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Thursday, January 03, 2008

Market Failure in Austrian Business Cycle Theory

Tyler Cowen has been discussing the Austrian theory of the trade cycle:

New money does not have to enter the loanable funds market, by Tyler Cowen:  It is one of the standard claims of Austrian business cycle theory that the "new money" enters the economy through the loanable funds market.  Yes it usually does, but it is important to recognize that this happens because of decisions by banks, not because government somehow forces the money to go there.

Consider an expansionary open market operation.  Banks now hold fewer T-Bills and more cash.  Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too), so the banks will do something liquidity-like with it.  That could mean making a loan, but it also could mean spending the money to refit the ATM machines, or for that matter increasing dividends to bank shareholders.

But no, bank managers make an independent judgment that there are loans worth making.  Of course sometimes they are wrong.  But they know they got this new money through open market operations.  And they decided to go ahead and make the loans anyway.  They didn't have to.  They could have re-routed the new money to some other injection path altogether.  But they didn't.

That is another reason why the Austrian theory of the trade cycle is as much a market failure theory as a government failure theory.

[Also, Bryan Caplan follows up with "What's Wrong With Austrian Business Cycle Theory."]

    Posted by on Thursday, January 3, 2008 at 02:25 AM in Economics, Macroeconomics, Market Failure | Permalink  TrackBack (0)  Comments (20)

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