The Austrian School Part 6: Business Cycle 1 of 2
Posted: Sun Jan 08, 2012 2:02 am
The Austrian School:
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
Austrian Business Cycle theory is the Austrian School's flagship theory:
http://mises.org/journals/aen/aen16_3_1.asp
In an earlier post I said that Hayek's critique of Keynes extended from Austrian criticisms of communism, the policies of Keynes a way to replicate communist failures in capitalism.
http://mises.org/tradcycl/monbuscy.asp
What this means is that the communist angle was to pool together the "savings" of hundreds of millions of people and invest in risky "desperate" ventures. The "roundaboutness" means there are several phases of production before the final product is realized. The Large Hadron collider, for instance, has some significant roundaboutness going on. If successful, the Russians would wind up with "capital" of massive capability. But the Austrian belief is that the projects were too ambitious, so what would happen is that the country's savings would be wiped out before the projects could finish.
In capitalism, Austrians have a lot to say about the natural rate of interest. The natural rate is determined by preferences for saving rather than spending. Savings are loaned to entrepreneurs as investment, and interest payments reflect the value savers place on money. If people are like Americans, interest rates need to be high to entice savings, since Americans love to spend. When a central bank sets interest rates lower than the natural rate, then entrepreneurs are disoriented, thinking money is cheap, and they are free to invest in ambitious projects with huge payoffs, but the payoffs are down the road.
In fact, not only are entrepreneurs tempted to think this way, the central bank is leading them into this temptation deliberately. In the article I cite above, Keynes is quoted,
Indeed, the Austrians will dispute that it will be worthwhile, but they won't dispute that the 3 1/2 percent will entice the undertaking of the project. Do you dispute it? If rates are 2.5% vs. 8%, won't you be more likely to buy your dream home?
Here's a Robinson Crusoe thought experiment that illustrates the Austrian logic well:
http://mises.org/daily/672
Consider a lone islander who survives by eating berries picked by hand. Suppose he wants to increase his standard of living by building a contraption that will harvest berries faster than he can pick them. To build the contraption, he must forego picking berries. So he decides how many berries he needs to eat per day and then saves the rest. Once he has enough savings, he spends part of his day picking berries, and part of the day building the contraption. He survives by eating all the berries he picks plus some from his savings. It's a calculated risk, he's never built a device like this, but he estimates based on the actual number of berries he has in stock that his chances are 90% to succeed. The moral of the story is that he must finish the project before running out of savings. Once the savings are gone, he can't write an IOU to buy himself more time. He must abandon the project and go back to picking berries full time. A lot of resources and time are wasted when projects are abandoned.
I want to extend this example. Suppose the islander has life very hard and must work all day just to feed himself. If a Keynesian were to arrive at the island with a box of berries of undisclosed quantity, he might offer to make the islander a loan on very good terms. To entice him to build the best possible berry-picking contraption, he offers a great interest rate. The islander has no idea what the "true" interest rate is because he has no idea how many berries the visitor has. But the visitor is willing to let the berries flow, so the islander starts building a complex picker while wolfing down berries with confidence. Halfway through the project, the Keynesian informs the islander that he's out of berries. Both are screwed, because the Keynesian got the islander into an interest rate that did not reflect the natural rate of interest of the economy. The "boom" is reflected in the massive capital expenditure and the "bust" is reflected in the failure to complete the capital at the time investment money dries up.
A Keynesian would reject this example, of course. For one, the Keynesian visitor arrives at a time when the islander is at full employment and output. I don't believe any Keynesian would say that if the economy is already at full output, we should "stimulate" it. Had the islander been working part days, however, and if Keynesian theory dictated that the islander had incentive problems for working full days, and if the textbook situation called for giving berries as an incentive to work full days, then perhaps the Keynesian visitor has enough berries to complete the project. If Keynesian theory is wrong, however, and the Austrian continues to only work half days but is glad to take the berries anyway and begin a half-day capital project, then both may be in trouble, especially if the Keynesian keeps increasing the number of berries he gives the islander or stretches out the time payback starts, thinking he has yet to provide the necessary stimulus.
Let's suppose that Keynesian theory is wrong, but the Keynesian, educated at a left-wing university, will not deviate from his textbook no matter what. How many hours the islander is accustomed to working we'll leave unspecified this time around, all we note is the Keynesian's textbook happens to advise at the islander's current output level, interest rates should be lowered. The islander is tricked by the easy rates offered him into building an elaborate berry picker, and it isn't finished yet when the Keynesian informs the islander that savings have run out. Now the islander has a hardship, as the lazy Keynesian is slow at picking berries and the islander must either sacrifice a portion of his berries and go hungry, or work longer hours to feed his neighbor.
Several weeks later, a box falls from the sky, it's a package for the Keynesian -- a box filled with berries from China. The Keynesian offers the islander a loan at low interest, hoping the islander wishes to build a berry picker again. The islander can't say no to the low rate and "thinks big." It's not long before the berries run out, however, and another defunct project is discarded half finished. A few hard weeks later, yet another box of berries falls from the sky. The Keynesian offers the islander a loan, he's tempted by the low interest rate, and goes to work on another too-complicated berry picker. Rational expectations suggests that this can't keep happening over and over. After being stung the first time, the islander would probably go conservative with the next project. But the Austrian theory demands that no matter how many times this scenario is repeated, the islander on average will create ambitious projects that can't be completed before savings are wiped out.
A third person arrives at the island, an Austrian. The Austrian knows exactly what's been going on and teaches the islander about Von Mises and Austrian economics. But this is to no avail. As soon as the Keynesian gets his next berry drop, he offers loans, and the islander will more likely than not be confused by the low rate and work on projects that are too ambitious and left unfinished as savings run dry.* This is the doctrine: an interest rate lower than the natural rate results in distorting the entrepreneur's judgement -- and that is final. If it were not final, and the entrepreneurs -- entrepreneurs who are dyed-in-the wool Austrians no less^ -- are allowed to eventually adjust their expectations and put their efforts into more modest projects when rates seem easy, then even though the Keynesian doctrine is both false and applied in full force, it fails to create a boom or bust, and the business cycle eventually disappears.
The general RE issues seem to have concerned some members of the community and in 2001, a paper was published that allowed the Austrian Business Cycle to have their cake and eat it too. A revolution?
*note that to keep consistent with Hayek's rule about market participants not having the knowledge of economists and economists not having the skills of the entrepreneur, I do not allow the Austrian visitor to be an entrepreneur and my assumption is that the converted islander comprehends the Austrian beliefs but does not have extensive Austrian knowledge. The Austrian visitor could potentially adjust his expectations, I believe, but he would be forbidden to have the practical skills to be an entrepreneur.
^though not Austrian economists
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
Austrian Business Cycle theory is the Austrian School's flagship theory:
Why We Are Winning wrote:AEN: What theoretical issue, besides method, most separates neoclassicals from Austrians?
SALERNO: No contest: the business cycle theory. The Austrian theory embodies all the distinctive Austrian traits...The model of applying this theory remains Rothbard's Americas Great Depression.
http://mises.org/journals/aen/aen16_3_1.asp
In an earlier post I said that Hayek's critique of Keynes extended from Austrian criticisms of communism, the policies of Keynes a way to replicate communist failures in capitalism.
Haberler wrote:hope it will be possible to give you a clear idea of what happens in our capitalistic societies during the business cycle by means of a comparison with a corresponding event in a communistic economy. What the Russians are doing now, or trying to do--the five-year plan--is nothing else but an attempt to increase by a desperate effort the roundaboutness of production and, by means of this, to increase in the future the production of consumer's goods.
http://mises.org/tradcycl/monbuscy.asp
What this means is that the communist angle was to pool together the "savings" of hundreds of millions of people and invest in risky "desperate" ventures. The "roundaboutness" means there are several phases of production before the final product is realized. The Large Hadron collider, for instance, has some significant roundaboutness going on. If successful, the Russians would wind up with "capital" of massive capability. But the Austrian belief is that the projects were too ambitious, so what would happen is that the country's savings would be wiped out before the projects could finish.
In capitalism, Austrians have a lot to say about the natural rate of interest. The natural rate is determined by preferences for saving rather than spending. Savings are loaned to entrepreneurs as investment, and interest payments reflect the value savers place on money. If people are like Americans, interest rates need to be high to entice savings, since Americans love to spend. When a central bank sets interest rates lower than the natural rate, then entrepreneurs are disoriented, thinking money is cheap, and they are free to invest in ambitious projects with huge payoffs, but the payoffs are down the road.
In fact, not only are entrepreneurs tempted to think this way, the central bank is leading them into this temptation deliberately. In the article I cite above, Keynes is quoted,
Keynes wrote:No one believes that it will pay to electrify the railway system of Great Britain on the basis of borrowing at 5 percent. . . . At 3 1/2 percent it is impossible to dispute that it will be worthwhile. So it must be with endless other technical projects."
Indeed, the Austrians will dispute that it will be worthwhile, but they won't dispute that the 3 1/2 percent will entice the undertaking of the project. Do you dispute it? If rates are 2.5% vs. 8%, won't you be more likely to buy your dream home?
Here's a Robinson Crusoe thought experiment that illustrates the Austrian logic well:
http://mises.org/daily/672
Consider a lone islander who survives by eating berries picked by hand. Suppose he wants to increase his standard of living by building a contraption that will harvest berries faster than he can pick them. To build the contraption, he must forego picking berries. So he decides how many berries he needs to eat per day and then saves the rest. Once he has enough savings, he spends part of his day picking berries, and part of the day building the contraption. He survives by eating all the berries he picks plus some from his savings. It's a calculated risk, he's never built a device like this, but he estimates based on the actual number of berries he has in stock that his chances are 90% to succeed. The moral of the story is that he must finish the project before running out of savings. Once the savings are gone, he can't write an IOU to buy himself more time. He must abandon the project and go back to picking berries full time. A lot of resources and time are wasted when projects are abandoned.
I want to extend this example. Suppose the islander has life very hard and must work all day just to feed himself. If a Keynesian were to arrive at the island with a box of berries of undisclosed quantity, he might offer to make the islander a loan on very good terms. To entice him to build the best possible berry-picking contraption, he offers a great interest rate. The islander has no idea what the "true" interest rate is because he has no idea how many berries the visitor has. But the visitor is willing to let the berries flow, so the islander starts building a complex picker while wolfing down berries with confidence. Halfway through the project, the Keynesian informs the islander that he's out of berries. Both are screwed, because the Keynesian got the islander into an interest rate that did not reflect the natural rate of interest of the economy. The "boom" is reflected in the massive capital expenditure and the "bust" is reflected in the failure to complete the capital at the time investment money dries up.
A Keynesian would reject this example, of course. For one, the Keynesian visitor arrives at a time when the islander is at full employment and output. I don't believe any Keynesian would say that if the economy is already at full output, we should "stimulate" it. Had the islander been working part days, however, and if Keynesian theory dictated that the islander had incentive problems for working full days, and if the textbook situation called for giving berries as an incentive to work full days, then perhaps the Keynesian visitor has enough berries to complete the project. If Keynesian theory is wrong, however, and the Austrian continues to only work half days but is glad to take the berries anyway and begin a half-day capital project, then both may be in trouble, especially if the Keynesian keeps increasing the number of berries he gives the islander or stretches out the time payback starts, thinking he has yet to provide the necessary stimulus.
Let's suppose that Keynesian theory is wrong, but the Keynesian, educated at a left-wing university, will not deviate from his textbook no matter what. How many hours the islander is accustomed to working we'll leave unspecified this time around, all we note is the Keynesian's textbook happens to advise at the islander's current output level, interest rates should be lowered. The islander is tricked by the easy rates offered him into building an elaborate berry picker, and it isn't finished yet when the Keynesian informs the islander that savings have run out. Now the islander has a hardship, as the lazy Keynesian is slow at picking berries and the islander must either sacrifice a portion of his berries and go hungry, or work longer hours to feed his neighbor.
Several weeks later, a box falls from the sky, it's a package for the Keynesian -- a box filled with berries from China. The Keynesian offers the islander a loan at low interest, hoping the islander wishes to build a berry picker again. The islander can't say no to the low rate and "thinks big." It's not long before the berries run out, however, and another defunct project is discarded half finished. A few hard weeks later, yet another box of berries falls from the sky. The Keynesian offers the islander a loan, he's tempted by the low interest rate, and goes to work on another too-complicated berry picker. Rational expectations suggests that this can't keep happening over and over. After being stung the first time, the islander would probably go conservative with the next project. But the Austrian theory demands that no matter how many times this scenario is repeated, the islander on average will create ambitious projects that can't be completed before savings are wiped out.
A third person arrives at the island, an Austrian. The Austrian knows exactly what's been going on and teaches the islander about Von Mises and Austrian economics. But this is to no avail. As soon as the Keynesian gets his next berry drop, he offers loans, and the islander will more likely than not be confused by the low rate and work on projects that are too ambitious and left unfinished as savings run dry.* This is the doctrine: an interest rate lower than the natural rate results in distorting the entrepreneur's judgement -- and that is final. If it were not final, and the entrepreneurs -- entrepreneurs who are dyed-in-the wool Austrians no less^ -- are allowed to eventually adjust their expectations and put their efforts into more modest projects when rates seem easy, then even though the Keynesian doctrine is both false and applied in full force, it fails to create a boom or bust, and the business cycle eventually disappears.
The general RE issues seem to have concerned some members of the community and in 2001, a paper was published that allowed the Austrian Business Cycle to have their cake and eat it too. A revolution?
*note that to keep consistent with Hayek's rule about market participants not having the knowledge of economists and economists not having the skills of the entrepreneur, I do not allow the Austrian visitor to be an entrepreneur and my assumption is that the converted islander comprehends the Austrian beliefs but does not have extensive Austrian knowledge. The Austrian visitor could potentially adjust his expectations, I believe, but he would be forbidden to have the practical skills to be an entrepreneur.
^though not Austrian economists