Financial Bubbles and Austrian Business Cycle Theory

In recent months, my interest in financial bubbles, their causes and their formation has prompted me to purchase an exciting book. Specifically, I purchased a copy of Boom and Bust: A Global History of Financial Bubbles by William Quinn and John D. Turner. Although they are not Austrian economists and do not cite the Austrian Business Cycle Theory (ABCT), their theories are very similar. At first, I was amazed by his theoretical framework and his approach to the concept of speculative bubbles.

What is the bubble triangle?

Quinn and Turner provided a simple explanation for understanding financial crises and named their analytical framework The Bubble Triangle. This triangle is made up of 3 elements: speculation, negotiability and credit/money.

The speculation they define as is the buying (or selling) of an asset to sell (or buy back) the asset at a later date with the sole motivation of generating a gain. For Quinn and Turner, speculation can become a problem when novices enter the market as it heats up. This relates to ABCT in that entrepreneurs can sometimes see speculative opportunities due to error (usually government intervention), and sometimes they lose the capital saved.

Another side of the triangle is marketing. When illiquid assets become relatively more liquid than they were before, they can be bought or sold with respective ease. Of course, when an asset has high levels of liquidity, buyers and sellers can find each other without hassle. According to the authors, this aspect is critical because when an asset bubble forms, it increases its tradability; it has a similar effect on the economy as if someone trying to stop the fire pours gasoline on it. This becomes very problematic, especially if everyone owns one through an investment or pension fund.

The last and most crucial element is the credit and money available in the economy. In this aspect, Quinn and Turner have Austrian-like elements that are not present in many other stories. Essentially, they point out that by increasing the credit available in the economy, entrepreneurs and businesses would invest in deficient projects that otherwise would not have been undertaken.

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

By integrating the ABCT model, the increased tradability of poorly invested assets, and the entry of novices into the trading system in a highly speculative period, we can explain why the bust part of the cycle is so harmful. A good analogy is that sometimes the economy can start a fire; if all goes well and there are firefighters nearby, the fire remains under control. If, on the other hand, each person has a gallon of gasoline near them, the fire can spread more quickly and cause more damage.

For example, look at poorly invested mortgages during the Great Recession. In 2005, many agencies rated many of these titles as AAA. After the crisis, 83% of these AAA titles were downgraded because companies have misinterpreted the real risk of these assets. In an illiquid market, loan defaults would not have the same impact as if those loans were made more liquid so anyone could buy them. That is, when highly liquid assets result from an error induced by lower interest rates, every economic agent seems to be affected in one way or another. This problem could explain the harshness of the recession phase and why it takes so long for the economy to recover.

More attention needs to be paid to central bank mismanagement. Anyone who has read me pencil by Leonard Reed would understand how complex the various stages of production are and how the division of labor and voluntary cooperation are so impossible to coordinate by central planning. If economists have agreed that central planning has failed to coordinate the production of goods and services, how can interest rate manipulations be expected to do anything? It is more difficult to coordinate intertemporal production than immediate future production.

Overconfidence is not enough to explain why this generalization of bad investments occurs not only among novice investors but also through investment firms. Yes, novices can make mistakes when trying to speculate. But this part of the market arbitrage process seeks to find and balance the rates of profit between the different investment demands.

Conclusion

Much remains to be done on the theory of business cycles. Whether the explanation comes from one school of thought or the other is not relevant to every individual. Even so, introducing different financial concepts into the Austrian analysis could help us understand the magnitude of the boom and the pain of the bust.


Carlos Martinez is a Cuban-American undergraduate student attending Rockford University. He is pursuing a BS in Financial Economics. He currently holds an Associate of Arts degree in Economics and Data Analytics.

Sharon D. Cole