Clarifications of the Austro-Wicksellian Business Cycle Theory

by Mario Rizzo

There has been a lively debate on forecasts of high inflation made by those worried about the Fed’s recent policy of quantitative easing. For details I refer the reader to Daniel Kuehn’s excellent blog. The question to which I address myself is solely “What do these predictions have to do with core Austrian Business Cycle Theory?” This is my answer.

We must start with a few general points. First, I am talking about the Austro-Wicksellian business cycle theory as developed by Friedrich Hayek and Ludwig von Mises and as synthesized by Roger Garrison in his book Time and Money. I cannot take responsibility for versions constructed by others.  It is not that I think the others are necessarily wrong (and I mean no disrespect to them), but I do not know with sufficient precision what all these others are saying in the name of “Austrian theory.”

Secondly, the Austro-Wicksellian theory begins with either an endogenous increase in credit through the banking system or with an “exogenous” increase initiated by a central bank. In the latter case, however, the theory itself has little to say about the extent to which increases in base money will manifest themselves in increases in bank credit to producers.  (This may not be much of an issue during a boom but may be an issue during a recession or in a recovery.)

Third, the theory is fundamentally one about the “upper turning point” in the cycle – it is a theory about why a credit-induced boom must come to an end. It is not a theory, for better or worse, about the “secondary” factors that develop consequent on the break-up of the boom. These include possible recessionary-problems relating to bank runs (there is an Austrian inspired banking literature, but that is not the cycle theory) or what exactly will get investment expectations to turn around.  As to deflation, Lawrence White has argued that the logic of the theory requires the avoidance of deflation in accordance with Hayek’s very early recommendation to keep M V from falling.  (Hayek departed from this in the Depression, and later admitted he was incorrect to do so.)

Now to more specific points:  

The Austrian theory rests, not on a catalyzing effect of core inflation or headline inflation, but on changes in relative prices that cause resources to be allocated in ultimately unsustainable ways. The Great Depression was not preceded by much inflation because productivity improvements allowed for increases in bank credit without increasing (by much) the price level. Hayek said repeatedly that the price level aggregate can hide the distortions basic to the cycle.

This point is especially important in the early stages of recovery when there is so much unused capacity and previous investment pessimism that expansions in bank credit (not meaning base money) may be returning to sustainable levels and inflation in the usual sense is unlikely. Nevertheless, as the recovery proceeds, there is a danger that maintenance of low interest rates by the central bank for long periods can induce a distorted character of investment, even as the total amount of investment measured throughout the economy has not recovered.

The important point is that, for Hayek, investment is not a homogeneous phenomenon. It matters where the investment is (that is, stages farther from or nearer to consumption). Not all investment should be analogized to simple inventory investment.

The policy-relevant point is that if the central bank decides not to allow interest rates to rise until aggregate investment has recovered to boom levels, it will have waited too long. The character of the investment will be distorted. Malinvestments will set in – even without inflation.

I do not think that the Austrian theory says anything unique about inflation – in the sense of increases in the aggregate price level – beyond the warning that aggregates of this sort can conceal the theoretically-relevant magnitudes for understanding business cycles.

Whether inflation precedes the upper turning point or whether it is unleashed in an effort to induce recovery is not what the Austro-Wicksellian theory is about. This is not to say that there are not compatible theories that can supplement the core theory at these points. But these are not the Austrian theory of the business cycle as Hayek, Mises, Garrison and I conceive it. (There are many others as well, but I am being extremely cautious here in not dealing with “all” that is out there.)

Finally, a point on forecasting: Most macro-monetary economists do not test their theories by making literal forecasts of future macroeconomic aggregates. What economists call “prediction” is really retrodiction or explanation of past events. The difference is crucial. All models treat important events or actions as exogenous. They do not forecast, for example, whether Ben Bernanke will die, whether he will be replaced by Brad DeLong, whether the politicians will agree on a new budget, and so forth. All of these could have a big effect on future macro-aggregates. Furthermore, most economists are happy if the model gets the direction of change correct (the sign of the variable). Making good numerical predictions has not been the forte of economists – let alone making good numerical forecasts.

Economists usually content themselves with a more modest form of testing. I see no reason to make an exception for a theory simply because it is disliked by certain economists.

31 thoughts on “Clarifications of the Austro-Wicksellian Business Cycle Theory

  1. This is a very good statement of the core propositions of ABC, what it is and what it isn’t.

    I want to clarify one issue. Hayek described a neutral monetary policy as one in which MV is constant. In his Appendix to Lecture IV of Prices and Production, 2nd ed., Hayek specifically denied that the concept of neutrality “provides a maxim which is immediately applicable to the practical problems of monetary policy.”

    On the contrary, “the concept was certainly not primarily intended for that purpose.” It is a theoretical constuct for analysis (129-30).

    It would be incredible to think of Hayek as advocating an activist monetary policy. Hayek always argued in terms of rules and institutions.

    In the Preface to Monetary Theory and the Trade Cycle, Hayek commented on “how little we really know of the forces which we are trying to influence by deliberate management; so little indeed that it would remain an open question whether we would try if we knew more.”

  2. Good post Mario. I am going to make the same point when I get back home and can write up something in response to my favorite economist, but it would obviously sound pettier coming from me.

    I will say, it had never occurred to me that when two “austerians” made a bet, that the outcome would be used to disparage fiscal austerity.

  3. Had the latest recession been average, Murphy would have been correct. It wasn’t. Estey’s book “Business Cycles” makes some important points. Estey wasn’t Austrian, but he was close in many ways.

    Estey pointed out that the real estate cycle is longer than the business cycle, about 20 years peak to peak. Recessions in a rising real estate cycle are short and shallow. Those involving a real estate decline are long and deep.

    Estey doesn’t say it, but commodities prices follow a similar long cycle.

    The massive deleveraging, increased regulation, shrinking of the banking sector, etc., made this recession much worse and prevented monetary policy from doing its normal thing of increasing cpi.

  4. Another thing that fooled me was thinking that all new money goes into cpi increases. But I learned from Machlup that much of it goes into assets, such as the stock market and gold. Or it can go overseas into higher yielding sovereign bonds.

  5. Excellent post Mario.

    While I do not think that ABCT is a general theory of the business cycle and I would certainly stress the “secondary deflation” part of the cycle much more than the boom phase, but I nonetheless think that your description of Austrian Business Cycle Theory is excellent and I hope it will be read by Austrian and non-Austrians alike.

    Empirically I think that both the US and particularly is in the secondary deflationary phase (in the sense that MV has fallen well below the pre-crisis trend). Therefore, I don’t think that monetary easing in at the present state is likely to lead to a Austrian style boom with distortion of relative prices.

    That said, unlike some other Market Monetarists I don’t think Austrian Business Cycle theory is irrelevant. Rather, I think that (variations of) ABCT will be helpful in understanding the “boom” in for example certain euro zone countries prior to 2008.

  6. Mario, there is a lot here with which I agree. I think where we fundamentally differ is that I see a very low (probably negative) natural interest rate where you don’t. I see the economic slump being the main reason for the low natural interest rate, not the Fed.

    Interest rates on safe assets around the world have moved down together, not something that can be easily explained by Fed policy

  7. As always, these debates get down to capital theory. I don’t think a negative natural rate is coherent in Austrian capital theory.

    Are firms earning positive returns on investments? If so, the natural rate is positive.

    The market for “safe assets” is being manipulated by central banks. When central banks distort interest rates, they no longer provide accurate market signals. That surely is the core finding of ABC. The Copenhagen lecture is a good clear and short statement of that. Along with P&P.

  8. Jerry, what evidence is there that the Fed is distorting treasury yields? The 10-year treasury yield has fallen from just over 5% in late 2007 when the crisis starts to about 1.6%, that is a long and pronounced decline. Yet, the Fed only holds 15% of all marketable treasuries, the same amount it roughly held prior to the crisis. Another way of saying this is that 85% of the largest run up in U.S. public debt was funded individual investors, their financial intermediaries, and foreigners. They are the real enablers not the Fed. See the link I gave above and this one which breaks down the Fed’s holdings of treasuries by maturity:

  9. The economic slump is not the cause of low interest rates, because you have to ask what caused the slump? Clearly it was the Fed. Even though it owns 15% of the supply of treasuries, its intervention in the market is the cause of interest rate distortions. It is not a free market institution. No Fed, no distortion. It’s a central planning body, and does things according to its socialist Plan.

  10. David Beckworth:

    You are insinuating that the prevailing rates on treasuries are a function of the percentage of treasuries the Fed owns.

    This assumption may be a good first guess, but it is woefully inadequate because it doesn’t take into account the value of what can be argued as an “implicit put option”.

    Even the mere threat of the Fed doing something, can affect nominal statistics. If it says it is going to keep rates low for years, and investors find it credible, then the Fed will not have to actually DO as much as they otherwise would have had to do. So when we see “only” 15% of the treasuries being owned by the Fed, that does not imply that you are entitled to say that real market interest rates are around that level of lowness. They could be low because of what the Fed threatens to do, not so much what the Fed is doing.

    You’re probably not going to adapt your thinking on this, because you think in terms of aggregates that act like mental barriers of cognition, but you can’t just point to the aggregate of 15% Fed ownership and claim that the Fed is not having an appreciable impact on treasury prices.

    Don’t you know about the Greenspan Put? Well, the Bernanke Put is even bigger.

  11. Same old, same old, enlisting Mises as a cover for essentially pseudo-Austrian neo-Banking theory of Selgin, White and Horwitz that ABCT is only about the ‘upper turning point of the cycle’. (where did Mises support your kind of theory, prof Rizzo? Any references? About stabilizing MV, or about the claim that the theory does not explain all phases of the parts of the cycle equally?).

    And especially strange is the insinuation that other non Rizzian and non-Whitean interpretations of the ABCT might have predicted the general price inflation (you know, those crazy Rothbardians may claim such a weird thing, who knows, I am just speaking for normal and sane guys, Garrison, myself, Selgin etc, nobody can predict what kind of nonsense de Soto or Hulsman or Salerno could utter about the price level ). But, the things is, no Austrian, Rothbardian, Hayekian, Whitean or any other type, would have ever argued that general price level must necessarily increase as a consequence of credit creation. And prof Rizzo of course perfectly well knows this. Why then spending half of the post to make this completely irrelevant distinction between ‘his’ Austrians and ‘others’, (in the post covering the general price theory, the issue on which all they perfectly agree).

    Rothbard derangement syndrome.

    P.S. Here is just one quotation from Rothbard:

    “Mises agreed with the classical “quantity theory” that an increase in the supply of dollars or gold ounces will lead to a fall in its value or “price” (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances”

  12. The Fed’s balance sheet does look anything like it did in 2007. It used to own short-term marketable securities. Now its balance sheet looks like a hedge fund’s. It is purchasing around 75% of Treasury debt and lots of MBS.

    The Fed’s policy guidance means buyers of Treasury debt get a one-way bet. It doesn’t matter who is doing the purchasing — the Fed is manipulating interest rates across the term structure.

    Zero- or one- or two-percent interest artes are divorced from economic reality.

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  15. […] Po mom mišljenju, ABCT je logički ispravan i vrlo koristan uvid, zapravo nadgradnja Wicksellove teorije o prirodnoj kamatnoj stopi (s tim da je Wicksell, ako se ne varam, pogrešno pretpostavio da je prirodna kamatna stopa ona koja bi rezultirala stopom inflacije od 0%), samo što je problem što neki ABC teoriji pokušavaju pripisati neka nadnaravna svojstva i pretvoriti ju u opću teoriju svega. Ali, time ne čine uslugu teoriji, a ni cijeloj školi. Što točno ABCT može objasniti, a što ne, lijepo objašnjavaju npr. Steve Horwitz ovdje i Mario Rizzo ovdje. […]

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