Austrian Business Cycle Theory Redux (long)

[DcifrThs]

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the first question i have is with respect to future consumption. how does increased wealth (and thus an increase in consumption ability) as a result of housing price increases (due in part to those low interest rates) and increased investment holdings (again due in part to lower interest rates) play into the theory.

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I'm no expert, but I believe the correct way to look at this is on an economy wide scale. Housing prices going up doesn't inherently create more wealth at all. The same houses still exist in the same fashion as before, only more expensive. Someone will gain from this (the seller) but someone will also be hurt by it (the buyer). Overall, the economy is not worse or better because houses are more expensive. So increasing housing prices does not create wealth. The amount of houses is still the same.

I'm pretty sure that's correct.

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I think you're half-right - overall real wealth doesn't change but the economy is worse off for the inflated prices. The way I read it, housing would be considered a factor of production, as shelter for labor. The artificially low interest rate leads to overvalued housing (investment properties). The misallocation of resources continues until an inevitable recession corrects for the mistakes.

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what proportion of houses in the economy are "investment houses" vs. "home" houses?

when i say that price appreciation increases wealth, i'm looking at the overall wealth of the economy on the grand scale. i.e. buyers of new houses at higher prices lose consumption ability while sellers gain it, but people who aren't looking to sell their houses are the ones i want to look at. they are, as a result of appreciation, able to either invest more for future consumption (via equity and other asset class risk premia that will create more wealth in the future) or choose to invest more now, which would drive up aggregate demand (though that would perpetuate the problem at hand according to the OP since it is just a dislocation of consumption rather than an increase in consumption ability in the future).

however, looking into the future, we can see that if overall house price appreciation can be expected to outpace inflation (i.e. population growth increasing the demand over time for teh same limit amount of land) there will be real wealth creation via strategic investment despite artificially lower interest rates. further, that "present consumption" that perpetuates the austrian cycle need not be a simple one time thing, but something expected in the future as some % of "home"owners use borrowings to spend now.

this increase in aggregate demand can be sustained into the future mopping up some of that excess production that businesses have invested in due to lowered rates.

anyways, my point is that there are things that lead to real consumption appreciation as a result of lower interest rates (in part) and a stronger economy. those things are capital appreciation via investments in stocks, bonds, REITs etc that do in fact create excess returns over and above the relative level of risk above the "risk free" rate of return.

that excess return, in aggregate, will lead to a larger ability to consume in the future.

my question is how does this play into the austrian economic theory assertion that one of the problems with managed economies and artificially low interest rates is the inability of future consumers to consume the extra investment (i haven't seen any treatment of it yet). if they can do this perpetually, then perhaps the system is beyond sustainable. i don't have the answers but i'm posing the question.

thanks,
Barron

[Eihli]

Thanks again Borodog.

[Borodog]

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thanks for taking the time to do this. great intro and well organized.

so let's go with one issue at a time.

the first question i have is with respect to future consumption. how does increased wealth (and thus an increase in consumption ability) as a result of housing price increases (due in part to those low interest rates) and increased investment holdings (again due in part to lower interest rates) play into the theory.

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I think your housing question might be related to equity perhaps? My understanding of Austrian theory is that the inflated money supply tends to find its way preferentially into certain secotrs of the economy and form larger bubbles there; this is typical in the stock market and real estate, and in the late 90s it occured in internet companies. In other booms it has been other sectors and industries. Inflation causes people who are still trying to invest to become increasingly sensitive to try to find investments that beat the inflation. If a sector or industry rises above the rest, it will tend to draw investment, which of course will inflate prices in that sector, which draws more investment, etc. A bubble forms, and values in the sector become divorced from the "real" value as much of their value comes from investment demand. Eventually though the bubble pops as discussed. By this time, there has been a lot of malinvestment.

From a recent article by Peter Schliss:

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This week, several of Wall Street’s best foreign customers announced staggering losses on the American mortgaged backed securities they had been sold. The fundamental issue underlying these losses is that Americans borrowed more money than they can afford to repay. As initially low teaser rates expire and mortgage defaults increase, foreign lenders are discovering that the residential properties that collateralize the mortgage bonds are not worth anywhere near the loan amounts.
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It will not be long before American borrowers come to a similar realization. When they do they will be faced with the shocking reality that all of their home equity is gone -- having disappeared just as quickly as did the paper profits of the Internet stock mania.

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one aspect you stated was that the dislocation of future consumption to the present due to low interest rates eventually leads to an inability of companies to sell the increased production they realized. but icnreased wealth (even if NOT used to borrow unsustainably via responsible mortgages or investment gains) definitely does lead to increased consumption.

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I'm not sure what you're saying here. There isn't any increased wealth, at least not compared to what there would have been in the absence of the artificial inflation. In fact, just the opposite; consumption has been increased all right, but that reduces wealth, savings has decreased, which reduces wealth, and malinvestments are created, which reduces wealth.

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is it the theory here that this increased consumption in the future isn't enough?

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? Enough to what? There is no increased consumption in the future; in fact there is less. That's the point. You get less consumer goods in the future because you over-consumed and under-saved and malinvested in the present. Today's artificial boom must be payed for with tomorrow's all too real bust.

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lets start with that issue first.

and just to head off a rebuttal: zygote has mentioned before that "investments in stocks don't result in real gains." i believe this issue has been put to rest that the capitalist system demands excess returns given to investors in order to compensate them for taking the risk of owning those shares. otherwise, they wouldn't hold shares. so investment in stocks (and other similar investments) do result in real gains, not just movement of savings into the future by the discounted value of that money.

therefore, real gains as a result of investment lead to increased consumption abilities in the future and increased aggregate demand...maybe enough to offset the dislocations you discussed...

Barron

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I'm not sure what you're saying here, exactly, but investment of real savings in stocks, like investment in say, art, still represent prior production that has not been consumed, which will then certainly lead to real economic gains. But that can't offset anything. It's just a particular form of the savings that I talked about before. Artificially expanding the money supply still has all the negative effects mentioned, because it increases current consumption, drives a wedge between real saving and investment, distorts the structure of production, and leads to malinvestments.

[DcifrThs]

one quick correction first, you said that investments in stocks represent prior production that has not been consumed. obviously that isn't correct as it represents claims on future production that will be consumed in the future.

other than that, thanks for responding. i think we may be talking past each other since there seems to be overall increased wealth from the investment in stocks.

given that low interest rates result in lower investment vs. consumption, it also would increase equity prices artificially in the present (though appreciation of equities over time will still outpace inflation, risk free rate etc.) and thus draw more investment to equities.

(i.e. studies have shown that increases in equity prices engender larger allocaitons to equities).

thus, there is some investment going on even with lower interest rates. this investment will in the future be larger than the simple discounted value of those cash flows (i.e. larger than the time premium). so wealth will be created and the ability to consume will be increased in the future.

relative to the overall economy though, this might be small enough to not have a big enough impact.

but stepping away from that part of the argument for a moment, i have another, maybe unrelated question:

let's assume for a moment that i were to agree 100% with austrian economic theory. what would you recommend on a day to day basis for somebody to do? do you think it makes sense to not study and read as i currently do (about our system as it is right now?)? even if i were to believe this 100%, i doubt that it will come into effect anytime in the near future (i.e. i think the managed system will persist for a long time).

so what is an austrian to do is my overall question? studying economic theory does little beyond the understanding of the theory. once you understand (and in this case of hypotheticals, agree with) it, there is little else to do on a daily basis. one then is left with the question of what to read and study.

personally i do a ton of reading about our current system and how to function optimally within it. just learning about austrian economics now is interesting and thought provolking, so thanks for that.

but whiel we discuss your original post, i'd like to get your thoughts on "what is an austrian to do?"

thanks,
Barron

[Zygote]

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zygote has mentioned before that "investments in stocks don't result in real gains."

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I did not. I said all capital gains result from successful entrepreneurial lending or other +ev bets, not passive investing. Passive/risk free investing would not result in gains since there is only time preference involved.

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i believe this issue has been put to rest that the capitalist system demands excess returns given to investors in order to compensate them for taking the risk of owning those shares. otherwise, they wouldn't hold shares.


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I think you need look at the last i reply i left in the 'Politics' thread.

Since there is no precise default rate available providing perfect information, investors generally must estimate these factors and should demand yields that are higher than default to get gains. However, not all investors are successful. Many investors end up in with higher true default risks relative to their expected yields and do lose out in the long run.

This can even happen with your "riskfree" treasury bonds. If the bonds were risk free they would never really need to raise interest rates either.

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so investment in stocks (and other similar investments) do result in real gains, not just movement of savings into the future by the discounted value of that money.


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I agree. These are entrepreneurial gains though, not pure capital gains (as in passively earned capital interest - originary interest).

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therefore, real gains as a result of investment lead to increased consumption abilities in the future and increased aggregate demand...maybe enough to offset the dislocations you discussed...


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Entrepreneurial lending can only suffice so many businesses because lenders only have so much real wealth to invest. Unless you can find a way to infinitely fund the businesses that are tied to the increase in consumption then this limited wealth aspect will catch up.

No one is saying these aren't profitable or useful companies per se, even though this is technically true, but mostly what is being said is that they are comparatively unworthy of capital. Given limited resources we must choose how much to invest now and how much to save for later. If we invest all of this now, from artificially low rates, then we are spreading this limited wealth into wide range of businesses. Not all of these businesses will do well in the long run, whether from lack of available investment or general operational failure, and since capital is cheap people do little discriminating as to where the money goes. If people were forced to admit the real wealth of society then they would only speculate on the more reliable businesses.

Peoples savings and credit also become eroded throughout this period and there is nothing left for future investment. By pushing artificially low interest you're essentially telling people that the future is worth very little, since originary interest results from time preference. This is going to influence the consumption/savings rate beyond any accordance with peoples time preferences.

If the world was ending tomorrow, people would spend like crazy and business would do extremely well. Interest rates would become basically useless and all society would be consumed as much as possible. Lets say however that the world ends up not ending. Have the people still made wise spending decisions in hindsight?

What has happened is they've consumed future resources. They only did this because their time preference was distorted. Interest rates come about from time preference so any time you distort them you are effectively doing some variety of the above paragraph.

[morphball]

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I think you're half-right - overall real wealth doesn't change but the economy is worse off for the inflated prices. The way I read it, housing would be considered a factor of production, as shelter for labor. The artificially low interest rate leads to overvalued housing (investment properties). The misallocation of resources continues until an inevitable recession corrects for the mistakes.

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I think Borodog hit this pretty well, I wanted to add that the fed's easy money did not just result in increased prices for existing homes, but also resulted in lot more homes being built than otherwise would have.

I can think of several builders that went on a building spree and now have unsellable inventories.

[Borodog]

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I think you're half-right - overall real wealth doesn't change but the economy is worse off for the inflated prices. The way I read it, housing would be considered a factor of production, as shelter for labor. The artificially low interest rate leads to overvalued housing (investment properties). The misallocation of resources continues until an inevitable recession corrects for the mistakes.

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I think Borodog hit this pretty well, I wanted to add that the fed's easy money did not just result in increased prices for existing homes, but also resulted in lot more homes being built than otherwise would have.

I can think of several builders that went on a building spree and now have unsellable inventories.

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Yes. And too clear those inventories they're going to have to sell at losses, revealing those investments to have been malinvestments, and all those resources wasted, in the sense that higher valued resources were turned into lower valued resources (the definition of a loss).

[cookmg]

Hey Borodog,

Great OP!

A question that I keep having (I'm still new to Austrian Economics) is how do Austrians reconcile the subjective nature of value with the concept that monetary losses = wasted resources? If value is ordinal and subjective, it seems that we can't draw that conclusion from knowing that higher priced goods were turned in to lower priced goods. What am I missing? Do Austrians just consider the price system as the most useful proxy available?

Thanks!

[DcifrThs]

Zygote,

either we are talking past each other, i'm not understanding your points, or you are not understanding my points.

let's first agree the point i was stating: it has to do with future consumption ability. i contend that investment in a passive portfolio to collect risk premia will deliver excess returns that will increase consumption ability in the future rather than just move that consumption (as a result of time preference) from the present to the future.

do you agree with that statement?

if not, i'll formalize my argument so that you can poke holes and show me exactly where my logic is incorrect.

thanks,
Barron

[NajdorfDefense]

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tl;dr: Artificial credit expansion causes the business cycle.

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tl/dr:
And how do you distinguish btw natural credit expansion and 'artificial? How do you know that assessment is correct, since it relies on 'self-evident' assertions rather than math and econometrics?

I do believe that they have made several important contributions to the field, however.

'3.4.2. The Incorrect and Controversial Aspects of the ABC
What then remains controversial about the ABC - and, as the sequel argues - incorrect? Some of the more important features of the ABC include:

Proposition 3: Monetary expansion distorts the structure of production in an unsustainable way.
Proposition 4: The ABC explains the "sudden general cluster of business errors."
Proposition 5: The ABC provides the best explanation for why downturns hit the capital goods sectors especially hard.
Proposition 6: Only the Austrian theory can explain the existence of inflationary depressions (or "stagflation").

Austrians along with almost all other economists accept that expansionary monetary policy tends to reduce interest rates (definitely real interest rates, and usually nominal rates as well) in the short term.[46] There is no question that this change in interest rates tends to affect the profitability of different investments; as Austrians emphasize, with lower interest rates, more "round-about" investments will become profitable. Projects with returns further in the future previously might have had a negative present discounted value; lower the interest rate, and the PDV quite possibly might become positive. Bohm-Bawerk's capital theory - focusing on the intertemporal coordination of numerous stages of production - does incline Austrians to be particularly aware of the tendency of lower interest rates to stimulate more round-about projects. But modern neoclassicals would surely also accept the claim that lower interest rates alter PDV calculations in favor of investments with more distant returns.[47]

Thus, it is readily conceded that (a) expansionary monetary policy reduces interest rates, and (b) lower interest rates stimulate investment in more round-about projects. Where then does the disagreement emerge? What I deny is that the artificially stimulated investments have any tendency to become malinvestments. Supposedly, since the central bank's inflation cannot continue indefinitely, it is eventually necessary to let interest rates rise back to the natural rate, which then reveals the underlying unprofitability of the artificially stimulated investments. The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account.

In short, the Austrians are assuming that entrepreneurs have strange irrational expectations. Rothbard states this fairly explicitly: "[E]ntrepreneurs are trained to estimate changes and avoid error. They can handle irregular fluctuations, and certainly they should be able to cope with the results of an inflow of gold, results which are roughly predictable. They could not forecast the results of a credit expansion, because the credit expansion tampered with all their moorings, distorted interest rates and calculations of capital."[48] Elsewhere, he informs us that: "[S]uccessful entrepreneurs on the market will be precisely those, over the years, who are best equipped to make correct forecasts and use good judgment in analyzing market conditions. Under these conditions, it is absurd to suppose that the entire mass of entrepreneurs will make such errors, unless objective facts of the market are distorted over a considerable period of time. Such distortion will hobble the objective 'signals' of the market and mislead the great bulk of entrepreneurs."[49]

Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation. Even if simple businessmen just use current market interest rates in a completely robotic way, why doesn't arbitrage by the credit-market insiders make long-term interest rates a reasonable prediction of actual policies? The problem is supposed to be that businessmen just look at current interest rates, figure out the PDV of possible investments, and due to artificially low interest rates (which can't persist forever) they wind up making malinvestments. But why couldn't they just use the credit market's long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates? Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot. Moreover, even if most businesspeople don't understand that low interest rates are only temporary, the long-term interest rate will still be a good forecast so long as the professional interest rate speculators don't make the same mistake. '
http://www.gmu.edu/departments/econo...an/whyaust.htm