The Austrian School Warned, the ECB Didn’t Listen


by Alvaro Martin 

Looking at the current situation, one can easily perceive that our economic environment is not in the best condition. The whole of Europe is suffering from an economic stagnation, if not in some countries even a slowdown, that could very well turn into an economic recession sooner than later if appropriate measures are not taken to restructure many parts of our monetary system. The US could start experiencing the same effects soon, as we can observe from current trends on employment and productivity. Short-sighted economic policy, as that of President Trump asking the Fed for lower interest rates, or the ECB’s loose monetary policy (necessary in great part due to the lack of structural reforms by European governments), has severe effects -mostly that it only works in the short term, and leaves a tremendous economic hangover, composed of huge debt burdens and skyrocketing deficit levels.

The Austrian Business Cycle Theory (ABCT) can also shed some light on the situation in Europe by looking at how the European Central Bank has acted over the last decade, and how its actions, even if they had mild positive economic effects in the short term, are now slowing down productivity growth, impeding economic reforms, and sending countries into debt oceans – and, thus, finally, potentially accelerating the economic slowdown.

The ABCT is an economic theory primarily developed by the Austrian School of Economics from the 19th century onwards, mainly by Friedrich Hayek and Ludwig von Mises. Briefly explained, this theory is based on the idea that a tinkering with the interest rates, leading to excessive increases in the money supply of a country, by a central bank or through fractional reserve banking, inevitably creates a cycle of economic booms and busts. Booms are mostly formed by excessive spending, low saving due to low interest returns, but simultaneous investment in otherwise unproductive economic activities due to cheap credit, which generates false profit perspectives. This corresponds with a lack of fiscal restraint by the government due to near zero-percent-interest payments on debt.

After Carl Menger, Austrian theories around capital and its contribution to economic growth and value creation have their roots in Eugen von Böhm-Bawerk’s Positive Theory of Capital, where he introduces time as a factor into economic analysis and presents production processes as a lengthy but rewarding period, in which the main input, apart from capital, is time. Time is employed in production in relation to expected future profits (interest), and capital consumption is not performed in moment t, expecting this capital to be greater at moment t+1, thanks to interest and value creation.

Obviously, this is not happening nowadays, when interest rates are set near to 0% in most lending operations. The time preference model is not working well due to excessive intervention, not just from governments, but from central banks. The saving rate in the European Union doesn’t even reach 10% of household income, while in those countries most effected by the expansionary monetary policy of central banks, like Spain and Portugal, savings rates don’t even reach 5%. Due to the lack of interest return one can expect, especially on financial products, people’s economic actions have shifted to consumption and real estate investment.

Contrast this with what would normally happen: when interest returns are high, economic agents will lend a greater share of their capital, consequently increasing capital availability in the economy and lowering interest rates. On the other hand, when economic conditions aren’t positive, economic agents will take funds out of the economy, and those who remain will ask for higher interest rates for their capital due to a higher risk environment. What this will lead to is that investment will just occur in those projects which are really profitable and secure. Zombie firms wouldn’t be able to survive, whereas today they can freely restructure their debts, causing an even greater economic downturn in the future, when these companies eventually fail.

When it comes to the ECB’s ultra-expansionary monetary policy over the last decade, then we can see the starting point in 2008 by its plan to inject 200bn euros in infrastructure and strategic enterprises and sectors. Unemployment in Europe wasn’t reduced in response – rather, unemployment “magically” went down faster in those countries which promoted liberalizing structural reforms, as was the case in Germany, Ireland, and on a smaller scale, Spain.

Even though the ECB strategy failed, in 2014 they presented another public investment plan, this time with more than 500 billion euros injected into the European economy. According to the ECB, this would accelerate economic growth in the EU by an extra 1.3% up to 2020. Instead, Keynesian stimulus has failed yet again, with countries as Italy or Germany technically in a recession, and many others as Spain or France suffering from a slowdown. We can certainly talk about a Japanization of the European economy at this point. The ECB’s balance sheet, at almost 4.7 trillion euros, is accounting for nearly 40% of the total eurozone GDP – an astronomic number in comparison to the U.S., where the Fed’s balance sheet accounts for less than 18% of GDP.

To conclude, manipulated interest rates have generated tremendous intertemporal disparities in production processes, have reduced margin profits and disarmed production mechanisms. On top of it, ultra-low interest payments have disincentivized public economic reforms, and impeded private innovation, reducing competition in industry. Where all of this will end in as long as the ECB doesn’t stop it’s ultra-loose monetary policy soon, no one knows.

Alvaro Martin is an incoming student at the Bachelor’s in Economics Program at the Cambridge University.


The views expressed on austriancenter.com are not necessarily those of the Austrian Economics Center.

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