Austrian Economists Can Explain the Coming Recession


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One of the reasons why the current economic situation is so tense is that the world is facing three types of business cycle mechanisms at the same time. The first two are well known, but the third, known as the Austrian Business Cycle Theory, is not.

The first driver of this phase of the business cycle is high energy prices, and the second is the need to deflate. Both are well known instruments. The Austrian theory, however, implies a very different mechanism and works something like this: Investors expected real interest rates to remain very low. They committed resources accordingly, and now the next rates are likely to be much higher. That means the economy is mired in malinvestment and will have to reconfigure itself in a painful way.

A bit of background: Before Covid, short-term interest rates were close to zero, long-term rates were still low, and price inflation rates were just under 2%. That combination meant real interest rates were at or slightly below zero. And it seemed that this state of affairs was going to continue for a long time.

The US economy was awash in liquidity and many projects seemed like good investments. If the fruits of an investment did not arrive 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 major tech companies, appeared to be more valuable than they turned out to be.

When the combination of high inflation and pending disinflation hit, real interest rates shot up. 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. However, market prices indicate that traders expect higher interest rates to continue for the decade, if not longer. Anecdotal evidence from secondary capital markets, such as venture capital, is very consistent with the notion that capital is more difficult and expensive to obtain.

The basic story here dovetails with the work of two Austrian economists, Ludwig Mises and Nobel laureate Friedrich von Hayek, and is thus called the Austrian Business Cycle Theory. The Austrian theory emphasizes how erroneous expectations about interest rates, caused by changes in the rate of inflation, will lead to bad and abandoned investment projects. The Austrian theory has often been attacked by the Keynesians, but in one form or another it continues to resurface in economic data, even if it is not the complete theory that the Austrians wanted it to be.

An immediate victim of the Austrian mechanism is real estate. With current mortgage rates in the 7% range, housing is no longer the investment it used to be. However, unlike the 2008-2009 crisis, the slowdown in real estate is unlikely to cause a major disaster. Homeowners and banks are not as leveraged, and homeowners even have some excess savings due to the pandemic. This period will be painful for many owners, but it is not the crux of the current dilemma.

The biggest issue concerns a decline in long-term construction and long-term projects.

The drop in asset prices first hit cryptocurrencies in late 2021. Cryptocurrencies were originally marketed as a hedge against inflation, but data has disproved that idea. Instead, cryptocurrencies have become a project to build a new and different financial system. That project has been years in the making, and even true believers admit that revolution is years away, if it comes at all.

In fact, at higher real interest rates—in essence, higher discount rates—the project looks less attractive. It is surprising that cryptocurrency prices, which are the least “establishment determined” of all major asset price classes, were the first to record this change in market expectations.

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

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

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• This economy is too difficult for economists to understand: Jared Dillian

This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

Tyler Cowen is an opinion columnist for Bloomberg. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is co-author of “Talent: How to Identify the Energizers, Creatives, and Winners Around the World.”

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