Does Comovement in the Data Undermine the Austrian Theory of the Business Cycle?

Tyler Cowen's Risk and Business Cycles is arguably the most learned criticism of the traditional Austrian Theory of the Trade Cycle.  But Tyler has put a lot of weight on an empirical claim in his criticism --- the amount of co-movement in the data on the production and consumption side.  He repeats this criticism today in a post at Marginal Revolution in his discussion of Paul Krugman's critique of the Austrian theory of the business cycle.

I am not sure the criticism is as problematic as Tyler and others have tried to make it out to be.  What do you think?  Also, the point about the methodological assumption of full employment is about the starting point, not throughout each stage.  It is a simple point -- to explain the phenomena of unemployment you must first begin in full employment and explain how unemployment can arise.

I think what Krugman, and by implication Tyler, is missing in this critique is the distortionary impact of the confusion in the signals.  In short, the Austrians by not pursuing a mechanical interpretation of the quantity theory are able to slightly modify the classical dichotomy that reals effect reals and nominals effect nominals, but showing that in the short-run nominals can impact reals.

To use an analogy from our current situation that I used in a public lecture last week --- the credit freeze is analogous to a 18 car pile up on Interstate 95 causing a 60 mile traffic jam, government is tasked with the responsibility to clean up the wreck and get traffic going.  The officials on the ground will (a) establish detour routes, and (b) get the wrecks off the highway so traffic can get moving again.  We can all agree this is the right thing to do.  But what if the signs set up for the detour did not direct traffic in a way to get back on the highway beyond the accident?  What if instead the signs directed travellers in wrong directions given their intended route, or worse sent them on a road which ended with them driving off a cliff?  The detour can misdirect and lead to real losses.

Perhaps my analogy doesn't work, or it is too pessimistic.  But what I would like to see is a serious discussion of this issue of co-movement in the data and whether or not it is an (a) accurate depiction of the data, and (b) devastating to the Hayekian rendering of the trade cycle.

Comments

[John]

For his point about wages, the problem is that there are two things going on. There is an investment boom and there is also a debasement of the currency. Also, an investment boom means additional demand for labor in the investing sector, putting upward pressure on wages.

[Richard]

I think you are far too pessimistic. Sure the bail-out plan is not perfect, but it is all that is on the table. Plus the bank bail-out (quasi-nationalization?) is easily reversible. No need whatsoever to worry about all this taking us further down the road to serfdom IMHO.

[Bob Murphy]

I think it's a good analogy, Pete. In response to one of Tyler's NYT pieces, saying that people were wrong to blame the Fed for bailing out Wall Street (note this was back in September 2007!!), I wrote in the Freeman:

"Tyler Cowen thinks the Fed’s recent actions are comparable to when the “police clear a road after a traffic accident.” But as I’ve shown, a better analogy would have the police firing their guns into the traffic and causing an accident, then ordering poorer drivers off the road so that any bankers injured in the pile-up could be rushed to the hospital."

http://www.fee.org/Publications/the-Freeman/article.asp?aid=8237

[Rafael Guthmann]

I think that the central idea in the ABCT is the idea that money is a loose joint in the system. And this loose joint idea is backed by the austrian microeconomic theory. I think that without the micro basis with austrian flavour the austrian macro theory falls apart (rational expectations and adaptive expectations are inconsistent with the theory). If Krugman does not know the austrian micro theory, he cannot understand the ABCT.

I think that this is the central point of the theory: If you give 1 thousand dollars to everybody, everybody will think that they are richer than the though they were before, this is a boom. But when they go to spend the money, prices will go up. The perception of the target utilities is them revised down, this is a bust. The central point about this theory is that agents take time to adjust their plans, first do adjust their planned spending, then the sellers take time to discover de increase in demand and adjust prices and the agents take time do discover these changes and the pattern of change. The market process reacts to a injection of money first the discovery of the money injected and the adjustment of spending plans then with the adjustment of prices the distortions are reversed. If this process starts in the baking sector, then the process will take years to be reversed because of the distortion in the intertemporal structure of production, then we have a real business cycle.

I think that the austrian perception about the market as a process with equilibrating tendencies is essential in the ABCT, without the the underlying theory of the process of plan revision that is generated by the monetary shock the ABTC does not "work". This means that economists must know and agree that the basic theory of the market process is a valid interpretation of economic reality before they can ever discuss the more complex developments of subjetivism.

[matthew mueller]

Co-movement is another term for what Hayek called the "Ricardo Effect," but in fact this term should be divided into the "Ricardo Effect proper" and the "Inverse Ricardo Effect." The former argues that an increase in the consumer goods industry will result in a fall in investment, while the latter argues that a decrease in the consumers goods industry will lead to an increase in investment.

Now Fiona Maclachlan has done a good job pointing out that Hayek dealt in his writings mainly with the "Ricardo Effect proper." But proving the Ricardo Effect proper does not prove that the "inverse Ricardo Effect" also holds.

But you do not need to adopt the Austrian roundabout process of capital theory to understand the Ricardo effect proper. All we need to recognize is that (1) the future is uncertain, and (2) production takes time. All heterodox economists make these points. So a demand in consumer goods will likely lead to a fall in investment because existing equipment will be worked harder and installation of new capital equipment will be delayed largely because no one is certain how long present conditions will continue. ***Only the Austrians seem to believe that relative price movements will result in MECHANICAL reactions by entrepreneurs to make the necessary adjustments.***

Now the inverse Ricardo effect is more difficult. It is very difficult to argue that a fall in consumer demand will increase investment spending. Now I know Austrians make a big deal about the abundance of credit driving down interest rates, but the point that they overlook is that no matter how low interest rates fall, if they are still above the *marginal efficiency of capital* no investment will be made. If the interest rate is above the profit rate, no investment will occur. And what happens in an economy experiencing falling consumer demand? Profits fall. Austrians have made a mistake by concentrating their efforts in elucidating the consequences of a cheap credit policy.

So to answer Boettke's question more directly, e.g., whether co-movement (Ricardo Effect) is "devastating to the Hayekian rendering of the trade cycle" --- here it is. This is how you do it. And heterodox economists familiar with Austrian economics have picked up on this point. See, most recently, Ted Burczak's "Profit Expectations and Confidence" paper published in the Review of Political Economy. Roger Koppl and William Butos wrote a paper defending Austrian economics against these criticisms, but in my opinion they "missed the boat."

[matthew mueller]

Co-movement is another term for what Hayek called the "Ricardo Effect," but in fact this term should be divided into the "Ricardo Effect proper" and the "Inverse Ricardo Effect." The former argues that an increase in the consumer goods industry will result in a fall in investment, while the latter argues that a decrease in the consumers goods industry will lead to an increase in investment.

Now Fiona Maclachlan has done a good job pointing out that Hayek dealt in his writings mainly with the "Ricardo Effect proper." But proving the Ricardo Effect proper does not prove that the "inverse Ricardo Effect" also holds.

But you do not need to adopt the Austrian roundabout process of capital theory to understand the Ricardo effect proper. All we need to recognize is that (1) the future is uncertain, and (2) production takes time. All heterodox economists make these points. So a demand in consumer goods will likely lead to a fall in investment because existing equipment will be worked harder and installation of new capital equipment will be delayed largely because no one is certain how long present conditions will continue. ***Only the Austrians seem to believe that relative price movements will result in MECHANICAL reactions by entrepreneurs to make the necessary adjustments.***

Now the inverse Ricardo effect is more difficult. It is very difficult to argue that a fall in consumer demand will increase investment spending. Now I know Austrians make a big deal about the abundance of credit driving down interest rates, but the point that they overlook is that no matter how low interest rates fall, if they are still above the *marginal efficiency of capital* no investment will be made. If the interest rate is above the profit rate, no investment will occur. And what happens in an economy experiencing falling consumer demand? Profits fall. Austrians have made a mistake by concentrating their efforts in elucidating the consequences of a cheap credit policy.

So to answer Boettke's question more directly, e.g., whether co-movement (Ricardo Effect) is "devastating to the Hayekian rendering of the trade cycle" --- here it is. This is how you do it. And heterodox economists familiar with Austrian economics have picked up on this point. See, most recently, Ted Burczak's "Profit Expectations and Confidence" paper published in the Review of Political Economy. Roger Koppl and William Butos wrote a paper defending Austrian economics against these criticisms, but in my opinion they "missed the boat."

[matthew mueller]

Apologies for the double post; I just want to ram this point home. ;)

[Steve Horwitz]

Once you invoke the "marginal efficiency of capital", you have stepped outside the world the Austrians are talking about where capital is heterogenous and such an aggregate makes little sense. Any criticism of the ABCT is going to have to deal with Austrian capital theory. Krugman couldn't and the Post-Keynesians can't either.

[Roger Koppl]

Here is the comment I just posted at Marginal Revolution:

I'm not sure the comments so far are really addressing Tyler's issue. He says, " the Austrian theory doesn't generate the very high degree of comovement found in the data." I think Roger Garrison has taken this issue seriously and arrived at a conclusion similar to Tyler's suggestion: "The best shot is to relax the Austrian-favored methodological assumption of full employment." Here is one exposition: http://www.auburn.edu/~garriro/strigl.htm.

Roger says we go off the PPF for a while. As far as I can tell, that's the right approach. I don't recall Roger addressing the obvious question, however. How can you go off the the PPF? He redefines the PPF as "showing *sustainable* combinations of consumption (on the vertical axis) and investment (on the horizontal axis)" (my emphasis). That hints at how you could get movement off the PPF, but I don't think Roger addresses the issue fully. I don't see why it would be that hard to do so, however. One area is the difference between measured values and the theoretical constructs they point to. Empirical co-movements are going on measured values only, of course. Second, the PPF is static, but we make intertemporal choices. Thus, I think you could get something like a movement off the PPF for the sort of reasons you get a cycle in the real-business cycles literature. In the boom you buy a new car, but you postpone that vacation you'd been planning because market opportunities *seem* to have improved. During the bust, you find you can no longer afford that vacation. Your lost leisure time helps us get off the PPF, but only temporarily.

[Arash]

The assumption of full-employment of labor is quite irrelevant to the ABCT. What is important is scarcity of what Hayek calls nonpermanent means of production, the services of which cannot be anticipated by reshuffling the capital structure. What Krugman and Cowen miss here is that the ABCT stems from the debates on the doctrine of forced saving - debates on the short-run nonneutrality of money. Since Thornton and Bentham economists knew (before Keynes) that even in the short run output can expand only by expanding capital in the first place. This is Mill's first proposition on capital (industry is limited by capital) applied to dynamics. His second propostion, capital accumulates by real saving only, is also important. But all this is outside mainstream macroeoconomics.

Economic analysis was indeed strong in the past.

[Arash]

@Mr. Koppl:

Garrison explains his views on going off the PPF in his recent discussion with Ahiakpor in ESHET's European Journal of the History of Economic Thought. I side with Ahiakpor that the PPF shouldn't be used that way.

But why not present intertemporal choices with the PPF? Static approaches are quite useful in stating the economic problem in terms of relative scarcities. Intertemporal statics, I believe, is a necessity in Austrian business-cycle analysis.

[matthew mueller]

Professor Horwitz,

I am aware of this criticism, and, to be honest, do not really know how it got started. The marginal efficiency of capital refers to the prospective yield of an investment project. That is all. Austrians can easily accomodate this concept into their "stages of production" conception of capital. The fact that they refuse to is not evidence of the difficulty of doing so. I would instead argue that the marginal efficiency of capital is devastating to the adverse consequences Austrians believe cheap credit engender. I am not sure Austrians really understand the marginal efficiency of capital. It is okay to go and read Keynes' 1936 book. It is very powerfully written. I actually enjoyed it a great deal. Please read chapter 11 and then we can talk about it some more. But to repeat the old criticism that Keynes dealt with an aggregate theory of capital and therefore we do not have to engage the Keynesian/Post Keynesian literature is a bit naive.

[matthew mueller]

And one more point,

The heterogeneity of capital is a concept Austrians use without much reflection. For example, what does this concept imply if we take it to its logical conclusion? Well, here is Ludwig Lachmann in a paper entitled "Reflections of Hayekian Capital Theory":

"If capital cannot be measured, neither can investment."

Well, if investment cannot be measured owing to capital heterogeneity, then how can we measure and identify malinvestment? You can see where this leads if we use the concept of capital heterogeneity to attack more positive theories that try to grapply with profit, investment, employment, and output, i.e. the marginal efficiency of capital.

The Ausrtians cannot have it both ways. What are we to take capital heterogeneity to mean exactly? Are we to follow Ludwig Lachmann on this point, or just say capita heterogeneity without really trying to understand what it means.

Again, Peter Lewin once wrote in an essay that capital theory is one of the distinguishing marks of Austrian economics. But since the 1970 revival, no Austrian has explored its implications.

[Roger Koppl]

Matt,

You've really got to dial it down, or no one will talk to you. Remember that when A and B speak, A is not reacting to B's model. A is reacting to his model of B's model, which is always and necessarily simpler than B's model. THAT is why we have the academic trope of modesty. "Oh, I don't understand, sir, your argument on this point. Won't you please help me to understand why xyz?" Idiots in a bar say, "You're a moron and I can prove it." Which way will it be for you? Choose.

Now to your earlier post on the MEC. I never saw the strength in such arguments. Sure, if you posit a Keynesian process of mass psychology, then you can get these results. You bet. But 1) we should ask what conditions let such a process get going. For Keynes, a stock market all you needed. Big Players theory says it depends on other factors, namely the underlying stability in the rules of the game and the presence or absence of Big Players. 2) My co-authors and I have put our ideas to the test with numerical data and the Big Players theory has passed the test so far. 3) The story as posited doesn't make much human sense to me. What's happening to real balances, for example, during the crisis of confidence? Eventually the real balance effect will catch up with you. And why does the epistemic diversity of the market, without which trading volumes would be waaay lower, suddenly dry up? In some of these Post Keynesian stories, it all just goes flooey for no particular reason. You can *posit* that without falling into a logical contradiction, I think. But it doesn't make human sense to me.

[John]

Roger, I'm a little lost on your first point, could you explain how going off the PPF would answer Tyler's criticism. There seem to be other explanations, like the points I made on the first post, that seem equally valid.

[Grant]

I read Garrison's work on ABCT before I ever read Hayek's. I'm no pro, but from where I'm sitting Tyler doesn't seem to understand ABCT or maybe Austrian micro (which seems a strange assertion to make, I know).

From what I understand, we can move to the upper-right in the PPF because the (non-neutral) new money leads to an over-consumption of savings (which is basically the same thing as saying unsustainable investments are being undertaken). Also, if economic actors suddenly see a bunch of new money, they are likely to work harder to get it (even if they realize it will just inflate prices a few months later they'd still want some).

Matthew, if I'm understanding you correctly, you're saying that there is some interest rate above which no investment would take place? Thats obviously incorrect on the micro level, isn't it? The expected returns of capital are highly dependent on the tacit knowledge of the entrepreneur. I don't think we can estimate capital, investment or malinvestment, but we can see their affects and how the market reacts to them.

[Ricardo]

Wow. This Matt kid really rattles you guys! No wonder you'd prefer he did not ask these questions and just parroted the standard rothbardian line like the rest of you (Roger Koppl & David P aside).

Also, why the silence from the younger bloggers on this? Perhaps they take second-best considerations seriously unlike the ideologues here.

[Steve Horwitz]

I love having people ask the kinds of questions Matt asks. My complaint is with the style not the substance in the sense that the same questions asked with a bit more intellectual modesty might be answered in a more charitable fashion.

[Josh Hendrickson]

Tyler writes, "The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages."

I think that the fundamental source of the problem is that Cowen (and Krugman) are talking about the level of the real wage rather than the effect on the real wage. This needs a much more detailed treatment, but I will try to make what follows suffice.

Let's first begin with a real business cycle model. The underlying assumption with the model is that we are in a steady state (this is consistent with Hayek, as in Prices and Production, he explicitly states that his analysis begins with a steady state). In an RBC model, the economy begins in a steady state and GDP is governed by deterministic growth. The wage is therefore constant. Booms (in RBC model) are the product of positive productivity shocks. A shock to productivity causes the price level to fall and thus the real wage to rise. Hence the pro-cyclical behavior of real wages and GDP growth (note that when we expand to include money, price level stabilization will result in a stimulus of demand which will push prices up, hamper the boom, and cause the real wage to fall).

Now let's make this analysis meaningful by incorporating money. When the central bank increases the money supply this results in force savings which lengthens the structure of production. This forced savings raises expenditures on intermediate goods and therefore consumption expenditures remain constant (although the quantity of goods consumes declines because individuals are paying higher prices). The increase in money-income from the production of intermediate goods subsequently results in consumers demanding the same proportion of consumption as they had prior to the change in the money supply. This causes the structure of production to become less roundabout and malinvestment is realized.

This background allows us to get straight to the point. As Larry White details in his paper on Hayek's monetary theory, it is explicit that the central bank should not attempt to stabilize the price level, but rather maintain a constant MV (in equation of exchange terminology).

In reality, economic growth is the result of increased productivity. Thus, if growth is governed by changes in productivity, the price level should be allow to fall (see George Selgin's work on the productivity norm). Attempts to stabilize will result in the boom discussed above. However, what we need to concern ourselves with is the co-movement of the real wage and growth.

If economic growth is governed by changes in productivity, then the real wage will rise in conjunction with economic growth (and hence co-movement). However, attempts to stabilize will result in the boom-bust scenario above which pushes prices higher and thus puts downward pressure on the real wage. It does NOT imply that the real wage moves counter-cyclical to the GDP growth, only that the increase in the real wage due to economic growth is hampered by attempts to stabilize the price level. Thus the level real wage will remain pro-cyclical, while the growth in the real wage may be depressed. (This should be clear from the data over the past seven years in which we had an artificial boom. Real wages were largely stagnant despite rising GDP while productivity growth was growing at a slower rate that in had in its peak in the latter part of the 1990s and the early part of this decade.)

[Mario Rizzo]

As interesting as this discussion is, I think it is a BIG MISTAKE to devote all of this time to the Wicksell-Mises-Hayek business cycle theory as if it were the only one consistent with Austrian economics. Neither Lachmann nor Kirzner thought Austrians should put this so front and center. I think this emphasis has narrowed and impoverished Austrian discussions of the current crisis.
While I am at, let me make a second point. Whatever the merits of the W-M-H
cycle theory in explaining the housing bubble, it does not explain the misvaluation of the mortgage backed securities, the excessive leveraging, etc. Without the latter problem the "crisis" would not have reached such large proportions.

[Ricardo]

My guess is that you guys consider Matt the potentially hottest property young Austrian since Leeson-Coyne. Hence why his deviations from the plumbline cause you so much anguish.

Am I right?

Keep at your stuff Matt.

[Peter Boettke]

It is also the case that Matt makes pronouncements that are WRONG. For example, to claim that nobody has worked on capital theory since 1970s is wrong. Peter Lewin wrote a book on capital theory; Roger Garrison has written on capital; Larry White's introduction to The Pure Theory of Capital; heck there is a literature on the Hayek/Knight debate that Avi Cohen and Russ Emmett have contributed to; the Scrafa/Hayek debate that Gary Mongiovi has contributed to. It is not like the issues don't get discussed.

Also even his claim about heterogeneity is not fully informed. It is about heterogeneity AND multi-specificity in use that matters and requires the shuffling and calculations that are finely balanced. Heterogeneity with 1 use would not raise the sensitive issue at the same level of acuteness.

Post Keynesians don't have an answer to Hayekian knowledge problems, and the don't have an answer to Buchanan public choice problems.

Matt went as far as to suggest to Steve Horwitz that he read the TGT again --- one more time with feeling I guess. I imagine people like Steve and I have read TGT through more times than either of us care to mention since we have been teaching almost as many years as Matt has lived --- ugh! But pointing readers to key chapters in TGT is not the way to get them to consider the point about uncertainty, expectations, long term view, and investment.

The Austrian argument about aggregate economics is not something that can be swept under the rug, and then ask well besides that what do you have to criticize.

The most surreal debate I ever had entailed Bryan Caplan, Ed Stringhman and myself on the proposition of the impossibility of a cat swimming the Atlantic Ocean. The claim was never that a cat couldn't try, but that the very constitution of being a "cat" would not permit a cat to survive such a trip. Caplan responded and said "What if we strapped a jet engine on the back of the cat?" Well then of course the cat could make the trip, but he wouldn't be swimming now would he, I replied. Stringham responded, what if the cat through evolution the cat developed flippers and gills? Well then the cat would no longer be a cat, I replied. BTW, both claimed victory in the argument for their innovative responses to the proposition that a cat could not swim the Atlantic Ocean. I never understood their confidence.

I don't understand Matt's confidence either. Hayek argued one thing, critics argued another, the opportunity for true engagement was missed. This is why I think Caldwell's Beyond Positive is to be recommend for the way we conduct debate in our field.

[John]

Mario, you're right, but your point is kind of obvious. The WMH theory isn't meant to and was never intended to explain every detail of a boom/bust cycle.

Roger Garrison has a good interview at mises.org where he talks about how business cycles always manifest themselves in areas of the economy where some fundamental change is always happening. I think that line of thought is another good way to approach this crisis. Sure you have a boom/bust cycle in housing, but no one is denying that there aren't a handful of other things explaining a part of what's going on. There's agencies problems in the mortgage origination business, problems with mathematical modelling in valuing MBS, agency problems in financial institutions, regulatory arbitrage encouraging more off-balance sheet transactions, and a host of other problems.

As always, I look forward to any of your articles on the subject.
John Hall

[Ricardo]

Given the length of Peter Boettk'es response I'll take that as an affirmative on my take on your assessment of matt's raw potential.

Why not just try and work with him instead of assuming you have the answer to everything. Chances are both you & Matt are wrong.

[Ricardo]

Also i think you likely don't get that Matt is not trying to convert you but merely attempting to see if you have good answers to the numerous objections to Austrian capital theory (etc) that he is raising.

He clearly respects you guys. His priors are obviously that you guys don't agree with him so he is asking what he is missing.

Humility cuts both ways people.

[Ricardo]

I think those 2 professors are trying to say that you define a cat (or the USSR) in a particular essentialist way. Would you say the USSR was socialist?
Actually, they have a more Polanyi take on the cat ? than you I suggest.

"The most surreal debate I ever had entailed Bryan Caplan, Ed Stringhman and myself on the proposition of the impossibility of a cat swimming the Atlantic Ocean. The claim was never that a cat couldn't try, but that the very constitution of being a "cat" would not permit a cat to survive such a trip. Caplan responded and said "What if we strapped a jet engine on the back of the cat?" Well then of course the cat could make the trip, but he wouldn't be swimming now would he, I replied. Stringham responded, what if the cat through evolution the cat developed flippers and gills? Well then the cat would no longer be a cat, I replied."

[Ricardo (not David)]

"My complaint is with the style not the substance in the sense that the same questions asked with a bit more intellectual modesty might be answered in a more charitable fashion."

Which leading Austrian monetary theorists aged 21 does Matt remind you of? (Short answer: all of them bar Hayek and Marget)

[matthew mueller]

I would like to add one thought. These issues are too damn important to end in a debate over my merits as a student of Austrian economics. No one is going to want to read or post on this board anymore if every time I write something I get attacked for being arrogant, inexperienced, and disrespectful. Boettke and Horwitz: I have met you guys before, and I hope it was obvious that I respect you guys a great deal.

I am going to continue posting my thoughts on whatever Professors Boettke and Horwitz want to discuss. I would suggest that we just take on the ideas and leave *me* out of it. To repeat: I am not saying anything new. These ideas have all been made before, I am just bringing them into the Austrian circle.

Ok: so let's get back to Austrian business cycles!

[Ricardo]

"These ideas have all been made before, I am just bringing them into the Austrian circle."

Exactly. Bravo to Matt!

[Ricardo]

"No one is going to want to read or post on this board anymore if every time I write something I get attacked for being arrogant, inexperienced, and disrespectful"

You are wrong: There are plenty of Austrian hacks eager to be here who wanted you gone (eg - silly Mason UG's like Ian 'I can square the Pope and RothbaRD' Dunois.

Hang in here Matt. The serious folk (Boettke etc think you are smart as hell). Ignore the dopey ideologues and keep pushing subjectivism as far as it may go.

[Ricardo]

Incidentally, everyone should note that Dr Boettke is not on the list of wacko fever-swamp anti-Krugman nuts that Brad Delong has compiled (unlike racist Dan Kline of GMU)

[Richard Ebeling]

This is a long debate that clearly is raising many essential points. One such point that has come up in the discussion is how can output and employment go beyond the production possiblity frontier during the upturn of the cycle; and why don't real wages fall during the investment phase of the cycle.

Much of the implicit discussion starts with Hayke's "Prices and Production," in which he says that as a methodological point it is necessary (preferred?) to start with full employment. Only with that starting point can we then (hopefully) work through an analysis that shows how a condition of significant unemployment may arise.

(By the way, the analysis need not start this way. Erik Lindahl in the early 1930s extended the Wicksell/Bohm-Bawerk analysis by assuming three different starting points: Full employment in the consumer goods sector, with unemployment in the investment goods sector; unemployment in the consumer goods sector, with full employment in the investment goods sector; and unemployment in both the consumer and investment goods sectors.)

Obviously, if you assume strict full employment as the starting point, it does raise the issue of how you have more investment goods activity (generated by the monetary expansion through the banking system) without resources being drawn from the consumer goods sector, and thus less consumer goods production.

Then, to "solve" this problem, you use an "Austrian" application of the distinction between the long-run and short-run agggregate supply curve, which enables short-run increases in output as a whole before factor prices catch up with the rise in final goods prices that initially created the stimulus to produce more in the economy.

But let me suggest that there is another "way out." And that is to take more seriously the analytical assumptions in Hayek's earlier work, "Monetary Theory and the Trade Cyle."

Hayek wanted to show that an attempt to stabilize the general price level in a growing economy could be destablizing. For a tendency for continuous coordination in the face of change (rising outputs due to cost-efficiencies and technological improvements) "equilibrium" required a falling price level (statistically measured) as individual prices adjusted downwards as respective supplies in each market shifted to the right in the face of these improvements.

To inject increases to the supply of money and credit in a growing economy in an attempt to stabilize the price level would likely push interest rates below their equilibrium, or "natural" rates.

Now, less us think about this: a growing economy. This means that over the time-period that we are analyzing the production possiblity frontier is moving outwards to the right (due to real grow). And matching this would be a "path" from a point on the earlier production possibility frontier to a point on the later production possibility frontier that would represent maintaining a "correct" balance between consumption and investment through time that matched the consumption/savings preferences of the market participants through that same time period.

Now overlayed on this "normal," "healthy" and intertemporally coodinated process (due to the market competitively setting prices, interest rates, and the allocation of resources), we superimpose a monetary expansion through the banking system, say, to "stabilize" what would otherwise be a falling price level reflecting that economic growth through time.

The "money" rates of interest are pushed below their "natural" rates. The "path" leading from a point on the earlier production possibility frontier to a point on the later, growth-induced production possibility frontier is deflected from the point at which it would have been aiming if not for the monetary expansion and the lower-than-equilibrium interest rates.

The "path" now leads to a point on the later production possibility frontier that represents a greater amount of investment activity relative to consumption than "real" equilibrium through time would have dictated.

But because the economy IS growing due to "real" improvements in the economy this does not mean that there must be less consumption (in an absolute sense) to provide the necessary resources to feed the additional investments induced through the interest rate distortion.

It just means that less of the greater amount of expanding output will initially go into consumer goods production than the underlying "real" factors woul have required, again, if not for the monetary expansion.

There will be more consumption goods output along with the greater amount of investment activity. It's just that the "mix" between consumption and investment in this growing economy is "wrong."

This is what eventually becomes unsustainable in the longer-run. The economy finds it necessary, eventually, to adjust to where the "correct" point is along the new production possiblity frontier, given the "real" consumption/savings preferences of the market participants.

This also means that through a good part of the upturn of the cycle real wages need not move inversely with the investment boom. It is just that out of the greater output that is being produced in this growing economy, real wages rise less than they otherwise would due to the greater monetary-induced investment activity.

If during the upturn of the cycle we assume a growing economy over which the monetary distortion is overlayed, rather than a "static" economy with a "given" production possibility frontier, some of the "problems" are more answerable.

And it is an analytical schema that is certainly consistent with Hayek's own "model" in "Monetary Theory and the Trade Cycle."

Richard Ebeling

[Hank]

Please ignore Ricardo. He's obviously just trying to goad you. Matthew's tone in his comment at 12:18 is blatantly inappropriate.

I'd like to note that your conversation here is a bit dense. Don't get me wrong. I applaud the depth of your conversation (perhaps the most serious conversation I've seen in blog commentary), but, as an outsider, it's difficult to follow your arguments. I'm perfectly content to look up the occasional name or theory, but I don't have all day to work my way through your posts. If you intend for this blog to be accessible to non-Austrians (if not, I apologize for intruding) it might be helpful if you paraphrased, summarized, etc. a bit more.

I'm a grad student in economics, but my program is very mainstream (I'm second year so my training thus far has consisted of a series of very difficult math classes). So when it comes to a discussion like this I'm very poorly informed. I've read Human Action (it gave me some very interesting insights into the foundations of economic thought) but that's about the extent of my understanding of Austrian Economics.

Anyways, on to my (very unsophisticated, possibly naive) thoughts on Krugman and Cowen's criticisms. First let me extract the meat of Krugman's argument from his name calling and derisive comments (it really is shameful that anyone who could spew forth that kind of invective should be chosen for the Nobel prize):

"...As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?"

followed a bit later by:

"...if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?"

In response to the first paragraph I'd say that money can be disposed of in ways that do not stimulate production. People can buy government bonds or hard assets like gold/land (few workers would need to be employed to provide these outlets for cash being drawn away from investment).

Of course, one would expect that this would drive up the prices of those assets. I suspect that this is what Cowen is talking about when he notes "there aren't that many countercyclical assets". That is, apparently, we don't see a large enough number of assets rising in price sufficiently during business cycle downturns to account for all the cash fleeing from investment (I don't have the nomenclature to handle the distinction between assets like those above and 'productive' investment; in my macro classes investment is always the thing that is an input to future production).

If the money isn't going into investment, or consumption, then clearly people must just be holding onto the cash itself. Which brings me to Krugman's second paragraph.

This is where my fundamental disagreement with Krugman lies. It's true that there is an increase in demand for money. It's true that this goes hand in hand with a freezing up of the financial system. But I don't believe that it is the CAUSE of the problem. I think that it's a symptom of the fact that people are afraid of committing their wealth to anything.

When the economy goes into a recession people are suddenly presented with an entirely new information set. Investments which formerly seemed to be doing quite nicely now turn out, often times overnight, to be misinvestments of the worst sort. Until the rate of appearance of these unpleasant revelations slows down, people see very high expected volatility. So they want to keep a relatively high proportion of their wealth out of markets altogether.

But it's not true that simply flooding the market with enough money to satisfy the increased money demand is a panacea (though it's worked well enough in many recent credit crises). The problem is the misinvestments. The solution is having the misinvestments fully revealed and eliminated. This implies a very real cost.

The fundamental flaw in that second paragraph as I see it is in the line "Why should this require that perfectly good productive capacity be left idle?" I would say that we can have no idea whether the productive capacity is perfectly good or not.

Misinvestment means that there are factories producing goods people do not desire (not at prices profitable to the owners anyway), homes built that no one wants to live in, etc. It means that real world resources have been misallocated. This productive capacity is not 'good'. To put these resources back into productive (profitable) use will require time, planning, and the realization of losses. This period of readjustment will alter the fundamentals under which all other agents are operating.

In the face of such changes investors are, quite reasonably, reluctant to commit their wealth to projects with outcomes that are particularly sensitive to these changes. In short, our uncertainty about the future justifies a period of low activity while entrepreneurs gather information (and wait for new info to be revealed) so they can undertake the process of reallocation effectively.

Well, I think that has some similarities to the Austrian perspective. In the very least it argues in favor of the belief that credit busts are a necessary correction for credit booms (or rather that both are the inevitable result of our uncertainty about the future), which, I think, is the fundamental proposition being debated here.

You guys could probably tell me that what I've said is just an amateurish restatement of so-and-so's theory of such-and-such. If so, please direct me to so-and-so. I'd very much like to read more rigorous ideas along the same lines.

Thanks!

[Ricardo]

"First let me extract the meat of Krugman's argument from his name calling and derisive comments (it really is shameful that anyone who could spew forth that kind of invective should be chosen for the Nobel prize"

Puff puff puff. Hank might be able to spell invective but he sure does not know it when he sees it. Check out Hayek on gentlemen like Mr Leonard Woodcock or Prof. Leontief.

Anyways, I'm glad to see Kaplunk U's phd program has at least 1 good student.

[Steve Horwitz]

Ricardo,

Suffice it to say you are pushing the limits of blog etiquette. We've booted people before for such breaches. You want to go after your hosts, that's one thing, but we (or at least I) won't put up with you insulting our commenters, especially ones who come in good faith with a serious contribution.

[Lee]

What are the best Austrian and Hayekian pieces addressing the type of objections that have been raised by Mathew Mueller?

Thanks in advance.

[matthew mueller]

Hello Lee,

The only reason I post on here is in the hope of someone asking the question you just raised.

As for the literature that has influenced me to ask the questions I did, I would certainly consult:

Fiona Maclachlan - Keynes' General Theory of Interest

Paul Davidson - A Keynesian view of Friedman's theoretical framework for monetary analysis, Journal of Political Economy, 1972

Nicholas Kaldor "Speculation and Economic Stability" The Review of Economic Studies, 1939.

and anything by Greg Hill published in "Critical Review."

As for the marginal efficiency of capital more generally, Keynes discusses this in chapters 11 and 12 of The General Theory. A more accessible treatment is found in Dudley Dillard's *excellent* book "The Economics of John Maynard Keynes.

-----

Now as for Austrian pieces addressing this literature, William Butos and Roger Koppl have written a bunch of interesting articles on Hayekian expectations. Rogger Koppl also has a book out entitled "Big Players" which I admittedly have not yet read. Their work is very important because a big part of my criticism relies on the instability of expectations.

Avi Cohen has probably done the most to address Post Keynesian capital theory questions from an Austrian/Hayekian perspective, and his work is very interesting (though I have only read a couple of his articles). His articles can be accessed here: http://econ.yorku.ca/~avicohen/cv2.html

Professor Boettke earlier mentioned some names like Roger Garrison and Larry White (his introduction to Hayek's 1941 book). Larry White's introduction is mainly a biographical account of Hayek's theory, and not really substantive, and Roger Garrison is arguably the best expositor of Austrian Business Cycle Theory, but a lot of his discussion is restricted to Austrian circles. It is very important to Austrians, but it doesn't reach out to the economists I like in the same way that Butos/Koppl and Cohen do.

Also, I really enjoyed Lawlor and Horn's article "Notes on the Sraffa-Hayek Exchange" published in the Review of Political Economy. That article clearly shows how Sraffa just devastated Hayek's theory of prices and production in every possible way. You will certainly want to know how Austrians have responded to this criticism, though I am not sure if Austrians have written anything about this exchange? Any help guys??

Hope this helps. This is an interesting area to study. But before you begin reading the Austrian responses to these criticisms, I would encourage you to read the actual crticisms. They are very good. Fiona Maclachlan--Greg Hill--G.L.S. Shackle--Paul Davidson are all good sources to consult on this question.

[Grant]

Can anyone explain exactly what Matthew's objections are? He says:

"Now I know Austrians make a big deal about the abundance of credit driving down interest rates, but the point that they overlook is that no matter how low interest rates fall, if they are still above the *marginal efficiency of capital* no investment will be made. If the interest rate is above the profit rate, no investment will occur. And what happens in an economy experiencing falling consumer demand? Profits fall."

Obviously no statistic on the marginal efficiency of capital exists or could exist for Hayekian reasons. If the interest rate is above the expected future profit rate of all possible investments (which seems like a very silly scenario to begin with) then obviously no investments will be made. However, the fall in profits during a recession isn't permanent, and no one expects them to be. So the expected future profit of an investment might not be influenced by short-term consumer demand at all.

Or am I reading this all wrong?

[David]

I'm no business cycle theorists, but I find parts of this exchange interesting, and parts basically just aggressive. As a non-specialist, all I can say is that all of the related theories that I have encountered seem quite persuasive, at least in isolation (most recently, I read Koppl's book). But what strikes me as somewhat problematic is the seemingly unicausal nature of most contributions that I know of - and this seems substantiated by the discussion here. Has there been any attempt to construct a multicausal theory, such as monetary infusions + big players + animal spirits etc? (I'm not claiming that these are the relevant factors, just that there may be more than one important cause).

[Rob Thorpe]

Interesting stuff.

Surely it is possible for ABCT to be a cause of recessions even if investment expenditure remains constant? The problem of malinvestment can still occur due to too much investment in capital goods of the wrong order. That could happen regardless of whether consumer spending drops.

Isn't much of the problematic comovement of investment and consumer spending likely caused by mis-measurement? Consumption is not measured directly, consumer spending is measured which isn't the same thing. When someone buys a car that is an investment just as buying a house is. A toaster is investment, eating the toast is consumption.

[Roger Koppl]

David,

You call for "a multicausal theory, such as monetary infusions + big players + animal spirits" and lament "the seemingly unicausal nature of most contributions."

I think we need to a better job of putting the pieces together. But the literature does not seem as uni-causal to me as it does to you. Big Players theory is a theory of expectations, not a theory of the business cycle. It is an input to the theory of business cycles. And it tells us when we get an economy subject to Keynes-style mass psychology. So Big Players complements ABCT; it is not an alternative. Similarly, I think Big Players integrates at least a good part of what should be saved from Keynes' General Theory and Post Keynesianism. (That's the idea behind the claim of Butos & me that Hayek gives us the more general theory. Armed with a Hayekian theory of expectations you can integrate the Keynesian dynamics and know when they apply. The reverse is not possible.)

I may be too optimistic or something, but it seems to me that we do have all the pieces for an Austrian macro that is applicable broadly and integrates the various pieces. I agree fully, however, that we haven't really put all those pieces together in one book or article.

[David]

Roger,

I realize Big Players and the Economic Theory of Expactations does not offer a business cycle theory, although it offers important implications for business cycles (by the way, I was really impressed by your ingenious combination of Hayek, Lachmann, Schutz and Wittgenstein!). If I remember the implication of the theory correctly, the thrust was that powerful actors with discretionary powers such as a central banker make expectations more important, leading to potentially erratic market behavior and wild swings in market indices, and then Keynesian animal spirits become important. Pretty persuasive stuff, but wouldn't it also be possible for influential/respected people to bring about expectation-triggered booms or busts even in the absence of any governmental powers to intervene in a discretionary way (e.g. a previously successful investor who tries to influence the general level of confidence for whatever reason)?

[Roger Koppl]

David,

I think I might say that Big Players make expectations less prescient, rather than "more important." Expectations are always important. Big Players theory addresses the issue of when those important expectations are good guides to action and when they are not. (I suspect that's what you had in mind. We don't parse that carefully on blogs.)

I think private actors who don't have any special government privileges can be Big Players, but only in the short run. One of the defining characteristics of Big Players is considerable immunity from the discipline of profit and loss. In the long run private actors have no such immunity unless the state gives it to them. Unfortunately, we have a high degree of such immunity for large enterprises today. We have the Big Players economy.

I don't see how you could get that much of a boom going without accommodating monetary policy. This was Hayek's critique of Schumpeter's otherwise sound theory of cycles: The innovation-driven boom cannot go far unless the money supply expands to allow it.

[Grant]

Anyone reading over these commends may want to see Robert Murphy's response to Krugman and Cowen here:
http://mises.org/story/3155

[Perrin]

How are you. In the end, we will remember not the words of our enemies, but the silence of our friends.
I am from Belize and too poorly know English, please tell me right I wrote the following sentence: "The electronic issue vacated figure to buy transactions notably and the affirmative one is an military pin, gold mastercards."

Thanks 8-). Perrin.