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Fallacies of the Austrian Business Cycle
Hey guys, I am a Liberal (not in the classical sense J ), who has taken an interest in reading Austrian Economics after a more free market oriented friend of mine used it to debate me. Although I have started only recently (and do not consider myself an expert) on the subject, I believe that I have a fairly good grasp of the Austrian structure of production and how it relates to boom and bust. I have read a variety of works including Tom Woods’ Meltdown and small sections of Jesus Huerta De Soto’s Money, Bank Credit, and Economic Cycles. It is in my opinion that although the Austrians present a solid theoretical construct of the structure of production and its relations to the business cycle, I believe that their arguments ultimately fail from their view of capital as a homogenous input, a lack of detail, and inconstancies in regards to their arrangement of production. Thus the critique below will focus solely on what I believe to be fallacies of the Austrian Trade Cycle (from now on I will refer to it as the ABCT). I am not here to put in its place another Keynesian or Monetarist prescription, but instead lay out what I think are its defects and hopefully someone will answer my questions. To be honest I find that the ABCT is one of the better arguments of the cause of boom and bust due to its innovative idea of looking at the capital structure, but I still find that some parts of it are lacking (or I have just not been able to figure them out).
So, in order to make sure that both the reader and the writer are on the same page, I will juxtapose what the Austrians consider savings induced growth with the credit expansion and proceed from there with my criticisms. I can only hope that people who respond to my criticisms can give me the same amount of respect and detail in their arguments. Although I will not provide the diagrams (as I am sure you guys do not need them), I will make reference to the Hayekian Triangles. (Along with my readings I have looked at Roger Garrison’s Power Points: http://www.auburn.edu/~garriro/macro.htm)
When society saves, funds go into cash balances and later into the market for loanable funds as investments. There is a decrease in the demand for goods in the lower stages, and a decrease in profits and investment in there for businesses. This means that people stop buying as many consumption goods, such as food, clothing, entertainment, iPods, cars, toys, etc. There is a decrease in investment in those stages. Wal Mart will not create more retail stores, McDonalds less food joints, TJMax less clothes, and Linens and Things less household decorations. In Garrison’s terms this is the derived demand effect ( “decreased consumption dampens the demand for the investment goods that are in close temporal proximity with consumable output”). However, the increase in the supply of loanable funds (and saying demand for investment stays equal) will lower the interest rate. The factors of production in these stages will be freed up and instead absorbed into the later stages of the production structure. The lower interest rate (caused by society’s increased savings) creates a greater demand for investment in the later stages, also known as the interest rate effect in Garrison’s terms (“A reduced interest rate, which means lower borrowing costs, stimulates the demand for investment goods that are temporally remote from consumable output.”)
In terms of the Hayekian Triangle, a part of the lower stages of production are taken off and instead used to expand the later stages. The output of consumer goods shrinks in height while the Triangle is lengthened (for a brief time). Because the factors of production were freed from the lower stages, the higher stages absorb the needed materials and are able to complete their expansions. The productive structure is lengthened, and a greater supply of goods will further lower consumer good prices and bring prosperity to society. In terms of the Hayekian Triangle now the hypotenuse of the entire triangle expands outward, reflecting society’s greater accumulation of wealth in the form of more capital and consumer goods.
But when the central bank expands credit beyond the supply of society’s saving, the interest rate is artificially lowered. Even though the interest rate is lowered society shows no desire to let go of consumption right now. People continue to buy consumption goods, purchase more food, clothing, entertainment, electronics, cars, toys, etc. Wal Mart continues to create more retail stores, McDonalds more food joints, TJ Max more clothes, and Linens and Things more household contraptions. There is no derived demand effect. However there is the interest rate effect and now businesses in the later stages of production expand their investments. Steel plants make more steel, mining companies mine more, plant construction booms, and a real estate market begins to grow. However, they will find that there has been no release of the factors of production in the later stages, and their prices begin to rise. In De Soto’s words, “with respect to supply, we must keep in mind that when credit expansion takes place without the backing of a prior increase in saving, no original means of production are freed from the stages closest to consumption….therefore the rise in the demand for original means of production in the stages furthest from consumption and the absence of an accompanying boost in supply inevitably result in a gradual increase in the market price of the factors of production (De Soto 363). This seems to be the main cause for the actual boom and eventual bust: no resources are freed in the present to aid the future. Tom Woods describes the “factors of production” with a little more specificity, saying “as the company works towards completing its projects, it will find that the resources it needs, such as labor, materials, replacements parts-called by economists “complementary factors of production”-are not available in sufficient quantities….the prices for these parts, labor, and other resources will therefore be higher than entrepreneurs expected, and business costs will rise” (Woods 69).
Business men who have embarked on their long term projects borrow more and more which starts to drive up the interest rate. Combined with the fact that the interest rates provoke borrowing from the earlier stages of production (businessmen there start to expand their retail stores, food production, etc) AND with the fact that consumers are borrowing credit for consumption (either durable, which counts as long term investment that originally provoked the boom, or plain consumption such as vacations which create an increased demand in the lower stages as well), society experiences a serious lack of “capital” in order to supply all of these ventures. It is as Ludwig von Mises says in “The Austrian Theory of the Trade Cycle” that “the material means of production and the labor available have not increased; all that has increased in the quantity of the fiduciary media which can play the same role as money in the circulation of goods” (p29). Either through hyperinflation (as the banks keep increasing the quantity of credit in order to push down the interest rate) or through a raise in the interest rate either naturally or by the banks do the businessmen in the higher order stages realize that their investments were wrong and a large slump in the capital goods industries occurs. Now the recession occurs as resources must be redirected away from the unprofitable capital goods industries. Without entering into the effects of the secondary depression, this is what the Austrians consider the actual bust: A poor structuring of resources in the capital goods industries.
In comparing these two seemingly different economic constructs, it seems that the main difference from savings induced growth and boom/bust is the fact that in saving the consumers postpone consumption and “release factors of production” for businessmen in the higher stages to use, whereas in boom/bust these “factors of production” are not freed and being used for current consumption. Only when these materials are “released”, only when the top of the Hayekian triangle is lobbed off and used for other stages can the growth be sustained. When they are still used, businessmen must pay more to bid them away with cheap credit which causes a rise in the interest rate and eventual crisis. Essentially it seems as though the “inputs” for the consumer good stages provided the needed inputs for the later stages. De Soto explains this succinctly, stating “in fact each increase in the demand for productive resources in the stages furthest from consumption is mostly or even completely neutralized or offset by a parallel increase in the supply of these inputs which takes place as they are gradually freed from the stages closest to consumption” (De Soto 324).
So what are these inputs, “real saved resources” (A common expression I heard in advocates of this particular theory), factors of production, etc? Is there any degree of specificity in them? Tom Woods gives a couple of examples (see above quote), but even those are pretty vague. What should make us believe that the “factors of production” for lower stages will be the exact resources needed for the higher stages? Can the construction materials used to make a new Dennys be used for the completion of a Power Plant? Take this rather silly but illustrative example; society saves 1% more of their cash income, the restriction of consumption came solely from the cutback of fast food. America instead decides that it does not require as much food and will used their savings for investments. The derived demand effect occurs in some food industries; they suffer from a decrease in demand and decide to free up resources. The resources freed are primarily food workers, grocery clerks, capital goods used in cooking and processing food, additional construction materials that could have been used for building more restaurants and stores, etc. Now, with or without the concept of full employment of resources (it is a variable for the business cycle, the theory can deal with whatever degree of resources are idle), these factors of production are the “real saved resources”.
Going back to the consumers investing their funds, the interest rate is lowered and the time discount effect occurs. According to the Austrians theory these resources should be fully incorporated into whatever resources are needed by the higher order businesses (See the De Soto quote above). For the theory to work correctly the resources would, because if businessmen needed more than were “given”, they would have to bid them away from earlier stages and raise costs and borrow more, and then not possibly complete any projects due to a lack of required materials. In any ABCT I have read, there is little to no mention of the actual resources themselves and whether they need to be specific or not, all that is said is factors of production geared towards consumption can be used to fuel earlier production. Is there mention of training for different labor, specificity of capital goods, distance between where the factors of production were freed up and where they will be used, etc? No, all that I am aware of is that the capital blob of from any saving of resources can be used to fuel the expansion of earlier industries. This seems to be the fatal flaw in the Austrian argument, what one man saves may not necessarily be the resources that another man requires. One man’s trash may really not be another man’s treasure.
There are other inconsistencies as well regarding the structure of production. In a similar tone in regards to “factors of production”, the Austrians make reference to the “higher stages”, and the “lower stages”. Well, what is the difference? I understand that the Austrians emphasis subjectivity in their economics, ranging from the basic fact of human action to marginal utilities and entrepreneurial decisions, but at what is the dividing point between the higher and the lower? Or in other words, when do businesses stop experiencing the derived demand effect and instead the interest rate effect? How far into the structure of production or the Hayekian Triangle will the resources be free from?
Lastly, in regards to the Hayekian Triangle and structure of production, how does the Triangle exactly move outward? Garrison never explains this in his PowerPoints, instead in slide 24 simply showing an the entire triangle/economy grow due to increased savings without an explanation But, how exactly? I understand that increased saving creates capital goods which improve production and more efficiency and later cheaper consumer goods, but the process is never expanded from that in relation to the productive structure. The triangle and the economie's resources seem to be built off of itself, meaning that via saving factors from the lower stages supply the needed inputs for the higher stages. So where do the resources come from to move the entire triangle outward?How do consumer goods industries, which initially lose their factors of production for later stages, suddenly get factors of production and expand? The Austrians, despite their highly complex view of time,saving, and production in the economy do not reveal these answers clearly.
Hopefully someone will be able to answer my questions regarding the structure of production and the homogeneous blob of capital resources.Remember that I am a fellow Liberal who has taken an interest in reading this material, I have only read a couple of books. Still I believe my understanding of the theory to be solid and these questions sufficient. If the Austrians and their view of Business Cycle/Growth is correct than these questions must be answered.
Jake McCloskey: liberty student:Then why did you call it homogenous? If you read his argument you might understand. His point is that resources might not be bid away from lower stages of production because they are not the resources that are required for the higher stages.
liberty student:Then why did you call it homogenous?
If you read his argument you might understand. His point is that resources might not be bid away from lower stages of production because they are not the resources that are required for the higher stages.
At the basest level, resources are "capital" (i.e., loanable funds, cash, etc.) and labor, both of which are fairly mobile.
A million dollars in the bank, waiting to be loaned out is the same to me as it is to you. But once I take that $1M and convert it to lathes and drill presses, you're going to have one hell of a time making basketballs with it, if my table-leg manufactory goes out of business.
So one problem that arises is that capital goods are not mobile, and generally well-suited for only a small handful of tasks.
So, following the credit/capital theory put forth by DeSoto/Garrison/etc., capital is bid away from some sector of the economy (theory says short-term productions) towards another sectory (thy says long-term productions) whereupon it is converted into capital goods which are heterogeneous, and this is where the problem occurs, because these capital goods are not easily or inexpensively repurposed. When it is revealed that these investments were made in error, as a result of the credit influx/boom, a real diminution of material well-being occurs, because a lot of capital goods are essentially junked/squandered.
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David Z
"The issue is always the same, the government or the market. There is no third solution."
I dont have the heart to rebuff you line for line, i note that from the start you make a shocker.
It is in my opinion that although the Austrians present a solid theoretical construct of the structure of production and its relations to the business cycle, I believe that their arguments ultimately fail from their view of capital as a homogenous input, a lack of detail, and inconstancies in regards to their arrangement of production.
acknowledging the heterogeneity of capital is a distinctly austrian viewpoint... so.....not off to the best start
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
As pointed out in the first response, the Austrian viewpoint of capital is heterogenous, not homogenous like the mainstream view.
When society saves, funds go into cash balances and later into the market for loanable funds as investments. There is a decrease in the demand for goods in the lower stages, and a decrease in profits and investment in there for businesses. This means that people stop buying as many consumption goods, such as food, clothing, entertainment, iPods, cars, toys, etc. There is a decrease in investment in those stages.
You're conflating terms here. A decrease in consumption and increase in investment means that investment increases, not decreases. A decrease in consumption means that less toys, ipods, clothes, etc. will be made. It doesn't mean that Walmart or McDonalds will cease to expand. If Walmart builds another store, that counts as an increase in the supply of capital goods. Another store, after all, is a long term, higher order project which earns profit after an amount of time. Higher savings means lower interest rates and lower profits for a business like Walmart, which might not hurt its overall performance. Lower interest rates might be able to offset the lower returns from new investments.
What happens is that because of lower profits, businesses like Walmart want to be able to produce consumption goods at lower prices in order to increase profits, which means that they will be able to utilize lower interest rates for capital expansion in order to lower costs. This percolates throughout the system, as the demand for more capital by companies like Walmart increases demand for capital by the companies that produce that capital, and so on.
Business men who have embarked on their long term projects borrow more and more which starts to drive up the interest rate.
This is not key to ABCT at all. If interest rates are lowered permanently, never to be changed again, the business cycle would still occur. ABCT is not a credit cycle theory, it is rather a theory which combines capital theory with credit. A lower interest rate causes capital expansion, but because consumption has not decreased, prices rise, effecting the profitability of long term projects. These projects become unprofitable as prices rise, forcing them to lower wages and lay off workers, which in turn causes a "death spiral" recession until prices reset, malinvestments are liquidated, and resources are reallocated.
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nirgrahamUK: I dont have the heart to rebuff you line for line, i note that from the start you make a shocker. It is in my opinion that although the Austrians present a solid theoretical construct of the structure of production and its relations to the business cycle, I believe that their arguments ultimately fail from their view of capital as a homogenous input, a lack of detail, and inconstancies in regards to their arrangement of production. acknowledging the heterogeneity of capital is a distinctly austrian viewpoint... so.....not off to the best start
krazy kaju: It is in my opinion that although the Austrians present a solid theoretical construct of the structure of production and its relations to the business cycle, I believe that their arguments ultimately fail from their view of capital as a homogenous input, a lack of detail, and inconstancies in regards to their arrangement of production. As pointed out in the first response, the Austrian viewpoint of capital is heterogenous, not homogenous like the mainstream view.
I understand that the Austrians view capital as heterogeneous, all I'm trying to say is that the theory of saving and boom bust involves the factors of production and resources saved to be compatible with any investment project. Read when I talk about the De Soto quotes and how these factors of production released from consumption provide the resources needed for long term projects.
krazy kaju:When society saves, funds go into cash balances and later into the market for loanable funds as investments. There is a decrease in the demand for goods in the lower stages, and a decrease in profits and investment in there for businesses. This means that people stop buying as many consumption goods, such as food, clothing, entertainment, iPods, cars, toys, etc. There is a decrease in investment in those stages. You're conflating terms here. A decrease in consumption and increase in investment means that investment increases, not decreases. A decrease in consumption means that less toys, ipods, clothes, etc. will be made. It doesn't mean that Walmart or McDonalds will cease to expand. If Walmart builds another store, that counts as an increase in the supply of capital goods. Another store, after all, is a long term, higher order project which earns profit after an amount of time. Higher savings means lower interest rates and lower profits for a business like Walmart, which might not hurt its overall performance. Lower interest rates might be able to offset the lower returns from new investments.
What I meant is that there is a decrease in investment in the stages closest to consumption, what Garrison calls the "Derived Demand Effect". (See my quotes above). Their resources are freed (the theory never specifies the resources, going back to my original point of capital being a blob) and used to augment production in the higher order stages.
krazy kaju:Business men who have embarked on their long term projects borrow more and more which starts to drive up the interest rate. This is not key to ABCT at all. If interest rates are lowered permanently, never to be changed again, the business cycle would still occur. ABCT is not a credit cycle theory, it is rather a theory which combines capital theory with credit. A lower interest rate causes capital expansion, but because consumption has not decreased, prices rise, effecting the profitability of long term projects. These projects become unprofitable as prices rise, forcing them to lower wages and lay off workers, which in turn causes a "death spiral" recession until prices reset, malinvestments are liquidated, and resources are reallocated.
Because consumption has not decreased, no "real resources" have been saved, and resources are directed towards consumption while businessmen try to bid them away to the higher order industries. Businessmen who have borrowed must borrow more funds to pay for these workers (in addition to businesses who have not even borrowed money, they must pay more for the Factors of Production) which drives up the interest rate. As the interest rate rises and rises businessmen realize their projects were committed in error and the bubble pops. In order for interest rates to stay forever low permanently (barring increase in saving), the banks would have to continue inflating in order to drive the interest rate up (which has been pushed up because of the increase in demand for investment). The relative interest rate always increases, unless the end result is hyperinflation.
Again, the main critque is how the Austrians view capital. Reread and prove me wrong.
Prove yourself correct.
Duckinstein:I understand that the Austrians view capital as heterogeneous
Then why did you call it homogenous?
Duckinstein:Again, the main critque is how the Austrians view capital. Reread and prove me wrong.
Your OP was ridiculously long and difficult to follow. You've been imprecise when labeling the Austrian theory as it pertains to capital.
And no offense, but this is a forum of laymen who answer when they choose to answer, if they choose to answer. So please don't make demands, because you have already done very little to facilitate any sort of incentive for someone to respond to such a demand.
As KoB suggested, prove you are right. And you can start by making sure your premise (that Austrians regard capital as a blob) is correct, before proceeding to claim you have refuted the theory.
If you find something evil that wobbles, push it. - Gary North
Duckinstein:I understand that the Austrians view capital as heterogeneous, all I'm trying to say is that the theory of saving and boom bust involves the factors of production and resources saved to be compatible with any investment project.
This is valid but I'm not sure it's a crushing blow to the theory. You are making a magnitude argument here. I agree that one of the main problems with the Austrian theory is magnitudes and your argument is novel, but I don't think it is the end of ABCT.
Actually, you seem to have a better grasp on ABCT than many people on this forum.
My critique is more akin to those of Gordon Tullock and Bryan Caplan. Tullock explains that while the raise in rates may lead to business failure, there will not necessarily be a drop in economic growth as the resources now freed from the malinvestment will be taken up by growing industries. There may be a slight uptik in unemployment and some loss due to movement of the resources and information costs, but to say that it will cause negative growth in all industries requires more. Caplan's argument is from rational expectations. If investors know the fall in rates is only temporary, they will invest accordingly. The fact that some rates rise after inflation is evidence tht they know the drop in the other rates is temporary. There won't necessarily be malinvestment.
The only situation in which there would be significant malinvestment would be if investors thought the natural rate fell along with the market rate. If you believe in the strong version of the EMH, than this isn't possible. I believe in a medium version which would still allow this sort of expectational failure, but I would need evidence to know if it actually occurred. (BTW, I don't want to get into an argument over the EMH).
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can you point me to an article where Tullock says this?
Tullock explains that while the raise in rates may lead to business failure, there will not necessarily be a drop in economic growth as the resources now freed from the malinvestment will be taken up by growing industries.
I could do with some cheap laughs.
Jake McCloskey:His point is that resources might not be bid away from lower stages of production because they are not the resources that are required for the higher stages.
are they bid from even higher stages??
where are they bid away from? no-where?. the magic from nothing economy. thank you. goodnight.
Jake McCloskey:If you read his argument you might understand.
I am a little tired of your incessant moaning that people aren't reading. It's barely possible to add less to the discussion, and yet you manage to find that way.
I understood his argument, but he is still wrong to call it homogenous. And the fact that it is heterogenous should incline him to question his premise.
See Nir's last response.
General comment: I think that, to fully answer these questions, requires a bit of background in the general ideas from which the ABCT arose. I'm not going to give that entirely, because when I try I fail to do it justice, but I'll give a bit of a sketch. The fundamental insight that separated Menger from the other marginal revolutionaries was a glimpse of an economic order entirely determined by consumer preferences. That is, a neoclassical picture might start with physical reality (piles of stuff/raw materials), followed by an arrow marked "causation" then finish with consumer goods. What exists is objective, consumer preferences are subjective. To this picture, Menger added a second arrow going the opposite direction. The first arrow is the arrow of physicality, the second is the economic arrow. What this second arrow suggests is that consumer preferences can affect what exists (once we understand that economic existence has to do with availability - only capital goods belong here, not things still in the ground) through backwards imputation. While all Austrians talk about subjective value, what Menger had was a subjective theory of everything, not just value.
Duckinstein: So what are these inputs, “real saved resources” (A common expression I heard in advocates of this particular theory), factors of production, etc? Is there any degree of specificity in them? Tom Woods gives a couple of examples (see above quote), but even those are pretty vague. What should make us believe that the “factors of production” for lower stages will be the exact resources needed for the higher stages? Can the construction materials used to make a new Dennys be used for the completion of a Power Plant? Take this rather silly but illustrative example; society saves 1% more of their cash income, the restriction of consumption came solely from the cutback of fast food. America instead decides that it does not require as much food and will used their savings for investments. The derived demand effect occurs in some food industries; they suffer from a decrease in demand and decide to free up resources. The resources freed are primarily food workers, grocery clerks, capital goods used in cooking and processing food, additional construction materials that could have been used for building more restaurants and stores, etc. Now, with or without the concept of full employment of resources (it is a variable for the business cycle, the theory can deal with whatever degree of resources are idle), these factors of production are the “real saved resources”.
Yes, there is a great deal of specificity. This is precisely why the PPF is shaped the way it is - the flattening at the ends illustrates just this principle. Consider the PPF for guns and butter. As P.J.O'Rourke commented, at the far end, cows are put to work in gun factories. What happens when you put a cow to work in a gun factory? You lose a lot of butter, and get only a very marginal increase in gun production. But you still are moving in the same direction along the curve, just at a different speed.
Now, the impact of this problem is the same whether consumer preferences or monetary policy have caused the spike in investment in the earlier stages. But, just as with the guns and butter PPF, there is a tendency among consumers not to press too far towards either end. The further you go towards either end of the curve, the worse the trade-off becomes, so market tendencies are to stay in the middle. There is no such feedback loop if we move because of monetary policy, though.
As you note, the trade off is different for different factors of production, and there is a cost of transition. Concrete is very easy to transfer, people somewhere in the middle, signs that say "Dennys" very hard to transfer. Food seems to me to be less of a problem - the food that was in Denny's supply chain can be purchased as part of the subsistence fund for upkeep of workers (as long as minimum wage laws and the like don't prevent providing some payment in food.)
Duckinstein:This seems to be the fatal flaw in the Austrian argument, what one man saves may not necessarily be the resources that another man requires. One man’s trash may really not be another man’s treasure.
When we talk about what one man saves, what do we mean? The PPF is generally cast in terms of allocation of money, which is entirely transferrable. Now, what if the physical goods are entirely suitable for consumption and not for production? I take this to be an incorrect statement that ignores Menger's arrow. The nature of the goods already out of the ground can be changed by an entrepreneur who applies them to the ends being sought. The goods being taken out of the ground can change. At worst, this is a process that requires time to adjust, not one that is impossible.
Duckinstein:Well, what is the difference? I understand that the Austrians emphasis subjectivity in their economics, ranging from the basic fact of human action to marginal utilities and entrepreneurial decisions, but at what is the dividing point between the higher and the lower? Or in other words, when do businesses stop experiencing the derived demand effect and instead the interest rate effect? How far into the structure of production or the Hayekian Triangle will the resources be free from?
Remember that the entire ABCT exists within the framework of Austrian economics. As such, the derived demand effect and interest rate effect are not forces operating on businesses in a deterministic way, and certainly not in a binary way. In all cases, the relevant factor is - how does the entrepreneur believe that the derived demand effect and the interest rate effect will impact the future? Everyone, from the candy producer to the producer of tiny screws used in computers that design robots that make other computers that design cars, experiences the interest rate change, and the derived demand effect change. The candy producer knows that, short run, the demand for candy is falling and he should make less - and that long run, there will be a greater demand for consumer goods. He has to make an entrepreneurial decision as to how candy will play into that. He may borrow money at the lower interest rate, even though consumption is falling, and use it to retool his factory to make fancier candy.
In short, I think that your answers illustrate an important point - that the ABCT is frequently (especially during the current crisis) presented as if it were free-standing as a contribution of Austrians to economics. But it isn't, it is inextricably tied to the Mengerian framework. We tend to use terms in presenting it that are more Bawerkian (Menger regarded Bawerk's theory of capital as a huge mistake) and to downplay the importance of the Kirzerian entrepreneur.
You admitted you couldn't follow the argument, which usually means you should go back and try rereading it.
Nir's response misses the point, which is that the resources aren't bid away, period. They never reach the higher order stages meaning the malinvestment never occurs.
well there you have it boys and girls, there are no malinvestments. boom and bust does not happen.
I think you've been on this forum too long. Did anyone ever say there were no recessions? The OP was a critique of the ABCT. In case you didn't know, there are other theories of the business cycle which have nothing to do with malinvestment.
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