Thursday, March 27, 2008

Austrian Business Cycle Theory And Rational Expectations

After my recent essay in Swedish about the Austrian Business Cycle Theory, I received a comment that linked to Bryan Caplan's objections to it. In essence, Caplan's objections are based on the Rational Expectations-school of macroeconomics, which argues that entrepreneurs are so rational that they won't be fooled by lower interest rates into malinvestments.

Yet there are two fatal flaws in Caplan's argument, each of which by itself is fatal to his argument. The first flaw is that in order for entrepreneurs to correctly anticipate the future downturn created by central bank policy they must be aware of and believe in the Austrian theories. If they don't believe in it, then they will not see that investments based on artificially lowered interest rates will turn out to be malinvestments. And since the Austrian business cycle theory is unfortunately only known and accepted by a small minority, the vast majority is not going to foresee the problems arising in the future.

Secondly, and perhaps even more importantly, even if the Austrian Business Cycle Theory became generally known and accepted among entrepreneurs, it would still make sense for profit maximizing entrepreneurs to act upon lower interest rates. The reason is simple. Because the central bank subsidizes interest rates during the initial boom phase, the economic gains for entrepreneurs during the boom will exceed the economic gains for the overall economy. Moreover, because the central bank generally tends to bail out failed investors during the bust phase of the business cycle, this means that the loss for investors during the bust will be smaller than the losses for the overall economy. A recent concrete example of this is the case of Bear Stearns.

Interestingly, Caplan notes that Austrian economist Roger Garrison has already put forth a version of that counter-argument, but Caplan's reply is simply to note that entrepreneurs will make investments that are profitable to them, while abstaining to make investments that aren't profitable to them. This is of course not an answer at all to the argument that there exists a distinction as to what is profitable for the entrepreneur and what is profitable for the overall economy, and that it might therefore be profitable to create malinvestments.

Finally, given the more realistic assumption that some investors will believe in the Austrian business cycle theory, while most won't and given the fact that investments in the form of both equities and bonds can be sold off, an additional incentive is created for investors aware of the Austrian business cycle theory to create malinvestments during the boom, enjoy the profits of it as long as the boom last, and then sell of the stakes in that investments to more clueless investors during the end of the boom.

UPDATE: I see on Wille Faler's blog a good illustration of how central banks bailout actions make it profitable for investors to create malinvestments.


Blogger Wille said...

Entrepreneurs being able to anticipate future downturns is a pretty ridiculous notion:
Looking at the current woes, there is sufficient evidence to confidently say that the average Joe isn't even able to comprehend the idea that interest rates actually change over time, sometimes quite dramatically (there is nothing that proves that average entrepreneurs are anything other than average Joes in terms of overall intellectual ability).

Besides, most people, even those that are highly intelligent are unable to predict the timing of future events, which further rubbishes the notion of prediction.
What most people tend to do is extrapolate a current trajectory, rather than be able to predict future changes in a trajectory (Case in point: predict the length of the current US recession and the timing of the next up turn. I'm guessing even you as a reasonably intelligent and knowledgeable person in this subject will have a hard time giving any more accurate an estimate than "the recession might be rather long").

11:47 PM  
Anonymous Justin Rietz said...

Using the sub-prime crisis as an example, I have an additional theory: businesses in some cases are forced into actions that they may deem unwise.

For example, even prudent banks were forced to offer loans at low rates in order to not lose business to their competitors.

Given that an unnaturally low interest rate means that there won't be enough savings to match borrowing demand, banks had to either become highly leveraged or offer uncomfortably high interest rates to savers, thus squeezing the banks' margins. The only way to make up for the resulting shortfall in profits was to increase the volume of loans, and in order to do this, banks had to lend to people that might have been less than credit worthy.


5:29 AM  
Blogger Flavian said...

Under a gold standard large and sudden findings of easily extracted gold, could create an inflationary boom which most likely will end in bust.

Theoretically prices could of course rise in precise and exact proportion to the new gold findings, but in reality there will most likely be a over-shooting, which has to be corrected by a deflationary purgation.

Boom and bust are too some extent market phenomena. Central banks and inflationomics just make those problems worse than they would be in a truly free market.

I think that one of greatest lessons of austrian economics is that the notion that the free market does not work perfectly, is not a reason to be against the free market.

7:20 AM  
Blogger stefankarlsson said...

Justin: of course the fear of losing market share made banks issue subprime loans. That is how many banks in fact reasoned.

However, assuming that they had known these would become bad loans and that they would have had to pay the natural interest rate to fund these loans and then take the full consequence of the credit losses, then they wouldn't have made them, so this is in line with the two arguments about how ignorance of Austrian economics and Fed subsidies during and after the boom created the crisis.

Moreover, there was no shortage of funds for these loans, because while voluntary savings was low this was compensated by the "forced savings" created by higher money supply, as well as the inflow of capital from foreigners who were foolish enough to believe that American bonds were a good investments (which they certainly weren't as the return has been negative for them because of the sliding dollar) or who were motivated by a mercantilist desire to hold down the value of their currency.

Flavian: there is no particular reason to believe gold discoveries will create a boom bust cycle, at least in the modern era. This is because for one thing gold production and the amount of gold available are so much higher than in the past that it is extremely implausible that there will be any new discoveries that would have an effect on the money supply that would cause anything similar to the money creation by modern central banks. The gold discoveries in for example Klondike and South Africa around 1900 would if they had happened today barely affect the gold markets.

And with the world more globalized than before there is no reason to believe it would lead to the kind of local money supply effects that we saw in the past. However, they would result in local economic upswings but this would be no different from the effects of large discoveries of other commodities.

10:14 AM  
Blogger Flavian said...


I agree with you that gold findings most likely would not create a boom and bust cycle.

Still a very modest inflation occured after the discovery of the Klondyke gold in 1896.

My point was that the although free market does not work perfectly it usually works far better than government intervention.

2:57 PM  
Anonymous Johan Nilsson said...

A credit expansion that has been created by central banks should show up in M0 statistics.

Where is it?

3:13 PM  
Blogger stefankarlsson said...

Johan, I assume you're new here, so I'll forgive you for making an assertion whose fallacy I've already explained.

M0 is the same thing as currency in circulation, AKA cash AKA notes and coins. That has really nothing to do with credit expansion and is instead mostly a function of public demand for notes and coins versus electronic money.

5:25 PM  
Blogger AJ Witoslawski said...

Flavian, a large influx of gold cannot possibly create a boom-bust cycle. It might temporarily slow the economy if the influx is slow, because it would cause an inflationary shock, but this would be the necessary response. However, it cannot create a traditional boom-bust cycle.

Modern business cycles are characterized by an influx of money into credit markets first, and only then that money leaves credit markets and enters the general economy. This first causes various assets linked to the credit markets, like capital goods, houses, cars, and their financial brothers, to appreciate. Only afterwards to other goods begin to cost more. This inflation in the general economy makes prior investments less profitable and makes some unable to repay loans. This then creates a bust to the preceding boom.

In a free market though, where money is discovered and put directly in the hands of people who will use the money according to time preferences, there cannot be an irrational boom because that money cannot first create appreciation in capital assets and only then in the general economy. In a free market, money is neutral, since it affects prices evenly.

That said, a discovery of a large gold deposit is unlikely to cause a big upswing in price inflation either way. Since money has value just like every product, less money would be produced when there would be price inflation, since it would be less profitable to produce it. Likewise, more would be produced (or mined) when there would be deflation because it would be more profitable to do so (due to the increased purchasing power of money).

Thus, even inflationary shocks are unlikely in a free market. In the rare event that they do happen, they would not have as bad an effect as they do today since there would not be a great number of unsound investments to liquidate.

2:06 AM  

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