Since the United States was rocked by a financial crisis in 2007-09, economists have worked to explain how and why it happened. In a new article by Assistant Vice-Provost and Program Head of Business, George Bragues, he takes on one of the crisis’ most popular explanations, Austrian Business Cycle Theory, and argues that it’s missing a crucial element. By comparing the conditions in the US and Canada, Dr. Bragues contends that ABCT is incomplete without a political element.
What is Austrian Business Cycle Theory (ABCT)?
Whenever you have a boom or a bust, one of the big problems is figuring out how everybody made the same mistake at the same time. ABCT contends that business cycles (booms and busts) occur when the money supply is artificially affected by something outside of the economy. This can happen when either a national or commercial bank puts too little or too much money into the system by adjusting interest rates. It’s usually caused by too much money. This then distorts the decision-making abilities of businesspeople who will tend to overproduce capital goods, goods where the payoff is way in the future. Real estate is a classic example of this, you buy it and the benefits are felt years down the line; something like airplane manufacturing is a good example too.
When there’s too much money in the system, it distorts interest rate calculations and makes long-term projects look more promising than they actually are. This causes businesspeople to all make errors together. Initially, there’s a boom: you’re buying these investments, you’re hiring people, purchasing materials. Eventually though, you find that there isn’t a demand for it, and this creates a bust.
How does ABCT explain the 2008 financial crisis?
ABCT says that it happened because there was excess money creation. Interest rates were low and that incentivized people to invest more than demand warranted. That meant too much housing was constructed and too much was financed.
What’s missing from that explanation?
I wanted a theoretical account to explain the forces that lead to money supply errors. The political element matters because political systems determine how the rules of the game are structured.
And explaining those political structures requires going all the way back to their founding?
Exactly. We have to ask who made the constitution, what the rules were and how they developed at key junctures. Though Canada and the US are both democracies, they have major differences. The US is more populist — it’s a system where the people have more ability to have their opinions expressed in the political system. This can happen many ways, such as how the sub-national units are structured. In America, the states have traditionally had a lot of power in banking, meaning there are more governments in play, and so people have more avenues to influence governments and advance their interests.
They also have more banks. Here in Canada we have just five major banks, but in America, they have thousands because each state had a role in banking. That means there are more points of entry for people who can push banks for better rates. Canada’s system is more elitist, so banks can set rates without worrying about the political consequences.
How does that lead to bigger booms and busts?
In my interpretation, the more populist a system is, the more vulnerable the economy will be to booms and busts. When there’s a political imperative to keep interest rates lower than they should be, you’re in danger. Most people borrow more than they save because they want to finance cars, houses and education, so they push for lower interest rates. Banks though, will want to charge higher interest rates to make more money. Remember that when interest rates get too low, it will eventually lead to a bust.
While America was hit hard by the financial crisis, Canada was relatively protected, why was that?
America has more chances for populist impulses, meaning their central bank is more likely to intervene in the economy and create an ABCT crisis. In the Canadian system, these impulses face more barriers: it’s harder for individuals to pressure banks for lower interest rates. This way, the Canadian financial system is less likely to make loans at the wrong rate.
Is the takeaway that too much democracy is dangerous for financial systems?
There’s nothing wrong with democracy per se, you just have to be careful of its excesses. That means we need checks and balances in our economic system. We need greater awareness of this need, but it’s also something that’s already part of our institutional design. Central banks like the Bank of Canada or the US’ Federal Reserve System aren’t democratic bodies — they’re expressly designed to be shielded from democratic pressures. Their leadership is appointed, not elected, they often serve longer terms than prime ministers and presidents and they’re very hard to remove unless their behaviour is truly scandalous. So we recognize that too much popular input is bad for the economic system, but the current attempt failed and requires new checks in place.
We live in a democracy and people’s views on financial policy need to be embodied in how our institutions are run, but they aren’t the only interests that have to be looked after.