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« Fun with Bastiat | Main | Political Economy Questions Which Even Market Monetarists Might Want to Think About »


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Thanks, Steve. Lars makes some good points about the overuse of a theory (and about the infiltration into economics of absurd anti-libertarian claims under the guise of protecting people from the contracts they make).

You offer a clear statement of the usefulness of a theory focusing on the role of interest rates in generating unsustainable booms. What do you think of Lars's claim that "the idea of a natural interest rate is more less useless"?

As you can tell from his little aside to others on that point Tom, he knows Austrians will disagree. And I do. I think the natural rate is still a useful concept, at least as an analytical device, to help us understand what it means to say a market interest rate is too high or too low to lead to intertemporal coordination. Of course we can't observe natural rates in the market place, but I still believe that Wicksell had it right in explaining why it's needed to understand the problems that inflation or deflation can cause.

I suspect those who don't think it's necessary are also less likely to appreciate the crucial role that capital, as Austrians understand it, plays in being able to explain the discoordination caused by the boom and why markets must be allowed to "re-coordinate" themselves in the bust.

The great accomplishment of Mises with respect to cycle theory was to bring together Wicksell and Bohm-Bawerk and infuse Austrian capital theory into Wicksell's work on the natural rate. This is precisely the point that Keynes never understood about the Austrian theory because he couldn't read German well (as he admitted) and, as Hayek notes, because he simply didn't know the history of economic thought very well outside of his narrow Marhsallian tradition.

This is sort of tangential, but since you brought up ABCT, I have a couple questions:

-Why do you keep talking about "the" rate of interest? One major reason Austrian economists caught my eye is you correctly identify the information-destroying characteristic of aggregation, especially when it comes to trying to compute "the rate of inflation." There are many rates of interest, not just a few, and surely the relative structure of interest rates plays a role in the business cycle as well.

-Why is there almost exclusive focus on the rate of interest as time-preference to the point where there seems to be no attention paid to risk-preference? For example, the recent housing bubble doesn't seem to fit so much into the "too much capital in roundabout methods of production" story so much as it does into the "too much money loaned to high-risk borrowers" narrative. The basic logic structure of ABCT ought to accommodate both, but I don't see the latter discussed much. If it is and i've just missed it, please correct me.

-This is especially puzzling when I note the Austrians' usual focus on marginal utility and subjective value. Investors tend to like high interest and low risk, so there is always an opportunity cost to choosing interest over risk-exposure and vice-versa. Central bank interference messes up the entire structure of interest rates so that investors can't obtain the interest rates they want without increasing their risk-exposure more than they would in a free market. This again seems to fit in the basic structure of Austrian-style reasoning, but it doesn't come up much.

Thanks, Steve. Josh put my query more directly. Given the risk/time-preference tradeoff (one could add the difference between long-term, and short-term, as well), how useful is the concept of "a" natural rate of interest in explaining cycles?

Short response:

I agree that we need to get away from speaking of "the" or "a" rate of interest. I have argued for awhile that I thought one of the great projects for someone is to try to integrate term structure and risk preference more explicitly into Austrian macro/monetary theory. I think it's actually a fairly difficult project and I don't have the finance background to do it. But boy is there an entrepreneurial opportunity for someone trained in financial theory who also understands Austrian macro to bring them together. That would be a transformative project.

One more quick thought:

What all of this conversation points to is that the ABCT has ALWAYS been an evolving theory as new ideas from elsewhere in economics came to inform it. Each generation has added and subtracted from the theory (e.g., removing the 100% reserve stuff from the AGD version of the theory and adding some of the things Garrison's work has and, I'd like to think, my own book), which is how disciplines work.

All of the issues Lars and Josh and Tom are raising are ones that should be pushing the grad students and young faculty who read this blog to think about the opportunities they have to respond to them and make their own mark.

Peter, here is an answer for you:

"the recent housing bubble doesn't seem to fit so much into the "too much capital in roundabout methods of production" story so much as it does into the "too much money loaned to high-risk borrowers" narrative."

This right here is my problem with the Austrian explanation. If I understand the theory correctly, I believe Austrians argue that the newly printed money enters the capital goods sector first. But did this actually happen? As Josh points out, it seems that most of this money went to borrowers.

Also Steve, doesn't Christensen's argument about the 1920's not being a period of rapid inflationary expansion drastically undercut ABCT? You don't seem to address that in your post.

For the record, I should state that I am a libertarian, but I haven't found the Austrians explanations of any of business cycle particularly persuasive.


The housing bubble does fit into a "too much credit funneled into long-term interest-sensitive assets" story which is a plausible version of ABCT, though certainly not the canonical one. I think it's worth asking whether the recent cycle leads us to try to generalize the ABCT a bit more by moving the focus away from loans to businesses for early-stage/higher order production goods and more broadly onto longer-term interest-sensitive investments. Surely housing policy is the reason it ended up there, which is precisely the sort of "unique" feature that I mention above.

And yes, IF the 1920s was not a period of expansionary monetary policy, then it does damage to the ABCT. Lars grants that 1925-27 may well have been inflationary, which might be enough to trigger the 1929 downturn, though as I note, not explain the depth and length of the depression that followed.

Whether the 1920s were inflationary remains a matter of much debate. Rothbard's argument has come under pretty good criticism from a variety of places and I think there's another great project to be done in trying to reconstruct his argument based on what more we might know now about the 1920s data as well as the theoretical advances surrounding money and interest rates that have arisen in the 50 (is it really 50!?) years since AGD was published.

As I've said here before, I would love to write a history of the GD for a broad readership that incorporated the ABCT, F&S, and Higgs stories (as well as Hoover/FDR and all that). I didn't imagine that project trying to do anything new, other than put a bunch of things all in one place, but conceivable it could also try to do that reconstruction of Rothbard's argument. It'll have to wait in the queue.


I like the concept of the natural rate of interest, but I think it shouldn't be too closely tied to cycle theory.

I see it as the interest rate that exists without monetary disequilibrium.

Related to Palmer's concerns about the yield structure, would be careful analysis of the impact temporary changes in the natural interest rate.

Suppose people expect lower natural interest rates in the future, but it turns out that saving supply is less or investment demand greater than expected?

Does the long term natural interest rate fall? Are investments made with that expectation malinvestment? What if it is funded with long term debt and so the entrepreneur is hedged, and the loss is to bond holders?

Suppose the "riskless" natural rate falls (a rather puzzling concept in an uncertain world, where "riskless" really means "risk shifted to someone else,) does this result in people undertaking more risky projects in a search for greater yield?

What happens when a seemingly high yield project is discovered, but the return turns out to be an illusion?

(Isn't about time for Ransom to appear and explain that Hayek has already answered all!)


Durable goods (whether a house or a factory floor or a drill press machine) involve production for the more distant future.

In ABCT, the new money does go to borrowers, but the traditional story is that banks only lend money to business. There was alot of truth to that 100 years ago. And the banks even tried to direct the lending to short term activities, but Mises argued that this freed up internally generated funds for long term projects.

It is a bit troubling that the "popular" versions of the story have entrepreneurs borrowing money for something that will only generate a final product in the distant future, but single family homes that will provide housing services to the owners next year, but also 20 years from now is a "round about" project because of the services in 20 years.

Some of the houses are malinvestments because the owners are underwater, or maybe it is just that mortgage holders can't sell except at a loss and regret being tied into low interest rates.

In this case, it is likely that someone will live in the houses, but some of the bulldozers that were busy clearing land for new houses sit in a garage somewhere, idle. The bulldozer was completed in the sense it was built, but it is never used up. The project of the bulldozer isn't completed. It might be melted down.

The problem with ABCT in this context is that maybe all of those houses were built with resources that would have been used to build cement plants in China. Or apartment buidings in China. It isn't clear that there was a shift from present to future prodution. It could have been a shift in the type of future production.

We had lots of banking regulation that pushed investment into housing because the regulators thought it was safe. But I also think that the securitization of real estate lending made "selling to a greater fool" more possible, making a speculative bubble possible in housing when it was much less likely when houses and mortgages were difficult to sell.

Steve and Bill, thank you for the responses. But Bill, the ABCT argues that money flows to the capital goods sector, not the durable goods sector. Capital goods, such as a factory, are used to produce consumer goods. Durable goods, such as a refrigerator or a house, do not produce consumer goods.

Yes I agree that many owners of houses may be experiencing loss aversion and that many houses may not be selling because they have not reached those market-clearing levels, but this has nothing to with malinvestment unless you assume that most homeowners were "house flippers." Some of this activity did occur during the boom, but I"m not sure it fully explains the recession.

Steve & Co., this is a very constructive discussion. Steve let us write that book!;-)

Steve is right that there is room for an Austrian to extend the ABCT. One way would be to start with the interest rate term structure (although it just popped into my head that Rothbard didn't make much of this), and to consider the effects of discounted cash flows on investment projects, in markets both undisturbed by central bank intervention (free banking) and subject to central bank distortions. A good book to start with in order to understand the finance issue would be Alfred Rappaport, Creating Shareholder Value, 2nd ed. (Ignore the shareholder value part.) John Burr Williams' book The Theory of Investment Value (1938), based on his Harvard dissertation, was a forerunner of his approach, I think.
Mises, Hayek et al. developed the ABCT before the concept of discouinted cash flow and how it affected investment projects was developed, but why later Austrians have ignored it I don't know. Maybe they just shun finance theory, thinking that it applies only on Wall St. and in the offices of business project managers ande CFOs. Not so IMO. It has major implications for ABCT. Steve, Pete, et al., tell your grad students that there's opportunity aplenty in this.

ABCT can't possibly be true:

The direct effect of a bursting bubble on measured output is zero. Nor, by the way, is a fall in asset prices counted as a decline in the capital stock, which is in principle measured in physical terms.” -- Paul Krugman

Hayek repeatedly said that the depth and length of the U.S. depression could not be explained by the ABCT. Hayek cited Hoover/FDR pathological policies and the severity of the unchecked secondary deflation, among other contributing causes for the length and depth of the Great Depression in America:

“It does not follow [from the fact that a disequilibrium generating inflation cannot be allowed to expand forever] that we should not endeavour to stop a real deflation when it threatens to set in. Although I do not regard deflation as the original cause of a decline in business activity, a disappointment of expectations has unquestionably tended to induce a process of deflation — what more than 40 years ago I called a ‘secondary deflation’ — the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform.”

– F. A. Hayek, “Full Employment at Any Price?”, 1975.

People seem not to know much of his work, but at the core of Hayek's monetary theory / trade cycle theory is monetary disequilibrium -- and Hayek again and again emphasizes that there are all kinds of monies and near monies and credit instruments, etc. that expand and contract in their liquidity and in their supply and demand. These are inter-related with real heterogeneous production goods and processes across time, but they also have tremendous explanatory power without need for very deeply sophisticated linkage to that structure, much beyond what you can get into a work of journalism, either in book form or in a good newspaper article.

Hayek was an economists who looked at changing relative values and alternative interconnections between relative values -- when assets became more or less liquid and more or less in demand and more or less valuable and more or less leveraged, etc. systematic system wide effect could be put into motion.

Here is a bit on the "shadow money" and liquidity change side of Hayek's trade cycle thinking:

Hayek explicitly says that his explanatory framework could and does have different characteristics given different institutional facts on the ground -- and the "stylized" explanatory toy that he had put together to illustrate how the explanation might go was not the only way the mechanism might operate and in fact applied to 19th century institutional facts on the ground better than to the very different world of the 2nd half of the 20th century.

"the ABCT argues that money flows to the capital goods sector, not the durable goods sector. Capital goods, such as a factory, are used to produce consumer goods. Durable goods, such as a refrigerator or a house, do not produce consumer goods."

This is a bit like saying that the explanatory frame of Darwinian biology can only be used to explain adaptation and species origins among birds and mammals because Darwin's examples of artificial selection all involve birds and mammals ...

"the ABCT argues that money flows to the capital goods sector, not the durable goods sector. Capital goods, such as a factory, are used to produce consumer goods. Durable goods, such as a refrigerator or a house, do not produce consumer goods."

The houses are "malinvestments" to the degree they have been sold to borrowers who did not actually have the future income to pay for their mortgages.

Underwater mortgages are most certainly not malinvestments--nearly all consumers are "underwater" on nearly all consumer loans. This idea that houses are in a magical category that should be immune not only to depreciation, but increase in value faster than the interest rate, is a cultural artifact and in no way based on sound economics. The problem is that there is government policy based on this fairy-tale, not that the fairy-tale isn't true.

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The higher ed bubble is a good example of how risk preference plays a key role in the boom-bust cycle.

In a free market, we would expect the interest rate on a student loan to be based on the probability of the student repaying the loan. Students with different educational aspirations and different qualifications would command different interest rates. For example, a C student who wants to major in psychology at a second-rate college isn't going to get interest rates as low as an engineering student at Purdue. And in general, we wouldn't expect student loan interest rates to be very low relative to the overall market, since even the best student is going to be a rather risky proposition.

The high interest rate would drive down the availability of funds, which would both result in far fewer students in majors unlikely to result in decent jobs and lower overall cost of tuition.

Of course, the precise opposite has happened. Not only does the federal government set the rate of interest equal for everyone, but it guarantees the bulk loans so there is zero risk to the banks. There's a glut of students in dead-end degree programs, and the price of higher ed is skyrocketing. There are two forms of malinvestment, too. Higher ed is a capital-goods sector, and it is consuming far too many resources to sustain the growth rates it's been enjoying. And graduates are capital as well--but far too many of them have spent 4 to 6 years developing skills that don't meet any market needs. And the glut is so bad that there's hardly any signaling value to a BA, too.

This is a case where I think focusing on the mucking-up of market risk-preference by government intervention adds a lot of explanatory power to the usual time-preference story, although there is obviously some time-preference going on as well, since it takes far longer for a person to join the productive economy when he goes through college as opposed to learning a trade.

Ack, forgot about the bust.

The bust is coming as students are slowly realizing that tens of thousands of debt in exchange for no marketable skills is a bad idea, as universities grow past the ability of even governments to keep feeding them cash, and as the high default rate of student loans begins to catch the eye of even the most spendthrift politicians. This isn't so much the "collapse before the project is finished" version of things you usually get in ABCT literature, but I think it does fit the broader theme of "market preference is ultimately revealed and exposes malinvestment for what it is."

Anyway, this is the sort of analysis you can do if you throw risk-preference into the mix, look at interest rate structures, and drop this notion of the "natural rate of interest" as being as useless as "the natural wage of a day's worth of pure labor."

There cannot be a theoretical explanation of AGD because it has been a historical unicum: any theory of the GD shall explain why it hasn't happen elsewhere in other crises, and a general theory of depressions would surely fail because it would explain too much, it would be too general.

That is why I prefer interpretations which rely on the uniqueness of the depression, i.e., on something peculiar to the '30s: Hoover and Roosevelt, for instance.

As an outlier, it is bad theory to consider the GD as a benchmark. As an outlier, it shalle remind us that historical unica may always happen, and it's the job of historians and not of economists to explain the never-repeated-again details.

Cole and Ohanian gave a perfect recostruction of the crisis and its aftermath, based on the very same intuitions of Rothbard and Chester Phillips, but with higher theoretical detail.

I don't think we can do much more, as economists.

Prof. Horwitz says:

"I have argued for awhile that I thought one of the great projects for someone is to try to integrate term structure and risk preference more explicitly into Austrian macro/monetary theory... That would be a transformative project."

As it turns out, I have a working paper where I'm trying to pull the basics of corporate finance into ABCT. If anyone would like to have a read, go to my work web page here: The last paper listed is the one you're after, under "Other Topics."

Prof. Horwitz, I sent a very early version to you about one year ago and got some good comments back. It's not my main research area, so I'm not able to move the project forward as quickly as I'd like to, but I am making progress.

People interested in the natural rate of interest might like this paper from CBO:

The author estimates the natural rate of interest using neoclassical growth models and gets some rather interesting results. Mainly, he shows price inflation & his estimate of the natural rate are inversely correlated.

Steve--In the spirit of staying away from overclaiming for ABCT, why not also say that it may not account for every single business downturn? That way its advocates don't need to try to fit the Great Depression or the financial crisis into the template if it turns out the template doesn't fit?



Did you miss this sentence in my original post?

"Note that if the ABCT is a theory of the unsustainable boom, then a recession caused by other factors would not invalidate the ABCT - e.g. a monetary deflation that brings on a recession would not invalidate ABCT."

In an earlier draft I had another sentence or two about that, but thought it drifted from the topic a bit. Implicit in that sentence is the claim that other things beside the ABCT can lead to downturns, so ABCT is not a theory of every downturn.

In my book I have a whole chapter on the effects of deflation that tries to integrate other ideas from Austrians with the monetary disequilibrium approach of Yeager, Warburton et. al. to explain how recessions can arise without the ABCT process.

So yes, I agree, and have been saying it for more than a decade.


I don't think your bubble story about student loans and higher ed has much to do with ABCT, but I am glad you brought it up, because it shows how malinvestment is ubiquitus.

The government subsidizes education. Specific investments are made to produce education at more extensive levels of production. The government stops subsidizing education. The investments were malinvestment. Just because the subsidy involved funneling credit to the favored sector doesn't mean that there was ever an excess supply of money or that market interest rates were too low to coordinate saving and investment. And, of course, housing had these sorts of subsidies in spades.

Bill Stepp mentions Rappaport book on economic value added and how that can be used in economics.

For those who can read Spanish and interested in see some work on this may be interested in the following piece:

Cachanosky, J. C. (1999). Value Based Management. Libertas.

There's seems to be a good niche to show how Austrian insight do a better job at describing how entrepreneurial decision are made, and how the market works. Therefore it may also be applied to the ABCT for a more financial flavor.

I am not an economist, but I think it could be useful to make follow von Mises and use praxeology and not just economics.

First there is a boom, the ABCT roughly explains why, although any Complex Adaptive System, such as the economy will fluctuate as a result of any change, such as a new invention. However, only government and central banks can create the really momentous oscillations in the system.

Secondly, there is a bust. ABCT cannot explain exactly where this bust will appear, but to me, to even look for it is trying to achieve precision where there is no precision to be had. Once the weakest link in the chain breaks, the whole house of cards comes crashing down.

But, thirdly, then comes the political reaction to the bust. Any major calamity will generate an almost unstoppable urge to "do something". If we are lucky, we have politicians who do nothing (Reagan 1987), only pretend to do something (Per-Albin Hansson in Sweden after 1932), or decide that the only thing worth doing is to cut government spending, like Harding.

On the other hand, one might be unlucky and be governed by Hoover and Roosevelt, or by a "compassionate" conservative such as George W Bush, or by a social democrat that does not want to let a crisis go to waste, Obama.

The real calamities come from trying to dampen the waves on the pond that is society by throwing big boulders into it.

To me, the real question is how do we tie the hands so that politicians and bankers become and remain "powerless" after a bust.

You can find dynamically changing risk preference repeatedly in Hayek (contra Tyler Cowen):

"The higher ed bubble is a good example of how risk preference plays a key role in the boom-bust cycle."

Bill, where is the money coming from? And is it coming in a sustainable equilibrium flow?

The answer is that it is not, and that international disequilibrium economics is implicated.

The idea that Hayek's econ is closed economy econonomics seems to derive from people who think all macro is also pathological closed economy macro. See Hayek's _Monetary Nationalism and International Stability_.

40% of the budget is borrowing, much from overseas. It looks like unsustainable money / credit disequilibrium with real structural effects to me.

Interest rates established in free trade, like other prices, serve as information and incentives to coordinate economic activity. Government intervention, where it distorts this information, disrupts the coordination. In the case of interest rates, monetary intervention disrups the coordination of economic activity over time. I take "natural rate of interest" as simply shorthand rubric for this understanding. The effective answer to critics may be simply to point this out.

Regarding capital vs durable goods: Different goods need not fall rigidly into one category or another, but may, in varying degrees and for various purposes, partake of both categories. (Similarly to how any given person can act as laborer, capitalist, and entrepreneur.) Houses clearly have a capital goods character for homeowners, invested in, perhaps on borrowed funds, and providing thereafter a stream of returns (shelter, pleasant ambience, conspicuous consumption, etc). if easy money from the Fed makes a particular investment in a house appear sustainable (in the sense that the loan payments can be met) when it is not, then when the unsustainability is revealed, the investment will need to be liquidated. on a large scale, this can lead to an economic bust--as it did--and the way it does so is effectively the very mechanism of the Austrian cycle theory. Do professional Austrian economists embrace it as such?

Beyond the qualitatively correct Austrian Macroeconomics is the quantitatively correct Lammert Saturation Macroeconomics...

Need hard data?

Saturation Macroeconomics: Gobbledy-Gook or the Real Deal?

Time for a new mathematical model, a new paradigm, for macroeconomics?

Is there a patterned science representing the time dependent evolution of macroeconomics?

The last paragraph of the Economic Fractalist main page ....

The ideal growth fractal time sequence is X, 2.5X, 2X and 1.5-1.6X. The first two cycles include a saturation transitional point and decay process in the terminal portion of the cycles. A sudden nonlinear drop in the last 0.5x time period of the 2.5X is the hallmark of a second cycle and characterizes this most recognizable cycle. After the nonlinear gap drop, the third cycle begins. This means that the second cycle can last anywhere in length from 2x to 2.5x. The third cycle 2X is primarily a growth cycle with a lower saturation point and decay process followed by a higher saturation point. The last 1.5-1.6X cycle is primarily a decay cycle interrupted with a mid area growth period. Near ideal fractal cycles can be seen in the trading valuations of many commodities and individual stocks. Most of the cycles are caricatures of the ideal and conform to Gompertz mathematical type saturation and decay curves.

For the Wilshire, the US composite equity index March 09 to October 2011 was a 4 phased Lammert growth and decay fractal series..

x/2.5x/2x/1.5x :: 5/13/10/7 months. That's an empirical real system observation - available to all - of the time dependent workings of the macroeconomic system.

2005 was the description, the hypothesis - March 2009 to October 2011 was the empirical asset valuation evolution...

The flash crash on 6 May 2010 ..... does that not meet second fractal criteria?

"A sudden nonlinear drop in the last 0.5x time period of the 2.5X is the hallmark of a second cycle and characterizes this most recognizable cycle."

Maybe this is all occurring by chance alone .... Likely.... Very very very likely ....not.

Stop it, Lammert: I almost punched my computer just now, and I can't afford another.

Lammert, you are of course joking? Or have you be smoking something?


OK, why is it that having a large budget deficit with a substantial part of it funded by foreign lending inconsistent with maintaining a constant growth path of nominal expenditure on output--3% or 5%?

I came late to this discussion. I just want to make a few quick points.

(1) Hayek's theory of economic fluctions was that there was a lack of intertemporal plan coordination resulting from monetary disturbances. It is most clearly presented in what is known as the Copenhagen lecture. Savings/investment equality or an equilibrium interest rate is a shorthand, more correcly associated with Wicksell than Hayek. I explained all this at length in Economics as a Coordination Problem and many papers since then.

(2) Rothbard's America's Great Depression is actually a better analysis of the Great Depression than of the boom. I speak here of his seminal analysis of the Hoover New Deal with its many interventions. Steve Horwitz has updated the story recently in a Cato paper. Rothbard's explanation of the Depression is just applied, orthodox price theory and not ABCT.

(3) In Volume 1 of his 3-volume history of the Fed, Allan Meltzer devotes 134 pages to the 1923-29 period. The short story (according to my reading) is the gold-exchange standard was a poor substitute for the pre-war gold standard. Too many countries were trying to return to the gold standard at pre-war parities after much wartime inflation. And finally, the Fed steralized a lot of the gold flows, so that the system did not self-correct as it should.

(4) Finally, I could not tell from all the comments whether critics understand that ABCT does not postulate that there must an increase in a consumer price index for there to be an "Austrian" business cycle episode.

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I should have mentioned that O'Driscoll & Horwitz put he Hayek / Mises explanatory frame in a very helpful broad frame, providing a deeper perspective on what is going on than the typical cartoon.

Hayek was perhaps mistakingly claiming that the Fed was not sterilizing gold inflows at least during much of the 1920s. Hayek really blames Britain for the parhologies. See Hayek's 1932 article on the gold standard.

Difficult stuff and we have a better empirical picture today.

"the Fed steralized a lot of the gold flows, so that the system did not self-correct as it should."

Thanks, Greg. We do not things we didn't know then. And there are still some disputed empirical questions.

I see no "Austrian" reason why the downturn in 1929 (which began before the stock market crash) should have been notable. The monetarists generally put it all the Fed's feet. I think Hoover, who was a Progressive and an interventionist, bears much of the blame.

Folks are increasingly pointing to French gold policy:

As I read him, David Glasner insists that Hayek knew all of this about France at the time, but I don't know what evidence Glasner has for that claim.

I'm not sure how you establish what Hayek knew when in the late 1920s and across the 1930s -- or how one can assume that what we now know today was also what Hayek knew then.

I'm shocked that Hayek had time to read a newspaper given his work load, much less that spend hours on sophisticated research into all of the various world monetary and macroeconomic data of the time.

Something had to give, and its clear to me Hayek simply did not have the time to do sophisticated and extensive research into economic data after he left his Austrian business research institute.

Another important point: do we have a list of reasons for the jobless recovery? This list would be more real than monetary or financial.

In the GD there was a cartel/trade union problem because of Hoover and Roosevelt. We don't have this problem now and no equivalent of the GD is to be expected, political revolutions aside.

The real problem is in the flow of real resources. Savings and capital inflows are not enough to fund the present public deficit and the past level of private investment, and the equilibrium requires very low levels of private investment now. Without investments there won't be new employment, and this can explain the jobless recovery, that is more jobless than recovery.

There are additional problems, such as debt overhang, financial fragility, regulatory uncertainty, and loan evergreening, besides excessive risk taking and capital distortions because of cheap credit. Financial nominal problems a là Iriving Fisher can be exacerbated by deleveraging, but this is a consequence, not a cause, of the crisis.

The problem is much less with financing (a financial concept) than with savings (the real concept): only through a fall in consumption (private and public) it will be possible to fund economic growth.

I don't think that ABCT should explain that I = S + (T-G) + (M-X) and that when G-T skyrockets, S increases only a little and M-X is halved I cannot grow because of lack of real resources. ABCT can only explain that any attempt to increase I today will precipitate a short-term crisis of adjustment because resources will be shifted from G and C to I, and for other less aggregate reasons.


The problem you describe will show up as shortages of goods. Government is using up too many resources, so we cannot get enough resources to produce capital goods. When we don't produce the capital goods, the expansion in output is smaller.

How significant are these resource bottlenecks being creating by the U.S. government grabbing so many resources?

Jerry O'Driscoll wrote:

"(3) In Volume 1 of his 3-volume history of the Fed, Allan Meltzer devotes 134 pages to the 1923-29 period. The short story (according to my reading) is the gold-exchange standard was a poor substitute for the pre-war gold standard. Too many countries were trying to return to the gold standard at pre-war parities after much wartime inflation. And finally, the Fed steralized a lot of the gold flows, so that the system did not self-correct as it should."

Robert Mundell also attributes the great deflation of the late 1920s-1930s to the return to the gold standard by European central banks at pre-war parity after the inflation of WWI:

He writes that Charles Rist, Cassel, and Mises warned against it at the time. I recall Hayek in a later interview (from the 1970s, I can't find the quote) saying the same thing.

Mundell also has an explanation for the recent crisis that attributes it to the fluctuating exchange rate between the dollar and the euro:

The ABCT is a wonderful explanatory model for a context in which a currency is subject to no more destabilizing forces than a central bank manipulating interest rates. But in an economy that has effectively two currencies (dollar, euro), each independently manipulated by its own central bank, the unpredictability of the exchange rate between them may completely overshadow each bank's individual policy as a destabilizing factor. No gradual malinvestment is then required for the structure of production to go out of whack: this can happen overnight when two central banks that have been traveling together suddenly move in opposite directions from one another (as happened, for example, in the summer of 2008, according to Mundell). As Steve Horowitz said, proponents of the ABCT do it no favors by invoking it as an explanation for events that it was never intended to explain; and in particular, for the Great Depression and the recent crisis, in both of which far cruder monetary factors were obviously at play in addition to those singled out by the ABCT.

The ABCT can't explain every detail of a cycle, which is why other theories that claim to be comprehensive theories of cycle should be seen instead as filling in the details of the ABCT at certain points in the cycle.

On consumer durable goods from Hayek’s “Pure Theory of Capital, Chapter X, “The Position of Durable Goods in the Investment Structure” p 126:

“In the last chapter the emphasis was entirely on goods in process, that is, on the accumulation of capital due to the actual duration of the process of production. This must not be taken to mean that this form of capital accumulation is the more important one. On the contrary, there can be little doubt that under modern conditions the much more important role is played by durable goods. The reason for our procedure was merely that certain relationships can be shown more clearly and easily for the case of a time consuming process where the input function has a simple and obvious meaning.”

Hayek and Mises always emphasized that the effect of credit expansion will differ depending on where the new money entered the market, whether through business borrowing, consumers borrowing for durable goods such as housing and cars, or through state borrowing and spending.

Hayek addressed term structures in the Ricardo Effect. A reduction in interest rates increases the profits on long term projects more than on short term projects, which spurs capital/durable goods investments.

Hayek’s “Profit, Interest and Investment” shows that profits guide investment even if interest rates don’t change.

As for risk, Hayek and Mises always insisted that people don’t suddenly adopt more risky behavior when interest rates fall. Lower interest rates mask risk. Projects suddenly seem less risky. Few people saw MBS’s as risky until after the collapse. Bank regulators encouraged banks to purchase MBS’s. Greenspan, the IMF, most economists praised the derivatives for spreading risks. Rating agencies gave them high ratings.

Claming that people take greater risks under lower interest rates is nothing but Monday morning quarterbacking.

I agree with Greg Ransom's last comment.

To McKinney, I read Hayek's theory as a theory mainly of the upper turning point. It predicts a downturn. It was crafted to explain a typical 19th century business cycle.

Governements did little or nothing back the to counteract depressions. As late as the short but severe 1920-21 depressions, the Harding governement did nothing. By the time the Fed responded, the economy was recovering.

NO theory predicted the absolutely unprecedented interventionism of the Hoover administration. Friedmand and Schwartz pretty much ignore these and focus just on the Fed. As have most analysts of that episode. Rothbard deserves credit for doing so.

Estey noted that depression are more severe and last longer when real estate speculation took place during the boom. Real estate bubbles were a major part of every significant depression.

See Washington Irving's account of the Mississippi Bubble of 1720. Housing and "equipages", or carriages, experienced bubbles, as did the stock market. In the latest boom it was housing, stocks and autos.

Housing also was a major part of the depression of the 1870's and the Great D.

Schumpter remarked that the excessive volatility of "constructional" industries in business cycles was well-recognized by the turn of the 20th century. It is not new.


What happens if the interest rate of 3 month bills falls, while the interest rate on 10 year notes rises?

What if the interest rate on todays 3 month bills falls, but the interest rate on three month bills that will be created in year from today is expected to be higher?

What if the interest rate on a loan payabe tomorrow morning falls, but the interest rates on overnight loans 5 years from today is expected to be higher?

That is what the term structure of interst rates is about. That a lower interest _rate_ will raise the present value of a project generating returns in 5 years more than one generating returns in 4 years is a different issue.

If _the_ interest rate is the interest rate banks charge on 90 day loans, and it is assumed that this interest rate is projected into the indefinite future, then there is no term structure of interest rates to worry about.

(Well, there might be some liquidity effect.)

@Bill Woolsey,

You might reread my earlier comments and, more importantly, reread Hayek's "Price Expectations, Monetary Disturbances and Malinvestments" (the 1933 Copenhagen Lecture).

Hayek there analyzes the coordination of plans among consumers and producers across all future time periods. He chooses to talk of relative prices and price margins, but those determine the real rates of return in each time period. There is no notion of "the" interest rate in the analysis. In fact, he rejects it.

This lecture was delivered just after publication of Prices and Production and before "Economics and Knowledge" (1937). His ideas on foresight in a multi-period allocation problem are developed there. And he specifically states the possibility of equilibrium in such a world depends on how entrepreneurs form expectations.

I don't know to whom or what you're responding, but it is not Hayek. Not, as I read him, Greg Ransom. But Greg can respond for himself.


What theories purporting to be comprehensive businss cycle theories fill in details left out by ABCT? What are some of the details they fill in that the ABCT either ignores or gets wrong?

Also, your later comment about lower interest rates leading to greater risk taking being "monday morning quarterbacking" is dead wrong, at least to the extent that lower rates are inconsistent with market-determined (i.e., natural) rates. I would suggest a reading of some finance, such as Rappaport's Creating Shareholder Value.
Lower than market rates cause investors to value cash flows with discount rates that too low, leading them to overvalue stocks, bonds, real estate, private equity, and even commodities in some cases. Artificially low rates also cause investment project managers to lower their hurdle rates, sometimes to levels that would lead to malinvestments.
Ramp up this process, throw in McKay's "Extroadinary Popular Delusions and the Madness of Crowds," and you get tech stocks that are valued at stratospheric levels ('95-'99), overly expensive real estate ('00-'06), commodity booms, etc.
This isn't to say that turning points of asset prices can be predicted with anything approaching certainty, but at least in principle there is a way to think about how these processes play out, and finance has a chapter to contribute to ABCT that hasn't been written yet.
Reading Rappaport might be helpful.
This is no MMQBing about it.

Bill, I would say all of the competing theories, Keynes’ liquidity trap, monetarists’ demand for money, psychological theories, Minsky’s financial theory, neo-classical’s fall in aggregate demand, all take place at some time in the cycle but don’t explain the cycle.

As for risk, don’t you think intentions matter? Can you really say that people who are normally risk averse suddenly take much greater risk, especially if they don’t know they’re taking greater risks? And why is it that the specific risks can’t be identified until after certain investments fail?

If people suddenly become river boat gamblers, then it should be easy before the crash to point to specific investments and say “those are too risky.” For example, if a banker quits investing in treasuries and suddenly takes his money and goes to Lost Wages to play roulette, I would have no problem telling him that his is taking excessive risks with is money.

But for most of the investments made during a boom no one knows which ones are risky and which ones aren’t. All of the name calling about river boat gamblers appears only after the fact of the crash.

The real estate boom is a perfect example. A few people warned about a potential bubble, but they were very few in number. Most saw real estate and MBS’s as a sound investment right up to the popping of the bubble. If someone thinks an investment is conservative at the time he makes it, can we really call him a river boat gambler?

I'm not sure what comment I made that raises Bill Woolsey last set of questions for me.

I'll get back to the earlier question later.


Rothbard gave the liquidity trap a proper burial in Man, Economy, and State.
In economics intensions don't matter, it's action that matters. River boat gamblers are going to lose for the same reason that most gamblers do. They face losing odds, and the house always wins on balance. It has nothing to do with business cycle concerns, although in a boom more people might gamble because their investments are increasing in value.
All investments are made with uncertainty, and there's always the risk of loss.
The fact that most people thought real estate investments were bullet proof is an empirical detail, but irrelevant to the theory of a boom and bust. Many people thought their tech stocks would only go up in price too in 1999 and 2000-- until they didn't.


"Hayek addressed term structures in the Ricardo Effect. A reduction in interest rates increases the profits on long term projects more than on short term projects, which spurs capital/durable goods investments."


I ordered up a book through interlibrary loan including the article. Thank you for the suggestion.

Good, Bill. Maybe we can talk about it in April.

Bill, actually that was me posting about Hayek and term structures. No Hayek did not consider every possible combination of interest rates from 3 mos to 10 years. He considered the effect on profits of investments for periods from 3 mos to a couple of years.

I don't think the term structure of interest rates is all that important to the business cycle. In fact, Hayek shows in PII how little importance interest rates have.

If long rates are low and short rates high, businesses will borrow long term. If short rates are low and long rates high they will borrow short term and use their own cash for funding long term projects or invest it long term. Banks aren't the only ones who can borrow short term for long term projects. Like banks, business people will tend to switch between long and short rates depending on the potential return.

Generally, lower short rates produce lower long rates and vice versa.

Bill, Intentions have a lot to do with the ABCT. The ABCT is primarily about problems with the coordination of plans, as several people have noted.

So if people know that they are making risky investments and those investments fail, then there is no coordination problem. But a coordination problem does happen when people make what they think are safe bets that turn out to be unsafe.

And if you want to say that lower interest rates cause people to engage in riskier behavior, then you have to show that people understood they were engaging in risky behavior. When someone invests in a AAA-rated MBS, they aren't engaging in risky behavior even though later the MBS became worthless.

Do rational people make markets work?

Or do well-functioning markets make people behave rationally?

If you tell me your answer to that, I can predict within a margin of error your position on many questions.

Investing in AAA paper carries the risk of a lower real return because of inflation.
Your last sentence is a contradiction.
It would be better to talk about coordination of action rather than plans.
An architect's plan is useless without a builder to construct it and a buyer to buy it. Everyone has a plan, but without executing a plan--without action--it's just "talk."
Mises called his book Human Action, not Human Plans, for a good reason.

People must plan before they act. There is some correlation between plans and actions. Few people in the market act without first planning.

Late comment: On the difference between durable and capital goods, I think the distinction is insubstantial. If one adopts Becker's household production protectiveness (also found sprinkled in Human Action), one sees that consumers do not consume houses; they consume housing services which they produce using houses and other inputs. The interest elasticity of (present) value of houses is high (relatively) being long-lived assets for whose services one has to wait a long time. ABCT suggests that such assets will be overproduced in a credit-induced boom - in this case fueled also by the specific housing policies.

I think it is immportant not to identify "durable goods" with durable consumer goods. Capital goods are durable as well.

Thinking of capital in terms of muliple stages of production has some value. But capital goods provide services in the near future and the distant future. Persistent changes in interest rates change the value of capital goods depending on their durability.

For example, the value of contruction equipment today depends on the present value of factory floor space in twenty years, and that is negatively related to the interest rate.

Of course, the factory provides services each and every year between then and now.

Stages of production, (which gives a feel like intermediate goods,) probably shouldn't be put front and center. Constructing the factory building that also provides services in 20 years _is_ production for the more distant future.

Steel is being made to make into a lathe, which will be used to make supports for mines, which will be used to produce coal, which will be used to heat a house. This ton of steel produced today is helping heat a house in the future. OK. But the durablity of the lathe, and the uprights in the mine are also a key part of the story.

P.S. My point is _not_ therefore, the ABCT is wrong.

I think the overemphasis on the stages of production leads to focus on inessentials.

Good point, bill woolsey. Housing and autos aren't the only durable goods. I mentioned them because some had thought that housing and autos don't fit into the ABCT.

But as you point out, even a simple increase in quality is an increase in capital goods investment. Hayek points that out in several of his works. Constructing a building that will last 30 years vs 5 years is an increase in capital goods.

Bill Woolsey, reflecting more on your comment about term structure of interest rates, it seems to me that the long rate will be the major determinant of long vs short term investment.

The long rate sets the hurdle rate for long term investment. Higher long rates raise the hurdle. So if long term investments can't clear the hurdle, then business people will pass them over for shorter investments, which according to the ABCT will be greater use of labor at the expense of capital investment.

However, if long rates are high due to inflation, then profits will likely be high as well and it won't be hard for an investment to clear the higher hurdle.

Finally, if business people think that the high long rates are temporary, they may go ahead with an long term (capital) investment that doesn't clear the hurdle today but will in the future.

Very interesting.

I am reminded of the oil boom and bust of the 1970s/1980s that was brought on by political factors (domestic price controls, foreign production decisions by state oil companies). This created a 'business cycle' that was 'macro' for Houston, Texas, at least.

Sectoral booms play into a monetary-induced boom/bust, certainly.

Bill Woolsey -- these are NOT my words:

"Hayek addressed term structures in the Ricardo Effect. A reduction in interest rates increases the profits on long term projects more than on short term projects, which spurs capital/durable goods investments."

You are quoting someone else, Bill, and mistakenly putting my name on it

David Glasner has made his claim more precise:

Glasner insists that Hayek had all of the correct facts about France and gold iin the 1920s and early 1930s which we have today, but the problem was that Hayek failed to understand how the the gold standard worked, e.g. Hayek's gold standard economics was mistaken -- i.e. Hayek's gold standard economics was scientifically / theoretically erroneous.

Hayek's Ricardo Effect does a good job of explaining what happens beyond the turning point. I think the ABCT is much weaker without it. Why do so many Austrians ignore it?





Off topic: Steve: welcome to Carleton!

David Glasner's argument is that the Great Depression was a purely monetary phenomena caused by the gold standard (e.g. growing gold demand and French & US gold hording) and didn't involve any ABCT cycle elements. And the reason Hayek & Mises got the Depression all wrong was because they believed in a false theory of money, fallacies and misunderstandings which can be traced to the Currency school.

If only Hayek and Mises had understood monetary theory, they would not have misunderstood how the gold standard worked, and they would have seen that the Great Depression can be fully explained as a purely gold / money problems not involving any elements of the ABCT theory.

So the Glasner view is that the ABCT isn't merely less than a complete explanation of the Great Depresssion, but in fact no element of the theory is envolved in any aspect of such an explanation -- the explanation is purely "monetary" in a way that excludes anything and everything that is involved in ABCT.

it seems to me that you are trying to square the circle again; to be a proponent of the ABCT in good standing and still not to trespass the Schwartz-Friedman dogma according to which severity of the Great Depression was caused by the Fed not inflating enough.

But, the ABCT is not just a theory of unsustainable boom, it is also a theory of the curing effects of the bust. The recession is a good thing that should not be tampered with. Moreover, you concede that yourself, when you say "we know that further inflation and interventionist attempts to prevent the necessary reallocation of resources will make matters worse,". Then, how can you accept the S-F "explanation" in the same time, that says exactly that the Fed should have inflated more in order to prevent the Great Depression?

We've debated definitions of inflation long enough for you to know the answer to that question.

Maintaining monetary equilibrium in the face of falling velocity by increasing the money supply is not inflationary, hence there's no contradiction in arguing that:

a. inflation during the 20s triggered the bust
b. deflation during the early 30s worsened matters
c. a non-inflationary expansion of the money supply to maintain ME at that time would have avoided making the depression any worse than it needed to be to correct the errors of the boom. (A position that Hayek, later, agreed with.)

Now let's watch Rothbardian heads explode when they read "a non-inflationary expansion of the money supply."


your entire house of card is based on the notion that there is a "good" credit expansion that just prevents the evils deflation, while not distorting the structure of production once again. But, that's just an article of faith (the Keynesian and monetarist one) without any logical support.

In the light of foregoing, you did not summarize your position correctly. You should have said:

a) credit expansion during the 20s triggered the bust
b) insufficient credit expansion during the early 30s worsened matters.
c) credit inflation is a bad during the boom, but a very good during the bust.

Furthermore, in your a) you accept the Austrian definition of inflation as an increase in money and credit supply. 1920 were inflationary, although the general price level was stable. However, in your c) you suddenly change your mind: now, "inflation" means an increase in price level (and non-inflationary policy is the one that stabilizes prices). So, what is "inflation" - the credit expansion, irrespective of the price level, or an increase in the price level?


your entire house of card is based on the notion that there is a "good" credit expansion that just prevents the evils deflation, while not distorting the structure of production once again. But, that's just an article of faith (the Keynesian and monetarist one) without any logical support.

In the light of foregoing, you did not summarize your position correctly. You should have said:

a) credit expansion during the 20s triggered the bust
b) insufficient credit expansion during the early 30s worsened matters.
c) credit inflation is a bad thing during the boom, but a very thing good during the bust.

Furthermore, in your a) you accept the Austrian definition of inflation as an increase in money and credit supply. 1920 were inflationary, although the general price level was stable. However, in your c) you suddenly change your mind: now, "inflation" means an increase in price level (and "non-inflationary" policy is the one that stabilizes prices). So, what is "inflation" - the credit expansion, irrespective of the price level, or an increase in the price level?

My definition of inflation is consistent throughout: an excess supply of money. Same as Mises: a supply of money in excess of the demand to hold cash balances at the current price level.

a) Such an excess seems to have existed during at least parts of the 1920s, causing the boom and inevitable turning point.

b) The money supply fell below the demand to hold it during the early 30s, causing a deflation that worsened the bust.

c) The proper remedy was to have increased the money supply up to but not beyond the demand to hold it.

a) inflation
b) deflation
c) a non-inflationary expansion of the money supply to restore monetary equilibrium

There's no inconsistency in my position, only an inability for you to understand it, it seems.

Seriously, why is this so hard for you to understand and characterize correctly, even if you disagree?

So please, either characterize my argument correctly and show me where's its wrong (instead of asserting it as you do), or just don't bother commenting.

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