Subject: Business Cycle Theory

From: [email-masked]
Date: Wed, 3 Jul 1996 16:24:51 -0700

Bryan Caplan writes:

>-----------------------------------------------------------
>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.

It appears that an explanation of booms and busts are in order, so we can
understand how Austrians define them.  The key to the Austrian theory is the
idea that artificial credit expansions cause a malinvestment of producer
goods, which ultimately impairs the output of consumer goods and leads to a
period of correction where producer goods are shifted back to their optimal
configuration.  The period of initial distortion is a boom, and the
subsequent correction is a bust.

Note that the artificially-stimulated demand for producer goods in the boom
phase does *not* mean that producer goods have somehow magically multiplied
in quantity as an immediate consequence of the credit expansion.  The
critical immediate consequence of a credit expansion is that non-specific
forms of labor, natural resources, and capital are shifted from stages of
production that are less remote from the consumer to stages that are more
remote, and that a substitution of technologies occurs where stages of
production take longer but yield greater output.  The artificial decline in
interest rates fools entrepreneurs into thinking that longer-term projects
are now more profitable, when in fact the long-term consumer time
preferences will not support such time-intensive modes of production.

In the correction, or depression phase, producer goods are shifted back to
shorter production processes.  Shifting as such is not a costless process,
either in the boom or the bust phase.  However, from a psychological
standpoint, the falsification of accounting and the increased demand for
labor during the boom phase make most of us feel more prosperous even if in
fact we are squandering our capital and generally wasting more of our
productive efforts.  The trauma of the bust, on the other hand, is
compounded by the wave of bankruptcies as the errors are revealed, useless
forms of capital are written off, and wage rigidity in hampered labor
markets brings about massive unemployment.

>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.

Various supply-side shocks (you forgot to mention Smoot-Hawley, which also
had the same effect) can account for price increases and declines in
consumer goods output, but they do not explain the existence of inflation
(which is classicly defined as an increase in money supply, not an increase
in prices), nor the existence of a boom-phase preceding the bust, nor the
concentration of boom/bust phenomena in capital-intensive sectors of the
economy.  Moreover, non-Austrian theories hold that demand-side stimulus
ought to spur more production and thus prevent depressions and mass
unemployment, albeit at the cost of price increases.  The real puzzle of the
1970s to non-Austrians was that stimulatory policies, while predictably
injurious to the value of the dollar, did *not* prevent a depression.  In
the 1973 to 1975 period in particular, there was a very nasty economic
downturn and a raging credit expansion/inflation occuring simultaneously.
The infamous stagflation did not fit the conventional paradigm, but it did
the Austrian paradigm.  Hayek, it should be noted, won the Nobel Prize in
1974 for his contributions to Austrian trade cycle theory.

The story of the early 1930s is complicated by the fact that supply shocks
(especially Smoot-Hawley and the dust bowl) and severe Hooveresque
interventions did occur in addition to the intitial credit collapse.  But
explaining 1929 is at the heart of our argument, and there is no obvious
supply shock you can point to that accounts for the start of the depression.

>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.  

Not at all.  While Rothbard doesn't focus much on durable consumer goods
when talking about trade cycle theory, other Austrians have.  I would
recommend Mark Skousen's _The Structure of Production_ for a more
comprehensive treatment of the subject.  In brief, durables are as much
subject to time-based calculations as are producer goods remote from the
consumer.  In _Man, Economy, and State_, Rothbard does discuss how durables
are capitalized over time according to the general rate of time preference.
It is a relatively straightforward application of time preference theory to
treat deferred consumption services provided by a consumer durable as
equivalent to a final stage of production.  The only complication is that
the price of the durable reflects a bundle of multiple services distributed
over time, not a service provided at a single time.

>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.

Whether purchasing a consumer durable or some form of fixed capital, one
calculates the present value of a good by discounting all the future
services provided by the good.  If interest rates are being manipulated, the
rate of discount changes over the course of the trade cycle.  In the boom
phase, low real interest rates imply a lower rate of discount on future
services, while higher real interest rates during the bust mean a steeper
rate of discount.  Durables, relative to non-durables, undergo an increase
in demand during the boom and a decrease in demand during the bust because
of this interest rate sensitivity of their demand.

The deferred purchases phenomena is not unknown to Austrian theory, though
there is no particular _a priori_ reason why consumer durables should be
more affected than consumer non-durables.  If one were afraid, say, of
losing their job, one might want to reduce all kinds of consumption and not
just defer durables 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.

But workers in the lower order industries suddenly have a lot of new
competitors for their jobs.  To the extent that labor is non-specific to the
lower and higher order industries, a uniform wage is going to prevail.  The
rise and fall in aggregate labor demand is due to the rise and fall in labor
demand by the higher order industries.  There is a minor mystery as to how
the higher order industry was able to pay for its increased demand during
the boom, but the answer is simple enough.  The banking system created
credit out of thin air and loaned it to the most time-intensive industries,
such that investment expenditures (which were paid to owners of various
factors of production, including labor) were able to increase without a
concurrent restriction in consumer expenditures.

  If unemployment increases because people 
>are moving between sectors, then unemployment should also rise during 
>the boom as well as the bust.

In a hampered labor market, wage rigidity is asymmetric.  Wages are usually
free to rise, but don't fall easily when all sorts of interventionist
devices are used on labor's behalf.  Nobody (except in Randian fiction)
organizes the employers to go on strike, nor does the government compel
workers to give employers special benefits or restrict the demand for labor.

>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.)

If a single investor knows the truth and profits from it, their is little
discernable macroeconomic effect.  If, on the other hand, lots of investors
begin to realize that a credit crunch is coming, something very interesting
happens.  Everybody tries to dump their 1% investments and become borrowers.
Guess what- you get a crash in the financial markets!  You wake up one
morning and see the Dow dropping a hundred points every half hour and Alan
Greenspan holding press conferences assuring the establishment that the Fed
stands ready to bail them out.  Entrepreneurs begin to recalculate how to
make a profit at the new interest rate, and quickly conclude that they must
disinvest from those businesses with the highest interest rate exposure.
The high-cap industries, suddenly cut off from credit, begin to discharge
workers and welch on their obligations.  It sure sounds a lot like the start
of a depression to me.

The point here is that a cluster of entrepreneurial errors, such as those
caused by the distortion of the structure of production brought about by
bank credit expansions, are corrected by new entrepreneurial information.
But arbitrage is only as good as the information that entrepreneurs possess.
If markets are initially ignorant of the distortion in the credit markets
and the production structure, the trade cycle will inevitably be set in
motion.  Ignorance will always prevail to some extent, so the credit
manipulations will always have some impact.  Perhaps after a few iterations
of the boom/bust cycle, some investors will learn to watch for advance signs
of credit expansions and time their investments accordingly.  The relevant
information needed for such a strategy to work is agonizingly difficult to
come by (and may not exist at all), but when it is available it can be
extremely profitable.  One wonders if the SEC has ever investigated
employees of the Fed for trading on inside information . . .

>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.

There seems to be a serious confusion here between long/short loan arbitrage
and arbitrage between current and future rates of return on production
projects.  The spread between input costs (like wages, royalties, and rents)
and output income that I get by engaging in a production process over time
is independent of how I financed the purchase of the inputs for the process.
Thus, my demand for credit is going to depend on my calculation of what
those spreads are.  Whether I sell short-term instruments, long-term
instruments, or shares of ownership of the business, the overall rate of
return on the initial expenditures for inputs is strictly a function of the
income generated by the production process.  The issuance of long or short
debt merely gives creditors a fixed portion of this income.

Since business debtors typically are not trying to be charitable to
creditors, they will not bid more for either a long or short loan than is
justified by the natural rate of return.  This means that in an unhampered
market, the yield curve on loan instruments should be flat except for
differences in risks on the various instruments.  The yield on stocks or
other evidences of ownership of productive assets likewise should conform to
the natural rate of interest.  The long/short type of arbitrage merely
serves to flatten out the yield on all types of investment securities.  Some
structural unflattening of the yield curve is possible if the central bank
prefers dealing in short-term instruments, but there is no inherent link
between the yield curve and credit expansion.  Because of long/short
arbitrage, a credit expansion injected into the short-term market will
depress long-term interest rates as well as short-term interest rates.  A
passive follower of long-rates such as was described by Mr. Caplan in his
previous post is not immune to the falsification of capital accounting
caused by the credit expansion.

Anticipated changes in the natural rate of return, however, should affect
all yields.  Expected changes in the spread between input expenditures and
output income affects all securities markets, including rates of return on
all forms of debt and equity.  It is silly to accuse Austrians of holding a
qualitative credit doctrine (which Rothbard in particular goes into great
detail to refute), because forecasts of the natural rate of return have
nothing to do with the differences between short-term and long-term loan
instruments in the Austrian trade cycle theory.  Rothbard and other
Austrians argue that a producer could just as easily track the long-term
rate instead of the short-term rate and still get burned by a credit
expansion/credit crunch sequence.

>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.

The phrase "This can be shown" in the above context is highly doubtful.
Have the positivist economists finally found some way to conduct a
controlled experiment on human beings?  Moreover, I can distinctly remember
market moves that were substantially greater than 1%.  Less than 10 years
ago, there was a stock market crash every bit as dramatic as what happened
in 1929 (losing 25% in one trading session as I recall), and the economy did
indeed slump into a downturn, though the subsequent response by the
government was mercifully less interventionist than in the Hoover/Roosevelt
scenario.  

Am I really supposed to take seriously the notion that markets are always
nearly perfectly informed?  Even the most casual glance at stock market
charts discloses a great uncertainty in the value of most companies, with
highly-leveraged cyclical companies in particular showing great flucuations
in share price.  A perfectly prescient market would not show such
variability in share prices, given that the sum of the discounted future
earnings of these companies historically have been much less variable.

>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.

See my comments above about the difference between external rates of return
on long vs. short financial isntruments and the internal or natural rate of
return on production processes.

>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%.

Austrians would be the first to tell you that economists make lousy
forecasters, and even Skousen is not a gold bug all the time.  What matters
in outperforming the market is having access to better information and
cashing in on it in a timely manner.  Having a sound grasp of economic
theory, or alternatively, having enough experience in the markets to have
good intuitions about cyclical phenomena and their effects on prices, is a
necessary but not sufficient condition for being a successful speculator.

>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.

If you cannot perform controlled experiments (where you systematically vary
one factor at a time), you can't really know what the future holds.  The
only reason why economic statistics have any forecasting value at all is
that humans tend to have the same circumstances and values tomorrow that
they had yesterday, and that there is a body of a priori theory that helps
us understand which variables are meaningful and what the direction of
causality is among these variables.  But we know humans, both individually
and en masse, can undergo substantial and even radical changes in
circumstances and values in an unpredictable fashion.  How many people do
you know who predicted the fall of the Soviet Union and the establishment of
a somewhat-capitalist Russia?  Ten years ago, how many people were investing
big bucks in the Internet?  How many of the statistical wizards in charge of
the mutual funds, etc. do you know who profited from the aforementioned
stock market crash?

>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.

(1)  So entrepreneurs are smart enough to figure out all the sudden twists
and turns of Fed policy, but they can't react to gradual changes in monetary
demand?  Since the exchange demand for money (the goods and services offered
in exchange for money) was relatively stable during the late 1920s, this
hypothesis supposes that there was a cluster of entrepreneurial error caused
by a sudden jump in the reservation demand for money (the desire by cash
holders to retain their balances instead of spending them).  This would
imply that a fall in consumer expenditures and incomes preceded the decline
in money supply and the implosion of the credit structure.  But where is the
evidence for this?  Incomes did not start falling catastrophically until
1931.  Also, it wasn't until 1931/32 that a real run on the banking system
took place.  But the challenge here is to explain what happened in 1929.
Why, at the peak of aggregate incomes and consumer expenditures during the
whole period, did it suddenly become so difficult for certain industries to
make a profit?  Why did the collapse in prices for capital goods, as
represented by stocks, begin their dive in the midst of such prosperity?

(2)  The downward rigidity of wages, while it explains why workers would
default in an environment where wages were falling, doesn't explain why
wages should fall in the first place.  The equilibrium wage is at the point
where the discounted marginal physical product of the marginal unit of labor
times the price of the output equals the wage per unit of labor.  Since
output prices and physical productivity were relatively stable, what factor
is left to account for the sudden decline in the value of labor in late
1929?  The rate of discount, of course.  It was the upward pressure on
interest rates that was putting downward pressure on wage rates,
particularly in the high-cap industries where the labor inputs were most
remote from the consumer (magnifying the effect of the discount).  It is
true that Hoover didn't allow wage rates to fall, thus creating mass
unemployment and compounding the defaults.  But Hoover didn't create the
artificially cheap credit that triggered the collapse in the first place.
One has to read Rothbard's AGD to discover who those villians were.

(3)  But since most of the defaulted loans were secured by various
collateral assets, there is the additional question of why the banks
couldn't recover their losses by selling the foreclosed collateral.
Obviously, the collateral assets had to have declined in value first before
loan defaults would cause any significant losses to the bank (significant
enough to render loan loss reserves inadequate).  Just as changes in the
rate of discount had caused downward pressure on wage rates, they also
caused a strong downward movement in the price of capitalized goods used as
loan collateral.  At a later stage (1932), rural banks faced the additional
problem that armed force was used to prevent them from recovering and
selling their property at market value (the infamous "penny sales").

Vincent Cook
[email-masked]
http://www.ucop.edu/ott/