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5/16/2005
Business Cycles

The essence of the Austrian theory of the business cycle is that interest rate moves induce businesses with different degrees of length of time in the production process, and debt relative to equity, to show differential responses in the prices they pay and the output they produce. "The expansion of credit due to the artificial reduction in interest rates increases the quantity of money in circulation, and this monetary increase inevitably reduces the subjective value of each monetary unit in the eyes of market participants. The producers of production goods usually borrow large sums of money to carry out their enterprises. Consequently they are among the first to respond to lower interest rates."  From a review by Bettina Greaves in Liberty magazine of Hayek's Journey: The Mind of Friedrich Hayek by Alan Ebenstein.

The theory assumes that people make irrational decisions and don't learn from experience, and that there are such things as business cycles. Furthermore, for investment purposes, that these effects somehow aren't taken into consideration by the stock market as it traverses its inevitable path. In any case, it's a suggestive hypothesis. It seems particularly relevant these days when technology stocks respond so much differently to reductions in interest rates, as on Friday, when Nasdaq was up 1% with the S&P down %. I will be presenting some empirical results sparked by these ideas shortly and am open to any specific hypotheses that might be tested with such things as the readily available Russell 2000 breakdown of stocks into 12 industry groups or the S&P 500 breakdown into energy, consumer staples, materials, financials, health care, industrials, consumer discretionary, utilities, telecom, and info tech.