Markets Fail, That is Why They Work: Thoughts on Garrison's Time and Money

Roger Garrison’s Time and Money lays out explicitly the Austrian Business Cycle Theory with a  focus on the impact of central bank intervention. His exposition is clear. In fact, so clear that it lays out a fundamental weakness in the theory. In the chapter title, “Sustainable and Unsustainable Growth”, Garrison argues booms funded by an increase in real savings don’t result in resource misallocation.

The market works. But just how the intertemporal markets work requires that we shift our attention to the intertemporal structure of production. The altered shape of the Hayekian triangle shows just how the additional investment funds are used. The rate of interest governs the intertemporal pattern of investment as well as the overall level. The lower interst rate, which is reflected in the more shallow slope of the triangle’s hypotenuse, favors relatively long-term investments. Resources are bid away from late stages of production, where demand is weak because of the currently low consumption, and into early stages, where demand is strong because of the lower rate of interest. That is, if the marginal increment of investment in early stages was just worthwhile, given the costs of borrowing, then additional increments will be seen as worthwhile, given the new, lower costs of borrowing. While many firms are simply reacting to the spread between their output prices and their input prices in the light of the reduced cost of borrowing, the general pattern of intertemporal restructuring is consistent with an anticipation of a strengthened future demand for consumption goods made possible by the increased saving. (64)

Garrison presents us with the beginning state, interest rates drop, and guides us to the end state, claiming that credit markets reallocate resources from the late stages of production to the earlier stages of production. Boom. There you have it. Interest rates coordinate production and markets adjust. But just how does this occur? This is a challenging question for Austrians who do not believe that business cycles can occur endogenously (not to suggest that this is the case for all Austrians).

The process of bidding away resources from the late stages of production does not occur smoothly. Let us imagine that the interest rate has dropped and new profit opportunities arise because there is a discrepancy between the rate of return for the new project and the rate of interest. Entrepreneurs will flock to the new opportunity. The more attractive the opportunity, the greater the number of entrepreneurs who will pursue the project. The entrepreneurs know that they are competing against other entrepreneurs and that not everyone can be successful in this endeavor. Likewise, banks provide credit to entrepreneurs that they believe will be successful. Again, the banks are aware that not every investment in this new opportunity will succeed, but they hope to do better than their competitors by allocating loans wisely and operating efficiently.

With the passage of time, entrepreneurs either reap rewards for their success or losses for their failure. The rise of the interest rate from increased demand for loanable funds and the fall in the rate of return on the new projects from the increase in entrepreneurial activity make this scenario unavoidable. There will be failure and it will occur under conditions where all actors are profit maximizing. If there was significant interest in the sector where the new investment opportunity arose, there may also be significant levels of failure, especially if the sector is highly competitive. We can expect that, alongside bankruptcies, prices in the sector will fall and credit will tighten due to debt-deflation. That is, bankruptcies will decrease the amount of funds available in the sector. Eventually, these assets will be bought by successful firms or new entrepreneurs at lower prices.

Thus, we have the formation of a business cycle without central bank intervention. This is not to suggest that central bank intervention in credit markets cannot encourage bubbles to be larger and more numerous, only that this should be the starting point of a business cycle theory. As Joseph Schumpeter argued in “The Explanation of the Business Cycle”,

…is it not imperative to develop for the purposes of fundamental explanation an analysis independent of the occurrence of impulses from without – an analysis of the way in which new things come to be done in industrial life, and old methods come to be eliminated together with those firms who cannot rise above them? (297)

It is imperative that we have an endogenous theory of the cycle as our starting point. This is a story where low interest rates induced from increased savings encourages a boom and subsequent bust. Garrison’s model does not allow for this. It suggests that markets transition smoothly from one state to the next as long as changes in the interest rate are produced endogenously.

That is, the change in the underlying economic realities imply an altered growth path; the market process translates the technological advance into the new preferred growth path; and there is nothing in the nature of this market process that turns the process against itself. (60)

Nothing to turn the process against itself? Nothing except the entrepreneur. Nothing except competition and failure. Markets fail. That is the beauty of markets.