Austrian theory of business cycle is key to explain upcoming Recession

One reason the current economic situation is so fraught is that world is facing 3 kinds of business-cycle mechanisms at the same time. First 2 are well-known, but the third - Austrian theory is not

One reason the current economic situation is so fraught is that the world is facing three kinds of business-cycle mechanisms at the same time. The first two are well-known, but the third — known as the Austrian theory of the business cycle — is not.

The first driver of this phase of the business cycle is high energy prices, and the second is the need for disinflation. Both are well-known instruments. The Austrian theory, however, involves a very different mechanism and works something like this: Investors expected that very low real interest rates would hold. They committed resources accordingly, and now forthcoming rates are likely to be much higher. That means the economy is stuck with malinvestment and will need to reconfigure in a painful manner.

Some history: Before Covid, short-term interest rates were near zero, longer-term rates were still low, and rates of price inflation were slightly below 2%. That combination meant real interest rates were at zero or slightly below. And it seemed that state of affairs was going to continue for a long time.

The US economy was awash with liquidity, and so many projects looked like good investments. If the fruits of an investment were not coming for another 10 or 20 years, the discount rate applied to those future benefits was low. This same logic meant that many long-term profitable franchises, such as those held by the major tech companies, appeared to be more valuable than turned out to be the case.

When the combination of high inflation and pending disinflation came along, real interest rates spiked upwards. It is difficult to estimate the current level of expected future real interest rates, because market participants disagree about the likely future course of inflation. Nonetheless, market prices are indicating that traders expect higher interest rates to continue through the decade, if not longer. Anecdotal evidence from secondary capital markets, such as venture capital, is strongly consistent with the notion of capital being harder and more costly to obtain.

The basic story here fits with the work of two economists from Austria, Ludwig Mises and Nobel laureate Friedrich von Hayek, and thus it is called the Austrian theory of the business cycle. The Austrian theory stresses how mistaken expectations about interest rates, brought on by changes in the rate of inflation, will lead to bad and abandoned investment projects. The Austrian theory has often been attacked by Keynesians, but in one form or another it continues to resurface in the economic data, even if it isn’t the complete theory the Austrians wanted it to be.

One immediate casualty of the Austrian mechanism is real estate. With current mortgage rates in the range of 7%, housing isn’t the investment it used to be. Unlike in the 2008-2009 crisis, however, the slowdown in real estate is unlikely to cause a major disaster. Homeowners and banks are not nearly so leveraged, and homeowners even have some excess savings from the pandemic. This period will be painful for many homeowners, but it is not the crux of the current dilemma.

The more significant issue concerns a decline in long-term building and long-term projects.

The decline in asset prices came first to crypto in late 2021. Crypto was originally marketed as a hedge against inflation, but the data have refuted that idea. Instead, crypto has become a project to build out a new and different kind of financial system. That project has been years in the making, and even true believers admit that the revolution is years away, if it comes at all.

In fact, at higher real interest rates — in essence, higher rates of discount — the project looks less appealing. It is striking that crypto prices, which are about the least “establishment-determined” of all major classes of asset prices, were to first to register this change in market expectations.

Major tech companies have also seen their valuations fall significantly due to higher interest rates. Whatever else they may be, Meta, Alphabet and Amazon are also some of America’s more promising corporate research labs, and now they don’t have the resources they did less than two years ago. Their successors will have a hard time as well, due to rising capital costs, again at the expense of innovation and America’s collective future.

The most optimistic and perhaps most likely scenario is that real interest rates eventually will fall, as indeed they have historically, and valuations will rise once again. More long-term projects will resume. But how much damage will have been done in the meantime? On the down side of three business cycles all at once is not a good place to be.