Financial bubbles and the Austrian business cycle theory

In recent months, my interest in financial bubbles, their causes and how they form has inspired me to purchase an exciting book. In particular, I bought a copy of it Boom and Bust: A Global History of Financial Bubbles By William Quinn and John D. Turner. Although they are not Austrian economists, and they do not cite the Austrian Business Cycle Theory (ABCT), their theories are very similar. At first, I was surprised by its theoretical framework and the way it addressed the concept of speculative bubbles.

What is the bubble triangle?

Quinn and Turner provided a simple explanation for understanding the financial crisis and named their analytical framework The Bubble Triangle. This triangle consists of 3 components: Estimate, Marketability and Credit/Finance.

They define speculation as the purchase (or sale) of an asset with the sole motivation of making a capital gain in order to sell (or repurchase) the asset at a later date. To Quinn and Turner, speculation can become a problem when it gets heated when newcomers enter the market. It is related to ABCT that entrepreneurs can sometimes see speculative opportunities due to a mistake (usually, a government intervention) and sometimes they can lose the saved capital.

Another side of the triangle is marketability. When liquid assets become relatively more liquid than before, they can be bought or sold with relative ease. Of course, when an asset has a high level of liquidity, buyers and sellers can find each other without difficulty. According to the authors, this aspect is critical because when an asset bubble forms, it increases its marketability; It has the same effect on the economy as if someone poured gasoline on a fire trying to stop it. This becomes extremely problematic, especially if everyone has through an investment or pension fund.

The last and most important element is the credit and money available in the economy. In this aspect, Quinn and Turner have an Austrian-like element that is not present in many other accounts. Basically, they point out that by increasing the credit available to the economy, entrepreneurs and enterprises will invest in deficit projects that would otherwise not have been undertaken.

How does the bubble triangle relate to the Austrian business cycle theory?

By incorporating the ABCT model, the increased marketability of vulnerable assets, and the entry of new entrants into the exchange system during highly speculative periods, we can explain why the bust part of the cycle is so damaging. A good analogy is that sometimes the economy can catch fire; Fires are under control if everything is in order and firefighters are nearby. Conversely, if each person had a gallon of gasoline with them, the fire could spread more quickly and cause more damage.

For example, look at the mortgage loans that were malinvested in the Great Recession. In 2005 many agencies rated many of these securities as AAA After the crisis, 83% of these AAA securities were downgraded because firms misinterpreted the true risk of these assets. In an illiquid market, loan defaults would not have the same effect if these loans were made more liquid so that someone could buy them. That is, when highly-liquid assets result in an error induced by a decrease in interest rates, every economic agent seems to be affected in one way or another. This problem may explain the severity of the bust phase and why the economy took so long to recover.

More attention should be paid to central bank mismanagement. Anyone who has read I, pencil By Leonard Reid to understand how complex are the various stages of production and how impossible is it to coordinate division of labor and voluntary cooperation through central planning. If economists agree that central planning has failed to coordinate the production of goods and services, how can we expect interest rate manipulation to do any good? Coordinating intertemporal production is more challenging than immediate future production.

Overconfidence is not sufficient to explain why this generalization of bad investments occurs not only among novice investors, but also through investment firms. Yes, beginners can make mistakes while trying to guess. But this part of the market arbitrage process seeks to balance and clarify the rate of profit between different investment demands.

Conclusion

There is still much work to be done on business cycle theory. Whether the interpretation comes from one school of thought or another is irrelevant to each individual. Nevertheless, introducing different financial concepts into the Austrian analysis can help us understand the magnitude of the boom and bust.


Carlos Martinez is a Cuban American graduate student studying at Rockford University. He is doing BS in Financial Economics. Currently, he holds an Associate of Arts degree in Economics and Data Analytics.

Leave a Reply

Your email address will not be published.