O’Driscoll and Rizzo Got There First

by Gene Callahan

I had believed that Tony Carilli and Greg Dempster (“Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” The Review of Austrian Economics, 2001) made a major advance in Austrian Business Cycle Theory by hitting upon the correct solution to the challenge presented by, for instance, Gordon Tullock, who once wrote:

“The second nit has to do with Rothbard’s apparent belief that business people never learn. One would think that business people might be misled in the first couple of runs of the [Austrian] cycle and not anticipate that the low interest rate will later be raised. That they would continue unable to figure this out, however, seems unlikely.” (“Why the Austrians Are Wrong about Depressions”)

By posing the situation as a prisoner’s dilemma, where businessmen are rational to exploit the short-term profit opportunities offered by the boom phase (since if they don’t their competitors will) Carilli and Dempster adequately answered Tullock’s complaint. (I especially liked their solution because I independently had hit upon the same idea, which I was working out while writing my book, Economics for Real People. Well, I wasn’t the first to print, but at least I was the first to reference their paper!)

But yesterday, while editing someone else’s work, I discovered that Gerald O’Driscoll and Mario beat us to the basic insight by several decades, although they did not give it a game-theoretical formulation:

“[T]here are profits to be made from exploiting temporary situations. . . . Though entrepreneurs understand [the macro-aspects of a cycle] they cannot predict the exact features of the next cyclical expansion and contraction. . . . They lack the ability to make micro-predictions, even though they can predict the general sequence of events that will occur. These entrepreneurs have no reason to foreswear the temporary profits to be garnered in an inflationary episode. . . . From an individual perspective, then, an entrepreneur fully informed of the Austrian theory of economic cycles will face essentially the same uncertain world he always faced. Not theoretical or abstract knowledge, but knowledge of the circumstances of time and place is the source of profits.” O’Driscoll and Rizzo, The Economics of Time and Ignorance

Note: I still think what Carilli and Dempster did, in giving this a game-theoretic formulation, is great work. I just see it is not quite as original as I had thought.

26 thoughts on “O’Driscoll and Rizzo Got There First

  1. These are excellent responses to Tullock’s complaint (sounds like an illness). In addition, the feed back loop is too long for most people to make the connection. The most common complaint about depressions is about greedy bankers and businessmen. That has been the diagnosis by the media and the man on the street for over 300 years. It seems irrational to most people that the easy credit that causes the obvious boom for a couple of years can have any bad side effects.

    Some people get it, though. I have watched a local oil business grow from almost nothing in 1970 to a worth of $7 billion. The owner never expanded during a boom; he just piled up cash. Then when a bust hit he would buy up bankrupt companies that grew on debt during the boom.

    My grandfather was a rancher with a 6th grade education. He was close to being a millionaire when he died because he did the same thing with real estate.

    People who get the cycles are knows as successful.

  2. Also, I think Hayek’s Ricardo Effect is a good response to the Tullock complaint. I wonder why Austrians don’t mention it more.

  3. With regards to expectations, Mises was first to discuss the implications of a change in expectations on his business cycle theory. See: Ludwig von Mises, “‘Elastic Expectations’ and the Austrian Theory of the Trade Cycle,” Economica 10, no. 39 (1943). His response, though, is probably not as sophisticated as Carilli’s and Dempster’s (although, the assumptions to make a case fitting the prisoner’s dilemma may not hold true, so Carilli’s and Dempster’s response may not even be necessary).

  4. This article is full of first-person pronouns (“I,” “us”), but it has no byline. Whom do the pronouns refer to?

    What is the date of Rizzo and O’Driscoll’s book, and what page does the quoted passage appear on?

  5. Tullock’s argument is really bad for a dozen different reasons.

    I’m shocked that an intelligent man could think it a good argument.

    But this sort of thing is commonplace in economics, isn’t it, on any and every issue touching the knowledge problem.

  6. I don’t think Carilli and Dempster’s prisoner’s dilemma defense of Austrian business cycle theory is very convincing, and, to the extent it is, it threatens the Austrian theory from a different direction.

    Here’s the PD argument: Banks may know the interest rate is below the natural rate, but they lend anyway because, if they don’t, they’ll 1) lose business to competitors and 2) they’ll still have to bear increased liquidity risk if other banks lend at low rates. Thus, the best strategy is to continue lending at low rates no matter what other banks do. But when all banks continue to lend at low interest rates, their relative returns remains unchanged, while their risk increases. Since this outcome is worse than the outcome that would result if all banks restrain their lending at low rates, we have a prisoner’s dilemma.

    Unfortunately, Carilli and Dempster don’t clearly explain why a bank that charges a higher interest rate and maintains a higher reserve is subject to increased liquidity risk when other banks continue to lend at low interest rates. One explanation might be that, when the bubble bursts all banks will face liquidity problems because of increased defaults. But surely banks that didn’t make more loans at low interest rates, and maintained greater reserves, are better positioned to cope with increased defaults than banks that let their reserves decline. If so, then the circumstances don’t constitute a PD because lending at low rates is no longer the dominant strategy. Rather banks must balance risk and expected return. And, therefore, this “PD” fails as a defense against Tullock’s critique.

    But suppose that all banks do, in fact, face liquidity risks when some banks continue to lend at artificially low interest rates. In this case, a bank’s easy lending creates an externality, imposing risks on other banks. The problem for Austrian theory, in this case, is that markets don’t work well when decision makers can impose costs on others. It is precisely these kinds of externalities that make “free banking” a risky institutional alternative.

    The PD argument can be turned on its head during the bottom of the business cycle. As Keynes put it in his Treatise on Money, while it’s dangerous for one bank to increase lending during hard times, it’s much less risky when all banks move forward together (because one bank’s lending increases deposits at other banks). Again, externalities are crucial, and that’s why some regulation is necessary.

    Finally, the PD argument is bit different than the O’Driscoll and Rizzo argument, which seems to say that Austrian theory is good enough to tell us when the Fed has pushed interest rates below their natural level, but not good enough to tell entrepreneurs when to lock-in low interest rates by selling long-term bonds.

  7. It’s more that the Carilli-Dempster paper is trying to make the so-called Austrian business cycle theory work in a perfect expectations framework, while O’Driscoll-Rizzo are discussing ignorance. I see our hosts’ explanation more as expanding on the paragraph about statistical aggregates and how an economy cannot be led by the law of large numbers in Hayek 45. Business people might very well be aware of the overarching narrative, they still wouldn’t know precisely how to take it into account in their day-to-day trade. They have very limited knowledge about their part in it, and how they will be affected by the bubble bursting. When it becomes obvious that investment were fueled by monetary illusions it’s already too late.

  8. Mathieu, you write that while “business people might very well be aware of the overarching narrative, they still wouldn’t know precisely how to take it into account in their day-to-day trade.”

    Regarding many day-to-day business details, I agree. But what about big decisions, e.g., whether to make a major investment or to finance a project with a line of credit or a long-term bond? What would you think of a businessman who excoriated the Fed for driving interest rates below their natural level, but continued to finance projects with short-term variable rate debt rather than long-term fixed rate bonds?

  9. Carilli and Dempster want to shift the emphasis of ABCT from the effects of interest rate changes to changes in the monetary footprint. They cite an example of a small increase in the value of firm’s debt due to an increase in the interest rate from 6 to 7%.
    They mention Mises’ division of interest into the originary rate and the entrepreneurial component, the latter being determined on the loan market with the involvement of political risk factors.
    Like all Austrians of whom I’m aware, they overemphasize the loan market in the analysis of the effects of interest rates on the economy, and ignore other markets, such as the equity market, both publicly traded (stock market) and private equity.
    Interest rates are used to value cash flows for both debt and equity, as well as in making other capital investments.
    (The 1990s tech boom was an equity market event, not a debt market occurence.)
    Boehm-Bawerk (capital structure) and Wicksell (natural rate of interest) /Mises (originary and entrepreneurial rates) put the two major components of the ABCT into place.
    It’s time to expand the ABCT by enlarging the enrepreneurial component from the (overemphasis on) loan market to all the markets it affects via cash flow calculations.

    Doing this will improve the theory and show just how irrelevant the criticisms of Tulloch, Wagner, and other critics are.
    (I inadvertently posted this at “Morality as Word Magic” earlier.)

  10. I am sympathetic to Bill Stepp’s call for more fully incorporating securities’ markets into ABCT. I’ve done that in the analysis of the housing boom and bust.

    There is an historical reason for the focus on banks. Banks were the source of credit for all but the largest companies.That changed only with the rise of the junk bond market in the 1970s.

    Interstingly, in the 1932 exchange of lettes to the Times by Cambridge and London, the Hayek side raised the issue of how falling interest rates affect the price of existing securities and this stimulate investment.

  11. As a footnote to Jerry O’Driscoll’s note, there was no systematic theoretical development of corporate finance until the mid-1950s, so there was no cross-pollinization from it to business cycle theory. .

    Here is an historical overview:


    The theory developed from the mid-1950s, but seems not to have had much influence on business cycle theory.
    Alfred Rappaport’s Creating Shareholder Value (2nd ed.) is a good overview of the building blocks. He also criticizes a leading competitor of shareholder value theory.
    You don’t need the shareholder value added part; the cash flow analysis is the part to focus on.

  12. I’d echo several commentators here and say that I don’t find Tullock’s argument to be a real challenge to ABCT.

    Central banks create credit that is not matched by savings all the time. Thus, interest rates on the credit markets are always distorted by the central bank and the businessmen do not really have a benchmark undistorted rate to which they could refer to make learned investment decisions. It is really unclear, therefore, what businessmen should learn. How to calculate the undistorted interest rates?

  13. Jonathan Catalán is right to point us to Mises’s 1943 article on expectations, though Mises does not deal with the specific problem raised here, namely the behavior of entrepreneurs who believe that interest rates are below their natural levels but take loans anyway. Mises seems to imply that ABCT is sufficiently well understood, by practitioners as well as academics, that entrepreneurs will be wary of accepting below-market loans in the future. But he still thinks it is extremely difficult to distinguish, in practice, artificial booms from real economic growth, particularly during times of rising prices. “Nothing but a perfect familiarity with [Austrian] economic theory and a careful scrutiny of current monetary and credit phenomena
    can save a man from being deceived and lured into malinvestments.” Mises also notes that one can hardly expect entrepreneurs to be “rational” in the modern sense when most economists, public officials, financial journalists, etc. preach and teach some version of Keynesianism!

    Another point, emphasized in various places by Roger Garrison, is that ABCT offers an explanation of business cycles that do in fact occur. If entrepreneurs correctly perceive that the central bank has pushed interest rates below their natural rates, and the majority of entrepreneurs do not believe they can make money during the boom and get out before the bust, then they don’t take the new loans, there’s no malinvestment, and no boom and bust. A business cycle anticipated may be a business cycle avoided, but this hardly constitutes a refutation of the Austrian account of business cycles that aren’t avoided.

  14. Bill: “Like all Austrians of whom I’m aware, they overemphasize the loan market in the analysis of the effects of interest rates on the economy, and ignore other markets, such as the equity market, both publicly traded (stock market) and private equity.”

    Machlup considered the equity market and I see a lot of Austrians quoting him. Also, Hayek’s “Profits, Interest and Investment” emphasizes that business people pay little attention to interest rates. They focus on profits. Changes in interest rates change the term structure of profits, which businessmen notice and respond to. Changing profits directly affect the equity market.

    I doubt many businessmen think the good times will last forever, but as someone said they have to dance while the music is playing.

  15. Machlup was an exception. If Hayek was referring to the corner grocer, I’d agree with him. But investors considering larger investments generally do cash flow calculations, or at least would gain insight from doing so, in order to value a potential investment.
    Also Hayek and Machlup wrote at a time when corporate finance was still in its infancy.
    (I assume you wouldn’t take Menger’s Principles as the last word on how markets work.)

  16. I think Mises and Hayek would find a lot that’s wrong with modern corporate finance as Benjamin Graham did. Modern finance is based on probabilities, but as Mises pointed out that is a misuse of probability theory. Class probabilities say nothing at all about case probability, yet modern finance requires applying class probability to cases.

    Graham points out that the CAPM and option pricing models rely on assumptions about future interest rates and income rates. Forecasting future growth and interest is impossible. But people have to do it in order to use modern finance tools and they can choose future discount rates and growth rates that justify any investment.

    Yes, businesses focus on cash flows, but isn’t cash flow just operating profit?

  17. The complaint about why entrepreneurs aren’t smart enough to avoid being lured by easy money neglects the diversity of entrepreneurs, in terms both of their astuteness and the quality of their contemplated capital projects. Changes in interest rates and credit availability affect the number of capital projects undertaken at the margin between go and no-go. Artificial credit expansion shifts that margin into the realm of lower quality projects undertaken by less astute entrepreneurs and financed by less astute lenders. A higher percentage of failures is inevitable.

    A similar point can be made about knowledge. Prices and interest rates established in free trade carry information but do not constitute a crystal ball. Central bank tinkering with credit degrades the information, inevitably increasing the amount of error at the go/no-go margin.

  18. Roger,

    I didn’t mean to give a blanket endorsement to corporate finance (e.g., the CAPM, EMT), much of which is bollocks, to use the technical term. Free cash flow is the one to focus on, which is operating cash flow less capital expenditures.
    Rappaport discusses this in detail in his book.
    Whatever measures investors use to value investments will be distorted by central bankers.
    Allan makes a good point about effects of interest rates and credit availablilty on the demand for capital projects, as well as on information and decision making.
    The affects of Interest rates on economic decision making can hardly be overstated; to the extent they are distorted by central planners they will have harmful consequences.
    Bernanke has done far more damage to the economy than bin Laden ever dreamed of doing.

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