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Austrian Business Cycle Theory: A Modern Appraisal

Andrew T. Young Department of Economics College of Business and Economics West Virginia University Morgantown, WV 26506-6025 ph: 304 293 4526 em : Andrew.Young@mail.wvu.edu

September 2012

JEL Codes: B53, B22, E30, E40, E50, R30 Keywords: Austrian business cycle, Federal Reserve, GSEs, financial crisis, housing market, structure of production, structure of consumption, risk structure I thank Chris Coyne, Pete Boettke, and Steve Horwitz for helpful comments on a previous draft. Errors are inevitable and invariably my own.

Austrian Business Cycle Theory: A Modern Appraisal

Abstract: Austrian business cycle theory (ABCT) is a body of hypotheses embodying particularly Austrian insights and assumptions. The canonical variant associated with Mises (1934, 1963) and Hayek (1933, 1935) is particularly well-suited to the Great Depression. However, it is an inadequate account of the recent US recession and financial crisis. This paper develops a suitable ABCT variant that explicitly incorporates not only the economys time structure of production but also (1) its structure of consumption and (2) its risk structure. The continuous input-continuous output nature of the housing market is highlighted, as well as the Treasury and Federal Reserves roles in externalizing the risk associated with GSEs debt. This paper then extends Garrisons (2001) graphical framework to illustrate this ABCT variant.

JEL Codes: B53, B22, E30, E40, E50, R30 Keywords: Austrian business cycle, Federal Reserve, GSEs, financial crisis, housing market, structure of production, structure of consumption, risk structure



According to the National Bureau of Economic Analysis (NBER), the fourth quarter of 2007 witnessed the end of nearly seven years of economic expansion in the US and the beginning of what is now known as the Great Recession. The economy was rocked by financial crisis in 2008. By the NBERs reckoning economic activity contracted for a year and a half. The unemployment rate reached a high of 10.6 percent and, as of this writing, remains at 8.2 percent. 1 Furthermore, if discouraged workers and part time workers who would prefer to have full time jobs are taken into account, US unemployment stands at about 15.6 percent. While the NBER dates the beginning of an expansion in the third quarter of 2009, real GDP growth has proceeded at an annualized rate of less than 0.9 percent in 2011. 2 Federal Reserve chairman Ben Bernanke felt confident in June of 2010 that a doubledip would not occur: My best guess is that well have a continued recovery [though] it wont feel terrific. However, by October of 2011 he was testifying to Congress that the recovery is close to faltering. 3 The anemic nature of the recovery if one can even call it that! comes as no surprise to students of the Austrian business cycle theory (ABCT). In light of the exceedingly loose monetary policy beginning in 2002 (John B. Taylor, 2009) and the massive expansion of the mortgage market by Fannie Mae and Freddie Mac, their

According to the Bureau of Labor Statistics for June of 2012: http://www.bls.gov/news.release/empsit.nr0.htm. 2 This statement is based on initial real GDP numbers published by the Bureau of Economic Analysis on September 29, 2011. These number, of course, will be subject to (what may be economically significant) revision as time passes. 3 Bernanke: No Double-Dip Recession (http://www.foxbusiness.com/story/markets/businessleaders/bernanke-double-dip-recession/) and Bernanke Urges Obama and Congress to Do More for Economy (http://www.nytimes.com/2011/10/05/business/economy/fed-chief-raises-doubts-onrecovery.html?ref=bensbernanke).

intuitions suggest that a policy-induced expansion of credit resulted in a misallocation of resources across economic structures. Such a situation can be rectified only through a reallocation of resources into sustainable structures via markets. For students of ABCT it is no wonder that the Feds new discounting facilities have failed to reflate the economy. The ineffectiveness of the Troubled Asset Relief Program (TARP) and the separate $168 billion and $787 billion Congressional stimulus packages also come as no shock. 4 However, while Austrian insights apply generally to business cycles, ABCTs most prolific modern expositor, Roger W. Garrison (1994; 2001, ch 6), argues that different variants of the theory are appropriate to specific business cycle episodes. For example, while what I will refer to as the canonical variant of ABCT (developed by Ludwig von Mises (1934, 1963) and Friedrich A. Hayek (1933, 1935)) focuses on policyinduced changes in the intertemporal structure of production, Garrison argues that changes in the risk structure of production were more relevant to the 1990-1991 US recession: Like the time-consuming production processes that were out of line with time preferences, speculative loan portfolios that were out of line with risk preferences generated an artificial boom in the 1980s that belonged to the same general class as that of the 1920s. However, the distinction between economic activities that are excessively speculative together with some institutional considerations allows us to see systematic differences between the 1930s and 1990s (Garrison, 1994, p. 15).

It is easy to forget just how many new Fed facilities came into existence in the aftermath of the crisis: Term Auction Facility (2007); Term Asset-Backed Securities Loan, Primary Dealer Credit, Commercial Paper Funding, and Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facilities (2008); Money Market Investor Funding Facility (2009).

While the canonical variant of ABCT was developed to account for the unsustainable boom of the 1920s and the subsequent Great Depression, for the business cycle experiences of the 1980s and 1990s, [p]arallels can be found not in the strict sense of a replay but in the broader sense of variations on a theme (Garrison, 1994, p. 8). 5 The purpose of this chapter is twofold. First, I argue that the US experience from roughly 2002 through the present is, in a general sense, an Austrian boom-bust cycle; but that Austrian economists have largely cast the episode in terms of the anachronistic canonical model. Second, I articulate a specific variation on the ABCT theme that more closely accounts for recent events in the US. This variant incorporates two key elements absent from the canonical variant: (1) the risk-externalization of debt issued by the government-sponsored entities (GSEs), Fannie Mae and Freddie Mac; and (2) the continuous input-continuous output nature of the housing market. The externalization of GSE debt casts the Federal Reserve in a supporting (indirect) role in fostering the boom. 6 The continuous input-continuous output nature of housing implies that the cycle features symmetric distortions of the risk and time structures of both production and consumption. I set about on my task as follows. In section 2 I briefly describe the canonical variant of ABCT against which what follows can be juxtaposed. Next I argue in section 3 that a correct accounting of the recent US business cycle must incorporate the role of the GSE mortgage giants in reallocating resources to the housing market. In particular, I

Compare Garrisons analyses to those of Arthur M. Hughes (1997) (and Paul Cwiks (1998) comment on that paper) and Cochran and Yetter (2004). John P. Cochran and Noah Yetter explicitly evoke Garrisons (2001) analytical framework but only to the extent that is exposits the canonical ABCT. Empirical studies based on data that cover the 1980s and 1990s also largely motivate their analyses in terms of the canonical ABCT (e.g., Andrew T. Young (2005), James P. Keeler (2001), and Robert F. Mulligan (2002, 2006)). 6 Garrison (1994; 2001; ch 6) stresses the risk-externalization associated with federal debt finance as the direct cause of the 1980s boom; the Federal Reserve plays the supporting role by making default risk on treasuries effectively zero via its ability to monetize the debt. In the variant of ABCT developed below, both the US Treasury and the Fed play supporting roles in externalizing the risk associated with GSE debt.

highlight the continuous input-continuous output nature of the housing market as well as the Treasury and Feds supporting roles in externalizing the risk associated with GSE debt. I then develop a variant of ABCT in section 4 that expands upon Garrisons (2001) the graphical framework. I provide a brief concluding discussion in section 5.


ABCT: The Canonical Variant

Austrian Business Cycle Theory (ABCT) provides a coherent story of a boom-bust cycle that is a consequence of credit inflation by a central bank (Mises (1963, 1934); Hayek (1933 & 1935)). The theory starts from a hypothetical equilibrium in the time structure of production and then derives the predictable results of a central bank disrupting that equilibrium. 7 The canonical ABCT came to prominence when Mises Theory of Money and Credit was translated into English in 1934 and, importantly, it was refined and presented to English-speaking audiences by Hayek (1933 & 1935) upon his arrival at the London School of Economics. Hayeks refinement and exposition of Mises theory was tailored to account for the Great Depression and the preceding boom in the 1920s. Prominent economists such as Gotfried Haberler (1932, 1937) and Lionel Robbins (1934), who adopted much of the Austrian perspective, further entrenched the discussion, unsurprisingly, in the context of the Great Depression.

Richard E. Wagner (1999, p. 66)) argues that the Austrian cycle theory has no place within the confines of a general equilibrium theory. He advocates a through recasting of the theory in the corpus of coordinationist [sic] macro theory with its focus on the emergence of spontaneous order. I am sympathetic to this criticism but ultimately feel that equilibrium theory is a convenient way to summarize the tendencies resulting from individuals actions in the business cycle context. The variant of ABCT elaborated on below will be a general equilibrium analysis. Walter Block (2001) criticizes Wagners attack (p. 64) on ABCT. However, a close reading of Block reveals that he focuses on what Wagner claims are implications of ABCT conditional on taking general equilibrium analysis too seriously. In other words, while Wagners article aims at saving the wheat while discarding the chaff (p. 65) of ABCT, Block replies that we have no chaff (p. 63) and then proceeds to criticize precisely the chaff.

When these authors looked at the events preceding the Great Depression and in particular the policy environment under which the events unfolded what exactly did they see? As Garrison (1994, p. 9) comments, the 1920s were characterized by (relatively) tight fiscal policy and loose monetary policy; furthermore, the money growth rate peaked near the end of the decade as the Federal Reserve attempted with increasing resolve to keep the boom going (p. 7). It is little wonder, then, that the canonical ABCT focuses on the (i) time structure of production, (ii) the potential for credit inflation to disrupt the relative prices of current versus future goods, and (iii) a misallocation of resources across more- versus less-time consuming production processes. Any discussion of the original Mises-Hayek ABCT begins with the observation that the production of goods and services is time-consuming. Resources will pass from firm to firm as they are fashioned from raw materials into intermediate goods and then finished goods. (Even if only a single firm is involved, internal production is still timeconsuming.) The finished goods themselves may be consumption goods or capital goods. If they are capital goods they will be used in the production of yet other goods and that will take time as well. Production is always time-consuming. Whether it is more or less so will depend on available technologies and the preferences of consumers for various goods and services. Concerning technologies, Eugen von Bhm-Bawerk (1959 [1888], v. 2, p. 12) built Austrian capital theory upon the proposition that the adoption of roundabout methods of production leads to greater returns from the production process. He considered this one of the most important and fundamental tenets of the whole theory of

production: more roundabout (i.e., time-consuming) production methods tend to be more productive. 8 To use a well-trodden example from economics (Rothbard, 1962, p. 50), Robinson Crusoe can catch fish using only his hands. He will be more productive if he uses a net. However, he must take time to fashion a net from nature-given resources before he can use it. While more roundabout production methods tend to be more productive, it is also true that people value time; they discount the future. 9 Implied, then, are tradeoffs for consumers between more goods later (that are ceteris paribus less valuable) versus fewer goods sooner (that are valued more). This creates profit opportunities for certain individuals entrepreneurs who are particularly savvy in ascertaining and acting upon consumers perceptions of these tradeoffs. Entrepreneurs are successful, in general, when they demonstrate alertness to hitherto undiscovered opportunities (Kirzner, 1973, p. 31). In doing so, of course, market prices are indispensable. When dealing with intertemporal tradeoffs, market interest rates embody the relative prices of goods sooner versus those only available later. Entrepreneurs discover discrepancies between the present prices of the complementary factors of production and the anticipated prices of the products minus the rate of interest (Mises, 1963, p. 547). On a given market for finance, a higher (lower)
See M. Northrup Buechner (1989) for an argument that Bhm-Bawerk did not equate roundaboutness and time-consuming in his analysis. I am unaware of much modern debate amongst Austrian economists on this point. However, for my purposes I only contend that Mises, Hayek, and their followers proceeded as if he did equate the two. 9 Rather than assuming that more roundaboutness processes tend to be more productive, as a technological fact, Rothbard (1993) provides the following reasonable interpretation that is a sufficient foundation for what follows: The first process to be used will be those most productive [...] and the shortest. [...] No one has maintained that all long processes are more productive than all short processes. The point is, however, that all short and ultraproductive [sic] processes will be the first ones to be invested in an established. It follows, then, that any more roundabout production processes that are actually invested in an employed will be more productive than the less roundabout processes in use. This is precisely because people discount the future (which is a fact of human action).

interest rate signals a higher (lower) price for current goods relative to those for future goods; higher (lower) time preference on the part of the marginal consumer. 10 Interest rates are determined on markets where entrepreneurs recognize the potential for higher productivity via more roundabout methods. They must obtain funds from savers who prefer goods today to goods in the future. Since individuals saving decisions imply their consumption decisions, the market interest rates will tend towards expressing the tradeoff between the productivity gains from waiting and consumers time preferences. But like any other market, if prices are regulated or otherwise manipulated by policy to not accurately express relevant tradeoffs, surpluses and shortages will develop. Funds will be allocated in ways that are inconsistent with consumers time preferences and the available technologies. Consider what happens when a central bank increases the growth rate of an economys money supply, inflating credit and lowering interest rates below their free market, natural rates (Wicksell, 1936 [1898]). To entrepreneurs this is a signal that the supply of savings has increased; consumers have become more willing to exchange goods today for goods in the future. Entrepreneurs respond by undertaking more roundabout ventures those to produce future goods, the demand for which entrepreneurs expect to manifest in the future. (Entrepreneurs are led to believe that people are saving more now so that they can increase their demand for goods later.) This represents the boom phase of the ABC.

The time preference component of interest rates is stressed in the canonical version of ABCT. This is what Mises (1963, p. 526) refers to as originary interest: the ratio of the value assigned to wanting satisfaction in the immediate future and the value assigned to wanting satisfaction in the immediate future. The risk premium component of interest rates is given attention in the account of the 1990-1991 recession and preceding boom offered by Garrison (1994; 2001, ch. 6).


The boom creates discrepancies between the investment plans of entrepreneurs and the plans of consumers. In particular, planned investments outstrip planned savings. Of course, at any given time more resources cannot be invested than are available. However, planned investments are projects that are pursued and completed over time. They involve both higher-order and lower-order goods, which are terms that Austrian economists use in reference to, respectively, goods applied during earlier and later stages of production (Menger, 2007 [1871]). The fact that the higher-order goods associated with an investment are available today does not necessarily imply that the lower-order goods needed to complete the investment will be available tomorrow. During the boom entrepreneurs reallocate resources towards more roundabout production processes with more stages of production. As the planned investments begin, the credit inflation places cheap money into the hands of entrepreneurs. The lowered interest rates signal to entrepreneurs that consumers are more future-oriented; that they are willing to forego enough resources to complete investments in more roundabout production processes. Since the new money enters the economy specifically through the entrepreneurs purchases of higher-order goods, the prices of those goods rise relative to the prices of lower-order goods (both consumption and investment goods). 11 This supports entrepreneurs interpretation of the lower interest rates. There are neither indications that consumers time preferences have not fallen nor that the planned investments cannot be affordably completed.

When the effect of new money on the economy is a function of the specific individuals, firms, industries, etc., that are the initial recipients, this is referred to as a Cantillon effect, after the 18th century economist Richard Cantillon. Recently, Mark Thornton (2006) has argued that Cantillon is the intellectual forefather of ABCT.



However, a bust is inevitable as entrepreneurs continue to pursue roundabout production processes to produce future goods for which no demand exists. As investments continue, this generates income for the producers of higher-order goods. Of course, their time preferences have not really changed and they express their demand for consumption (lower-order) goods. This leads to increases in the prices of those lowerorder goods and this effect is exacerbated by other entrepreneurs stepping forward to meet that demand, increasing their own demand for lower-order investment goods. Suddenly the indications that consumers time preferences have not actually fallen and that the completion of roundabout production methods will not actually be affordable rear their heads. 12 The turn from boom to bust finds entrepreneurs who had initiated investments in more roundabout production methods in a tug-of-war with consumers (Garrison, 2005, p.32). Entrepreneurs are attempting to call upon resources to complete roundabout processes aimed at the production of future goods; consumers are calling for more resources to be devoted to satisfying their demands for current goods. Cochrane (2001, p. 19) refers to this conundrum as one of dueling production structures. Ultimately, entrepreneurs cannot profit by acting contrary to consumer preferences. 13 Resources must be reallocated towards less roundabout production processes. As the prices of lower-order goods rise, the completions of investments begun during the boom are realized to be unprofitable. Those incomplete investments are

This development could in principle be put off by an acceleration of the credit inflation by the central bank. However, Austrians hold (quite reasonably) that if ever-accelerating inflation is needed to maintain the boom, the well-known ills associated with hyperinflation will manifest and put an end to the efforts of even the most determined central bank. 13 Regarding a market economy, no one makes this point more forcefully and consistently than Mises (2009 [1958], pp. 23-24): economic power is ultimately vested in the hands of the buying public of which the employees themselves for the immense majority.


abandoned (along with the jobs that had been associated with them). The reallocation of resources to a sustainable time structure is painful (i.e., there is a great deal of real value lost) because that structure is complex with capital components that are heterogeneous and largely particular process-specific (Ludwig Lachman, 1978 [1956]). The higher-order capital goods put in place during the boom are not straightforwardly placed into less roundabout production processes. Costly liquidation is an inevitable part of the bust.


The Need for a New Variant on the ABCT Theme

The canonical variant of ABCT was developed in a particular historical context. That it can be, without modification, applied in other contexts is a heroic assumption. 14 Applying an ABCT to a given business cycle episode may involve adding additional elements to the canonical model (e.g., Hayeks (1996 [1970]) explicit discussion of labor market institutions). Alternatively, it may call for a more fundamental change in perspective (e.g, Garrisons (1994; 2006, ch. 6) shifting of focus from the time structure of production to its risk structure.) While several authors have provided Austrian analyses of the recent US business cycle, they have to too great an extent attempted to fit that cycle into the mold of the canonical ABCT. Unfortunately, the fit is not entirely flattering. The boom of the earlyand mid-2000s was particularly (and dramatically) pronounced in the housing/mortgage market. I will argue that two important aspects of this housing-centered boom and

This is not to say that the statements of the canonical ABCT are not true statements derived from the axiom of human action. (I am not claiming that they all are either! For an example see Jrg Guido Hlsmann (1998) for a criticism of, and attempted rectification of, the Mises (1934) ABCT as being founded on a lack of prudent attitude toward credit inflation on the part of entrepreneurs, which is not a universal of human action.) Rather, certain true statements about human action my undoubtedly not be particularly important for understanding a given episode.



subsequent bust have not been adequately addressed in the ABCT literature: (1) the risk associated with the secondary mortgage market was externalized by the GSEs with the support of the US Treasury and Federal Reserve; (2) housing, relative to other goods, is associated with a high degree of roundaboutness in consumption. The risk-externalization associated with the mortgage market, (1), has not been adequately addressed in the Austrian literature. This has led, in my view, to an unacceptably monolithic focus on Fed-based inflation of the monetary base that, while appropriate for the 1920s and 1930s, seems out of place in the context of the 2000s. Also, the ABCT literature has not adequately bridged the gap between the changes in the time structure of production stressed by the canonical variant and the changes in the risk structure that seem more relevant to the Great Recession. While risk externalization has not been adequately addressed, the high degree of consumption roundaboutness in housing, (2), has been to my knowledge entirely ignored. I argue that a key to understanding the severity of the Great Recession lies in the recognition that distortions in both the time and risk structures of production were accompanied by symmetric distortions in the time and risk structures of consumption. Below I consider just a couple of examples of Austrian analyses of the recent US business cycle. 15 Both are important and insightful pieces, but they are also representative of how more needs to elaborate a specific ABCT appropriate to the recent cycle. 16

To avoid awkward and wordy phrasings, whenever an author offers a discussion of the recent business cycle propounding ABCT an (accurate) explanation, I refer to the author as Austrian. I do so with apologies to any such authors who do not brand themselves as such. 16 Other Austrian analyses of the recent cycle include Lawrence H. White (2009), Peter J. Boettke and William J. Luther (2010), Gene Callahan and Horwitz (2010), and Horwitz (2011).



David L. Prychitko (2010, p. 212) claims that the Austrian theory of the business cycle is already fit to explain the onset of the crisis. 17 The usual suspect of an injection in credit (p. 212) is rounded up, but as to why this credit found its way disproportionately into the housing market Prychitko offers only: The housing bubble developed between 2001 and 2006 when the Fed lowered the federal funds rate and government agencies (through the Community Reinvestment Act and other devices) encouraged and targeted credit towards the housing industry in particular (p. 215). Prychitko does not elaborate on how credit was targeted. Importantly, there is no mention of the externalization of risk generally or in that specific sector of the economy. The canonical variant stresses that credit inflation ends up, broadly, in the hands of entrepreneurs and that, given lower-than-natural interest rates, they pursue more roundabout production methods. There are two problems with fitting this canonical story to the recent episode. First, during the boom mortgage rates were not actually low relative to rates in other financial markets. Figure 1 plots 30-year conventional mortgage rates and Aaa corporate bond yields from 1990 through 2001. During the boom these two rates tracked each other closely; if anything, starting in 2004, the mortgage rate rose relative to the corporate yield and remained high until the crisis began to unfold. If a greater supply of credit was simply targeted to a particular sector then, all else equal, rates would have been relatively low in that sector. Furthermore, is there any reason to think that housing production is particularly roundabout relative to, say, a given manufacturing industry? In Young (2012) I attempt to

Prychitko is primarily concerned with evaluating Hyman Minskys financial instability hypothesis versus ABCT as interpretive models for a bust a Minsky moment. Prychitkos discussion of the competing hypotheses is compelling; his conclusion convincing: financial crises are more fruitfully viewed through an Austrian, rather than a Minskian, lens.



use data from the Bureau of Economic Analysis (BEA) input-output (IO) tables to classify US industries (during the 1998 through 2009 time period) in terms of their roundaboutness. I argue that the value of total industry outputs used by a given industry, taken as a fraction of that given industrys value-added, will be proportional to its stages of production. 18 Construction does not rank amongst the most roundabout industries; real estate ranks amongst the least roundabout (Young, 2011, Table 3). In this way, the canonical variant of ABCT seems an awkward fit to the recent cycle. Steven Horwitz (2010) provides another Austrian analysis of the recent cycle. Horwitz (2010, p. 101) begins his discussion by acknowledging that: [A]lthough theoretical propositions are universally valid, they provide only the framework of a full historical explanation. In applying theory to specific historical episodes, Austrians recognize that the particular details of each episode may vary in important ways, even as the outlines of the episode conform to the pattern identified by the theory. Horwitz then correctly highlights the importance of the GSEs and the implicit promise of government support that allowed the market for mortgage-backed securities [..] to tolerate a level of risk that truly free markets would not (p. 103). (The marginal effects of the Community Investment [sic] Act (p. 104) are also alluded to.) While Horwitz provides details concerning the set of policies that artificially reduced the costs and risks of home ownership (p. 102) he does not elaborate on the links between the Fed and Treasury that gave the implicit promise bite and allowed for
The intuition is that, relative to value-added, the counting up of gross outputs used en route to that valueadded involves double-counting. (Think of the expenditures approach versus value-added approach to counting up GDP that we teach in principles of macroeconomics classes.) Assuming that rates of return tend towards equalization across sectors, more stages of production will, all else equal, be associated with more double counting while summing up gross outputs used.


risk to be externalized across taxpayers broadly. 19 As I argue below, the Feds explicit ability to monetize Fannie and Freddie debt, along with the Treasurys mandate to purchase that same debt, was fundamental to distortions in the risk structure of both US production and consumption. As regards the latter, Horwitz also does not consider the importance of consumption roundaboutness in the housing market. In a notable paper on the recent US cycle, Joseph T. Salerno (2011, p. 3) does extend the [ABCT] analysis of the effects of the central banks manipulation of interest rates [...] to household choice among intertemporal consumption patterns. This is a welcome contribution, especially in light of criticisms that ABCT is unable to account for the positive co-movement between consumption and investment spending during the cycle (e.g., Paul Krugman (1998), Tyler Cowen (2008), and J. Brad DeLong (2008)). However, Salerno (2008, p. 16) focuses on how a depressed interest rate misleads households into a falsely optimistic appraisal of their real income and net worth that stimulates consumption and depresses saving. These wealth effects are complementary to, but also different than, the effects of policy on the time structure of consumption that I am emphasizing.


The GSEs and the Housing Market

My call for a new variant of ABCT rests on the institutional, policy, and market particulars associated with the historical context of the recent US cycle. Here I briefly document these particulars. In doing so I draw heavily on my recent writing on the GSEs


In a separate paper, Horwitz and Luther (2011, p. 77) appear to be more dismissive of the importance of risk externalization vis--vis the canonical story of credit inflation: The underlying reason for these errors, regardless of where they would turn up, was too-easy monetary policy.


role in precipitating the housing boom, the financial markets crisis, and the Great Recession (Young, 2010) The Federal National Mortgage Association (or Fannie Mae) and the Federal Home Mortgage Corporation (or Freddie Mac) factored critically into the housing boom and subsequent bust. These GSEs were chartered by the US Congress, separately, to provide liquidity in the mortgage market by creating a secondary market for those loans. They became dominant participants in the US secondary mortgage market during the quarter century leading up to the Great Recession. By that time they had about $5.5 trillion in obligations (bonds and credit guarantees), accounting for about half of US residential mortgage debt (W. Scott Frame, 2008, p. 127). To put this in historical perspective, in 1980 Fannie and Freddie accounted for only about 7 percent of mortgage debt (Frame and Lawrence J. White, 2005, p. 162). 20 Operating on the secondary market, Fannie and Freddie do not nor legally can they originate mortgages. Rather, the GSEs deal in selling, buying, and securitizing mortgages. Mortgages are mostly originated by depository institutions such as commercial banks and savings and loans; also by mortgage companies. The activities of the GSEs can be broken down into swap programs and cash programs. (Figure 2 provides an illustrative flow chart for what follows.) The former of these involves an originator which provides a GSE with a pool of mortgages in exchange for a marketable mortgage-backed security (MBS). The MBS is based on the same promised future payments represented by the pool of mortgages. However, the GSE guarantees the payments for a fee; about 20 basis points on the principle of the mortgage pool (Frame

White and Frame (2005) and Frame (2008) both provide excellent reviews of the histories, activities, and institutional characteristics of Fannie and Freddie and I draw extensively from those sources below.



and White, 2005, p. 160). The originators retain the MBSs on their portfolios while a GSE carries the default (credit) risk of the underlying loans. In 2008 the GSEs combined net credit guarantees on these swaps amounted to about $3.7 trillion. The GSEs also purchase mortgages and private-issue MBSs for their own portfolios. The sources of mortgages and MBSs for cash program outright purchases are originators and investment banks. In the case of the later, private financial institutions purchase mortgage pools from originators and securitize them. The resulting MBSs are what the GSEs subsequently purchase. The GSEs can subsequently sell out of that portfolio to other private market participants. Similar to private financial institutions, Fannie and Freddie have two basic sources of funds with which to make their mortgage and MBS purchases: debt and equity. The GSEs have traditionally been highly leveraged; in 2008 their book equity was less than 4 percent of their total assets (Frame, 2008, p. 126). Fannie and Freddies primary source of funds is the issue of debt for purchase by investors. The activities of the GSEs involve considerable risk, as one would expect given their involvement with long-term loans to finance long-term real assets. This risk is stems from the one sector of the economy in which the GSEs operate: the housing/mortgage market. However, this risk was (and continues to be) externalized across taxpayers generally. While Fannie and Freddies debt obligations were not explicitly backed by the federal government during the boom, markets participants believed that they were implicitly backed. This perception was founded on what the Federal Reserve and the US Treasury were explicitly authorized to do in regards to the GSEs. The Treasury had the authority to


purchase up to $2.25 billion of their securities. This authority amounted to a line of credit from the federal government a line that existed previous to the GSEs being taken into conservatorship in September of 2008 and formally bailed out. Importantly, the GSEs debt was also classified as US government securities. In addition to being stamped as if they were US Treasury securities, this also meant that they were eligible for purchase by the Fed during its open market operations. Simply put, the Fed could monetize the GSEs debt if it so chose. That this resulted in market participants not bearing the risk associated with the housing market was evidenced by the 25 to 30 basis point advantage that Fannie and Freddie enjoyed on their debt issues (Brent W. Ambrose and Arthur Warga (2002) and Frank E. Nothaft et al. (2002)). The risk associated with the financial and underlying-real assets did not just disappear during the boom. It became implicit in the liabilities of the Treasury and Fed it became the burden of the US taxpayer. Interest rates in the mortgage market, and the quantities of mortgages and real estate and housing, did not reflect that risk. Likewise, taxpayers took on the risk not as a result of their individual choices based on their individual risk tolerances, but rather based on policy. This policy was encouraged by a series of legislative and oversight-based innovation from 1992 through 2004. These included the 1992 (ironically-named) Federal Housing Enterprises Financial Safety and Soundness Act that established targets for credit to low- to moderate-income and special affordable households, as well as underserved areas. Also, the Clinton administration requested in 1995 that the Department of Housing and Urban


Development (HUD) begin enforcing the GSAs efforts towards these goals. 21 In 2004, HUD issued its controversial GSE final rule (HUD, 2004). This rule established home purchase subgoals for GSE acquisitions of goal-qualifying home purchase mortgages on owner-occupied properties in each of the three overall goal categories (HUD, 2008). 22 The real assets underlying mortgages (i.e., housing), while not necessarily particularly roundabout in terms of the production processes that resulted in them, were exceptionally roundabout in terms of the services that they produced. Housing is clearly best described in terms of a continuous input-continuous output process. There is a timeconsuming process that leads to the completion of a structure; also a time-consuming process over which the services of that structure are enjoyed. If policy distorts price signals in the housing market, this can lead to distortions in not only the time-structure of production, but also of consumption. Importantly, the distortions in construction and consumption will be symmetric; misallocations of resources that amplify one another rather than offset. Young, Travis Wiseman and Thomas L. Hogan (2011) report evidence consistent with the idea that policy distorted the time-structure of consumption in the housing market. We find that, starting in the 1990s, the market prices of the mortgages and MBSs held by commercial banks indicate that they had become effectively shorter-term. As these loans primarily financed the purchases of completed structures, this change in perceptions would have been associated with consumers taking on longer-lived real

HUD was requested to do this under the auspices of the previously-toothless Community Reinvestment Act of 1977. HUDs involvement led to Fannie and Freddies first forays into the subprime mortgage market starting in 2000 (Theresa R. Diventi, 2009). 22 These subgoals excluded refinance mortgages and were especially targeted towards first-time homebuyers (HUD, 2006). Included in the final rule were explicit and implicit exceptions to previous GSE standards aimed at moving the GSEs further into the subprime market.


assets despite their actual time preferences not having changed. Intuitively, low mortgages rates and rising house prices convinced consumers that (a) they could afford to finance a home over a long period of interest payments and/or (b) they could flip the house in the near-term. In the latter case, consumera were (incorrectly) convinced that their desire to sell before the state time to maturity of their mortgage was with the desires of others wishing to buy at the elevated prices. 23


A Garrisonian Exposition

Garrison (2001) provides a graphical exposition of the canonical ABCT that is helpful for both organizing the fundamentals of the theory in a coherent fashion and for introducing new students to the theory. For both these purposes, I introduce the elements of riskexternalization and a time-varying consumption structure into that exposition. The result will, hopefully, not only offer a clear presentation of the Austrian features relevant to the recent cycle, but also provide students and researchers with framework flexible enough to illustrate alternative variants of the ABCT theme. Figure 3 presents the basic set of graphs utilized by Garrison (2001). The top right-hand-side graph represents production possibilities. The curve assumes constant resources and technology; given these, various combinations of consumption and investment goods that are feasible. The bottom right-hand-side graph represents the loanable funds market where, in the absence of policy intrusions, the interplay of individuals supplies of and demands for funds establishes a (natural) rate of interest.

Hugo Bentez-Silva, Selcuk Eren, Frank Heiland, and Sergi Jimnez-Martn (2009) find that, from 1992 through 2006, homeowners overestimated their homes values by between 5 to 10 percent on average.



That rate corresponds to an equilibrium bundle of consumption and investment goods that are consistent with production possibilities. The left-hand-side graph is a Hayekian (1935) triangle and it provides the uniquely Austrian element: a variable time structure of production. 24 Investment goods do not simply become part of a homogenous stock of capital. Rather, investments contribute to a complex capital structure, one dimension of which (i.e., roundaboutness) is represented by the triangle. The horizontal axis measures time consumed during production. The vertical axis measures value. The hypotenuse of the triangle, then, records goods thus far produced at each instant of time during the process; each stage of production. Holding the vertical right arm of the triangle in place, if the triangle expands leftward then the structure of production is lengthening; if it contracts rightward then the structure of production is shortening. As a quick example of how this unified set of graphs operates, assume that the time preferences of individuals decrease (uniformly or on average). Figure 4 illustrates this scenario in two frames. In the top frame the decrease in time preferences implies that individuals increase their savings as a portion of their incomes. Given a constant demand for funds, increased savings initially result in a lower interest rate and, given production possibilities, a shift towards more investment and fewer consumption goods. The time structure of production expands as the shift towards investment goods implies that a greater amount of resources is devoted toward future consumption goods production.


See Barnett and Block (2006) for a thorough criticism of the use of Hayekian triangles. By thorough I mean that the use of Hayekian triangles is criticized on quite possibly every dimension imaginable. However, I ultimately disagree with their claim (p. 39) that the use of triangles as expository devices is highly problematic, if not fatally flawed[.]


As the new investments are made the bottom frame of figure 4 and lead, eventually, to the completion of new capital structures, the production possibilities expand. This occurs because the lengthened production structures associated with increased capital-intensity lead to a greater value flow of consumption goods and investment goods. This occurs although, by assumption, no increase in natural resources or technology has occurred. Rather, the economic growth is entirely capital-based. 25 The task is now to incorporate two new elements to the framework: (1) a timevariant structure of consumption and (2) a risk-structure of production. 26 Figure 5 does just that. Straightforwardly, the original Hayekian triangle representing production is joined to another triangle representing consumption. Together, these two triangles represent a continuous input-continuous output structure. 27 Starting from the right vertical arm of the production triangle, the area of the right-hand-side triangle which represents the value of consumption goods produced indicates the length of time over which that total value is enjoyed. The hypotenuse of the consumption triangle records the remaining value not yet enjoyed at each instant of consumption time. 28 Consistent with the above modification, the production possibilities axes are now relabeled from consumption and investment to, respectively, present consumption and

Garrison (2001, Chs. 3 & 4) claims that long-run, sustainable economic growth can continue via this process. I argue (Young, 2009a) that Garrison is mistaken in this case. Rather, assuming that there are diminishing returns to capital accumulation (and increased roundaboutness) there must be some source of technical change, broadly understood, for growth to be sustainable. I offer nonrivalrous intangible capital and the associated positive externalities as a solution. Lucas M. Englehardt (2009) claims that I am in error; Young (2009b) is my response: to wit, au contraire! 26 Arguably and especially since I am introducing an independent time structure of consumption to go along with that of production I should introduce, separately, risk structures to both production and consumption. However, since introduction of a risk structure period involves an additional axis to the Hayekian triangle, I believe that separating that element into production and risk components would be prohibitively costly in terms of dimensions. 27 The traditional Hayekian triangle represents a continuous input-point output structure. 28 As in the case of the production triangle, the linear nature of the consumption process over time is for simplicity of exposition and is not assumed to be particularly realistic.



future consumption. When resources are allocated towards more future consumption this may either take the form of foregoing present consumption to accumulate capital goods or foregoing present consumption by producing non-capital goods that are durable, the consumption services of which are largely enjoyed later rather than sooner. 29 In either case, there are forward-looking resource allocations being made at the expense of current enjoyment. Garrison (2001, pp. 47-49) claims that, while incorporating a time structure of consumption is straightforward, doing so adds complexity while clouding the fundamental relationships that are captured by the simpler structure[;] there is little to be gained analytically[.] Barnett and Block (2006, p. 55) disagree: both the time-structure of production [...] and the time-structure of consumption [...] are affected by changes in interest rates [...] and thus both should be part of the ABCT[.] 30 I, of course, agree with Barnett and Block on this point. Furthermore, since I argue above (see section 4) that risk externalization in the housing sector channeled funds into relatively roundabout consumption (rather than production) structures, the representation in figure 5 does not cloud the fundamental relationships relevant to the recent cycle but, rather, highlights them. The importance of risk externalization leads also to the representation of an additional economic structure: the risk structure. Austrians insist that capital in an
Alternatively, a third dimension could be added to the production possibilities. I believe, however, that doing so would be slipping off-balance from Occams razor. The Austrian insights and implications, that I seek to highlight, are largely to be seen in changes in the Hayekian triangles. Therefore I reserve the third dimension for that graphical component. 30 Barnett and Block (2006, p. 55) also note that the representation in figure 5 may conflate production structures that, once in place, yield flows of goods throughout time and, on the other hand, goods that are consumed over time: [c]onsistency and clarity warrant that the figure be labeled continuousinput/continuous (or point)-output/continuous-consumption[.] This point is duly noted: what I am referring to by continuous output in this paper is the continuous flow of value through the consumption of goods already produced.


economy is a complex structure. That complexity goes well beyond the single dimension of time. The canonical ABCT merely stresses that one dimension of the structure. I am here claiming that, for the recent episode, additional dimensions of that complex structure need to be made explicit. 31 Figure 5 now includes an axis projecting in a third dimension that represents risk involved in both the (time-intensive) production and consumption of value. The vertical arm shared by all three triangles is now best interpreted as the expected value of consumption goods arising from production and to be enjoyed over time. The horizontal axis of this third triangle is labeled as risk. Thus the triangle can expand or contract as more or less risk is being incurred during either the planned process of production or that of consumption. However, a caveat: unlike the other two triangles the interpretation of the hypotenuse and the triangles area is, unfortunately, not straightforward. Distortionary policies can cause changes in the shape of the risk triangle. These changes can only be loosely interpreted as discrepancies between the risk structure created by the policies and that which would be consistent with the preferences and decisions of both consumers and entrepreneurs in the absence of such policies. This is an admitted weakness of the framework and refinements in representing and interpreting the risk structure are certainly desirable.

That economic structure is multidimensional is a characteristic belief of Austrians. However, the canonical ABCT focuses on a single dimension of that structure: the time structure. Ludwig M. Lachman (1978, p. 54) presents the broader view of capital theory in terms of the consistency [...] of plans within the economic system as a whole, i.e., the plan structure of the economy. Note that Lachman explicitly limits his discussion to capital theory [P]roduction plans are the primary object of the theory of capital. but his description of the plan structure is easily grafted to a description of consumption plans. Also, Anthony M. Carilli, Christopher J. Coyne, and Peter T. Leeson (2008) provide a characteristically Austrian analysis of the bridging-versus-bonding structure of social capital and how it can be distorted by government interventions.



All three dimensions (i.e., both of the time structures and the risk structure) cannot be viewed as independent. In particular, as the time involved in production and/or consumption increases the risk involved will all else equal tend to increase. As the time contemplated increases, so do the possibilities for unanticipated outcomes as well as the number of probabilistic outcomes. 32 For the sake of examining each structure clearly and independently I for the moment assume that the more or less roundaboutness of production or consumption does not imply changes in risk all else equal. (This assumption can easily be abandoned without damaging any of my claims below.) 33 Figure 6 uses the framework to, first, examine a canonical ABC save for the fact that the time structure of consumption is allowed to vary. The boom-bust episode represented is not essentially changed but one can now see how changes in the time structure of consumption amplify the policy-induced distortions. In the top frame a boom is initiated by a policy-induced increase in the supply of funds, represented by a shift to the right of the savings curve. This shift (by assumption) is not based on changes in individuals time preferences but, rather, by a central bank credit inflation. The interest rate falls and production shifts towards more future consumption relative to present consumption. The cheaper funds allow entrepreneurs to plan on the completion of more roundabout production processes. For consumers part, the lower interest rate entices them to plan on financing purchases of longer-lived consumption goods. Both time structures on the graph expand according to these plans.

This statement conflates the concepts of risk and uncertainty that should be made distinct in many contexts. However, in the context of this specific illustration of ABCT it is not important. Frank H. Knight (1921), of course, is the classic source of distinction between risk and uncertainty. 33 Distortions in either time structure will result in misallocations of resources, and the same will be true for distortions in the risk structure, if roundaboutness and riskiness are inherently, positively related. The two types of misallocations are not, except by complete serendipity, offsetting of one another.



However, the sustainability of these more roundabout time structures the completion of these production and consumption plans depends on an increased amount of loanable funds being available not only today but also in the future at the depressed interest rate. Unfortunately, time preferences have not actually fallen; individuals do not actually wish to save more. Indeed, the bottom frame of figure 6 traces the depressed interest rate over to the actual (and still unchanged) savings schedule, demonstrating that individuals are actually postponing the consumption of a smaller amount of resources. Tracing up to production possibilities, individuals desire more present consumption than they had previous to the credit inflation. At the depressed interest rate a comparison of the (contracted; bottom frame) time structure triangles to the (expanded; top frame) triangles indicates the discoordination between production and consumption plans and the actual amount of voluntary saving. In the case of production plans, the planned investments are revealed to be malinvestments. In the case of consumption plans, at first blush it may seem nonsensical that individuals consumption plans are inconsistent with their savings plans. This would certainly be true if we were dealing with a rational (in the Robert E. Lucas (1976) sense) representative agent. However, individuals make consumption plans based in part on financing made available by other individuals savings. Given the cheap funds made available by an inflation of credit, it is completely plausible that all (or many) individuals make consumption plans that assume future savings that will never materialize. At the time of the bust, the shaded areas in the bottom frame of figure 6 embody inconsistencies between production and consumption plans that are distorted towards more roundabout structures and savings plans that are distorted towards being more


present-oriented. 34 The inconsistencies mean that planned capital structures must be abandoned (e.g., half-built factories are left incomplete); also that roundabout consumption plans must be aborted (e.g., mortgages are defaulted on; homes are foreclosed on). 35 Importantly, the variation of the consumption time structure could be ignored in figure 6 (by deleting the right-hand-side triangle; assuming just a continuous input-point output scenario) while changing nothing else about the exposition. However, when that variation is introduced, the distortions in the time structure of consumption complement those is the time structure of production. The boom-bust cycle is amplified. Furthermore, which of those two distortions is more empirically relevant will depend upon the specific Cantillon effects corresponding to a particular historical business cycle. For example, if credit were to be injected only in the form of mortgage loans to consumers, the time structure of consumption would expand while producers, without access to those funds, would not necessarily undertake more roundabout production structures. 36 Moving away from the canonical ABCT, the narrative from section 4 is played out in figure 7. Initially (top frame) the channeling of funds into the housing market comes about through the GSEs secondary market purchases. These are funded through

Note, what is being highlighted is the inconsistencies that manifest during the bust. They are not inconsistencies relative to what plans would have been in the absence of the credit inflation. However, this is not a welfare analysis; I am not claiming that these are deadweight loss triangles (or something of that sort). The shaded areas are meant to indicate plan inconsistencies created by policy and given the policy. These are the points of crisis that manifest with the onset of bust. 35 There is also an inconsistency of plans visible in the risk structure. This does not indicate a positive relationship between risk and roundaboutness (which I have assumed away; see above). Rather, in lieu of such a relationship, all else equal risk is proportional to the value of present consumer goods. Given this simplification, the inconsistency is between plans for less present consumption (less risk) and plans for more present consumption (more risk). 36 Of course they might; specifically, if the construction of homes called for production structures that were more roundabout than the typical production structure in the economy, then the shift towards home construction would entail a lengthening of the aggregate time structure of production. However, there is no a priori reason to believe that this is the case. (See section 3 above and Young (2012).)



an increased supply of savings (i.e., purchases of Fannie and Freddies debt) that is encouraged by externalizing the risk associated with mortgages. The GSEs debt is implicitly guaranteed by taxpayers broadly and individuals who purchase it do not bear all of the risk associated with the activities being funding. At the same time, by loosening their standards in terms of which mortgages they buy, the GSEs open borrowing opportunities to individuals who, by those previous standards, would have been deemed not creditworthy. Mortgage originators are essentially given incentives to ignore adverse selection problems. As these individuals gain access to the mortgage market, the effective demand for funds increases. Again, the risk associated with these new market participants is externalized to the taxpayers generally. Since both supply and demand are increased in the loanable funds market, the effect on the interest rate is ambiguous. In the reality of the recent cycle, the Federal Reserve was maintaining loose monetary policy during the years following the 2001 recession. Interest rates, in response, were generally low. However, note that the ambiguous effect on the interest rate makes intelligible the boom in the housing market specifically while mortgage rates were not particularly low relative to other US interest rates. (See figure 1.) For simplicity, figure 7 is drawn such that the net effect on the interest rate is nil. In the bottom panel of figure 7 highlights unsustainable economic distortions that become apparent during the bust. The inconsistencies between the planned time structure of consumption and savings plans are shaded. Also shaded are the discrepancies between the triangles drawn in third dimension. These discrepancies are between production and


consumption plans initiated during the boom and alternative plans that are consistent with choices made assuming that the relevant risks are internalized. The above exposition is admittedly crude. There are some particulars that I am not entirely comfortable with. As I comment on above, for example, the interpretation of the risk structure triangles hypotenuse and area is, unfortunately, not straightforward. Increasing the complexity of the framework can go a long way towards smoothing out these rough points. However, in experimenting with more complex alternatives I faced the danger that the exposition was becoming muddled and unwieldy. I therefore leave further refinements to future research.


Concluding Discussion

Some theories of the business cycle are identified with a particular source of the cycle, e.g., real business cycle theory. Real business cycle is the particular hypothesis that a large part of macroeconomic fluctuations are caused by exogenous productivity (or technology) shocks. Compare this to new Keynesian theory which is body of hypotheses that emphasize certain aspects of the economy price and wage rigidities; preference shocks (animal spirits); imperfect competition, etc. A new Keynesian theory incorporates at least some of these elements but not necessarily all of them in an attempt to explain or account for the business cycle. I view ABCT as akin to the latter in this regard. Austrians emphasize capital as a complex structure; the essentiality of the price system for conveying information and coordinating individuals; the monetary calculations of entrepreneurs, etc. An ABCT is an account of the business cycle or a particular cycle that attributes importance to some


combination of these elements. As Garrison states, Austrian explanations for the cycle are variations on a theme. The canonical ABCT, developed by Mises and Hayek to account for a Great Depression world, is one such variation. But it is only one such variation. I have argued here that too many authors have been content to cram the recent business cycle and financial markets crisis into the contours of the canonical theory. The fit has not necessarily been flattering. Specifically, I argue that two elements essential for an account of the recent episode have been largely neglected: (1) the risk externalization in the housing/mortgage market arising as a result direct result of the GSEs (and indirectly as a result of the Federal Reserve) and (2) the time structure of consumption and the particularly roundabout nature of housing services. To rectify for this neglect, I articulate an ABCT that emphasizes (1) and (2). This theory, along with the empirical facts, makes intelligible a boom that was centered in the housing/mortgage market despite mortgage rates that were not relatively low in the US. The theory is illustrated as an extension of Garrisons (2001) diagrammatical framework. In addition to accounting for the recent cycle, the extended framework can be used to illustrate various ABCTs that are consistent with various particular historical contexts. Policy-based distortions to the workings of the price system can be analyzed in terms of the time structure of production (consistent with the canonical ABCT) but also the time structure of consumption and the risk structure of the economy. Hopefully, the present theory and exposition can guide empirical investigations of the recent US cycle. Essentially all econometric studies of ABCT have been guided by the canonical theory; their testable implications based on the time structure of production (e.g., Le Roux and Levin (1998), Keeler (2001), Mulligan (2002, 2005, 2006), Young


(2005), Bismans and Mougeot (2009), and Sechrest (2009)) . Future work should exploit the opportunities to estimate, document, and examine Austrian-type patterns in the risk and consumption time structures. The same can be advised for cliometric studies. Historical data can be sought and gathered in reference to risk and consumption time structures.


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6.00 MORTG 4.00 AAA


0.00 1990-02-01 1991-03-01 1992-04-01 1993-05-01 1994-06-01 1995-07-01 1996-08-01 1997-09-01 1998-10-01 1999-11-01 2000-12-01 2002-01-01 2003-02-01 2004-03-01 2005-04-01 2006-05-01 2007-06-01 2008-07-01 2009-08-01 2010-09-01

Note: data are from the Federal Reserve Board of Governors. Bond yields are Moodys seasoned Aaa corporate bonds.