Austrian Business Cycle Theory Questioned

The Mises Institute received the following questions about the Austrian business cycle theory:

1. How can an injection of credit bring about a general boom? Won't it merely transfer resources from consumer industries to capital goods industries? It seems to me that according to Mises the injection of credit would merely redistribute resources.

2. If it is true that the injection just changes the structure of production (by lengthening it), and that this creates a cluster of error revealed when customers re-establish their time preferences, then doesn't the initial injection also create a cluster of "error" since resources will be bid away from consumer goods industries, making them appear unprofitable? Wouldn't one say that there are a large number of business failures at the initial injection and at the "end" of the cycle?

An excellent paper for understanding this issue is Roger Garrison's Overconsumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle. I won't try to repeat the entire paper here, but the core of the answer to both questions is that when the banking rate of interest is below the natural rate of interest, the structure of production of the economy is pulled in two directions at the same time:

1. consumer/savers faced with a lower rate of interest on savings and investment, will at the margin consume more and save less. This tends to shift productive resources toward the consumption end of the production structure.

2. entrpreneur/borrowers, seeing the cost of capital fall, find that the marginally unproductive project has become productive, if the prices of the inputs do not rise before the project is completed. They undertake more investment projects, and proportionally more interest-rate sensitive projects, which are located furthest from the consumption end of the production structure.

As Garrison masterfully explains, sustainable production and consumption can only be increased at the expense of one another, but for a time, an unsustainable increase in both consumption and investment can occur. The unsustainable increase is the boom, and the return to a sustainable (or below the sustainable) level of consumption and production is the bust. The possibility of an unsustainble boom comes about because of the relative price distortions introduced by the credit expansion. If all prices adjusted immediately to the increased amount of credit, then interest rates would immediately reflect the nominal level of inflation, and no credit-driven boom would occur.

Because the production processes that are undertaken at the long end of the productive structure take time, and depend on additional resources becoming available at forecasted prices some time after they are started, the forecasting errors do not show up immediately.