Sunday, January 30, 2011

The Austrian School of Economics

Pictured Above: The Great Ludwig Von Mises

I am not a strict adherent to the Austrian School of Economics and Ludwig Von Mises, because I recognize that their methodology poses some problems, however their explanation of the business cycle does seems to fit our current situation. As with any school of thought, it's worth exploring and integrating the more sound theoretical elements into your worldview and rejecting that which does not stand up to the tests of observation, experience and analysis.

Austrian economists focus on the amplifying, "wave-like" effects of the credit cycle as the primary cause of most business cycles. Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.[35]

According to the Austrian business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "monetary boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable.

Austrian economists argue that a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when credit creation cannot be sustained. They claim that the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

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