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#1
08-20-2007, 03:08 AM
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Austrian Business Cycle Theory Redux (long)
I'm posting this here because I'm really not in the mood for the usual vitriolic attacks from the usual vitriolic suspects in Politics.
I posted on the business cycle once before in Politics (another megapost perhaps 2 years ago now), but my understanding of the theory has matured since then, and it has come up a lot lately, so I thought it was time for an update. So here it is. Not a bit of this is original, by the way, barring my presentation. But the theory all comes from von Mises, Hayek, and Garrison (and the Ivan analogy comes from Garrison, too). I'm not proofreading this thing, so forgive the typos. One last thing. A lot of people have the mistaken belief that because Austrian economists aren't in the "mainstream" that the school is just some bunch of fringe wackos; this isn't the case at all. The Austrians and the neoclassicals disagree on some fairly fundamental epistemological issues, but most neoclassicals agree with the Austrians on the acutal the important stuff; marginal utility, downward sloping demand curves, minimum wage laws cause unemployment, price ceilings cause shortages, price floors cause uncleared surplusses, protectionism bad, free trade good, all the good stuff (well, except for money; the Austrians are the only major hard money school, for exactly the reasons presented here). Where the Austrians and the neoclassicals disagree is that the Austrians think the neoclassicals waste a bunch of time checking things that don't need to be checked, because they can be known to be true or false a priori, and that neoclassicals believe that mathematical models of the economy based on completely false assumptions are particularly useful. The latter has led to some pretty terrible government actions (for example, "perfect competition"), and the Austrians have a lot of problems with that. But lest anyone say that the Austrians don't know what they're talking about on business cycles, this is the theory that won Friedrich Hayek the Nobel Prize in economics. Austrian Business Cycle Theory Hayek said to understand how something could go wrong, you must first understand how it could go right. First, let’s define the factors of production, that is, land, labor, and capital. By land we mean land in the economic sense, economically accessible natural resources, whether it is farmland, mineral deposits, trees, flora and fauna, etc. By capital we do not mean money (we’ll get to that later), but rather the stock of capital goods, tools, machines, equipment, i.e. goods that increase the productivity of labor. Labor should be pretty clear in definition. At any given time, the factors of production are fixed. These factors can be allocated in a near infinitude of different combinations to form innumerable lines of production for various goods, like cars, twinkies, golf clubs, screwdrivers, drill presses, leisure time, etc. Because the actual factors of production are finite, to increase the production of one good necessarily requires a decrease in the production of at least one other good as factors of production must be shifted to increase the output of the desired good; production always has opportunity costs, since other opportunities must always be foregone to produce anything. Hence, at any one time, the factors of production are allocated among different lines of production to produce various goods in various quantities. One can imagine that a surface of allowed possible allocations exists in a (highly) multivariate production space for any given set of factors of production. For a fixed set of factors of production, one can reallocate the factors, moving along the surface of this “Production Possibilities Frontier” (PPF), but one cannot move beyond it, since that would require additional factors of production that do not exist (at least not yet). To simplify this, imagine that there are only two possible goods that can be produced, guns and butter. To produce more guns, factors of production must be shifted away from producing butter, and vice versa. One can then draw the PPF in this two dimensional space:  Two possible allocations of the factors of production are shown. The exact shape of the PPF is irrelevant; the only important thing is that there is an inverse relationship between the production of any good and at least one other good (in a space of only 2 goods, this means the slope is always negative). Now we will construct a PPF diagram that includes not two individual goods, but rather two classes of goods: consumer goods and producer goods. The former are goods that are produced for immediate consumption, like hamburgers, gasoline, and video game systems. The latter are goods that are used to more productively create consumer goods in the future, like tools, machinery and other equipment, buildings and other infrastructure, economically accessible natural resources like ore and trees, etc.  Given that capital and resources are used up during the production process (as even durable capital goods have a finite lifetime; bits dull, iron rusts, parts wear out, etc.), some portion of the producer goods is simply put towards the replacement of worn out capital goods and resources. This leaves some fraction of producer goods that increases the total supply of the factors of production:  As long as there is some production of producer goods above and beyond that needed for replacement, the total supply of the factors of production increases over time, and hence the production possibilities frontier moves outward, allowing both greater production and consumption:  This is the economy growing normally. Note that if not enough production is allocated to maintenance of the capital stock, the PPF could actually move <u>backward</u> as factors of production are lost over time. We’ll come back to that later. Note that the factors of production are not just allocated willy-nilly. There is actually a “structure of production” that operates over time. Producer goods that are immediately used to make consumer goods are called first order goods, and production goods that are used to make other production goods are called higher order goods. For example, fish might be consumer goods. A net made of palm fronds to catch fish would be a first order good, and rope to make a net to catch a fish would be a higher order good. The point of higher order goods is that they ultimately lead to higher production of consumer goods, but since they take time to create and deploy, they must be saved up to create; they delay consumption and require savings.  The longer the structure of production, the more stages it has, the more “roundabout” the production process, the higher productivity becomes. Note that I’ve drawn the structure of production with 5 stages, but this is just an example. It could have been 3 or 17. Even what you call a “stage” is largely arbitrary; the important thing is that the longer the production process, the higher the eventual productivity. Also, the more stages of production there are the more remote in time are the final production of consumer goods from the initial stages of production. Note that the process of producing producer goods that will be used to create consumer goods in the future is investment. In moving along the PPF away from consumption, we necessarily move in the direction of investment. Note that I am not saying that consumers simply abstaining from consuming immediately creates investment; this is the Production Possibilities Frontier, after all. If consumers change their patterns of spending and consumption, it takes time for entrepreneurs to realize this and adjust the allocation of the factors of production. However, in terms of what is produced at any given time, it is certain that a move away from the production of consumer goods creates investment as those factors are shifted into the production of producer goods. So, the people in the economy each have their monetary incomes, some portion of which they devote to consumption, and some to savings for future consumption. The latter constitutes the loanable funds market (careful; I am talking about a hypothetical free market without intervention in the monetary system). So, what happens to the economy if people change their ratio of consumption to savings? If they become more thrifty, then they consume less, and save more. What this would mean is that, in general, the public had become more future oriented, i.e. they have lower time preference:  What is the effect of this? Well, more productivity is devoted to increasing productivity (investment), and hence the PPF (i.e. the economy) will be able to grow faster, as increases in the total amount of the factors of production compound over time:  Note that after a time, because the economy is growing at an accelerated rate due to increased investment, consumption in the more thrifty economy (blue dashed line) is actually higher than consumption in the less thrifty economy (red dashed line) after the same amount of time has passed. This is because the PPF is advancing outward at a higher rate. Back to what actually happens when consumers become more thrifty, because the changes in the allocation of the factors of production do not happen instantly. When consumers start consuming less and saving more, it has two immediate effects on the market: it lowers the demand for current consumer goods, and increases the supply of loanable funds (their savings). This increase in the supply of loanable funds lowers the market interest rate for loans. The interest rate in the free market is the “price” of a loan determined by the supply of funds available for loan and the demand for borrowed money, hence an increase in the supply of loanable funds drives down the market price. Entrepreneurs will respond to these two changes by shifting the factors of production to a new point on the PPF. Factors of production will be shifted away from producing consumer goods, because of the lower demand, and into producer goods, because of the lower interest rate. Entrepreneurs see that long term business ventures or lines of production that previously would not have been profitable now are because of the lower cost of servicing the debt. This results in a lengthening of the structure of production:  Notice that when consumers change their preferences, entrepreneurs respond by reallocating the factors of production sure that the structure of production changes shape. Less factors are devoted to late stages, but more factors are devoted to earlier stages. This has the effect of lengthening the structure of production, increasing the number of stages. New R&D can be undertaken for example. Note that because of the increased rate at which the economy grows, the new slimmer triangle will eventually be taller than the original triangle; again we see that the new thriftier economy (in green, going from solid to dashed in time) will soon support more consumption than the old spendthrift one (in red, doing the same):  Note that it is the interest rate that coordinates the efforts of the entrepreneurs in time. Since they must bid against each other for access to the finite factors of production, and the pool of loanable funds is also finite and is in fact the savings of the consumers themselves, the interest rate coordinates the actions of the entrepreneurs (who want to borrow the funds to gain control of factors of production) with the actions of the savers/consumers. The higher the time preference of consumers, the harder it is to get them to defer consumption for savings, the more they demand immediate consumption, hence the less profitable it will be to invest in long term production processes since consumers will be less likely to have funds available to spend on those future goods (since they are spending it now). But the entrepreneurs will naturally tend to avoid these long term investments because of the high interest rates they would have to pay on the loans required to finance them. But the lower the time preference of consumers, the easier it is to get them to defer consumption for savings, the less they demand immediate consumption, hence the more profitable it will be to invest in long term production processes that will produce future consumer goods that will be ready when consumers actually have savings to purchase them (since they are not consuming but rather saving right now). And entrepreneurs will now be more likely to invest in exactly these long term projects, because of the lower interest rates. Hence the interest rate essentially tells entrepreneurs how many real resources exist, how much has been saved up and not consumed, because monetary savings are a proxy for unconsumed resources, i.e. factors of production. This is how the interest rate temporally coordinates the actions of entrepreneurs as they adjust the structure of production to fit the changing ratio of preferences for consumption to savings, in a market free of monetary intervention. Artificial Inflation So what does artifical credit expansion do to this story? Artificial credit expansion means that a central bank inflates the money supply by injecting new money into the loanable funds market. This is money that has not been saved by consumers. It represents no real unconsumed factors of production. Because it increases the supply of money in the loanable funds market, it lowers the interest rate, just as real savings would have. This artificial change in the interest rate has two effects: 1) It disincentivizes savings and incentivizes consumption. Because would-be savers do not get as good of a return on investment (because of the lower interest rate) they do not have as high of an incentive to defer consumption. Hence consumption goes up. This will drive up investment in the late stages of production to produce more consumer goods. 2) It tricks the entrepreneurs into investing in long-term production projects. These projects appear as if they will be profitable because of the artificially lowered interest rate. This will drive up investment in the early stages of production. The problem is this: the factors of production are finite; to increase production at the top and bottom of the structure of production, you must divert factors from the middle. You create “dueling triangles” that do not meet in the middle:  Entrepreneurs are trying to invest more real resources than are available. Think of it this way. Suppose you are a Soviet Housing Commissar, and you decide that some new houses new to be built. So you send Comrade Ivan down to the brick yard to inventory the bricks. Ivan heads down and counts bricks enough for 5 houses. But wanting to please his boss and avoid a trip to the gulag, he comes back and reports to you that there are enough bricks to build 6 houses. So, you have construction started on 6 houses. But when they are 5/6 completed, it becomes clear that there are not enough bricks. Bricks have been malinvested into starting more houses than could be built given the actual number of saved up bricks. So to finish some of the houses, others have to be liquidated. It’s worse than just having to knock down one house, too. Because in tearing down the house you actually break a lot of bricks. So it takes 2 torn down houses to get enough bricks to finish the other 4. One house has been lost due to that lying bastard Ivan (and it appears that two have been!), and a lot of pain and trouble had to be gone through to reallocate the bricks. Ivan is the interest rate. The interest rate tells entrepreneurs how much has been saved and not consumed, and hence how many resources are in the economy that can be allocated. They use the savings to bid against each other in order to allocate them. When Ivan, I mean, the interest rate, lies to them and tells them there are more resources available than there actually are, then those resources get misallocated into projects that cannot be completed. Those malinvestments must be liquidated, and that liquidation is a painful process in which jobs have to be lost, businesses must close, and a lot of capital gets abandoned. That’s the recession. So how can these malinvestments accumulate in the first place? What actually produces the “boom”? Shouldn’t these effects be immediately seen if the factors of production are finite? How can this go on for a decade? The answer lies in the replacement investment. Recall that some fraction of production goes toward replacement of worn out factors of production like tools, machinery, and equipment. When entrepreneurs use the injected credit to gain access to the factors of production to expand their production, they bid up the prices of those factors (more money in the economy chasing the same amount of factors means higher prices). As costs start to increase, the first place to get squeezed is replacement investment in existing lines of production. This is the “middle” of the structure of production mentioned earlier. Maintenance and replacement is deferred or skipped as the factors required are diverted elsewhere. The effect of this is that the economy appears to be expanding faster than it otherwise would; there is an unsustainable “boom”. It appears as if everything is great; wages are rising, unemployment is low, profits are high, interest rates are low (artificially so; which started off the whole thing recall). But what is really happening is that the structure of production is being distorted, the economy is rotting at the core as capital is being worn out and not replaced. The boom has to end of course. You can’t cheat the PPF. The boom ends in one of two ways: either entrepreneurs finally realize that they cannot finish the projects they started because there simply aren’t enough resources to finish those projects profitably, because the prices for the too scarce inputs have been bid up too high, or they will realize that consumers simply don’t have the savings to buy the stuff they invested in producing, i.e. output prices are too low to turn a profit. In either case, resources have been massively misallocated. Trying to stave off the latter by extending credit only makes the former worse when it finally hits. In either case, all of those malinvestments must be liquidated, jobs must be lost, unprofitable businesses must close, and a lot of bricks get broken. It is very, very painful, and you end up worse off than if there was never an artificial boom in the first place. It is not, despite what Ben Bernanke wants you to believe, better to have boomed and busted than never to have boomed at all. Not only will the PPF not be at where it would have otherwise been because you increased consumption at the expensive of savings, the wear and tear on the capital stock could actually have led to capital consumption; meaning the PPF might have actually shrunk during the boom, leaving you not only worse off compared to where you could have been without the boom, but worse off compared to where you were before it even began. Luckily, just as the artificial boom has the seeds of the bust built into it, so too does the bust have the seeds of the recovery built in. Jobs are lost and businesses close and factors are shifted from the least important lines of production. Those workers, businesses, and factors are picked up on the cheap by entrepreneurs that can better allocate them to serving customers profitably. When the economy tanks in the bust, the natural reaction of consumers is to tighten their belts, which automatically increases savings at the expense of consumption, exactly what the economy needs to recover. What is the worst things you can do in a recession? Keep the interest rate artificially low (can you say Japan?). Keep inflating the money supply and perpetuating the malinvestment and over-consumption. Don’t allow unprofitable businesses to go bankrupt (can you say bailout?). Let workers stay unemployed instead of finding productive work (can you say ever-extending unemployment benefits?). Increase taxes, especially capital gains taxes, to deter savings and investment. Artificially support wages and prices, creating unemployment (can you say FDR?). Increase government spending, especially on consumption, which comes at the expense of private investment (can you say FDR again?). Increase regulations that prevent the market from efficiently allocating resources (can you say FDR for the trifecta?). Fight a nice war (oh wait, I covered that in government consumption spending; never mind). Blame capitalists and “speculators” (an oldie but a goody). Seize private assets and destroy them Pretty much intervene in the market at all, and it will harm a recovery. tl;dr: Artificial credit expansion causes the business cycle. 
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#3
08-20-2007, 10:33 AM
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Re: Austrian Business Cycle Theory Redux (long)
Googling for some more info, I found this article to be particularly relevant. Some interesting quotes:
[ QUOTE ] Why has the Chicago school been more successful than the Austrian school? Both favor private enterprise, low taxes, minimal government, free markets, and sound money. Although differing on methodology and occasionally on policy (e.g., the Austrians support either free banking or a gold standard while the Chicago monetarists advocate a controlled fiat money policy), they have more in common than not. [/ QUOTE ] [ QUOTE ] With its concentration on entrepreneurship, capital theory, and subjectivism—the foundations of microeconomics—Austrian economics has a bright future and may even eclipse the Chicago school [/ QUOTE ] [ QUOTE ] If Austrians devote most of their energy debating abstractions, I’m afraid they will remain an obscure school preaching only to the choir. [/ QUOTE ] The latter is what bothers me most about the Austrian theory. Relying on logical axioms of human behavior can only take a theory so far.
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#4
08-20-2007, 11:33 AM
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Re: Austrian Business Cycle Theory Redux (long)
[ QUOTE ]
Googling for some more info, I found this article to be particularly relevant. Some interesting quotes: [ QUOTE ] Why has the Chicago school been more successful than the Austrian school? Both favor private enterprise, low taxes, minimal government, free markets, and sound money. Although differing on methodology and occasionally on policy (e.g., the Austrians support either free banking or a gold standard while the Chicago monetarists advocate a controlled fiat money policy), they have more in common than not. [/ QUOTE ] [ QUOTE ] With its concentration on entrepreneurship, capital theory, and subjectivism—the foundations of microeconomics—Austrian economics has a bright future and may even eclipse the Chicago school [/ QUOTE ] [ QUOTE ] If Austrians devote most of their energy debating abstractions, I’m afraid they will remain an obscure school preaching only to the choir. [/ QUOTE ] The latter is what bothers me most about the Austrian theory. Relying on logical axioms of human behavior can only take a theory so far. [/ QUOTE ] Action, not behavior (they're very different). I would advise you to learn more about Austrian economics before coming to such a conclusion, because nothing is further from the truth. Also, taking theory "farther" than it may correctly be taken is not a good way to do science.
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#6
08-20-2007, 11:52 AM
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Re: Austrian Business Cycle Theory Redux (long)
[ QUOTE ]
What is the distinction between human action and behavior? [/ QUOTE ] Praxeology is the study of action as such, i.e. the implications of the fact that humans act purposefully to employ scarce means to achieve desired ends. I would say that studying "behavior" would be to study why people choose certain ends over others, and why they choose some means over others to achieve those ends. Mises makes clear that praxeology/economics cannot address such questions.
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#7
08-20-2007, 11:55 AM
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Re: Austrian Business Cycle Theory Redux (long)
If you want to learn Austrian Economics from the ground up, you should start with Man, Economy & State, by Murray Rothbard.
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#9
08-20-2007, 01:56 PM
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Re: Austrian Business Cycle Theory Redux (long)
Boro,
I hope this generates some good discussion here. This is very interesting, but a lot to digest, and a good response / questions will take some time. I'll give this some thought this evening.
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#10
08-20-2007, 02:06 PM
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Re: Austrian Business Cycle Theory Redux (long)
Boro,
This is good. I personally think you should send this to Mises or Lewrockwell and see if they are interested in using it as an introduction piece to the business cycle. I think this could go down well as a video podcast or a podcast + slide show. Either way I applaud the effort.
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Linear Mode
