by Mario Rizzo
There has been recent discussion in the blogosphere of the so-called Austrian Business Cycle Theory (ABCT). (We must not forget to give the Swedish economist Knut Wicksell credit as well.) Some of it is interesting (mostly because of the comments) but much of it is ill-informed since the bloggers don’t like to read scholarly Austrian work. For a good blog post with references to what others have been saying, see Pete Boettke’s discussion at Coordination Problem.
The first thing to keep in mind is that while this theory embodies “Austrian” characteristics it is not an official Austrian theory. What do I mean by that? Eminent Austrian economists have made important criticisms of the bare-bones theory. For example, Israel Kirzner has criticized the theory for not taking entrepreneurship seriously. Where are the alert entrepreneurs either in the boom phase or the recession phase? There are profits to be made from avoiding mistakes. Another eminent Austrian economist, Ludwig M. Lachmann — one of the main contributors of the development of the idea of capital heterogeneity which is an important constituent part of the cycle theory — criticized the ABCT for assuming that agents simply expand their investment whenever interest rates fall. And Ludwig von Mises agreed that we need to take account of what the agents expect about the future course of interest rates.
Second, the ABCT is only a partial theory of the cycle — specifically of the upper turning point. We should also not expect it to explain all business cycles — just those which are generated by excessive credit expansion to businesses.
Third, the ABCT is a work-in-progress. I agree with Tyler Cowen that we can build on it. On the other hand, I am not so critical of its present state to believe that it does not capture important features of the current cycle unseen through Keynesian glasses.
As the reader will see below there are certain “Keynesian” features in the boom and in the recession. But the key difference is that aggregate movements are constituted by relative (sectoral) movements or distortions. Thus, the boom becaomes unsustainable due to real factors (resource constraints).
(I should add that the idea that aggregate (demand) movements are “really” relative movements — a mismatch between sustainable supply and demand in various sectors or a failure of coordination goes back as far as J.B. Say. This is how informed economists understood Say’s Law long before Keynes wrote. So calling this aggregate aspect a “Keynesian” feature gives Keynes undeserved credit. See Steven Kates, On the True Meaning of Say’s Law, Eastern Economic Journal, Spring 1997.)
Keynes was completely uninterested in why the boom collapses except to talk about “animal spirits.” People lose confidence. Yes, but why? Are they simply nuts? Not in the Austro-Wicksellian view.
The conversation would be advanced quite a bit if people would read the scholarly literature.
Below I reproduce portions of my article for the New Palgrave Dictionary of Economics (on-line) called, “Austrian Economics: Recent Work.” So begin here. (For the bibliography, go either to the gated New Palgrave site or to my bepress site)
“The Austrian Business Cycle Theory (ABCT) received a major systemization and reﬁnement in the work of Roger Garrison, culminating in his book, Time and Money: The Macroeconomics of Capital Structure (2001). The previous work in the subject was scattered in many articles by Friedrich Hayek and in the work of Ludwig von Mises. It was also very imperfectly linked to the brilliant, but underrated, work by Ludwig Lachmann, Capital and its Structure (1956). Garrison corrects these deﬁciencies and adds coherence to ABCT which had previously been unknown. In a sense, Garrison has done for ABCT what John Hicks and Alvin Hansen did for Keynes’s macroeconomics, except that the Garrison’s work is an accurate rendition of Hayek, Mises and Lachmann.
The subtitle of Garrison’s book, ‘The Macroeconomics of Capital Structure’, expresses the important claim that Austrian macroeconomics cannot adequately be appreciated without understanding that ‘investment’ is not a homogeneous decision. This insight is developed at length by Peter Lewin in Capital in Disequilibrium: The Role of Capital in a Changing World (1999), the most important work in Austrian capital theory in many decades (see also Endres and Harper, 2008). The ABCT focuses on the inappropriateness of the capital structure (malinvestment) generated by artiﬁcially low real interest rates (that is, interest rates that are lower than the real supply of savings would allow). Thus, the term over-investment is, by itself, a misleading characterization of the ABCT process. While excessively low interest rates do increase the level of investment relative to its previous position, they do so in a biased way – those stages of production further from consumption are aﬀected to a greater extent.
However, as Garrison’s recent work (2004) has shown, there are even more widespread distortions in the production structure generated by artiﬁcially low interest rates. These include initial ‘overconsumption’ as the result of reduced savings and of increased incomes on the part of factors of production. Increased investment in close temporal proximity to the overconsumption is labeled the ‘derived demand eﬀect’. This is in addition to the ‘discount eﬀect’, described above, which increases the proﬁtability of new investment distant from consumption. These two contrary eﬀects come at the expense of intermediate stages of production as well as reduced maintenance of existing capital at all stages. They may even result from the utilization of unused resources during periods of less than full employment. These eﬀects show that the ABCT is a type of ‘coordinationist macroeconomics’ insofar as it describes the discoordination of various sectors of the economy, and is not simply a micro choice-theoretic approach to macroeconomics (Wagner, 2005).
Accordingly, in this Austrian view recessions are characterized not simply by low levels of aggregate economic activity but also by the misdirection of resources caused by previous boom-induced malinvestments. These systematic sectoral imbalances – too much investment in interest-sensitive areas of economic activity – must be corrected as recovery proceeds.
The Austrian theory, however, is not a complete theory of the business cycle. It accounts mainly for the process leading to and including the cycle’s upper turning point. It is a theory of the crisis. How long the resulting recession lasts is not predicted by the theory or even, strictly speaking, by the degree to which resources were misallocated. The length of the recession will depend, for example, on those factors aﬀecting the mobility of resources.
None of this implies that Hayek, Garrison or Horwitz are insensitive to the problems that would be induced by an aggregate increase in the demand to hold money (a fall in income velocity), which can accompany recessions. This ‘secondary deﬂation’ should be avoided by a concomitant increase in the supply of money by the relevant monetary institutions. Horwitz (2000) is the ﬁrst to integrate Austrian macroeconomics with monetary disequilibrium theory to analyse deﬂationary processes. Nevertheless, recessions are not primarily deﬂationary phenomena (or at least need not be), but occasions for correction of the misdirection of resources.”
“An important variant of the ABCT in Risk and Business Cycles: New and Old Austrian Perspectives (1998), developed by Tyler Cowen, focuses on the integration of business cycle theory with developments in modern ﬁnance. The main sense in which this can be called a variant of ABCT is that changes in the riskiness of investment decisions are linked to the ‘old Austrian’ concern with the degree of futurity or roundaboutness in investments. For example, in Cowen’s analysis, an increase in the acceptable level of risk will encourage undertaking more longer-term investments (as well as, of course, investments of any given length with more uncertain yields). These can be both investments in durable capital goods (that is, investments with a continuous ﬂow of payoﬀs over a long period of time) and investments with a long period of gestation before the ultimate output is produced. Cowen associates less risky (‘safe’) investments with consumption and shorter-term investments.
Cowen’s analysis is more general than the traditional ABCT because it allows many factors besides a fall in real interest rates to generate a lengthening of the capital structure. These include exogenous risk-preference shifts, increases in savings, easing ﬁnancial constraints, and reductions in uncertainty (so as to reduce ‘waiting’ for acceptable investment opportunities). Any of these changes can generate an increase in the riskiness of investment. None of these changes must necessarily cause a cyclical boom and bust, but they might do so.”