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If You Are So Smart...

Mises Daily: Friday, January 28, 2005 by

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After a recent article I wrote dealing with the Austrian Business Cycle Theory, I received the following e-mail: 

You have knowledge of the Von Mises business cycle and can predict booms and busts. Go long on the booms and short on the busts and you'll soon make a bundle.

You must all be rich.

If not, why not?

If you are not all rich, why is that?

Seems a rather good question.

Now, the writer of this e-mail was not trying to give me investment advice or complimenting me on my writing. The tone obviously is sarcastic, and the writer seems to believe that he is making a strong point against the ABCT. Indeed, he wants to know, if Austrian Economists are so knowledgeable about the origins and workings of the business cycle – and do by also criticizing the mainstream Keynesian approaches – then it would make sense that Austrians should be able to transfer that information into investment patterns that created personal wealth.

On the other hand, the writer implies without saying, if Austrians who claim to understand the ABCT are not rich, then perhaps the ABCT itself is flawed. After all, Austrians have to be following the investment advice of someone, and if one's investment patterns do not follow what one believes to be true, then such behavior would constitute an absurdity. Moreover, if Austrians do not follow the theories they purport to be true, then they would be engaged in an ultimate act of hypocrisy and dishonesty.

First, for reasons of full disclosure, I am not a wealthy person. That state of affairs is not due to my having followed flawed economic theories, but rather is the result of some short-sighted decisions on my own behalf. Furthermore, I do not purport to know the personal financial status of fellow Austrians, nor have I asked them about their investment decisions. Thus, I am in no position to know if my colleagues are wealthy.

(On the contrary, if Austrians are subjected to the "why aren't you rich if you are right" test, then it would be fair game to ask Keynesians the same thing. If government-generated "aggregate demand" is the key to creating wealth, then if all Keynesians are not rich, would it not make sense to say that a state of affairs in which Keynesians are not wealthy is de facto a means of discrediting Keynesian theory?  If one wishes to be consistent – which is what the writer of the e-mail is demanding – then Keynesians ought to be judged by the same test. However, there is an alternate explanation; the economic theories to which one holds do not automatically reveal themselves in an individual's personal wealth. To put it another way, one can be right, but not rich. For that matter, one can be rich and not right. Many wealthy people have expounded what can only be crackpot theories on wealth "redistribution" or other such things.)

The ABCT has been explained any number of times on this page, but some things bear repeating. For those not familiar with the theory, I hardly can do it justice in these few paragraphs. However, for the sake of simplicity, I will outline how the ABCT works.

The first step involves government authorities – generally through the central banks – attempting to give the economy a "kick" by forcing down interest rates to artificially low levels. (In the United States, the Federal Reserve System generally goes on an aggressive program of expanding bank reserves, with the initial growth in reserves helping to spark an increase in new lending.) 

The lending surge then affects capital markets, with the addition of new capital helping to create a boom. However, because the lending policies have been contrived through artificially low interest rates, sooner or later it becomes apparent that the new capital spending does not reflect the buying habits of consumers. In other words, the boom cannot be sustained, and the malinvested capital either must be liquidated or applied to other uses. During the recession, the malinvestments are purged from the economy and the stage is set for the economic recovery.

Now, I have left out large portions of the theory, especially the explanation of how time fits into the entire scheme. Again, I do that on purpose only because of the constraints of space. (If one wishes to learn the ABCT in depth, the first portion of Murray N. Rothbard's America's Great Depression gives a clear and detailed explanation. The book also can be read online through the Ludwig von Mises Institute's website.)

One of the things that sets Austrian Economics apart from the professional mainstream is the Austrian's insistence on time being a factor of production. (Mainstream theory operates under the unrealistic assumption that consumer goods are created and sold instantaneously. Time has no bearing in the standard approaches.)  Capital accumulation takes place over time; malinvestments occur over time; the business cycle takes place over time.

Furthermore, the ABCT is a qualitative, not quantitative theory, and it is based upon a priori analysis. The theory says that whenever central banks set an economic process in motion upon artificially lowering interest rates over a period of time, certain events will be occurring. In an economy like ours that is identified by having large amounts of capital, the fundamental economic relationships between capital and interest will be affected in a predictable way.

(Austrians, who emphasize the a priori analysis of economic science, differ with the mainstream, which holds to an a posteriori view, or what is called "logical positivism."  Both camps say that economic theory should be able to qualitatively predict events – i.e. price controls will create shortages – but Austrians hold that if the assumptions are true and the theory is logically constructed, then the theory also is true – and will have the power to predict. Logical positivists, on the other hand, say that assumptions don't matter, and that one can only know a theory's power after an event has occurred. Thus, the "law" of demand, under this viewpoint, really is not a law, but rather a hypothesis that constantly must be "tested" to see if it "holds" under the latest conditions.)

Having established these things, I am able to explain why the ABCT is a qualitative theory about business cycles, not a theory of daily investment strategy. Whenever the central bank helps to create an unsustainable boom, Austrians know that the boom will end in a bust. What Austrians do not know is how long the boom will go on and when the bust will occur. It is one thing to have a general idea of when these things will happen, but quite another to have the specific knowledge that is needed when one engages in the kind of financial speculation in which traders go long and short.

For example, in August 2000, I wrote that the "New Economy" was about to go bust, and four months later, I pointed out why the "dot.coms," which had been the media darlings earlier in the year, were tanking left and right. Two months later, I announced a recession that officially had not hit the books but clearly loomed ahead.

None of these predictions were made because I was a crack day trader, but rather because I understood the ABCT. No, I did not go long during the NASDAQ stock bubble, nor did I go short when the index began its freefall. (Yes, I wish I had done these things, but my excuse was that I was in graduate school at the time and poverty-stricken grad students have no business speculating in stocks, especially when they do not have the means to speculate.)

In a recent paper in The Independent Review, Mark Thornton noted that the economists who most accurately predicted the stock bubble, crash, and subsequent recession were the Austrians. Did all of them go long and sell short?  Does it matter?

Ultimately, the power of the ABCT is not whether some economists of the Austrian School rolled the dice on some day trades and made money. The power of the ABCT is grounded in its ability to explain the underlying causes of the boom-and-bust cycle. While political operatives and economists who should have known better were hailing the "New Economy," made possible, they assumed, by higher marginal income taxes and loose money from the Fed, Austrians were singing a very different tune.

In the end, we found that there was no "New Economy," and that whatever was the state of affairs in the last days of the go-go 1990s could not be sustained because it was built on a foundation of inflation. Austrians – and only the Austrians – understood that truth all along. That their knowledge did not result in all of them becoming paper millionaires does not discredit the larger truth of what they knew and when they knew it.

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 William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive. Comment on the blog.