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The intellectual lineage that Mises and Hayek always saw in their monetary theory of the business cycle was:

(a)A version of the quantity theory of money that emphasized the non-neutral effects on the structure of relative prices (Cantillon; Henry Thornton; John E. Cairnes);

(b)The relationship of monetary changes to the real structure of production (Bohm-Bawerk);

(c)The institutional setting in which monetary injections tend to occur, i.e., through banking system in most of the contemporary world, with an influence on market rates of interest that potentionally distort savings/investment relationship (British Currency School; Wicksell, Mises, Hayek, Machlup, Rothbard).

As such it is a monetary theory of the trade cycle that possesses significantly different features from other quantity theories (Irving Fisher, Milton Friedman), as well as from more recent "real" business cycle theories.

As such, there surely still needs to be some label or classification for this distinct monetary tradition.

May I suggest that one useful one is "Austrian."

Richard Ebeling

Is there any article or source that is worth reading to contrast the 'Austrian' theory with the 'currency theory' referred to here?

It certainly not Austrian in the sense that the cycle theory relies on entrepreneurship and alertness at its core. Israel Kirzner has made this point often -- at least in discussion.

If we begin to supplement the theory with other factors like the effect of unsustainable fiscal policies, industrial policy style credit allocations (aka "quantitative easing"), increased risk taking, consumer credit expansions, and exchange rate effects there is even less reason to call it "Austrian." And these complications are critically important in the present situation.

Any real world cycle today is going to require eclectic explanations. Personally, I think of the common element in all this as cyclical sectoral distortions largely, although not entirely, initiated by monetary phenomena. So perhaps a "monetary sectoral-distortion theory of the cycle"

The crucial element of the "Austrian" approach to monetary and business cycle phenomena is, surely, the non-neutrality of money.

And the particular "Austrian" twist is that the non-neutrality is not one that looks only or primarily at general macro-output effects. The focus in the "Austrian" analysis is the attention given to money's non-neutral impact on the relative price and production structures.

Certainly Mises in "The Theory of Money and Credit" and Hayek in chapter I of "Prices and Production" place central emphasis on this.

And Hayek, with some excessive exaggeration, claimed that the next step in monetary theory would be to ignore whether or not changes from the money-side influenced or modified the general purchasing power (and, therefore, the general price level) at all!

The form of the effects of monetary expansion depend upon how an monetary change enters the economy, e.g., new gold discoveries (Cairnes brilliantly traced out how the new gold discovered in Australia was dispersed around the world in a temporal-sequential pattern); new money, say, to cover the direct expenses of government during a war; or monetary injections that come through the banking sector and first influence market rates of interest.

The general theory needs to be applied to the particular historical and institutional circumstances being analyzed and interpreted by the economist (and economic historian).

Thus, the notion that each cycle mechanistically repeats itself is one that neither Mises nor Hayek would have defended or argued for.

Thus, in the present crisis, as Mario points out, besides the monetary injections that have impacted on interest rates, an distorted savings and and investment relationships in the "traditional" Austrian analysis, there have been the influences of Fannie Mae and Freddie Mac, etc.

This does not "invalidate" the logic of the Austrian theory. It just must be applied and combined with other relevant historical facts to correctly explain unique historical events and cycles.

And in this, as I said, I am absolutely certain neither Mises nor Hayek would have disagreed with.

Richard Ebeling

Mario is right in pointing to enrepreneurship and alertness as a key point in the Austrian (or monetary) thoery of the business cycle, as is Richard in mentioning the non-neutrality of money.
In his interview with Russ at EconTalk, Charles Calomiris discussed the importance of a microeconomic approach to understanding how government intervention distorts the incentives (and we might add economic calcuations) of entrepreneurs.
The hallmark of ABCT is a rigorous focus on the microeconomics of money, banking, interest, investment, and profits (and losses; and I would add cash flows); and how these are distorted from their free market path by various government interventions, especially central banking; and how they distort economic coordination.
This I think is the main point of disagreement between monetarists, various brands of Keynesians, and others. The non-Austrians tend to focus more on macroeconomic aggregates, and don't "decompose" them to investigate their microeconomic, discoordinationg effects as rigorously as Austrians do.

Richard Ebeling and I are talking about slightly different things. He is focusing on the core theory.

I agree that Austrian economists elaborated this monetary-structure of production approach. But did the Austrian economists make an Austrian theory? I think Kirzner sees the entrepreneurial market process as the essence of Austrian economics. Therefore, this theory is at best marginally Austrian.

Now I was thinking more of applied theory. If I were to try to explain the current recession, I would go beyond the core theory. Now if I add enough, it must stop being the core theory at some point. And then what should it be called? As you like it...

Mario, one way to address Kirzner's concern is, of course, to reject his characterization of entrepreneurial alertness as the core of Austrian economics. If one sees capital heterogeneity, the time structure of production, consistent methodological individualism, an emphasis on subjective beliefs and expectations, and the like as the essence of Austrian economics, then the Austrian theory of the business cycle is exceedingly Austrian!

I'm not saying, I'm just saying.

Why not calling it the "Praxeological Business Cycle Theory"?

Even within Kirzner's framework, ABC seems as Austrian as wiener schnitzel. On a very stripped down level: the central bank monkeys with the relative prices that funnel consumer sovereignty into arbitrage opportunities. They muddy up the signal entrepreneurs rely on.

Surely Kirzner's not saying that entrepreneurs mystically commune with underlying scarcities unmediated by money prices. Can you clarify what he means Mario?

First, the word praxeology conveys little to the rest of the world. I don't like to use it.

Second, there is no alertness in the cycle theory -- or at least it is limited. Entrepreneurs simply respond to market prices mechanically. They do not, except as a limitation of the applicability of the theory, second guess, say, a fall in interest rates. They act as if it is sustainable and then are caught short.

I am aware of the exchange between Mises and Lachmann on the elasticity of expectations (see Ebeling above). But note when entrepreneurs are "smart" there is no cycle.(Or, at least, it is more like a speculative hot-potato cycle.) But the core theory proceeds as if they were not smart or alert. There is no learning mechanism that is an important part of the theory.

The best reason not to call it "Austrian," however, may lie in other considerations that may emerge if we do not have an intelligent Peace in Our Time.

Thanks, Mario. I guess I was reading more "ecological alertness" in to Kirzner than he himself does.

Is there "no" learning in the cycle? I'm rapidly reaching the limits of my ABC knowledge, but I thought that learning was a critical part of the bust.

I see the point about alertness and learning not playing a role in how the story is usually told, but it seems to me that its robust against their introduction for two reasons.

First, even if entrepreneurs "second guess" the interest rate drop, they don't know how much absent direct observability of relative scarcities.

Second, I think of Kirznerian entrepreneurship as often operating in the way Hayek thinks of immanent critiques. You stand "inside" (or at the edge of) a network of existing practices and peer out marginally. So you're not strictly bound by existing relative prices, but they are the foundation of your judgment (or perception or whatever). If the whole array gets out of whack, those marginal changes can potentially go out of whack because distorts the perception of your starting point.

Mario, to push a little harder, I think you've hit on a key limitation of the alertness metaphor. Alertness is an ex ante concept; profit and loss -- and the "cluster of errors" that constitutes the bust in ABCT (or MBCT or whatever we're calling it) -- are manifest ex post.

Isn't the real-estate developer who recognizes an opportunity to develop land, to flip houses, to repackage loans, or whatever, when interest rates fall, a Kirznerian real-estate entrepreneur? A Kirznerian homeowner is one who takes advantage of an ARM or zero-down mortgage to move into a bigger house, while other homeowners fail to perceive the opportunity created by this disequilibrium "gap" in the market. Likewise for the Kirznerian banker, mortgage-backed securities trader, and the like. Isn't the claim that market participants tend to respond to such *perceived* opportunities -- regardless of ex post gains and losses -- the essence of the Kirznerian entrepreneurial market process?

Let's just drop the alertness metaphor, which doesn't seem helpful in this case, and talk about uncertainty and error. We could contrast a "neoclassical" story, in which agents respond automatically to price signals, with a version in which entrepreneurs act under uncertainty, credit expansion increases uncertainty and makes entrepreneurial forecasting more difficult, bailouts and stimulus programs inhibit the entrepreneurial selection mechanism, and so on. That sounds pretty Austrian to me.

central bank monkeys

Adam, that's an insult to monkeys!--what do have have against them?

To Adam and Peter: All of your considerations are interesting and important. But this part of a revised or expanded or supplemented theory. The theory as expounded by Mises and Hayek was pretty simple and did not deal very much with the issues you discuss. You may think they are implicit. But implicit is not explicit, of course. My point is that after we add new elements, the simple story collapses. The resource misallocations may look different than in unadjusted version.

But look why insist on calling something by a name that evokes theory of nearly EIGHTY years ago. In America everything that is useful is new (except for Keynes, of course). Let's stop the ancestor worship.

Mario Rizzo,

it is still unclear what is the difference in regard to their learning and anticipative capacity between the old fashioned Misesian-Hayekian entrepreneur acting in the condition of uncertainty, and Kirzerian "alert" entrepreneur? Are you suggesting that P. Klein is wrong when describing mistake-prone real estate developer in the recent house boom as Kirznerian entrepreneur? If so, then his comment could not be "interesting and important" as you say, but clearly wrong. If his comment is true (as I believe it is) then your claim that Kirzerian explanation of entrepreneurship is superior to that of Mises and Hayek is without the merit. What Kirznerian entrepreneur can anticipate and ex ante include in his plans and actions what Misesian one cannot?

Mario, your point is well taken, but I don't think those of us who use the "Austrian" label in this context mean it as ancestor worship. It's just a convenient label until something better comes along. Is "monetary malinvestment theory" or "intertemporal coordination view" or "neo-Currency School approach" really an improvement?

I must admit that I'm new to economics and my English is not very good, but I believe that Mr. Ebeling was quite clear when he said:
"The general theory needs to be applied to the particular historical and institutional circumstances being analyzed and interpreted by the economist (and economic historian).

Thus, the notion that each cycle mechanistically repeats itself is one that neither Mises nor Hayek would have defended or argued for."

The ABCT is so very consistent across millenia (I've just read about the Mongol Empire and it's fall, interesting no one linked it with the hyperinflation during Kublai Khan) and, most of all, is really really easy to grasp. I'm not very bright, but it's logic is so human and so in according with common sens, I just don't understand how people don't get it.

I think that the "Down with Bernanke Theory of Business Cycles" (DWBTOBC) is ok.

Niko: That ABCT is easy to grasp is probably an illusion. There is as much to study to understand ABCT as in understanding any other serious theory of the business cycle. Not using math makes things illusorily easier, but not really easier.

It took me a few years to understand it, but it is really not that hard. I have the benefit of working in real economy and see first hand what is going on in real life. For a while I've seen people repeating what were essentially the same mistakes, even if they were in (totally) different situations, disciplines of activities and so on, and I did not understand why until I've heard, and studied, praxeology and it's implications.

Sorry for my spelling, but the life of me, what's so hard about it?

Well, if ABCT is summarized as the theory which says that money injected in credit markets create too many investments that later need to be liquidated, everything is easy and intuitively appealling, as it is a good fit with the day-to-day experience. This is the newspaper version of ABCT.

However, it is not a conspiracy of keynesian economists if this account doesn't hold water at a more careful scrutiny.

For instance, if investments rise, coeteris paribus, consumption must fall. This is a point which everybody does against ABCT (Krugman, Cowen...). The logic is that if production is constrained, than the choice between investment and consumption is mutually exclusive, and thus the BOOM should be characterized by a FALL in consumer well being. This doesn't make any sense: the newspaper version of ABCT doesn't account for the most obvious of the observations.

A keynesian will tell you that this comovement of conumption and investment arises because production constraints are not hit (inefficiently unused capacity); a new classical will tell you that it is generated by positive technology shocks or pro-cyclical labour supply movements. Newspaper ABCT can't give an answer.

Partial answers (besides the new classical, which is obviously right) can be that consumers are richer in durable goods but not in nondurables (it is false, I think, but less false than the previous statement), or that consumption of capital occurs.

So, the detailed Austrian solution to the paradox is the theory of capital consumption, or Garrison's "pulled-at-both-ends triangles". Now, whatever can be said about the newspaper version of ABCT, the theory of capital consumption is very complex, and it is necessary to explain a relatively obvious fact (that consumption rises during booms).

The fact that you need a hammer to crack a nut is probably something that keeps economists from believing (and understanding) ABCT. However, at least the nut is cracked, which is what really matters.

Other complications arise in almost any detail of the theory. An incomplete and probably incomprehensible list may be:

1. Does the stock of money or the flow of monetary services (the product of the stock of money and its velocity) matter for intertemporal discoordination?

2. Does discoordination arise because of a systematic and persistent failure of entrepreneurs or is it really necessary? The 1943 Mises paper which is being discussed said "maybe entrepreneurs may stop being deluded by inflation in the future, so far it has not been the case" (said more clearly: in Mises's - and Hayek's - ABCT there is no compelling answer against the ratex critique).

3. Does the boom really helps growth (does real forced saving outweighs, at least in the first stages of the boom capital consumpion)? If not, why booms tend to occur in periods of high productivity growth?

4. What happens in an open economy? Can fixed or floating exchange rate eliminate international intertemporal discoordination? Does expansion in one country creates malinvestment in others? How much trade deficit is related to ABCT and how much to real profitability?

5. What's the role of financial markets, for instance consumer credit, non-monetary means of exchange (M2, MZM), insurance (or hedging) against entrepreneurial errors?

6. What is the role of risk in all these developments?

7. If monetary injections make capital goods more expensive, why investment doesn't fall (instead of rising) due to higher input costs? (this I think it's an argument used by Keynes in his General Theory, but doesn't make much sense).

8. Is a crisis at the end necessary or can the long term consequences of miscoordination take the form of a less flamboyant secular stagnation?

I think that some of these questions may still be waiting an answer. But what matters for my argument is that a book which answers these and similar questions would be as long as the Bible and as difficult as a graduate course in quantum mechanics.

As far as I know ABCT is a theory of malinvestment, not overinvestment, a theory of misallocation of capital due to price fixing, mainly the interest rate. It is build on top of other work on monetary theory, human action (individualism) and so on.

None of the details you point out make any sense to me, but I'll try to say what I think about them:
1. Yes, combined with the fact that money are not neutral, it has a big place.
2. Well, what Mises said in 1943 it is still correct, as reality keeps telling us.
3. Because in this periods you also have genuine growth, so a possible investor can piggy bank on an idea of previous successful business in order to obtain credit.
4. I have no idea.
5. 6. I guess (M2, MZM bla bla) mask risk, they provide the illusion of reduced risk and so on.
7. Because it is expected that the higher costs would be offset by the price of the final product? Otherwise, why invest in the first place?
8. The crises at the end is not necessary, it is inevitable. It is the logical consequence of an ordinarily bad investment. It is just at a larger scale because of the previous price fixing (interest rate etc.).

That being said, have a good day.


The ABCT involves *both* over- and mal-investment. You might want to read Garrison's 2004 article in HOPE to see the argument really spelled out.

Garisson talks about overconsumption, not over overinvestment. It is also an ideea that was proposed by Bemjamin Anderson, as far as I know. But the consumption credit does not cause so much problem as the investment credit. The main and actually only culprit for the crises the investment credit.

Steve's point raises interesting matters. Recent work by Garrison and others has shown that, even on its own terms, the Hayekian business cycle theory involves more complex forms of misdirection of resources than was previously understood (by most people).

Furthermore, the theory is a theory, as Garrison says, of the upper turning point of a cycle. So to understand the length and severity of a recession one must bring in other factors. Steve has previously posted on this. Thus, this cycle theory is both more extensive and more limited than many people think.

I might point out that Garrison's analysis of "overproduction" as well as malinvestment, in which for a period of time output is outside the production possibility frontier, occurs in this way only because of a misreading of Hayek's analysis in "Monetary Theory of the Trade Cycle" and the relevant parts of Mises' "Human Action."

In fact, both Mises and Hayek, if you read them carefully, assume a growing economy during the process of the business cycle, and thus the production possibility frontier is moving out to the "right" which the cycle is going on.

This is clear in Hayek, because the very purpose is to show that attempting to stabilize the price in a growing economy can be "destabilizing."

What happens, in fact, is that the artificially lowered interest rate is moving the investment/consumption "mix" to a wrong point on the moving-to-the-right production possibility frontier.

The assumption in Hayek's model in "Monetary Theory of the Trade Cycle" is that there is sufficient "real" savings in the economy so that there can be real net investment, the output outcome of which is what would be tending to bring about a lower general price level if not for the attempt to "stabilize" that price level through monetary expansion.

What "loops-back" is not from a point outside the production possibility frontier, as Roger Garrision assumes, but to a lower production possibility frontier that is between the original one from which the analysis began and the new one that would have been sustainable if not for the misdirection of investment that leads to a degree of capital loss when the cycle has finished it process.

This is why it is, in most historical cycle processes, that when the cycle ends output may be less than it was at the "top" of the boom, but it rarely is back to it where it was several years earlier when the cycle began.

Malinvestment has been overlayed on real net investment that "wastes" part of the capital due to the attempted inducement of more real investment than the growing economy can sustain and fund on the basis of the available real savings.

Richard Ebeling

Just two quick points before I get back to burning incense to my Bohm-Bawerk shrine:

(1) Is it too cute to say, "We call it the Austrian business cycle theory because it's the business cycle theory that a lot of Austrian economists endorse"? I mean, every year they have the "Austrian Scholar's Conference" in Auburn. But what's so Austrian about the conference? I robotically go to the same location every time. If they relocated it, I'm not sure I would be able to adapt.

(2) I think it's an "Austrian" business cycle theory because it relies on "Austrian" capital theory. Without capital theory in the Austrian tradition, at most you get a suboptimal accumulation of capital goods. Mario, when I would try to explain the ABCT to my classmates at NYU, they either didn't get it at all or would say, "So it's an overinvestment theory?" You can't have an unsustainable boom with malinvested resources in a simple model with capital stock K.

To see the relevance, in the bust period you need to know about malinvested resources to understand the Austrian prescription for doing nothing. Krugman and his sidekick Matt Yglesias say every once in a while things like, "It's not as if workers suddenly lost their schools, or machines stopped working. America is just as productive now as it was in 2007, in fact more so because people have learned in the interim. So we just need to pump up demand to reach our capacity for output."

Without understanding Austrian capital theory, you can't explain what Krugman and Yglesias are missing.

Oops typo in the above, I meant to write:

"It's not as if workers suddenly lost their SKILLS..."

Bob's argument about capital theory is the best reason to continue to identify the theory as "Austrian." Whether other considerations outweigh it is another question.

Prof. Ebeling:

I don't think Garrison is misreading Mises or Hayek. Mises was clear in Human Action about the fact that during the boom there is malinvestment and overconsumption. Overconsumption means that consumers consume resources which under equilibrium conditions would have been invested: this is the pulling of the hayekian triangle in Garrison's account.

True, Mises added that growth increases production and this has historically compensated malinvestment and overconsumption.

Considering the whole problem through the concept of the production possibility frontier (PPF):

1. Genuine growth implies an exogenous (from the point of view of the business cycle) shift of the PPF toward higher production.

2. Overconsumption and malinvestment imply a monetary-caused movement of the economy beyond the PPF (if interpreted as "the sustainable PPF"), which must be self-reversing because sooner or later overconsumption and malinvestment will start shifting the PPF toward the left, offsetting the effect of genuine growth.

3. Forced savings can add to the supply of savings and shift the PPF to the right.

Point 3 is inconsistent with overconsumption, so that there can be a growth effect of forced savings only if there is no overconsumption (necessary condition: it is also necessary that forced savings outweighs malinvestment and discoordination). It appears that Mises wasn't aware

The first two explanations are complementary, but overconsumption is an important part of our experience with cycles. When consumers perform "equity extraction" out of their real estate or stock market wealth to increase consumption, they are consuming their net wealth under the illusion that the boom in stocks or houses is fundamentally sound.

This reminds me prof. Horwitz data on US real income: Horwitz was right in pointing out that genuine growth has probably offset malinvestment and overconsumption in the last twenty years and the average american is probably better off at least in terms of durable consumption goods. That doesn't mean, however, that there isn't a component of "over-income" in the present data.

Human Action p559: "As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment."

p565: "The characteristic mark of economic history under capitalism is unceasing economic progress ... The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by malinvestment and overconsumption."

p575: "The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment."

On the original point: whether the theory is "Austrian." Let's call it whatever gets the most people, who are not already convinced, to listen. I'd be willing to call it the Sex Theory if that would help.

What it is called is less important than how the theory can be expanded, improved and applied. Roger Garrison attempted to broaden the Mises-Hayek or Austrian Business Cycle Theory into a "capital-based macro" emphasizing and expanding on the blend of monetary and capital theory that make ABCT a 'real' cycle theory with monetary causes. A discussant on my recent SEA/SDAE paper suggested 'capital structure' based macro.

That paper concluded (referring to an analogy criticizing Hayek by Keynes in the GT):

"Hayek highlighted the complexities of the dynamics of capitalistic production embedded in a structure of production. Maintaining a structure of production, which takes place through time, requires constant replacement of used up, consumed, capital goods. While his development of capital theory was initially part of Hayek’s attempts to provide a better foundation for his cycle theory, the capital structure concepts also provides the foundation for a better understanding the complexities that underlie the critical arguments in the calculation debate, the use of knowledge in society developments, and are of extreme importance in better understanding the nature of economic development and growth. Capital structure as a key component of economic development is explored in detail and in a historical context by Shenoy (2007). Perhaps the lesson from this current crisis is not that the duck (capital theory) should be left tangled in the weeds, but that the profession should have been more diligent in sending clever dogs down into the murky waters of capital theory and worked more diligently on its multiple implications for institutions and policy in a dynamic economy."

Lastly, let me recommend an excellent recent article in RAE by Young and Subrick, "Nobelity and novelty: Finn Kydland and Edward Prescott's contributions viewed from Vienna."

They conclude, " Austrians should be to some extent encourage. KP's methodology is in several ways radically different than both Keynesian and neoclassical methodologies and many of these differences parallel to Austrianism. ... At least their contribution signals that the mainstream can be and has been persuaded to accept a radically different type of analysis."

"On the other hand, KP's achievement should also give pause to Austrians to critique themselves. ... Why is 'time inconsistency" a critique of policy makers to be reckoned with while the 'necessity of economic calculation" is now rarely discussed in the main stream?"

To Mario's point: I think Arnold Kling's "recalculation argument" (or theory) is getting tons of attention, albeit skeptical attention. And although it's not the same as ABCT, in practice it is. He makes the same points about the problems with stimulus spending that any Austrian would.

So I think it shows the idea is a good one, but people can't take "the Austrian business cycle theory" seriously whereas "recalculation argument" sounds like something worth blogging about.

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