Part 1: A Legacy outside the institution
Part 2: Currents in Austrian School; fundamentalism, scholarship, media, etc..
part 3: Financial economics: The Efficient Market Hypothesis
Part 4: Classsical economics and Market Socialism; Updating classical
Part 5: Hayek vs. Central Planning; Hayek Vs. Rational Expectations
Part 6: The Cycle and Rational Expectations; island Parables
Part 7: The Cycle as a Prisoner's Dilemma -- in "Anarcho Capitalism"?
Part 8: 2008 Crisis and Market Efficiency; Keynes vs. Chicago vs. Hayek vs. Warren Buffett
In 2001, Anthony M. Carilli and Gregory M. Dempster wrote a paper called, "Expectations in Austrian Business Cycle Theory: An Application of the Prisoner's Dilemma."
http://www.springerlink.com/content/r31732821rt68700/
This must be a good paper because unlike most of the material I've seen referenced and available for free, you've got to pay for this one. This solution to the rational expectations challenge, which I discussed in my last post, has taken roots within in the community significantly, so it deserves attention.
The abstract reads,
abstract wrote:The standard account of Austrian Business Cycle theory posits that central bank manipulations of interest rates fool bankers and investors into believing that there has been an increase in the real supply of loanable funds available for capital investment. However, reliance on foolishness ignores the entrepreneurial emphasis within the Austrian tradition and fails to produce the strongest possible case for Austrian Business Cycle theory. We use the prisoner's dilemma framework to model the profit maximizing behavior of bankers and the investors under uncertainty when the market rate of interest is below the underlying rate of time preference.
Assume a large economy. The main point is that if the business down the street is taking maximum advantage of low interest rates to expand their market presence, even though we might be concerned the economy is headed for trouble down the road if everyone expands, we can't risk being left out in the cold. It might be easier to see the point in the housing market. How many people do you know bought a house well within their means and how many people do you know who bought the biggest possible house they could get the loan for? If the latter is the general rule, then think about it from another perspective. With everyone taking advantage of low rates, you may find yourself thinking prices are so high that you can barely get a place that meets your minimum standards for the maximum loan you can get. You may have little choice but to take on more risk than you'd like, as the alternative is being left out in the cold with no house. And again, the Austrian point is that not every business that takes the bait will fail in the future, but every business by taking too much risk ensures that on average the collective errors results in a sub-optimal outcome for the economy, in this case, a bust. It's a "prisoner's dilemma".
The prisoner's dilemma (just see wiki) basically; fellow thieves are locked in seperate rooms and each asked to testify against the other. If neither testify, no case and they go free. If one testifies against the other and the other says nothing, the accused is guilty and receives a big sentence. If both testify against each other, they each receive a light sentence. The rational decision for each thief to make is to testify against the other even though the optimal solution is for neither to testify. So if the incentives of low rates create a prisoner's dilemma for borrowers, then borrowers are individually acting rationally even though collectively the outcome is irrational. In the real world, maybe something like vaccination will be argued as a PD. The personal risks for me (and many or most individually) might not be enough to justify getting a shot. Many people would rather get the flu than get the shot. But the risks of spreading the flu and the dangers of the flu to older people and sick people might make these individually rational decisions lead to a sub-optimal outcome for society as a whole.
Does this solve the RE criticism?
By definition, PD solves the problem. If a PD is played out an unlimited number of times, the rational decision remains unchanged. If low interest rates create a PD, then we can have a business cycle every year and the rational decisions of individual firms keep the cycle perpetuating, even if participants are acutely aware they are trapped in a prisoner's dilemma.
But do low rates really create a prisoner's dilemma? Bear in mind that most libertarian economists believe that PDs and other market failures; externalities (often PD plays a role here), public goods, monopolies etc. exist somewhere in the real world. Libertarian economists invented these examples. But certainly, it's the Left that really takes advantage. If you're a Leftist and the market doesn't solve for your hobby horse, just shout "prisoner's dilemma" and call for government action. When I took a look into externalities after years of not thinking about any of these things, I was surprised to find some of the inventive constructions of policy advocates. And I had to wonder, what are a group of self-proclaimed "anarcho-capitalists" who hang out at the "muscle beach" of market defense doing crying "prisoner's dilemma" as an apologetic? Take a look at this review of a book by Sowell that criticises Sowell for being too liberal on externalities:
http://mises.org/daily/622
The Austrians and Sowell will be suspicious of policy makers who easily uncover examples of the prisoner's dilemma. but in cases where Austrians and Sowell agree PD holds, the Austrians will say that the PD only exists because of government. In other words, there are few if any actual market failures, but because of government, a contrived situation -- like the actual prisoner's dilemma thought experiment! -- emerges where the good libertarian spirit of man fails his brothers. In the case of low interest rates,
book wrote:In Carilli and Dempter's paper, the central bank plays the role of the "prison authorities." The "Prisoner's" are the entrepreneurs..."
What's so Austrian about Austrian economics, pg. 192
That's fine and good, but we know from Austrian economics that the business cycle predates central banks as fractional reserve banking, which Rothbard et al use to explain the business cycle prior to the Federal Reserve. All it takes, in fact, is a lone private bank acting in its own interest as a profit-maximizing firm to cause a business cycle. The bank can be without recourse to bail-out money and, therefore, forced to run judiciously. All it takes is for the money supply to expand a little, to dip interest below the "natural rate" and this is an example of libertarian bankers locking libertarian entrepreneurs into a prisoner's dilemma and driving an economy into boom and bust. No government needed. In a world where thou shalt not multiply externalities beyond necessity, where anarcho-capitalism dispels myths of the prisoner's dilemma and public goods, if the only prisoner's dilemma left standing happens to be the one necessary to explain the Austrian flagship theory, I think it's convenient.
Another challenge is that if PD holds, it is quite revolutionary because the long tradition of Hayek maintaining a middle ground between central planning and rational expectations is no more. This paper, right there in the abstract, levels the charge that resisting RE or "reliance on foolishness" is inadequate not just for the Business Cycle, but for the "entrepreneurial emphasis within the Austrian tradition" which includes ABC but is not limited to it. The Austrian argument for active fund management also relies on the failure of rational expectations, does this put Austrian fund managers out of a job? And further, there are sympathies similar to Keynesian critiques of human "rationality" in hindsight of the 2008 crisis. How are these positions tenable? In my readings of papers and blogs, I'm seeing a lot of mix and match between the two worldviews and that doesn't work; though, I admit this is mostly from the lay clergy. You get arguments like: barrier number one is that Rational Expectations is wrongheaded for reasons x,y,and z, but there's a failsafe, because if that doesn't stop the bullet, you've got to explain away the prisoner's dilemma -- barrier number two. Since the two ideas are incompatible, hard decisions need to be made if we're going with PD and the implications across the board for the Austrian movement must be understood and accepted.
The rejection of rational expectations and the prisoners dilemma arguments make up orthodox Austrian Business Cycle doctrine from what I can gather. There are theories that criticize both appearing within the Austrian Review even, but I need to stop somewhere, so it's here.
While there are fundamentalist and populist currents within the Austrian movement, there are also thoughtful reflections that show contamination from mainstream thought and acknowledge the validity of mainstream criticism. To the extent ABC continues to mature, empirical research needs more traction within the community and ultimately, peer review. At any rate, the 2008 crisis and failure, or perceived failure, of mainstream ideas most certainly gives a window of opportunity to the fringe and opens up the forum for new perspectives. The Austrian School has become part of the 2008 crisis in a very real way. The mere suggestion from a chairman and former chairman of the Federal Reserve that Austrian ideas deserve a second look gives the Austrian School a right to a second look, in my opinion, no matter how unorthodox they may be within the mainstream of economics.
The 2008 crisis will be my concluding post.