Prof. Bryan Caplan

Econ 918

Spring, 1998

Week 5: The Austrian Theory of the Business Cycle and Rational Expectations

  1. Austrian Business Cycle Theory: Some Background
    1. First appears in Mises' Theory of Money and Credit, combining Mises' ideas on money, the natural interest rate theory of Wicksell, and Böhm-Bawerk's capital theory.
    2. Later developed by Hayek (and also Robbins); cited as one of Hayek's main contributions by the Nobel committee.
    3. Rothbard offered several clear and clean explanations of ABC, along with virtually the only empirical application of the theory.
    4. Rothbard's close associates have continued to defend the theory's universal applicability. Others have made far more moderate claims. Another large group of Austrians simply lost interest in ABC, without much explanation.
    5. Why study ABC?
      1. It's a topic where GMU students have a comparative advantage (assuming it's at least a somewhat promising theory).
      2. It's a clear and practical piece of applied Austrian economics.
      3. Extremely strong claims have been made in its favor, which makes it especially interesting to me: "Followers of the Misesian theory have often displayed excessive modesty in pressing its claims; they have widely protested that the theory is 'only one of many possible explanations of business cycles,' and that each cycle may fit a different causal theory. In this, as in so many other realms, eclecticism is misplaced. Since the Mises theory is the only one that stems from a general economic theory, it is the only one that can provide a correct explanation." (Rothbard, America's Great Depression [1963])
      4. Interesting to see whether ABC is consistent with RE.
  2. The Structure of Production and the Natural Rate of Interest
    1. Neoclassical economists typically model capital as a single good. Since Böhm-Bawerk, Austrians have taken a quite different approach:
      1. Heterogeneity of capital goods.
      2. Time dimension of capital goods: Production is not contemporaneous with consumption; instead, each period people are consuming the product of last period's production.
    2. Mises combined Böhm-Bawerk's capital theory with Wicksell's theory of the natural rate of interest. The natural rate of interest is the "fundamental" rate determined by time preference. (Note that this is identical with the conclusion reached in the notes of week 1).
    3. Note the implications of the natural rate on the time structure of production: as the natural rate falls, projects with gains further in the future become profitable.
      1. Just combines the logic of PDV calculations with the insight that production is typically not instantaneous.
      2. Note the value spread between each stage, as can be seen in a "Hayekian triangle." Spread includes both value added of factors plus implicit interest return.
  3. What's Puzzling About Business Cycles?
    1. Rothbard describes three puzzles that a business cycle theory ought to solve:
      1. Why is there a sudden general cluster of business errors?
      2. Why do capital goods industries fluctuate more widely than consumer goods industries?
      3. Why does the quantity of money increase during the boom?
        1. Why does the money supply generally contract during the bust (as of 1963)? (Extra puzzle: Why doesn't the money supply contract during the bust in the post-war era?)
  4. ABC, I: The Boom and the Bust
    1. Suppose that the interest rate is at its natural rate. Then the government prints up some money and loans it out, pushing the interest rate below its natural rate as determined by time preference.
    2. This change in interest rates misleads entrepreneurs: they suddenly find that with lower rates, projects with returns further in the future seem like they will be profitable, so they undertake them.
    3. But one injection of money won't keep interest rates low for long. Eventually, the old time preferences re-assert themselves, interest rates rise back to their natural level, and projects predicated on continued low rates are shown to be unprofitable.
    4. Of course, the government could "repeatedly dope the horse" by continuously injecting more money into the loan market to try to hold rates down. But eventually inflation will be too severe for the money injection to continue. When this day passes, interest rates are allowed to rise back to their natural level - and wide-scale entrepreneurial errors become apparent throughout the economy.
    5. In short: Artificially low interest rates confuse entrepreneurs, leading them to invest too much in long-run projects, too little in short-run projects. Once interest rates rise back to their natural level, the errors are revealed and the correction can begin.
      1. Bank failures, need to defend the gold standard, etc. may actually force the money supply to decline rather than merely cease growing.
  5. ABC, II: Unemployment
    1. Early criticism of ABC: "it assumes full employment."
    2. Reply: full employment is not an assumption; its a conclusion. If there is unemployment, it just shows that wage rates are too high - as with all other goods.
    3. The ABC initially seems to have no clear prediction about employment: in the boom, labor demand in long-term projects grows, while labor demand in short-term projects declines. In the bust, the situation reverses.
      1. Sectoral shifts models would suggest that unemployment would be high during both transition periods!
    4. A minor premise of the ABC, however, is that when the government's monetary injections stop (or slow), AD falls (or rises at a slower-than-expected rate). In itself, this is harmless vis-a-vis employment, but combined with nominal wage rigidity it can give rise to mass unemployment.
      1. N.B. Austrians typically blame nominal wage rigidity entirely on government price controls, or on unions (especially when they enjoy government support of some kind).
  6. Caplan's Critique of ABC: (from "Why I Am Not an Austrian Economist")
    1. The real-wage/employment connection is right and important, but almost all modern economists would accept this. (albeit with a more sophisticated theory of wage rigidity).
    2. The rest of the ABC is wrong:
    3. The ABC violates RE: entrepreneurs are assumed to stupidly think that low interest rates will prevail indefinitely, and base their PDV calculations on this assumption.
    4. While temporarily low interest rates stimulate investment in more long-run projects, there is nothing unsustainable about this unless entrepreneurs systematically over-estimate how long the low rates will last.
    5. How can entrepreneurs be so smart about the market but so dumb about government policy?
      1. N.B. If entrepreneurs are dumb, but financial market wizards aren't, the former could just use the information of the latter as captured by the term structure of interest rates.
    6. Garrison's reply to the RE critique of ABC.
    7. Other problems:
      1. Why don't consumer goods industries actually expand during depressions?
      2. Doesn't Böhm-Bawerk's capital theory imply short-run suffering during the boom and short-run prosperity during the bust? (The asymmetry puzzle).
      3. Simple RE monetarism explains Rothbard's first and third puzzle.
      4. Neoclassical durable goods theory provides a simple explanation for Rothbard's second puzzle - why capital goods industries have extra cyclical sensitivity.
      5. Stagflation no argument for ABC.
  7. Cowen's Critique of ABC (from "The Austrian Claim")
    1. Even if you don't believe that entrepreneurs have RE, the ABC will only be true if a long list of assumptions about entrepreneurs' irrational expectations is true.
    2. A1: "Entrepreneurs make systematic errors in the most costly possible direction by choosing excess capital-intensity."
    3. A2: "Volatility associated with inflation might discourage rather than encourage long-term investments."
    4. A3: "Entrepreneurs will confuse monetary inflation with an increase in private savings only if private savings is volatile."
    5. A4: "Entrepreneurs might confuse monetary inflation with declines in investment demand, rather than with increases in private savings."
    6. A5: "Confusions about real vs. nominal interest rates may imply that chosen term-lengths are too short rather than too long."
    7. A6: "Austrian claim requires that interest rates provide relevant and significant signals about the composition of consumer demand."
    8. A7: "Requires special (and implausible) assumptions about how investors interpret interest rate signals."
    9. A8: "Constant or roughly constant rates of nominal money growth may validate newly chosen long-term investments to considerable degree."
    10. In sum: RE implies that ABC is false, but not-RE does not imply that ABC is true.
  8. ABC and Austrian Economics
    1. The ABC is at least practical economics. It addresses a number of substantive issues and tries to explain them. Even if it lacked the sweeping validity that e.g. Rothbard claims for it, it would be an impressive piece of work, and worth doing further research on.
    2. Unfortunately, the ABC is on inspection scarcely coherent. Not only does it violate RE (as I emphasize), but it requires many specific non-RE assumptions (as Tyler emphasizes).
    3. Any further research on ABC needs to deal with these expectational objections, moderate its claims, and recognize the extent to which some parts of the ABC are already conventional wisdom.