Austrian theory say to this objection? If business people, aided by legions of "Fed watchers" and econometricians, could tell just what the Fed (or any other central bank) is up to, would we see a disappearance of the cycle? To begin an examination of that question, I would like to recall the metaphor of the hyperactive pediatrician. Unsatisfied with how his patients were growing, the doctor kept administering doses of hormones that alternately sped up and slowed down that process. Let us imagine that we visit one of these patients after ten years of "treatment." What do we know about this child's height compared to what it would have been without the treatment? Very little, I contend. The child might be taller than he would have been at his natural rate of growth, shorter, or even, by chance, exactly the same height. We might know that, at present, the doctor is applying growth-promoting hormones. But are they merely boosting growth up to where it would have been without the previous round of growth-retarding hormones, or are they boosting it above that?

Entrepreneurs are in a similar situation vis-à-vis the central bank and the rate of interest as it might have been on an unhampered market. When, exactly, could we point to a time when we saw that rate on the market? The Fed is always intervening, attempting to establish some rate. We might assume that, at least some of the time, the Fed-influenced rate has been close to the market rate, but how do we know at which times? Even if we somehow did know that on, for instance, July 12, 1995, the interest rate was at its natural level, how could we relate that fact to what the rate should be now? Fed watchers might be able to tell entrepreneurs that the Fed is easing. But is it easing toward the market rate of interest from some level above it, or further past the market rate from some level already below it? The idea that entrepreneurs are committing significant errors by not somehow divining where the rate ought to be is to criticize them for lacking superhuman capacities.

"The Austrian explanation fits well with the experience of real booms and busts."

Entrepreneurs do know, however, whether the Fed is currently easing or tightening. But here the knowledge that is most important to them is how long that policy will be pursued. The Fed has a motivation to act contrary to whatever expectations the business community forms. If businessmen feel the Fed will raise rates, and therefore they refrain from hiring, undertaking new projects, making new capital good orders, and so on, then the Fed, watching the statistics collected on new hires, capital good spending, etc., will be less likely to raise rates. The Fed will explain that the economic growth seems "under control." Of course, the reverse is true as well: If the Fed thinks businesses, busily hiring, undertaking new projects, and so on, are not anticipating a rate increase, it will be more likely to raise rates — the economy is "overheating."

Wagner's point, mentioned above, that businesses have become better at watching the Fed must be complemented by the observation that the Fed has become better at watching businesses. Entrepreneurs and the Fed have entered into a sort of poker game, and it is hard to see how entrepreneurs can be faulted for not always guessing correctly which card the Fed is about to play.

We must also look at the issue of which entrepreneurs will have the strongest motive to first take advantage of easier credit, and in what position that will place the remaining entrepreneurs.

Let us, for simplicity, divide entrepreneurs into classes A and B. (Such a sharp division is not crucial to our analysis, as you'll see; it is merely a device to simplify our picture.) Class A entrepreneurs are those who are currently profitable, i.e., those most able to interpret the current market conditions and predict their future. Class Bs are struggling, money-losing, or, indeed, unfunded "want-to-be" entrepreneurs, less capable at anticipating the future conditions of the market.

Now, let us go to the start of the boom. It is 1996, and the Fed begins to expand credit. To where does this new supply flow? The As are not necessarily in need of much credit. If they wish to expand, they have available their cash flow. In the state of the market prior to the expansion, they were the ones most able to secure loans. They quite possibly have been through several booms, and, adept at interpreting the state of the market, suspect that they are witnessing the start of another one. They are cautious about expansion under such conditions.

The situation for the Bs is quite different, however. Their businesses are marginal, or perhaps nonexistent. They have previously been turned down for funding. Even if they could tell that they are witnessing an artificial boom, it might make sense for them to "take a flier" anyway. As it is, they are either not capitalized, or on the verge of failing. If they ride the boom, they will have a couple of years of the high life. And who knows, their business just might make it through! Or, perhaps, they will build a sufficient customer base to be purchased, maybe even enough to retire on. In that case, it might not matter to them if their company ultimately fails.

They use the easy credit to expand or start their business. We should notice that the As are much less susceptible to such a motivation — they expect to be "living the high life" anyway, since their businesses are already doing well. As the Bs create and expand businesses, the boom begins to take shape. However, we can see that the actual situation of the As has changed:

Of course, in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher. (Mises, Human Action)

Although the most skilled entrepreneurs suspect that the expansion is artificial, most can't afford to shut down their business for the duration of the boom. But if they can't, they must increasingly compete with Bs for access to the factors of production. Take, for instance, the A company Sensible Software, Inc., and the B company, Dotty Dotcom.

Dotty Dotcom, flush with venture capital and an "insanely great business plan," is luring top Java engineers with salaries matching Sensible's while throwing in stock options that could be worth millions after the IPO. (That is an investment in higher-order capital goods, as top engineers are needed chiefly for more complex projects, which typically can take several years to complete.) Sensible simply cannot afford to lose all of its best programmers to Dotty. It must bid competitively for them.

However, in order to do so, Sensible must take advantage of the same easy credit that Dotty is using to back its bids. At the market rate of interest existing at the start of the boom, Sensible was already bidding as much as it deemed marginally profitable for producer goods. So the A entrepreneurs, willy-nilly, are forced to participate in the boom as well. Their hope is that, in the downturn, the basic soundness of their business and the fact that they have expanded less enthusiastically than the Bs will see them through, perhaps with only a few layoffs.

Or, take the case of a class A mutual fund manager who suspects that stock prices are artificially high. If he simply puts his funds in cash and attempts to sit on the sidelines, he's sunk. All of his customers will leave, and he'll never survive to see the bust that proves he was right. In order to stay in business, he will continue to invest in stocks, perhaps keep a bit more money in cash than usual, and watch carefully for signs of the turn.

Our analysis of the banks proceeds in the same fashion. It is precisely the marginal lenders, those with the least ability to evaluate credit risks, that have the least to lose and the most to gain from an enthusiastic participation in the boom. They will tend to have the strongest motivation to expand credit. The more prudent lenders are eventually sucked in, in order to compete.

The problem is compounded by the tendency of the International Monetary Fund, central banks, and other government bodies to jump in and bail out large investors when they get in trouble. The Mexican bailout of 1994 and 1995, and the bailout put together, at the Fed's urging, after the collapse of Long Term Capital Management a few years later, are two prominent, recent examples of the creation of moral hazard. If you are promised all of the upside of making a risky loan, should the borrower being funded succeed, but are protected on the downside by the likelihood of a bailout, you are much more likely to make the loan!

Our A/B division of entrepreneurs adds to the explanation of the radical difference between an artificial boom and a savings-led expansion. In the latter, the A entrepreneurs are able to sense that the consumers really do desire a lengthening of the production process and an increased investment in capital goods, as demonstrated by increased saving. Therefore, they are eager to take advantage of new credit. There is no reason to turn to the B entrepreneurs to find takers for the new funds.

Of course, there is no sharp A/B division in entrepreneurial ability. That was introduced only to simplify the discussion above, but the fundamentals remain unchanged under a more realistic assumption.

Another source of investment maladjustment from the boom, in addition to the intertemporal one, is the interpersonal one — the Bs are those entrepreneurs whom the consumers least want to have capitalized! One of the corrective forces operating to bring on the downturn is the fact that capital must be wrested back from the Bs and into the hands of the As, who can better satisfy the desires of the consumers.

The Austrian explanation fits well with the experience of real booms and busts. For example, an architect I worked with several years ago was quite aware that we were in a boom phase. He told me stories of witnessing a previous wipeout in Connecticut real estate in the late eighties. He expected another downturn, yet he had expanded his business anyway. There were simply jobs that he couldn't afford to turn down coming his way. Meanwhile, with the established builders so busy, new builders popped up everywhere. When the downturn came in 2001, one local contractor told me, "Some guys are going broke — but they're the ones who should not have been in the business in the first place." As Auburn University economist Roger Garrison said, in commenting on this chapter:

In lectures more so than in print, I have often referred to the "marginal loan applicant" in explaining it all (your Class B entrepreneur). At the operational level, the relevant margin is the creditworthiness of the borrower and not an eighth of a percent difference one way or another in the rate of interest.

The Rate Game

As Wagner points out, the idea that the Austrian cycle depends on systematic, foreseeable errors on the part of entrepreneurs arises from confusion between individual outcomes and aggregate outcomes. Certainly, an omniscient socialist planner in perfect control of the economy, who had by some miracle solved the problem of economic calculation in the absence of a market for capital, would not choose to misalign the time structure of production. But in a market economy, as Wagner says, the "standard variables of macroeconomics, rates of growth, levels of employment, and rates of inflation, are not objects of choice for anyone, but rather are emergent outcomes of complex economic processes."

I'd like to introduce one last metaphor to clarify Wagner's point. Picture a small town centered on a village green. It is an ordinary town, except that the town council has acquired an odd ability and has chosen to use it in a most curious way. Somehow, the council has devised a way to abscond with 50% of each resident's store of goods, including money, every evening at midnight. No effort to hide wealth from the council is of any avail. In a redistributionist fantasy, the council has decided that it will deposit this pile of stuff in the middle of the green every morning at six o'clock, available to anyone who wants to grab some.

"The idea that the Austrian cycle depends on systematic, foreseeable errors on the part of entrepreneurs arises from confusion between individual outcomes and aggregate outcomes."

It is obvious that this activity cannot make the town as a whole better off. In fact, as everyone will now be spending time trying to grab back as much wealth as they can, the town will be worse off. (They obviously had better things to do before this program started, as they weren't all hanging out on the green at six.) Some less-well-off residents may occasionally do OK, but as time goes on, the net effect of the lost productivity will tend to punish them as well. Our process also will alter the distribution of wealth, with wealth moving from those who are best at meeting the needs of the consumers to those who are best at grabbing things from the green.

Still, it is not an economic error on the part of residents to plop down on the green at 5:55 every morning. They are subject to a phenomenon that they cannot control. Each of their micro-level decisions leads them to participate despite the fact that, at the macro-level, the activity is wasteful. There is only one error necessary to generate this wasteful activity, and that is the error of the town council's foolish policy.

During a credit expansion, the entrepreneurs are in a similar position. On the one hand, they may suspect the frantic activity around the green is in the long run unproductive. On the other hand, they cannot produce without resources, without being able to secure access to the factors of production.

To the extent that those factors are being placed out on the green every day, the entrepreneurs must go and participate in the competition to employ them. There are many long-term plans already under way that count on access to those factors. In many cases it is not financially feasible to halt those plans until the central bank's expansion has ended.

Anthony M. Carilli and Gregory M. Dempster, in a paper in the Review of Austrian Economics, look at ABCT from a game theory perspective. As I mentioned earlier, Austrians tend to view game theory as having limited applicability to market exchange. But the relationship between investors and the Fed is like a game in many ways.

Carilli and Dempster employ a simple game theory model to help explain expectations and ABCT. The Fed acts as "the house." The players are the investors. The best net result for all of them is when no one takes advantage of artificially low rates. But for any individual player, the worst result is when he fails to take advantage of the low rate while all of his competitors do take advantage of it. And the best result for each individual player is when he does take advantage of the credit expansion while his competitors don't. Since no entrepreneur can count on all of his competitors to abstain from the easy credit, his best move is to get "his bus" heading across the desert first.

Earlier, we had a single bus driver, representing the entrepreneurs, driving a single bus, representing the economy. The passengers (the consumers) had voted on a level of air-conditioning for the trip, but the Fed had replaced their vote with its own.

To incorporate the game theory perspective, we need to have many buses crossing the desert, each with its own driver. Meanwhile, scattered across the desert are several gas stations, with limited supplies of gas, where the drivers can refuel. The drivers are competing for passengers, who will, to a great extent, board a particular bus based on the combination of comfort and speed that the driver offers them. The drivers, while knowing that they do not have the passengers' real preferences on air-conditioning, do not know what those preferences are, or how the temperature they have been handed actually relates to those preferences.

In particular, the drivers (entrepreneurs) who first take advantage of a low apparent time preference from the passengers have the best shot at making the crossing. They will arrive at the intermediate gas stations first, and have the first shot at the scarce gas available to complete the crossing. Meanwhile, the drivers who hesitate to use the low apparent time preference may not attract any passengers.

In addition, as the supposed air-conditioning preference (the interest rate) is lowered, it lures more drivers into the business, many of whom are not really qualified, but may have no better shot at "making it" than to attempt the desert crossing. Perhaps, after all, they will get across! It is clear that the situation is far from optimal.

Whenever the Fed sets a supposed demand for air-conditioning (current consumption) that is too far below the real one, many buses will fail to make the crossing. Recovering from the problem (liquidating the failed investments, or, we might say, sending out the tow trucks) adds unnecessary costs to production, creating the losses of the downturn. But it is hard to see why the bus drivers are to blame.

Gene Callahan is studying at the London School of Economics. He is the author of Economics for Real People, from which this article was excerpted. His first novel will be available in June, 2006. Send him mail. See his archive.