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    Austrian Business Cycle Theory:

    A Modern Appraisal

    Andrew T. YoungDepartment of Economics

    College of Business and EconomicsWest Virginia University

    Morgantown, WV 26506-6025ph: 304 293 4526

    em :[email protected]

    September 2012

    JEL Codes: B53, B22, E30, E40, E50, R30

    Keywords:Austrian business cycle, Federal Reserve, GSEs, financial crisis, housingmarket, structure of production, structure of consumption, risk structure

    I thank Chris Coyne, Pete Boettke, and Steve Horwitz for helpful comments on aprevious draft. Errors are inevitable and invariably my own.

    mailto:[email protected]:[email protected]:[email protected]:[email protected]
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    Austrian Business Cycle Theory:

    A Modern Appraisal

    Abstract:Austrian business cycle theory (ABCT) is a body of hypotheses embodyingparticularly Austrian insights and assumptions. The canonical variant associated withMises (1934, 1963) and Hayek (1933, 1935) is particularly well-suited to the GreatDepression. However, it is an inadequate account of the recent US recession and financialcrisis. This paper develops a suitable ABCT variant that explicitly incorporates not onlythe economys time structure of production but also (1) its structure of consumption and(2) its risk structure. The continuous input-continuous output nature of the housingmarket is highlighted, as well as the Treasury and Federal Reserves roles in externalizingthe risk associated with GSEs debt. This paper then extends Garrisons (2001) graphicalframework to illustrate this ABCT variant.

    JEL Codes: B53, B22, E30, E40, E50, R30

    Keywords:Austrian business cycle, Federal Reserve, GSEs, financial crisis, housingmarket, structure of production, structure of consumption, risk structure

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    1. Introduction

    According to the National Bureau of Economic Analysis (NBER), the fourth quarter of

    2007 witnessed the end of nearly seven years of economic expansion in the US and the

    beginning of what is now known as the Great Recession. The economy was rocked by

    financial crisis in 2008. By the NBERs reckoning economic activity contracted for a

    year and a half. The unemployment rate reached a high of 10.6 percent and, as of this

    writing, remains at 8.2 percent.1Furthermore, if discouraged workers and part time

    workers who would prefer to have full time jobs are taken into account, US

    unemployment stands at about 15.6 percent.

    While the NBER dates the beginning of an expansion in the third quarter of 2009,

    real GDP growth has proceeded at an annualized rate of less than 0.9 percent in 2011.2

    Federal Reserve chairman Ben Bernanke felt confident in June of 2010 that a double-

    dip would not occur: My best guess is that well have a continued recovery [though] it

    wont feel terrific. However, by October of 2011 he was testifying to Congress that the

    recovery is close to faltering.3

    The anemic nature of the recovery if one can even call it that! comes as no

    surprise to students of the Austrian business cycle theory (ABCT). In light of the

    exceedingly loose monetary policy beginning in 2002 (John B. Taylor, 2009) and the

    massive expansion of the mortgage market by Fannie Mae and Freddie Mac, their

    1According to the Bureau of Labor Statistics for June of 2012:http://www.bls.gov/news.release/empsit.nr0.htm.2This statement is based on initial real GDP numbers published by the Bureau of Economic Analysis onSeptember 29, 2011. These number, of course, will be subject to (what may be economically significant)revision as time passes.3Bernanke: No Double-Dip Recession (http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/)and Bernanke Urges Obama and Congress to Do More forEconomy (http://www.nytimes.com/2011/10/05/business/economy/fed-chief-raises-doubts-on-recovery.html?ref=bensbernanke).

    http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/http://www.foxbusiness.com/story/markets/business-leaders/bernanke-double-dip-recession/
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    intuitions suggest that a policy-induced expansion of credit resulted in a misallocation of

    resources across economic structures. Such a situation can be rectified only through a

    reallocation of resources into sustainable structures via markets. For students of ABCT it

    is no wonder that the Feds new discounting facilities have failed to reflate the economy.

    The ineffectiveness of the Troubled Asset Relief Program (TARP) and the separate $168

    billion and $787 billion Congressional stimulus packages also come as no shock.4

    However, while Austrian insights apply generally to business cycles, ABCTs

    most prolific modern expositor, Roger W. Garrison (1994; 2001, ch 6), argues that

    different variants of the theory are appropriate to specificbusiness cycle episodes. For

    example, while what I will refer to as the canonical variant of ABCT (developed by

    Ludwig von Mises (1934, 1963) and Friedrich A. Hayek (1933, 1935)) focuses on policy-

    induced changes in the intertemporal structure of production, Garrison argues that

    changes in the riskstructure of production were more relevant to the 1990-1991 US

    recession:

    Like the time-consuming production processes that were out of line with

    time preferences, speculative loan portfolios that were out of line with risk

    preferences generated an artificial boom in the 1980s that belonged to the

    same general class as that of the 1920s. However, the distinction between

    economic activities that are excessively speculative together with some

    institutional considerations allows us to see systematic differences

    between the 1930s and 1990s (Garrison, 1994, p. 15).

    4It is easy to forget just how many new Fed facilities came into existence in the aftermath of the crisis:Term Auction Facility (2007); Term Asset-Backed Securities Loan, Primary Dealer Credit, CommercialPaper Funding, and Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facilities(2008); Money Market Investor Funding Facility (2009).

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    While the canonical variant of ABCT was developed to account for the unsustainable

    boom of the 1920s and the subsequent Great Depression, for the business cycle

    experiences of the 1980s and 1990s, [p]arallels can be found not in the strict sense of a

    replay but in the broader sense of variations on a theme (Garrison, 1994, p. 8).5

    The purpose of this chapter is twofold. First, I argue that the US experience from

    roughly 2002 through the present is, in a general sense, an Austrian boom-bust cycle; but

    that Austrian economists have largely cast the episode in terms of the anachronistic

    canonical model. Second, I articulate a specific variation on the ABCT theme that more

    closely accounts for recent events in the US. This variant incorporates two key elements

    absent from the canonical variant: (1) the risk-externalization of debt issued by the

    government-sponsored entities (GSEs), Fannie Mae and Freddie Mac; and (2) the

    continuous input-continuous output nature of the housing market. The externalization of

    GSE debt casts the Federal Reserve in a supporting (indirect) role in fostering the boom. 6

    The continuous input-continuous output nature of housing implies that the cycle features

    symmetric distortions of the risk and time structures of both production and consumption.

    I set about on my task as follows. In section 2 I briefly describe the canonical

    variant of ABCT against which what follows can be juxtaposed. Next I argue in section 3

    that a correct accounting of the recent US business cycle must incorporate the role of the

    GSE mortgage giants in reallocating resources to the housing market. In particular, I

    5Compare Garrisons analyses to those of Arthur M. Hughes (1997) (and Paul Cwiks (1998) comment onthat paper) and Cochran and Yetter (2004). John P. Cochran and Noah Yetter explicitly evoke Garrisons(2001) analytical framework but only to the extent that is exposits the canonical ABCT. Empirical studiesbased on data that cover the 1980s and 1990s also largely motivate their analyses in terms of the canonicalABCT (e.g., Andrew T. Young (2005), James P. Keeler (2001), and Robert F. Mulligan (2002, 2006)).6Garrison (1994; 2001; ch 6) stresses the risk-externalization associated with federal debt finance as thedirect cause of the 1980s boom; the Federal Reserve plays the supporting role by making default risk ontreasuries effectively zero via its ability to monetize the debt. In the variant of ABCT developed below,both the US Treasury and the Fed play supporting roles in externalizing the risk associated with GSE debt.

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    When these authors looked at the events preceding the Great Depression and in

    particular the policy environment under which the events unfolded what exactly did

    they see? As Garrison (1994, p. 9) comments, the 1920s were characterized by

    (relatively) tight fiscal policy and loose monetary policy; furthermore, the money

    growth rate peaked near the end of the decade as the Federal Reserve attempted with

    increasing resolve to keep the boom going (p. 7). It is little wonder, then, that the

    canonical ABCT focuses on the (i) time structure of production, (ii) the potential for

    credit inflation to disrupt the relative prices of current versus future goods, and (iii) a

    misallocation of resources across more- versus less-time consuming production

    processes.

    Any discussion of the original Mises-Hayek ABCT begins with the observation

    that the production of goods and services is time-consuming. Resources will pass from

    firm to firm as they are fashioned from raw materials into intermediate goods and then

    finished goods. (Even if only a single firm is involved, internal production is still time-

    consuming.) The finished goods themselves may be consumption goods or capital goods.

    If they are capital goods they will be used in the production of yet other goods and that

    will take time as well. Production is always time-consuming. Whether it is more or less

    so will depend on available technologiesand thepreferences of consumersfor various

    goods and services.

    Concerning technologies, Eugen von Bhm-Bawerk (1959 [1888], v. 2, p. 12)

    built Austrian capital theory upon the proposition that the adoption of roundabout

    methods of production leads to greater returns from the production process. He

    considered this one of the most important and fundamental tenets of the whole theory of

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    production: more roundabout (i.e., time-consuming) production methods tend to be

    more productive.8To use a well-trodden example from economics (Rothbard, 1962, p.

    50), Robinson Crusoe can catch fish using only his hands. He will be more productive if

    he uses a net. However, he must take time to fashion a net from nature-given resources

    before he can use it.

    While more roundabout production methods tend to be more productive, it is also

    true that people value time; they discount the future.9Implied, then, are tradeoffs for

    consumers between more goods later (that are ceteris paribusless valuable) versus fewer

    goods sooner (that are valued more). This creates profit opportunities for certain

    individuals entrepreneurs who are particularly savvy in ascertaining and acting upon

    consumers perceptions of these tradeoffs.

    Entrepreneurs are successful, in general, when they demonstrate alertness to

    hitherto undiscovered opportunities (Kirzner, 1973, p. 31). In doing so, of course,

    market prices are indispensable. When dealing with intertemporal tradeoffs, market

    interest rates embody the relative prices of goods sooner versus those only available

    later. Entrepreneurs discover discrepancies between the present prices of the

    complementary factors of production and the anticipated prices of the products minus the

    rate of interest (Mises, 1963, p. 547). On a given market for finance, a higher (lower)

    8See M. Northrup Buechner (1989) for an argument that Bhm-Bawerk did not equate roundaboutnessand time-consuming in his analysis. I am unaware of much modern debate amongst Austrian economists

    on this point. However, for my purposes I only contend that Mises, Hayek, and their followers proceeded asif he did equate the two.9Rather than assuming that more roundaboutness processes tend to be more productive, as atechnological fact, Rothbard (1993) provides the following reasonable interpretation that is a sufficientfoundation for what follows: The first process to be used will be those most productive [...] and theshortest. [...] No one has maintained that alllong processes are more productive than all short processes.The point is, however, that all short and ultraproductive [sic] processes will be the first ones to be investedin an established. It follows, then, that any more roundabout production processes that are actuallyinvested in an employed will be more productive than the less roundabout processes in use. This isprecisely because people discount the future (which is a fact of human action).

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    interest rate signals a higher (lower) price for current goods relative to those for future

    goods; higher (lower) time preferenceon the part of the marginal consumer.10

    Interest rates are determined on markets where entrepreneurs recognize the

    potential for higher productivity via more roundabout methods. They must obtain funds

    from savers who prefer goods today to goods in the future. Since individuals saving

    decisions imply their consumption decisions, the market interest rates will tend towards

    expressing the tradeoff between the productivity gains from waiting and consumers time

    preferences. But like any other market, if prices are regulated or otherwise manipulated

    by policy to not accurately express relevant tradeoffs, surpluses and shortages will

    develop. Funds will be allocated in ways that are inconsistent with consumers time

    preferences and the available technologies.

    Consider what happens when a central bank increases the growth rate of an

    economys money supply, inflating credit and lowering interest rates below their free

    market, natural rates (Wicksell, 1936 [1898]). To entrepreneurs this is a signal that the

    supply of savings has increased; consumers have become more willing to exchange goods

    today for goods in the future. Entrepreneurs respond by undertaking more roundabout

    ventures those to produce future goods, the demand for which entrepreneurs expect to

    manifest in the future. (Entrepreneurs are led to believe that people are saving more now

    so that they can increase their demand for goods later.) This represents the boomphase of

    the ABC.

    10The time preference component of interest rates is stressed in the canonical version of ABCT. This iswhat Mises (1963, p. 526) refers to as originary interest: the ratio of the value assigned to wantingsatisfaction in the immediate future and the value assigned to wanting satisfaction in the immediate future.The risk premium component of interest rates is given attention in the account of the 1990-1991 recessionand preceding boom offered by Garrison (1994; 2001, ch. 6).

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    The boom creates discrepancies between the investment plans of entrepreneurs

    and the plans of consumers. In particular, planned investments outstrip planned savings.

    Of course, at any given time more resources cannot be invested than are available.

    However, planned investments are projects that are pursued and completed over time.

    They involve both higher-order and lower-order goods, which are terms that Austrian

    economists use in reference to, respectively, goods applied during earlier and later stages

    of production (Menger, 2007 [1871]). The fact that the higher-order goods associated

    with an investment are available today does not necessarily imply that the lower-order

    goods needed to complete the investment will be available tomorrow.

    During the boom entrepreneurs reallocate resources towards more roundabout

    production processes with more stages of production. As the planned investments begin,

    the credit inflation places cheap money into the hands of entrepreneurs. The lowered

    interest rates signal to entrepreneurs that consumers are more future-oriented; that they

    are willing to forego enough resources to complete investments in more roundabout

    production processes. Since the new money enters the economy specifically through the

    entrepreneurs purchases of higher-order goods, the prices of those goods rise relative to

    the prices of lower-order goods (both consumption and investment goods).11This

    supports entrepreneurs interpretation of the lower interest rates. There are neither

    indications that consumers time preferences have not fallen nor that the planned

    investments cannot be affordably completed.

    11When the effect of new money on the economy is a function of the specific individuals, firms, industries,etc., that are the initial recipients, this is referred to as a Cantillon effect, after the 18thcentury economistRichard Cantillon. Recently, Mark Thornton (2006) has argued that Cantillon is the intellectual forefatherof ABCT.

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    However, a bust is inevitable as entrepreneurs continue to pursue roundabout

    production processes to produce future goods for which no demand exists. As

    investments continue, this generates income for the producers of higher-order goods. Of

    course, their time preferences have not really changed and they express their demand for

    consumption (lower-order) goods. This leads to increases in the prices of those lower-

    order goods and this effect is exacerbated by other entrepreneurs stepping forward to

    meet that demand, increasing their own demand for lower-order investment goods.

    Suddenly the indications that consumers time preferences have not actually fallen and

    that the completion of roundabout production methods will not actually be affordable rear

    their heads.12

    The turn from boom to bust finds entrepreneurs who had initiated investments in

    more roundabout production methods in a tug-of-war with consumers (Garrison, 2005,

    p.32). Entrepreneurs are attempting to call upon resources to complete roundabout

    processes aimed at the production of future goods; consumers are calling for more

    resources to be devoted to satisfying their demands for current goods. Cochrane (2001, p.

    19) refers to this conundrum as one of dueling production structures.

    Ultimately, entrepreneurs cannot profit by acting contrary to consumer

    preferences.13Resources must be reallocated towards less roundabout production

    processes. As the prices of lower-order goods rise, the completions of investments begun

    during the boom are realized to be unprofitable. Those incomplete investments are

    12This development could in principle be put off by an acceleration of the credit inflation by the centralbank. However, Austrians hold (quite reasonably) that if ever-accelerating inflation is needed to maintainthe boom, the well-known ills associated with hyperinflation will manifest and put an end to the efforts ofeven the most determined central bank.13Regarding a market economy, no one makes this point more forcefully and consistently than Mises (2009[1958], pp. 23-24): economic power is ultimately vested in the hands of the buying public of which theemployees themselves for the immense majority.

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    abandoned (along with the jobs that had been associated with them). The reallocation of

    resources to a sustainable time structure ispainful(i.e., there is a great deal of real value

    lost) because that structure is complex with capital components that are heterogeneous

    and largely particular process-specific (Ludwig Lachman, 1978 [1956]). The higher-order

    capital goods put in place during the boom are not straightforwardly placed into less

    roundabout production processes. Costly liquidation is an inevitable part of the bust.

    3. The Need for a New Variant on the ABCT Theme

    The canonical variant of ABCT was developed in a particular historical context. That it

    can be, without modification, applied in other contexts is a heroic assumption.14

    Applying an ABCT to a given business cycle episode may involve adding additional

    elements to the canonical model (e.g., Hayeks (1996 [1970]) explicit discussion of labor

    market institutions). Alternatively, it may call for a more fundamental change in

    perspective (e.g, Garrisons (1994; 2006, ch. 6) shifting of focus from the time structure

    of production to its risk structure.)

    While several authors have provided Austrian analyses of the recent US business

    cycle, they have to too great an extent attempted to fit that cycle into the mold of the

    canonical ABCT. Unfortunately, the fit is not entirely flattering. The boom of the early-

    and mid-2000s was particularly (and dramatically) pronounced in the housing/mortgage

    market. I will argue that two important aspects of this housing-centered boom and

    14This is not to say that the statements of the canonical ABCT are not true statements derived from theaxiom of human action. (I am not claiming that they all are either! For an example see Jrg GuidoHlsmann (1998) for a criticism of, and attempted rectification of, the Mises (1934) ABCT as beingfounded on a lack of prudent attitude toward credit inflation on the part of entrepreneurs, which is not auniversal of human action.) Rather, certain true statements about human action my undoubtedly not beparticularly important for understanding a given episode.

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    subsequent bust have not been adequately addressed in the ABCT literature: (1) the risk

    associated with the secondary mortgage market was externalized by the GSEs with the

    support of the US Treasury and Federal Reserve; (2) housing, relative to other goods, is

    associated with a high degree of roundaboutness in consumption.

    The risk-externalization associated with the mortgage market, (1), has not been

    adequately addressed in the Austrian literature. This has led, in my view, to an

    unacceptably monolithic focus on Fed-based inflation of the monetary base that, while

    appropriate for the 1920s and 1930s, seems out of place in the context of the 2000s. Also,

    the ABCT literature has not adequately bridged the gap between the changes in the time

    structure of production stressed by the canonical variant and the changes in the risk

    structure that seem more relevant to the Great Recession.

    While risk externalization has not been adequately addressed, the high degree of

    consumption roundaboutness in housing, (2), has been to my knowledge entirely ignored.

    I argue that a key to understanding the severity of the Great Recession lies in the

    recognition that distortions in both the time and risk structures of production were

    accompanied by symmetric distortions in the time and risk structures of consumption.

    Below I consider just a couple of examples of Austrian analyses of the recent US

    business cycle.15Both are important and insightful pieces, but they are also representative

    of how more needs to elaborate a specific ABCT appropriate to the recent cycle.16

    15To avoid awkward and wordy phrasings, whenever an author offers a discussion of the recent businesscycle propounding ABCT an (accurate) explanation, I refer to the author as Austrian. I do so withapologies to any such authors who do not brand themselves as such.16Other Austrian analyses of the recent cycle include Lawrence H. White (2009), Peter J. Boettke andWilliam J. Luther (2010), Gene Callahan and Horwitz (2010), and Horwitz (2011).

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    David L. Prychitko (2010, p. 212) claims that the Austrian theory of the business

    cycle is already fit to explain the onset of the crisis.17The usual suspect of an injection

    in credit (p. 212) is rounded up, but as to why this credit found its way

    disproportionately into the housing market Prychitko offers only: The housing bubble

    developed between 2001 and 2006 when the Fed lowered the federal funds rate and

    government agencies (through the Community Reinvestment Act and other devices)

    encouraged and targeted credit towards the housing industry in particular (p. 215).

    Prychitko does not elaborate on how credit was targeted. Importantly, there is no mention

    of the externalization of risk generally orin that specific sector of the economy.

    The canonical variant stresses that credit inflation ends up, broadly, in the hands

    of entrepreneurs and that, given lower-than-natural interest rates, they pursue more

    roundabout production methods. There are two problems with fitting this canonical story

    to the recent episode. First, during the boom mortgage rates were not actually low

    relative to rates in other financial markets. Figure 1plots 30-year conventional mortgage

    rates and Aaa corporate bond yields from 1990 through 2001. During the boom these two

    rates tracked each other closely; if anything, starting in 2004, the mortgage rate rose

    relative to the corporate yield and remained high until the crisis began to unfold. If a

    greater supply of credit was simply targeted to a particular sector then, all else equal,

    rates would have been relatively low in that sector.

    Furthermore, is there any reason to think that housing production is particularly

    roundabout relative to, say, a given manufacturing industry? In Young (2012) I attempt to

    17Prychitko is primarily concerned with evaluating Hyman Minskys financial instability hypothesis versusABCT as interpretive models for a bust a Minsky moment. Prychitkos discussion of the competinghypotheses is compelling; his conclusion convincing: financial crises are more fruitfully viewed through anAustrian, rather than a Minskian, lens.

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    use data from the Bureau of Economic Analysis (BEA) input-output (IO) tables to

    classify US industries (during the 1998 through 2009 time period) in terms of their

    roundaboutness. I argue that the value of total industry outputs used by a given industry,

    taken as a fraction of that given industrys value-added, will be proportional to its stages

    of production.18Construction does not rank amongst the most roundabout industries; real

    estate ranks amongst the least roundabout (Young, 2011, Table 3). In this way, the

    canonical variant of ABCT seems an awkward fit to the recent cycle.

    Steven Horwitz (2010) provides another Austrian analysis of the recent cycle.

    Horwitz (2010, p. 101) begins his discussion by acknowledging that:

    [A]lthough theoretical propositions are universally valid, they provide

    only the framework of a full historical explanation. In applying theory to

    specific historical episodes, Austrians recognize that the particular details

    of each episode may vary in important ways, even as the outlines of the

    episode conform to the pattern identified by the theory.

    Horwitz then correctly highlights the importance of the GSEs and the implicit promise

    of government support that allowed the market for mortgage-backed securities [..] to

    tolerate a level of risk that truly free markets would not (p. 103). (The marginal effects

    of the Community Investment [sic] Act (p. 104) are also alluded to.)

    While Horwitz provides details concerning the set of policies that artificially

    reduced the costs and risks of home ownership (p. 102) he does not elaborate on the

    links between the Fed and Treasury that gave the implicit promise bite and allowed for

    18The intuition is that, relative to value-added, the counting up of gross outputs used en route to that value-added involves double-counting. (Think of the expenditures approach versus value-added approach tocounting up GDP that we teach in principles of macroeconomics classes.) Assuming that rates of returntend towards equalization across sectors, more stages of production will, all else equal, be associated withmore double counting while summing up gross outputs used.

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    role in precipitating the housing boom, the financial markets crisis, and the Great

    Recession (Young, 2010)

    The Federal National Mortgage Association (or Fannie Mae) and the Federal

    Home Mortgage Corporation (or Freddie Mac) factored critically into the housing boom

    and subsequent bust. These GSEs were chartered by the US Congress, separately, to

    provide liquidity in the mortgage market by creating a secondary market for those loans.

    They became dominant participants in the US secondary mortgage market during the

    quarter century leading up to the Great Recession. By that time they had about $5.5

    trillion in obligations (bonds and credit guarantees), accounting for about half of US

    residential mortgage debt (W. Scott Frame, 2008, p. 127). To put this in historical

    perspective, in 1980 Fannie and Freddie accounted for only about 7 percent of mortgage

    debt (Frame and Lawrence J. White, 2005, p. 162).20

    Operating on the secondary market, Fannie and Freddie do not nor legally can

    they originate mortgages. Rather, the GSEs deal in selling, buying, and securitizing

    mortgages. Mortgages are mostly originated by depository institutions such as

    commercial banks and savings and loans; also by mortgage companies. The activities of

    the GSEs can be broken down into swap programs and cash programs. (Figure 2

    provides an illustrative flow chart for what follows.) The former of these involves an

    originator which provides a GSE with a pool of mortgages in exchange for a marketable

    mortgage-backed security (MBS). The MBS is based on the same promised future

    payments represented by the pool of mortgages. However, the GSE guarantees the

    payments for a fee; about 20 basis points on the principle of the mortgage pool (Frame

    20White and Frame (2005) and Frame (2008) both provide excellent reviews of the histories, activities, andinstitutional characteristics of Fannie and Freddie and I draw extensively from those sources below.

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    and White, 2005, p. 160). The originators retain the MBSs on their portfolios while a

    GSE carries the default (credit) risk of the underlying loans. In 2008 the GSEs combined

    net credit guarantees on these swaps amounted to about $3.7 trillion.

    The GSEs also purchase mortgages and private-issue MBSs for their own

    portfolios. The sources of mortgages and MBSs for cash program outright purchases are

    originators and investment banks. In the case of the later, private financial institutions

    purchase mortgage pools from originators and securitize them. The resulting MBSs are

    what the GSEs subsequently purchase. The GSEs can subsequently sell out of that

    portfolio to other private market participants.

    Similar to private financial institutions, Fannie and Freddie have two basic

    sources of funds with which to make their mortgage and MBS purchases: debt and

    equity. The GSEs have traditionally been highly leveraged; in 2008 their book equity was

    less than 4 percent of their total assets (Frame, 2008, p. 126). Fannie and Freddies

    primary source of funds is the issue of debt for purchase by investors.

    The activities of the GSEs involve considerable risk, as one would expect given

    their involvement with long-term loans to finance long-term real assets. This risk is

    stems from the one sector of the economy in which the GSEs operate: the

    housing/mortgage market. However, this risk was (and continues to be) externalized

    across taxpayers generally. While Fannie and Freddies debt obligations were not

    explicitly backed by the federal government during the boom, markets participants

    believed that they were implicitly backed.

    This perception was founded on what the Federal Reserve and the US Treasury

    were explicitly authorized to do in regards to the GSEs. The Treasury had the authority to

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    purchase up to $2.25 billion of their securities. This authority amounted to a line of credit

    from the federal government a line that existed previous to the GSEs being taken into

    conservatorship in September of 2008 and formally bailed out. Importantly, the GSEs

    debt was also classified as US government securities. In addition to being stamped as if

    they were US Treasury securities, this also meant that they were eligible for purchase by

    the Fed during its open market operations. Simply put, the Fed could monetize the GSEs

    debt if it so chose. That this resulted in market participants not bearing the risk associated

    with the housing market was evidenced by the 25 to 30 basis point advantage that Fannie

    and Freddie enjoyed on their debt issues (Brent W. Ambrose and Arthur Warga (2002)

    and Frank E. Nothaft et al. (2002)).

    The risk associated with the financial and underlying-real assets did not just

    disappear during the boom. It became implicit in the liabilities of the Treasury and Fed

    it became the burden of the US taxpayer. Interest rates in the mortgage market, and the

    quantities of mortgages and real estate and housing, did not reflect that risk. Likewise,

    taxpayers took on the risk not as a result of their individual choices based on their

    individual risk tolerances, but rather based on policy. This policy was encouraged by a

    series of legislative and oversight-based innovation from 1992 through 2004. These

    included the 1992 (ironically-named) Federal Housing Enterprises Financial Safety and

    Soundness Act that established targets for credit to low- to moderate-income and

    special affordable households, as well as underserved areas. Also, the Clinton

    administration requested in 1995 that the Department of Housing and Urban

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    assets despite their actual time preferences not having changed. Intuitively, low

    mortgages rates and rising house prices convinced consumers that (a) they could afford to

    finance a home over a long period of interest payments and/or (b) they could flip the

    house in the near-term. In the latter case, consumera were (incorrectly) convinced that

    their desire to sell before the state time to maturity of their mortgage was with the desires

    of others wishing to buy at the elevated prices.23

    5. A Garrisonian Exposition

    Garrison (2001) provides a graphical exposition of the canonical ABCT that is helpful for

    both organizing the fundamentals of the theory in a coherent fashion and for introducing

    new students to the theory. For both these purposes, I introduce the elements of risk-

    externalization and a time-varying consumption structure into that exposition. The result

    will, hopefully, not only offer a clear presentation of the Austrian features relevant to the

    recent cycle, but also provide students and researchers with framework flexible enough to

    illustrate alternative variants of the ABCT theme.

    Figure 3presents the basic set of graphs utilized by Garrison (2001). The top

    right-hand-side graph represents production possibilities. The curve assumes constant

    resources and technology; given these, various combinations of consumption and

    investment goods that are feasible. The bottom right-hand-side graph represents the

    loanable funds market where, in the absence of policy intrusions, the interplay of

    individuals supplies of and demands for funds establishes a (natural) rate of interest.

    23Hugo Bentez-Silva, Selcuk Eren, Frank Heiland, and Sergi Jimnez-Martn (2009) find that, from 1992through 2006, homeowners overestimated their homes values by between 5 to 10 percent on average.

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    future consumption. When resources are allocated towards more future consumption this

    may either take the form of foregoing present consumption to accumulate capital goods

    or foregoing present consumption by producing non-capital goods that are durable, the

    consumption servicesof which are largely enjoyed later rather than sooner.29In either

    case, there are forward-looking resource allocations being made at the expense of current

    enjoyment.

    Garrison (2001, pp. 47-49) claims that, while incorporating a time structure of

    consumption is straightforward, doing so adds complexity while clouding the

    fundamental relationships that are captured by the simpler structure[;] there is little to be

    gained analytically[.] Barnett and Block (2006, p. 55) disagree: both the time-structure

    of production [...] and the time-structure of consumption [...] are affected by changes in

    interest rates [...] and thus both should be part of the ABCT[.]30I, of course, agree with

    Barnett and Block on this point. Furthermore, since I argue above (see section 4) that risk

    externalization in the housing sector channeled funds into relatively roundabout

    consumption (rather than production) structures, the representation in figure 5 does not

    cloud the fundamental relationships relevant to the recent cycle but, rather, highlights

    them.

    The importance of risk externalization leads also to the representation of an

    additional economic structure: the risk structure. Austrians insist that capital in an

    29

    Alternatively, a third dimension could be added to the production possibilities. I believe, however, thatdoing so would be slipping off-balance from Occams razor. The Austrian insights and implications, that Iseek to highlight, are largely to be seen in changes in the Hayekian triangles. Therefore I reserve the thirddimension for that graphical component.30Barnett and Block (2006, p. 55) also note that the representation in figure 5may conflate productionstructures that, once in place, yield flows of goods throughout time and, on the other hand, goods that areconsumed over time: [c]onsistency and clarity warrant that the figure be labeled continuous-input/continuous (or point)-output/continuous-consumption[.] This point is duly noted: what I amreferring to by continuous output in this paper is the continuous flow of value through the consumptionof goods already produced.

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    economy is a complex structure. That complexity goes well beyond the single dimension

    of time. The canonical ABCT merely stresses that one dimension of the structure. I am

    here claiming that, for the recent episode, additional dimensions of that complex structure

    need to be made explicit.31Figure 5now includes an axis projecting in a third dimension

    that represents risk involved in both the (time-intensive) production and consumption of

    value. The vertical arm shared by all three triangles is now best interpreted as the

    expected value of consumption goodsarising from production and to be enjoyed over

    time.

    The horizontal axis of this third triangle is labeled as risk. Thus the triangle can

    expand or contract as more or less risk is being incurred during either the planned process

    of production or that of consumption. However, a caveat: unlike the other two triangles

    the interpretation of the hypotenuse and the triangles area is, unfortunately, not

    straightforward. Distortionary policies can cause changes in the shape of the risk triangle.

    These changes can only be loosely interpreted as discrepancies between the risk structure

    created by the policies and that which would be consistent with the preferences and

    decisions of both consumers and entrepreneurs in the absence of such policies. This is an

    admitted weakness of the framework and refinements in representing and interpreting the

    risk structure are certainly desirable.

    31That economic structure is multidimensional is a characteristic belief of Austrians. However, thecanonical ABCT focuses on a single dimension of that structure: the time structure. Ludwig M. Lachman(1978, p. 54) presents the broader view of capital theory in terms of the consistency [...] of plans withinthe economic system as a whole, i.e., theplan structure of the economy. Note that Lachman explicitlylimits his discussion to capital theory [P]roduction plans are the primary object of the theory of capital. but his description of the plan structure is easily grafted to a description of consumption plans. Also,Anthony M. Carilli, Christopher J. Coyne, and Peter T. Leeson (2008) provide a characteristically Austriananalysis of the bridging-versus-bonding structure of social capital and how it can be distorted bygovernment interventions.

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    All three dimensions (i.e., both of the time structures and the risk structure)

    cannot be viewed as independent. In particular, as the time involved in production and/or

    consumption increases the risk involved will all else equal tend to increase. As the time

    contemplated increases, so do the possibilities for unanticipated outcomes as well as the

    number of probabilistic outcomes.32For the sake of examining each structure clearly and

    independently I for the moment assume that the more or less roundaboutness of

    production or consumption does not imply changes in risk all else equal. (This

    assumption can easily be abandoned without damaging any of my claims below.)33

    Figure 6uses the framework to, first, examine a canonical ABC save for the fact

    that the time structure of consumption is allowed to vary. The boom-bust episode

    represented is not essentially changed but one can now see how changes in the time

    structure of consumption amplify the policy-induced distortions. In the top frame a boom

    is initiated by a policy-induced increase in the supply of funds, represented by a shift to

    the right of the savings curve. This shift (by assumption) is not based on changes in

    individuals time preferences but, rather, by a central bank credit inflation. The interest

    rate falls and production shifts towards more future consumption relative to present

    consumption. The cheaper funds allow entrepreneurs toplan on the completion of more

    roundabout production processes. For consumers part, the lower interest rate entices

    them toplan on financing purchases of longer-lived consumption goods. Both time

    structures on the graph expand according to these plans.

    32This statement conflates the concepts of risk and uncertainty that should be made distinct in manycontexts. However, in the context of this specific illustrationof ABCT it is not important. Frank H. Knight(1921), of course, is the classic source of distinction between risk and uncertainty.33Distortions in either time structure will result in misallocations of resources, and the same will be true fordistortions in the risk structure, if roundaboutness and riskiness are inherently, positively related. The twotypes of misallocations are not, except by complete serendipity, offsetting of one another.

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    present-oriented.34 The inconsistencies mean that planned capital structures must be

    abandoned (e.g., half-built factories are left incomplete); also that roundabout

    consumption plans must be aborted (e.g., mortgages are defaulted on; homes are

    foreclosed on).35

    Importantly, the variation of the consumption time structure could be ignored in

    figure 6(by deleting the right-hand-side triangle; assuming just a continuous input-point

    output scenario) while changing nothing else about the exposition. However, when that

    variation is introduced, the distortions in the time structure of consumption complement

    those is the time structure of production. The boom-bust cycle is amplified. Furthermore,

    which of those two distortions is more empirically relevant will depend upon the specific

    Cantillon effects corresponding to a particular historical business cycle. For example, if

    credit were to be injected only in the form of mortgage loans to consumers, the time

    structure of consumption would expand while producers, without access to those funds,

    would not necessarily undertake more roundabout production structures.36

    Moving away from the canonical ABCT, the narrative from section 4 is played

    out in figure 7. Initially (top frame) the channeling of funds into the housing market

    comes about through the GSEs secondary market purchases. These are funded through

    34Note, what is being highlighted is the inconsistencies that manifest during the bust. They are notinconsistencies relative to what plans would have been in the absence of the credit inflation. However, thisis not a welfare analysis; I am not claiming that these are deadweight loss triangles (or something of thatsort). The shaded areas are meant to indicate plan inconsistencies created by policy and given the policy.

    These are the points of crisis that manifest with the onset of bust.35There is also an inconsistency of plans visible in the risk structure. This does not indicate a positiverelationship between risk and roundaboutness (which I have assumed away; see above). Rather, in lieu ofsuch a relationship, all else equal risk is proportional to the value of present consumer goods. Given thissimplification, the inconsistency is between plans for less present consumption (less risk) and plans formore present consumption (more risk).36Of course they might; specifically, if the construction of homes called for production structures that weremore roundabout than the typical production structure in the economy, then the shift towards homeconstruction would entail a lengthening of the aggregate time structure of production. However, there is noa priori reason to believe that this is the case. (See section 3 above and Young (2012).)

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    an increased supply of savings (i.e., purchases of Fannie and Freddies debt) that is

    encouraged by externalizing the risk associated with mortgages. The GSEs debt is

    implicitly guaranteed by taxpayers broadly and individuals who purchase it do not bear

    all of the risk associated with the activities being funding. At the same time, by loosening

    their standards in terms of which mortgages they buy, the GSEs open borrowing

    opportunities to individuals who, by those previous standards, would have been deemed

    not creditworthy. Mortgage originators are essentially given incentives to ignore adverse

    selection problems. As these individuals gain access to the mortgage market, the effective

    demand for funds increases. Again, the risk associated with these new market participants

    is externalized to the taxpayers generally.

    Since both supply and demand are increased in the loanable funds market, the

    effect on the interest rate is ambiguous. In the reality of the recent cycle, the Federal

    Reserve was maintaining loose monetary policy during the years following the 2001

    recession. Interest rates, in response, were generally low. However, note that the

    ambiguous effect on the interest rate makes intelligible the boom in the housing market

    specifically while mortgage rates were not particularly low relative to other US interest

    rates. (See figure 1.) For simplicity, figure 7is drawn such that the net effect on the

    interest rate is nil.

    In the bottom panel of figure 7highlights unsustainable economic distortions that

    become apparent during the bust. The inconsistencies between the planned time structure

    of consumption and savings plans are shaded. Also shaded are the discrepancies between

    the triangles drawn in third dimension. These discrepancies are between production and

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    consumption plans initiated during the boom and alternative plans that are consistent with

    choices made assuming that the relevant risks are internalized.

    The above exposition is admittedly crude. There are some particulars that I am not

    entirely comfortable with. As I comment on above, for example, the interpretation of the

    risk structure triangles hypotenuse and area is, unfortunately, not straightforward.

    Increasing the complexity of the framework can go a long way towards smoothing out

    these rough points. However, in experimenting with more complex alternatives I faced

    the danger that the exposition was becoming muddled and unwieldy. I therefore leave

    further refinements to future research.

    6. Concluding Discussion

    Some theories of the business cycle are identified with a particular source of the cycle,

    e.g., real business cycle theory. Real business cycle istheparticular hypothesisthat a

    large part of macroeconomic fluctuations are caused by exogenous productivity (or

    technology) shocks. Compare this to new Keynesian theorywhich is body of hypotheses

    that emphasize certain aspects of the economy price and wage rigidities; preference

    shocks (animal spirits); imperfect competition, etc. A new Keynesian theory incorporates

    at least some of these elements but not necessarily all of them in an attempt to explain

    or account for the business cycle.

    I view ABCT as akin to the latter in this regard. Austrians emphasize capital as a

    complex structure; the essentiality of the price system for conveying information and

    coordinating individuals; the monetary calculations of entrepreneurs, etc.An ABCT is an

    account of the business cycle or a particular cycle that attributes importance to some

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    combination of these elements. As Garrison states, Austrian explanations for the cycle are

    variations on a theme. The canonical ABCT, developed by Mises and Hayek to account

    for a Great Depression world, is one such variation.

    But it is only one such variation. I have argued here that too many authors have

    been content to cram the recent business cycle and financial markets crisis into the

    contours of the canonical theory. The fit has not necessarily been flattering. Specifically,

    I argue that two elements essential for an account of the recent episode have been largely

    neglected: (1) the risk externalization in the housing/mortgage market arising as a result

    direct result of the GSEs (and indirectly as a result of the Federal Reserve) and (2) the

    time structure of consumption and the particularly roundabout nature of housing services.

    To rectify for this neglect, I articulate an ABCT that emphasizes (1) and (2). This

    theory, along with the empirical facts, makes intelligible a boom that was centered in the

    housing/mortgage market despite mortgage rates that were not relatively low in the US.

    The theory is illustrated as an extension of Garrisons (2001) diagrammatical framework.

    In addition to accounting for the recent cycle, the extended framework can be used to

    illustrate various ABCTs that are consistent with various particular historical contexts.

    Policy-based distortions to the workings of the price system can be analyzed in terms of

    the time structure of production (consistent with the canonical ABCT) but also the time

    structure of consumption and the risk structure of the economy.

    Hopefully, the present theory and exposition can guide empirical investigations of

    the recent US cycle. Essentially all econometric studies of ABCT have been guided by

    the canonical theory; their testable implications based on the time structure of production

    (e.g., Le Roux and Levin (1998), Keeler (2001), Mulligan (2002, 2005, 2006), Young

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    (2005), Bismans and Mougeot (2009), and Sechrest (2009)) . Future work should exploit

    the opportunities to estimate, document, and examine Austrian-type patterns in the risk

    and consumption time structures. The same can be advised for cliometric studies.

    Historical data can be sought and gathered in reference to risk and consumption time

    structures.

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    FIGURE 1.30YEAR CONVENTIONAL MORTGAGE RATES AND AAA CORPORATE BOND

    YIELDS,1990-2011

    Note: data are from the Federal Reserve Board of Governors. Bond yields are Moodysseasoned Aaa corporate bonds.

    0.00

    2.00

    4.00

    6.00

    8.00

    10.00

    12.00

    1990-02-01

    1991-03-01

    1992-04-01

    1993-05-01

    1994-06-01

    1995-07-01

    1996-08-01

    1997-09-01

    1998-10-01

    1999-11-01

    2000-12-01

    2002-01-01

    2003-02-01

    2004-03-01

    2005-04-01

    2006-05-01

    2007-06-01

    2008-07-01

    2009-08-01

    2010-09-01

    MORTG

    AAA

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    FIGURE 3.THE GARRISON (2001)FRAMEWORK

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    FIGURE 4.THE GARRISON (2001)FRAMEWORK:A DECREASE IN TIME PREFERENCES

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    FIGURE 5.INCORPORATING A TIME STRUCTURE OF CONSUMPTION AND A RISKSTRUCTURE

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