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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.
============================
David Z
"The issue is always the same, the government or the market. There is no third solution."
Duckinstein:For the Austrian analysis of saving to be correct, the inputs (the factors of production) for the stages closer to consumption must match up with the inputs (the factors of production) for the stages farther away.
I beileve this is incorrect and the crux of your misunderstanding.
If you find something evil that wobbles, push it. - Gary North
liberty student:I beileve this is incorrect and the crux of your misunderstanding.
Care to elaborate?
consequentialist.wordpress.com
@Duckinstein: "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."
I don't think it is even a flaw. You think of how a clerk serving at McDonalds can be transferred and employed at, say, General Motors' new car building project as a junior engineer. How much ever valid your example may be, it is quite aloof from reality.
Businessmen do have a rough idea of the availability of various resources, and their prices over a particular period of time. As the period elongates, the lesser become the accuracy of business forcasts, usually.
Try a better example, interest rates plunge and GM decides to plan out a ten year project which requires some 200 junior engineers. Some entrepreneur who is into the education industry anticipates this demand for junior engineers over the next decade, and may be even longer. So he makes out a loan and starts with building a new engineering college to train junior engineers in 3 or 4 years. Even the already-existing colleges will expand the capacity of their engineering courses expecting future demand.
I am a guy from India, and trust me, the IT revolution out here churned lacs of IT engineers. Companies started having close ties with universities for almost the first time in our history, and started employing freshers.
The market is really quick to adapt, provided it is allowed to express the right signals.
De Soto's very clearly explains how capital goods are very much not homogeneous in diferent parts of the same book, here is a good example:
The errors consist of launching and attempting to complete a series of investment projects which entail a lengthening and widening of the capital goods structure, projects which nonetheless cannot come to fruition, due to a lack of real saved resources. Moreover once resources and original factors of production have been transformed into capital goods, these goods become non-convertible to a certain extent.
In other words, many capital goods will lose all of their value once it becomes clear there is no demand for them, they were manufactured in error and they should never have been produced. It will be possible to continue using others, but only after spending a large amount of money redesigning them.
The production of yet others may reach completion, but given that the capital goods structure requires that the goods be complementary, they may never be operated if the necessary complementary resources are not produced. Finally, it is conceivable that certain capital goods may be remodeled at a relatively low cost, though such goods are undoubtedly in the minority.14 Hence a widespread malinvestment of society’s scarce productive resources takes place, and a loss of many of its scarce capital goods follows. This loss derives from the distorted information which, during a certain period of time, entrepreneurs received in the form of easier credit terms and relatively lower interest rates.15 Many investment processes may also be left half-completed, as their promoters abandon them upon realizing they cannot continue to obtain the new financial resources necessary to complete them, or though they may be able to continue to secure loans, they recognize that the investment processes lack economic viability. In short the widespread malinvestment expresses itself in the following ways: many capital goods remain unused, many investment processes cannot be completed, and capital goods produced are used in a manner not originally foreseen. A large portion of society’s scarce resources has been squandered, and as a result, society becomes poorer in general and the standard of living drops, in relative terms. (Money, Bank Credit, and Economic Cycles pages 415-416)
You also left out the end of the paragraph from page 334, which I'll quote below for everyone's benefit (emphasis mine):
Thus for entrepreneurial coordination to exist between the stages in the productive structure of a society which is immersed in a process of increased saving and economic growth, it is particularly important that the corresponding factor markets, especially the markets for original means of production (labor and natural resources), be very flexible and permit at a minimum economic and social cost the gradual transfer of these factors from certain stages of production to others.
When taken together it is pretty clear these two quotes make very clear De Soto's view that labor and natural resources are much easier to move between the various stages of production than other capital goods. He also shows that capital goods used in malinvestments can either be modified for other uses at a cost, become completely worthless, or become worthless until such time as complementary factors of production change in price. The same concepts could be applied to a dramatic shift in consumer preferences .
But that's besides the point. Entrepreneurs will not bid away capital goods that are non-transformable, they will bid away those that can be most profitably put to use. That would include easy to retrain labor, resources, and capital goods that are easily modified for use in the higher stages of production. Capital goods that are not easily modified will not be bid away without an enormous change in the savings rate, why would they?
Also in the short run, if the labor, resources, and capital goods are not bid away from the lower stages of production, where do they come from?
Your view of De Soto's arguments is a strawman, as you would see if you read through the rest of his book, and as you can see from the quotes above.
For the ABCT to work it is enough, that extra credit will induce the production of "earlier stage" production goods by biding away original factors of production - labor and raw materials.
They are not homogenous, but if you understand how any capital goods are produced, you must see, that any lengthening of the production structure is done by using original factors to produce different capital goods then otherwise.
If it is due to capital accumulation, there is no problem. If it is done by biding away original factors from shorter processes, we have an unsustainable structure of production.
Prashanth Perumal:I am a guy from India, and trust me, the IT revolution out here churned lacs of IT engineers.
Lac = hundred thousand.
And you hit the nail on the head. Austrian critiques forget that the market is dynamic, and Austrians don't expect that the supply of capital will be fixed or appropriate for every fluctuation. Obviously where demand changes, inventories will be created AND cleared as the capital structure adjusts to changes in consumption and saving. That is why a consumption economy differs in structure from a savings economy. Stone Cold Creamery probably doesn't happen in a low time preference economy.
Again, the main critque is how the Austrians view capital. Reread and prove me wrong.
I'm not sure that there is really any "Austrian view" of capital. Capital is capital. A factory is capital. A store is capital. The more capital you have, the more goods you can produce. There is capital that produces capital (e.g. cranes and bulldozers) and capital that produces the capital that produces capital (whatever machines are used to build cranes), and so on. The more capital you have, the more productive economy you have. More capital in the stages furthest away from consumption (the capital that builds the capital that builds the capital that builds the capital that produces consumer goods, and so on) means that the economy can grow at a faster rate as more capital goods, and thus more consumer goods, can be produced. More loanable funds means that more capital equipment can be produced. A lower interest rate means that capital equipment with lower rates of return will be produced more often.
Ultimately, as I've stated before, there is absolutely no requirement that the interest rate increase for ABCT to be correct. If there is a set interest rate, as there is today in most countries of the world, ABCT still applies. So say, even if the Federal Reserve kept interest rates forever at 0.25%, the business cycle would happen. This is simply because the money that goes towards the earlier stages of production in the form of loans would then be spent on consumption goods, increasing the profitability of consumer good production and increasing inflation, thereby harming the profitability of the early stages of production. This is enough to put workers out of work in the early stages of production, which then turns into a downward economic spiral, forcing more and more businesses to lose profitability until only the strongest businesses survive and are able to turn the economy around.
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liberty student:That is why a consumption economy differs in structure from a savings economy. Stone Cold Creamery probably doesn't happen in a low time preference economy.
You can't chastise Austrians for viewing the economy as non-dynamic and then say this. Cold Stone can occur in a low time preference economy, it simply depends on the size of the economy we're talking about. Obviously, Zimbabwe does not have the necessary capital or wealth to make Cold Stone, or even cable TV, a simply past-time. On the other hand, if you doubled the economy of a country like Luxembourg, the wealth produced by the amount of capital present would make Cold Stone simply another past-time that a low time preference economy would be able to sustain.
My point here is that someone who earns $200k a year can easily afford to save 50% of his income and at the same time eat out often and get a ton of ice cream from Cold Stone.
Jake McCloskey: Your comments make no sense. Did I say those theories were correct? I said that the rejection of ABCT does not imply a rejection of the reality of recessions. In fact, I never said malinvestment couldn't occur if ABCT is incorrect anyway.
Your comments make no sense. Did I say those theories were correct? I said that the rejection of ABCT does not imply a rejection of the reality of recessions. In fact, I never said malinvestment couldn't occur if ABCT is incorrect anyway.
Again, I'm going to remind you that not understanding a theory or someone's position does not make them/it wrong, and you right. The OP needs to realize that no one is going to take 2 hours out of their day to refute a nobody who doesn't understand ABCT, at least not for free. You're right, there are trade cycle theories which don't involve boom-bust, such as Schumpeter's, but they're all wrong.
This looks interest, I'll read through it and respond once I get the time.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
Duckinstein: In regards to homogenous capital, I thought that I answered that in my original post I understand that Austrians believe they view capital as a heterogeneous variable, the point I am trying to make is that when you look at their view of saving/boom/bust, capital really is considered a homogenous blob.
No, Austrians speak of "capital ceilings" (industry specific) where too much of one form of capital is created, thus taking resources away from other, more profitable investment ventures; hence, malinvestments. The problem occurs because certain investment activities, during an inflationary period (when the market rate is suppressed below the natural rate), either cannot be completed at all, on time, or at the expense of more justified activities. So no, no Austrian ever considers capital to be a homogeneous structure. Austrians look at the structure of production realizing that capital is heterogeneous and complementary (not just supplementary, as Keynes has it).
Again, this is confusing to an Austrian. Austrians speak of the "original means of production" (labor and land), and the "factors of production" (which includes land, labor, and producer's goods as well as intermediary goods, which are semi-finished or unfinished products). During the boom higher stages bid capital away from the lower stages, as well as labor, thus increasing factor prices. Essentially, "inputs" are not homogeneous, there are specific capital goods, and non specific capital goods; the former being drawn away from the lower stages towards the higher stages, and vice versa (increased capital intensity, and a longer structure of production). It seems that many people don't understand the term "structure of production." You should read Prices and Production (more than once) if you wish to understand the nature of boom-bust in greater detail.
david_z: 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.
Was this directed at me? If it is, I don't need to be lectured on the ABCT. I agreed the OP's point was valid, which you didn't refute, but qualified that it is quantitatively insignificant.
david_z: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.
This is the point that Tullock takes issue with, and that I still haven't seen a viable response to. These capital goods aren't created for industries with zero pre-existing demand; the demand for them during the boom phase is just overstated. After the maliinvestment is discovered, these capital goods can still be used for the purposes they were made for, but since the supply of them has increased, their price will go down. This might cause businesses that invested in them to go bankrupt, but the goods themselves would not be squandered. This doesn't deny the effect of the credit, only that it wouldn't lead to a recession.
I would be interested to hear a response to that point.
@liberty student
hehe, yeah! Kind of adding an Indian flavor to this forum
Jake McCloskey: These capital goods aren't created for industries with zero pre-existing demand; the demand for them during the boom phase is just overstated.
...And the demand for consumption goods is also overstated during the boom phase of the BC, during which (without a prior accumulation of capital sufficient to meet the new 'excessive' demand) a portion of the capital stock is depleted. At some point, the boom is revealed as a boom, when it goes bust. The capital depletion is what's left. Many businesses have worn their capital to unsalvageable levels (A) trying to ride out the boom, others have 'invested' in capital (B) that could have satisfied some future consumption demand, except the demand is not in the future, it's now.
During the boom and in the context of time preferences, too much of some goods have been produced, and not enough of other things have been produced.
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