Government Failure and The Global Financial Crisis
Jeon, Yoong-Deok and Hag-Soo Kim
In this paper, the Austrian Business Cycle Theory(ABCT) is examined both theoretically and empirically. In addition, we also confirm the economic wisdom that the boom and bust cycle is caused by government failure. The ABCT in a nutshell asserts that the boom and bust cycle occurs as the government keeps the interest rate below the natural rate of interest by increasing money supply. As the interest rate is distorted by the expansionary monetary policy, both mal-investment and over-consumption are caused. In orther words, government intervention by adjusting interest rate will result in the dis-coordination of inter-temporal resource allocation.
The austrian school classifies a business cycle into three stages. The first is a boom which occurs when mal-investment and over-consumption occurr in almost all sectors. The mal-investment
implies both overinvestment in some industries and underinvestment in other industries. In the business world, overinvestment tends to happen in higher order production industries, such as capital goods industries, while underinvestment tends to happen in consumable goods industries. In this boom period, overall production factor income goes up since demand for production factors goes up in higher order production industries. As a result, the increased income causes the increase in consumption. In addition, asset prices for stock and real estate increase.
Such an artificial boom is not sustainable in the long run and eventually initiates a stage of crisis as some firms realize that their investments are no longer profitable. In this second stage, asset prices start to fall and structural reform of capital goods is required moving resources from over-invested industries to under-invested industries. This happens because consumers do not have enough savings to purchase new products that those higher order product industries deliver to markets. Therefore, it is implied that the crisis is caused by the over-consumption, not under-consumption. Eventually many industries and firms suffer from the bankruptcy, lay-offs, structural reforms, M&A, and such. The stage of depression arrives with frictional unemployment of labor and capital as a distinctive phenomenon.
The crisis and depression stages and often referred together as the bust period. However, a business cycle does not end with the 3-stage mentioned above. There are several emerging secondary symptoms of economic depression that can be characterized by the deflation as a result of the bank’s credit crunch and the increase in money demand. Monetary disturbances due to the expansionary monetary policy have the characteristic of self reversing via depression and deflation.
A bust is a necessary and unavoidable process of market adjustment toward recovery. If governments implement policies to intervene with the free market in order to overcome a coming bust, those policies will prolong the period of the bust and become the seeds of new business cycle. Specially, the expansionary monetary policy during a bust is so-called reflation policy that will cause inflation again.
Therefore, the best policy against busts would be to do nothing and let the market process adjust the mal-investment and overconsumption that occurred in the last boom. The institutional cause of a business cycle would be that there are too many unnecessary regulations in the financial markets, or that those regulations are anti-market and the money market is monopolized by government.
In order to find some empirical evidence for the ABCT, we employ both a micro-approach and a macro-approach. In our
micro-approach, US 63-industry level investment trends over the period of 1991～2007 are examined. Along with this, we construct industrial stock price indices for the same 63 industries using the stock prices of individual firms that are traded in the New York Stock Exchanges to see if the bust process after the year 2007 was as the ABCT asserts. We also analyze with the macro-approach, a 3-variable vector error correction model to see if the expansionary monetary policy causes an economic boom and bust cycle.
Findings from the micro approach can be summarized as follows: First of all, the higher order production industries invest more than the overall average during the artificial boom induced by the expansionary monetary policies and the unsustainable overinvestment seems to be cleared during the bust. This coincides with what the ABCT asserts. Second, the industries producing consumption goods show the trends of overinvestment during the artificial boom and reduce their investments drastically during the following bust. In theory, there is no mention that there would be overinvestment in the lower-order production industries and it would be cleared during the bust. Rothbard clearly asserts that the lower-order production industries will suffer from the lack of investment while the higher-order production industries will have overinvestment. However, Garrison (2004) did not clearly
mention about the possibility of the over-investment in lower order production industries such as consumption goods industries even if he says that more resources are moving into the consumption goods industries. The second point should be clearly identified in further theoretical studies. Lastly, it is not always true for all industries that their investments increase during the artificial boom and decrease during the bust. However, there are some industries taking advantage of low interest rate as the results of government policies as counter measures against the economic down turn following the unsustainable boom, which might cause a next boom and bust cycle.
The estimation results of the 3-variable VECM using the aggregate data from 1954 Q3～2009 Q2 imply that the policy-induced overinvestment and overconsumption are not sustainable in the long-run and a bust to correct the short-run disequilibrium is following, which is the main argument of the ABCT. According to the impulse response function, the investment and consumption increase very fast until around t+10 quarters when the shock of lowering short-term interest rate is given in t. Then the economic boom induced by expansionary monetary policy will not be lasting permanently and the increasing rate of investment and consumption start to decrease about 10 periods later, which also supports for the