Austrian Theory of the Business Cycle

Did Tyler Cowen really lampoon the Austrian theory with his bananas example?  I actually am not persuaded.  In the current example, there were distortionary policies on both the supply and demand side of the housing market.  In many ways, our current financial situation is a consequence of a "perfect storm" of government failures that distorted market signals and provided perverse incentives all of which resulted in malcoordination on a massive scale.

What is your impression of the contemporary relevance of the Austrian theory of the trade cycle?

Comments

[Greg Ransom]

I'm not at all in awe when Tyler Cowen discusses "Austrian" business cycle theory. I'm appalled at his basic ignorance and mistakes. Appalled.

Cowen invariably get the theory WRONG when he discusses it, i.e. he proves again and again that he hasn't mastered the economics.

If you've read Hayek's 1929 book _Monetary Theory and the Trade Cycle_ you know that what Hayek presents as one playing out of the misallocation of production goods across time comes from what you might call "enhanced expectations". Cowen always presents this as a falsification of Hayek's work -- when it _is_ Hayek's work. That's appalling.

Here's a recent variation on the theme from the link provided by Pete to a Cowen commentary on "Austrian" business cycle theory: "An alternative theory is that markets are bubble-prone and that easy monetary policy was simply a trigger that set off an irrational speculative excess."

That's just a starter on why I'm not at all in awe of Cowen's economics when it comes to Hayek's work Or should I say, why I continue to be appalled by the ignorance and irresponsibility displayed by the good professor.

[Greg Ransom]

On Cowen I need to add this.

I'm never in awe of anyone who can "defeat" a position only by invoking "the principle of anti-charity" -- doing as much as you can to misrepresent or present the weakest possible interpretation of something for purposes not of engaging it, but of belittling it and marginalizing it.

Cowen isn't Paul Krugman, his stuff on Austrian macroeconomics is of the same intellectual integrity.

[Stephen]

I think the Austrian theory of the trade cycle is probably right in some cases, and perhaps is an exacerbating factor in the current crisis. However, I think that the causes of the various ebbs and flows of the business cycle are probably heterogenous – the government-pumped asset bubble, for example, is not likely to happen again any time soon in the United States. I'm not an expert (nor do I know much at all) on business cycles, but I find it difficult to believe that all recessions and booms are the result of monetary policy, and it's no stretch of the free marketer's imagination to presume that there are many ways in which the government can screw up the economy. I absolutely reject, however, any notion of "animal spirits" or any other claims of the inherent irrationality of markets.

[LVDH]

The Austrian theory of the business cycle should provide the general (and generally correct) framework for thinking about business cycles. It won´t take long anymore before the theory will figure in the mainstream macro textbooks. It´s only a matter of time. With every crisis we come closer to that moment, no doubt about that.

[Martinf]

Stephen said: "I find it difficult to believe that all recessions and booms are the result of monetary policy"

Well, it doesn't have to be so. I think ABCT is a powerful explanatory tool for events like the Great Depression or the current crisis, but it doesn't mean there aren't other causes of bubbles (expectations) or busts (natural disasters is one example).
So, business fluctuations are more than ABCT, but it provides an excellent analytical framework

[Roger Koppl]

I think the ABCT has the vital element missing from other theories: capital theory. But I think we've done a bad job of working on capital theory. IMHO it's a briar patch and we haven't really attended to the problems. Peter Lewin wrote fine book on capital theory. Steve Horwitz has written some nice things on capital. But we haven't squarely faced the problem of linking Austrian capital theory with an empirical research program in cycle theory. Peter Lewin came out with a great suggestion that may not have been published, namely, use of McCauly's duration. (Did I spel McCauly right??) Basically, duration is the elasticity of asset value with respect to the rate of interest, although the formula is slightly tweaked from that. Duration really cuts the Gordian knot IMHO. Without out that device, we'll never get around the problem that wheat and steel are used to make wheat and steel. Which is of a "higher" order?

[Peter Boettke]

I'd love to hear the best response to the bananas story of Cowen and Caplan. I actually found John Taylor's little book on monetary policy to be outstanding, but it did miss the mechanism by which the deviations from the Taylor rule where channeled into the housing book. But Zywicki's work on ARM, etc. sort of provides that I think. In short, there was a "perfect storm" of loose money, moral hazard, interference in ratings, etc.

So I believe that given the distorted signals and the perverse incentives it can in fact be very reasonable to keep piling bananas on a roof. But I would like to hear how others construct the story to counter the claims of Cowen and Caplan.

BTW, I actually find Caplan's "admission" that every once in a century things go heywire to be the most intellectually unsatisfactory thing I have ever heard out of Bryan's otherwise brilliant mind --- well that and his "bucket" in discussing probability distributions and the concept of utter or sheer ignorance. It seems to me that he is "punting" at precisely the point he must be ready to "go for it" in both instances. What do you think?

[Jim]

The current boom-bust cycle really looks like a near text book example of ABCT, and this is really helping to get these ideas into the minds of average businessmen. As to how things play out from here, the insights of Austrian and Public Choice political economy are also just as important.

[Current]

I think it would be very useful if there were a more "international" version of the theory. International capital flows are very important these days.

That said, I expect there have been attempts at this, I just don't know about them.

I think that the theory needs to say something more about *risky* investment as opposed to more roundabout investment. Cheap credit clearly seems to encourages both.

[liberty]

"the government-pumped asset bubble, for example, is not likely to happen again any time soon in the United States"

What was the housing bubble/crisis?

I think Austrian business cycle theory offers a much better, closer explanation or framework than other cycle theories, but it seems to be too narrow, or to be interpreted in too narrow a fashion. I also think some bad criticisms and misunderstandings of it have convinced far too many (often Austrian-sympathetic) economists to dismiss it. To remedy this, I think we need a few papers and books that bring it up to date and perhaps don't say it is ABCT in the papers and books, just remind people later that this is what it was--sneak it in the back door--just because it has such a lousy reputation.

To update and improve, I think these theorists should make sure to talk about financial instruments (how do these help to hide risk, offer profit to intermediaries even when interests rates might drop again soon, etc), international monetary policy, subsidies and GSEs and other policy tools that distort price signals, buy up risky assets etc, and talk about how the bubble must burst and how these things look when it does--follow the whole life cycle and use historical (including recent) examples.

I do think that these things can all be connected using ABCT, and can explain most or all of the bubbles and crashes in (at least) the past century.

[libertyfirst]

The Fed have been trying to avoid, successfully in 1987, 1990, 1998 and 2001, the US real and financial markets to respond to market time and risk preferences in order to pump the GDP and make everyone happy in Washington DC; the interest rate has been manipulated and couln't possibly work as a signaling device* for market coordination; risk premia where distorted because of moral hazard; the market and natural rates of interest diverged systematically; savers were either put to death with low rates (the Keynesian euthanasia of the rentier) or pushed to make equity extraction out of fake capital values for assets and real estate; the US economy has made the day for so long only because of China, internet, the fall of the Berlin Wall and Reagan deregulations.

Is this an economy that can be said to be prone to instability? Survival is a miracle after such a prolonged and intensive amount of interventionism. It appears as if Cowen wanted us to believe that markets can work without prices, and charges the market for the inexistance of an almighty and omniscent walrasian auctioneer.

Partially O.T.: abct is not appreciated by ratex economists. Up to now I found only two refs in the literature defending abct. Carilli & Dempster have written a very good paper several years ago on RAE, and Horwitz considers the issue in his book on microfoundations. Are there any other refs?

* Marcus Miller in 2002 wrote a paper on the Greenspan put showing that Greenspan could have doubled the level of the DJIA with his moral hazard. George Kaufman wrote a paper in 2000 for the Chicago Fed (?) saying that interventionist monetary policies increased the potential for systemic fragility. These are two examples, I think there are others.

PS Koppl is perfectly right in stating that there has been no job (not enough, at least: I just know a part of the relevant literature) on capital theory.

[Current]

Another problem I think is that ABCT goes from prices straight to capital theory.

Businesses though sit in-between. So how it works depends on industrial organization. Lots of folks these days describe it by saying that incorrect price signals are given to businesses. That is true how though do they translate into incorrect capital decisions. The PPF of each business gives one answer, but not a very realistic one.

[Greg Ransom]

This is my impression as well, but I've not recently searched the literature on the topic. Has Roger missed some recent work on capital and interest theory, or empirical work on these topics which engages "Austrian" capital theory which folks should know about?

Roger:

"I think the ABCT has the vital element missing from other theories: capital theory. But I think we've done a bad job of working on capital theory. IMHO it's a briar patch and we haven't really attended to the problems. Peter Lewin wrote fine book on capital theory. Steve Horwitz has written some nice things on capital. But we haven't squarely faced the problem of linking Austrian capital theory with an empirical research program in cycle theory."

[Greg Ransom]

Garrison also has a double story, as he presented at FEE in 2008.

There will be many books on the complex ins and outs of all this. I've collected over 50 different articles at "Taking Hayek Seriously" looking at well over a dozen different parts of this "perfect storm".

Folks should also look at former BIS chief economist William White's "Austrian" work of the mid 2000s. At Jackson Hole White actually took on Greenspan man to man in 2003 raising misallocation / low interest rate issues with the "Maestro". Greenspan ignored White.

Peter writes:

"I actually found John Taylor's little book on monetary policy to be outstanding, but it did miss the mechanism by which the deviations from the Taylor rule where channeled into the housing book. But Zywicki's work on ARM, etc. sort of provides that I think. In short, there was a "perfect storm" of loose money, moral hazard, interference in ratings, etc."

[John]

Carsten Detken has done some interesting research at the ECB(working papers 364,732, 1039). More on empirical evidence of cycles than necessarily an Austrian bent. I think some in the ECB, like Stark and Weber, are influenced by this research.

[Lee Kelly]

I haven't studied the Austrian theory of the business cycle in any depth, but, from what I have read, my own views accord nicely. In fact, I am quite appalled at the economics profession. Alarm bells started ringing in my head the moment the functions of the Federal Reserve were explained. I kept on asking my professor to clarify and restate, since I could not believe what I was being told. The rationalisations given for inflation-targeting, credit expansion, interest rate manipulation, and counter-cyclical fiscal policy seemed nuts, and now even more so.

Anyway, I am not well-qualified to discuss Cowen's understanding of ATBC, but his comments seem to betray a misunderstanding of his topic. I am, however, not surprised, since I do not think Tyler Cowen is a good economist.

[Jayson Virissimo]

Am I the only one here who thinks that a general theory of trade cycles is an unrealistically high goal for macroeconomics? Does biology have a general theory of population cycles or do they have multiple theories for different causes of the cycles?

[Rafael Roos Guthmann]

I think that it is sad that all non-austrian economists that talk about the ABCT never try to understand the ABCT from the point of view of the austrian microeconomic theory, with is the only point of view were it makes sense. It is easy to criticize a subjectivist theory of the business cycle from the point of view of modern macroeconomics, with is based on the notion of the macroeconomy as a system of interdependent aggregates. Even expectations are aggregates in a sense in modern macro.

For example, John Quiggin, when speaking about the austrian theory makes the standard critique based on the rational expectations hypothesis. What he doesn't seen to understand is that the rational expectations hypothesis is the product of the equilibrium always mentality, were business cycles, as common people know then*, cannot exist by definition.

Also, if one entrepreneur does predict that in the future interest rates will rise, then he will profit from it and doing so he will be contributing to the business cycle process. Now, if all entrepreneurs predict that interest rates will rise, but then they will not rise, since the interest rate will already be at their long run equilibrium position at time zero and the cycle would never happen.

The business cycle is the process by with the market deals with monetary expansion. The larger is the capacity for the entrepreneurs to learn, the shorter the business cycle becomes. To assume that everybody is perfectly alert is to assume that the business cycle cannot happen.

*As the event were systematic plan failure occurs.

[Danny]

Pete,

Have to agree with you on Caplan's diagnosis of the crisis. I thoroughly enjoy hearing what he has to say, and I probably read that post of his on econlog three or four times before I could process that he really had nothing to say at all. A real disappointment, especially for someone who has been so exposed to Austrian thought regarding the horrible incentives that face market participants today.

[Mike]

" I think ABCT is a powerful explanatory tool for events like the Great Depression or the current crisis, but it doesn't mean there aren't other causes of bubbles (expectations) or busts (natural disasters is one example).
So, business fluctuations are more than ABCT, but it provides an excellent analytical framework"

Isn't that basically Kirzner's position as well?

[John Papola]

Pete,

I have a suggestion to update this post with another "lampooning" by Mr. Cowen that is pretty interesting (and confusing if you ignore the date it was written).

at http://www.marginalrevolution.com/marginalrevolution/2005/01/if_i_believed_i.html

Tyler writes:
-------------------------------------------------
If I believed in Austrian business cycle theory

1. I would think that Asian central banks, by buying U.S. dollars, have been driving a massive distortion of real exchange and interest rates.

2. I would think that the U.S. economy is overinvested in non-export durables, most of all residential housing.

3. I would think that we have piled on far too much debt, in both the private and public sectors.

4. I would think these trends cannot possibly continue. Asian central banks may come to their senses. Furthermore the U.S. would be like an addict who needs an ever-increasing dose of the monetary fix. This, of course, would eventually prove impossible.

5. I would think that the U.S. economy is due for a dollar plunge, and a massive sectoral shift toward exports. Furthermore I would think it will not handle such an unexpected shock very well.

6. I would buy puts on T-Bond futures and become rich.

7. I would think that Hayek's Monetary Nationalism and International Stability, now priced at $70 a copy, is the secret tract for our times.
-------------------------------------------------

I'm not an economist, just a passionate novice, but that sure seems like a pretty accurate recounting of many elements of our current situation.

What's the catch? It was written in 2005 as a criticism. As if to say "none of this seems likely".

Especially interesting is what Tyler was reacting to at the time. A link to Brad Delong's blog where none other than Timothy Geithner is worried about the effects of heavy Asian lending. Again, in 2005.

Things like this have made me very interested in ABCT, because it does seem to make tremendous sense. I also think that the Cantillon Effect and jagged nature of inflation is a very interesting and intuitive explanation of the re-distributive nature of inflation. That ABCT is so frequently subjected to strawman dismissal by people with whom I usually disagree (Krugman, DeLong, etc) in and of itself makes it interesting.

Love your econtalk on ABCT, btw. Just re-listened to it today.

[John Papola]

Let me just add that I find a mixture of ABCT and Talebian skepticism about theory and risk calculate to be my cocktail of choice right now. I'm especially interested in the way both Nassim Taleb and Rothbard attack fractal banking as fraudulent (by spirit if not letter). Taleb goes further in his desire to ban most financial products as fraudulent misrepresentations of risk built on math... and I think that seems pretty interesting if not a closed case.

If these vehicles of credit produce such shocks, and the debt and leverage leave the system so fragile, that occasional busts wipe out all of the gains of the boom and then some, I think it's worth revisiting their merit. The fraud argument helps ground the action in a libertarian legal approach instead of a preventative discretionary regulatory regime approach... which I think we've witnessed the failure of on a massive scale already.

Or it could be that I have absolutely no idea what I'm talking about and being blinded by confirmation bias galore.

[LVDH]

Is it correct that Nassim Taleb has criticized fractional-reserve banking? I was not aware of that. I thought these kinds of topics are totally off his screen. (He is a financial engineer.) Can anyone provide an exact reference?

[martinf]

LDVH,
I'm not sure. You can listen to EconTalk's podcast. He criticises the current banking system, but he doesn't mention explicitly frb.
http://www.econtalk.org/archives/2009/03/taleb_on_the_fi.html

[John Papola]

I haven't heard Taleb specifically attack FRB but he has attacked leverage and banking in ways that seem to arrive at the same conclusion.

Listen to this planet money where Taleb suggests banning most financial products and rails against debt and leverage as the principle creator of fragility.

http://www.npr.org/blogs/money/2009/04/hear_nassim_taleb_checks_in.html

I've also heard Taleb talk about reducing banks into "money warehouses" akin to a utility provider, I believe on Bloomberg on the Economy's podcast. Trying to hunt that down.

[LVDH]

The important question in my opinion is this: suppose the FED is abolished, or at least FED-initiated credit expansion limited; could financial products, financial innovation etc. by themselves generate a crisis as we have seen?
I have heard no convincing argument that this is the case.