Reply to Jason Sorens: -------------------------------------------------------------------- You are quite correct that I was only describing the Fed's effect on financial markets. Other markets, such as labor markets, do not appear to be nearly as quick to respond to policy changes. Probably because an individual arbitrager can make millions by noting that inflation will be 1% higher than expected, whereas for most workers it isn't even worth thinking about in low-inflation regimes. I don't know what you mean when you say that business cycles are "continuous, institutionalized, and regular." Can you predict when the next downturn will be, how severe it will be, and how long it will last? Clearly they aren't regular in that sense. What sense do you mean? I think you need to review the exact powers of the Fed more closely. The Fed does not control interest rates by imposing price controls, as you seem to imply. It controls interest rates by adjusting the rate of money supply growth. Thus, when the Fed "raises interest rates to forestall inflation," there is nothing foolish in its behavior; this is just another way of saying that the Fed reduces money supply growth to forestall inflation, which is the only workable way to do it. ----------------------------------------------------------- Reply to Vincent Cook: ----------------------------------------------------------- By "boom," I mean a period of unusually high output, not "an increase in consumer demand relative to the demand for producer's goods." Perhaps I don't understand your definition, but it would appear to be the case that consumer goods output and prices could fall 30%, producer goods output and prices could fall 50%, and under your definition there would be a "boom" in consumer goods. You are certainly wrong when you write that "No non-Austrian theory even begins to coherently explain the existence of inflationary depressions." Here's a few: a. Natural resource shocks, e.g. oil (reduces supply, raising price and reducing output). b. Workers wake up from their real/nominal wage confusion and demand a raise to compensate for inflation (again, reduces supply, raising price and reducing output). Lucas won the last Nobel prize for his work on this idea. c. Technology shocks (again, reduces supply, raising price and reducing output). The theory which attributes business cycles to technology shocks, known as Real Business Cycle Theory (RBC), has been the hottest topic in macro theory for a decade. If you want other explanations for why capital goods industries are hurt _worse_ than consumer goods industries, there is also a simple alternative view which fits the facts better. One interesting business cycle fact is that DURABLE consumer goods suffer about as much as other capital goods industries. Very hard for the Austrian theory to explain. One simple explanation is that _any_ durable good purchase, whether durable capital goods or durable consumer goods, is going to be much more sensitive to changes in income or profitability than non-durable purchases. In any period buyers of durable goods are both replenishing their stock to account for depreciation, PLUS adjusting their desired total stock depending upon new information about profitability (for firms) or permanent income (for individuals). The arrival of a depression causes both forecasts to be adjusted downwards; often this means that there is no point even making up for depreciation, since natural wear-and-tear simply moves you closer to your new, lower total stock. Thus, mainstream neoclassical economics has a perfectly clear and simple explanation for the relative price changes you discuss, which has the added virtue of explaining the decline in durable consumer goods purchases. Your attempt to describe the asymmetry of the sectoral shift from consumer goods to capital goods makes very little sense. Wage workers in capital goods industries are unhappy when old time preferences re- assert themselves. But wage workers in consumer goods industries should be overjoyed. The former suffer while they find a new job; the latter enjoy a period of high wages. If unemployment increases because people are moving between sectors, then unemployment should also rise during the boom as well as the bust. A mistaken sectoral shift does indeed have a real cost; I agree to that without complaint. But the Austrian explanation _by itself_ does nothing to explain why unemployment is high during the "bust" and low during the "boom." It can't even explain why output declines. Bohm-Bawerk's capital theory, on which Rothbard wisely built his work, would suggest that actually the SHORT-run effect of switching to consumer goods production would be a period of _greater_ production, followed by a period in which production is less than it would otherwise have been if longer period products were tried instead. Moving along. You give four reasons why it is harder to forecast and compensate for government policy. a. Arbitrage won't work. Yes, it will; I'm talking about inter- temporal arbitrage, and I'll tell you precisely how to make money. Suppose that cheap money has lowered interest rates this year to 1%. I know that this is not sustainable, and that next year interest rates will be back to 10%. But entrepreneurs, ignorant of the Austrian theory, stupidly expect the 1% interest rate to prevail forever, ad make business decisions based on a 1% interest rate. If the long rate is 1% too (reflecting the erroneous expectation of a permanent 1% rate), it's easy to make money. Just borrow long. The first year put the money in a CD and each 1%. When the CD matures, interest rates have risen to 10%, so you loan out the money. At the end of the year, you pay back the original 1%/year bond, and pocket the extra 9%. This strategy is sure to make you money unless the long rate is 11% over a two year period. (Thus, if you have to pay back $1000 in 2 years, then the issue value must be $900.09, and $909.09 a year later.) The whole point of the Austrian theory is supposed to be that low interest rates mislead entrepreneurs; they discount future income streams at the current, low rate of interest, and wind up holding the unprofitable bag when interest rates rise. What I am saying is that due to intertemporal arbitrage, which is going on all the time all over the world, this will never happen. Even a moron knows that you don't use the current short-term interest rate to discount all future income flows. The existence of inter-temporal arbitrage on longer-term debt provides a simple and accurate alternative way to discount future income streams rationally so the "malinvestment" problem need not arise. b. People (or at least politicians) aren't predictable. Sure they are. Not perfectly. But quite well. This can be shown by looking at stock market movements immediately upon the announcement of new policies. There are often sharp changes - representing the market's correction of its forecast error - but they are incredibly small as a percent of the value of the shares traded. It is a plus or minus 1% change, not a plus or minus 50% change. Thus, in most cases the market's forecasts of government behavior are quite accurate. At least as accurate as its forecasts of world oil supply, gold discoveries, and a million other things. c. How could a passive price-taker know when interest rates were too high or too low? Easy. If the long rate is above the short rate, a robot could determine that rates are temporarily low. The bigger the disparity, the bigger the divergence. d. Investors and economists are ignorant of economic theory. Well, journalists sure are. But big mutual funds have very smart people working for them who are not ignorant. I see no evidence that Austrian- influenced funds do particularly better than just buying an index fund. Gold bugs must have been kicking themselves all through 1995 as gold stocks made almost no money while the rest of the stock market gained 35%. Your remarks on problems with government statistics are all probably right, but that hardly prevents forecasting from working. It is just less accurate than it otherwise would be. Similarly, statistics were less ample and quickly available in the 20's, but there was still plenty of information. Finally, you wisely wonder what caused the bank failures and defaults in the first place. There were several factors at work. First, an increase in money demand, which tends to create defaults throughout the economy. Second, wage rigidity encouraged by Hoover created more defaults. And finally, deflation and bank failure can and did form a vicious cycle: deflation makes it impossible for people to repay their loans, causing banks to fail, which further reduces the broader money supply and worsens deflation. ------------------------------------------------------------------- Reply to Tim Starr: ------------------------------------------------------------------- First of all, I think we should at least keep this polite. As for your substantive points: 1. It is true that small businesses cannot borrow and lend with equal ease at the quoted market interest rates. However, small businesses are a very small part of the U.S. economy; larger firms are in a very different situation. They have access to corporate bond and commercial paper markets, which allow precisely what I said -- borrowing or lending at market rates with ease. Moreover, even small businesses can usually easily implicitly lend by repaying some of their debt, so they aren't nearly as constrained as one might think. 2. I think you are confusing market-clearing interest rates and natural interest rates. Central bank intervention _lowers_ the market-clearing rate below the natural rate; it doesn't reduce rates below the market- clearing rate. Of course, lenders have no choice but to lend at the lower rate if the central bank cuts its rates. But at my remarks to Vince indicate, there is no reason for long-term interest rates to be deceptive or cause malinvestment. If due to central bank intervention, interest rates are temporarily 1%, and (known only to Austrian economists) will have to rise back to 10% next year, then this year, lenders must take 1%. But if they lend out for 2 years, they won't stupidly lend out at 1%/year for two years. Arbitrage prevents it. Otherwise, lenders could only buy short-term debt during the low-rate period, and then once rates rise they can be sure to earn the higher rates. 3. Thus, my view of business operations bears no relation to the story you tell. If rates are low now, but will be higher later, I wouldn't tell my boss not to lend. I would suggest lending short, so we could take advantage of higher rates once they hit. I would however get fired if I presented an analysis of a project's profitability, and in my calculations I stupidly used currently low short-term rates to discount all future cash flows. There is an easy way to avoid this error - look at long-term rates. And if I do so, there is no reason for any malinvestments to occur -- no more than usual error would create, anyway. 4. One way that real wages can be rigid is if it takes time for them to change. Perhaps the phrase "real wage _inflexibility_" would make the meaning clearer. 5. I do believe in malinvestments. I just don't think that the reason for clusters of malinvestments is central bank policy. Anytime someone calculates that a project will be profitable, and it isn't, there is malinvestment. But intervention in short-term rates has no systematic effect on profitability calculations. 6. As for why still-employed workers would get a compensating increase. Simple. The whole Austrian theory is based on the idea that during the boom, there is a sectoral shift from consumer goods industries to capital goods industries. Hence, during a bust, the reverse shift occurs. It stands to reason that when any shift occurs, people already in the sector for which demand is increasing would benefit, just as people in the sector for which demand is decreasing would suffer. 7. You are quite correct to mention that a decline in money supply has the same effect as an increase in money demand. However, as Rothbard clearly points out, the bust occurs when the money supply increase _ceases_. On the Austrian view, the bust could occur even if the money supply remained constant at its higher level; monetary contraction is not an integral part of the theory (although as Rothbard points out in the pre-war period monetary contraction typically did occur). This is fortunate for the theory since there has not been an absolute decline in the money supply since WWII (with one debatable month in the late 40's if I recall). 8. Hazlitt once remarked that Keynes said nothing both original and true. The same goes for the Austrian business cycle theory; insofar as it is true, it is not original, and insofar as it is original, it is not true. You amazingly claim that I have "reinvented the Austrian theory of the business cycle" by attributing unemployment to a combination of monetary contraction (or money demand increase) and rigid nominal wages. To the contrary, this explanation for unemployment has enjoyed the universal agreement of all academic macrotheorists of all schools since the 1920's. It is not an Austrian view. Keynes repeatedly affirmed it in his _Treatise on Money_ and _General Theory_. The British economist Pigou used it in his _Theory of Unemployment_ [that title could be slightly off] published in the 20's. The only difference is that Keynes accepted nominal wage rigidity as politically given, and tried to figure out ways around it. Stupid followers of Keynes failed to understand the microtheoretical underpining of the Keynesian model, but Keynes and his smarter followers such as Modigliani always knew that they were implicitly assuming nominal wage rigidity. Since the 1970's, even the stupidest Keynesian has been made aware of this fact; and essentially all academic macrotheory has built on this idea, with the exception of Real Business Cycle theory. Real Business Cycle also accepts the view that nominal wage rigidity _would_ cause unemployment, but they deny that there is any significant nominal wage rigidity. Economic journalists may still be oblivious to this fact, but no academic macrotheorist is. They may however think that reducing nominal wage rigidity is so politically difficult that they don't think the topic is very interesting.