A New Year's Resolution for Macroeconomists
January is that time of year where resolutions get made. Improvements to guide your behavior over the next twelve months and hopefully allow you to usher in the coming year a better person than you once were.
That the resolution making of January follows the gift giving of Christmas generally means that we have fodder for our thoughts as we turn to self-betterment. Bank of International Settlements economist Claudio Borio gave us all one such gift in his recent working paper “The financial cycle and macroeconomics: What have we learnt?”
Not content with merely pointing out the errors of the macroeconomists leading up to the crisis, Borio goes a step further by pointing out three difficulties macroeconomists encounter when linking financial crises to business cycles. He also provides the reader with three directions for modern macroeconomics to go in order to avoid these problematic issues in the future. All six points should be welcomed by Austrian-School economists—as we will see, they include facets of the business cycle that are fundamental to Austrian business cycle theory (ABCT) in general, and Austrian capital theory in particular.
Three Analytical Challenges for Macro Modelers
First, Borio is quite clear that the “financial boom should not just precede the bust but cause it.” The key linkage is that the boom, according to Borio, “sows the seeds of the subsequent bust” by allowing vulnerabilities to accumulate in the economy. A more concise overview of an ABCT is difficult to find. For macoreconomists adhering to mainstream traditions, this point is difficult to accept. The dominant modern view of exogenous demand-side shocks propagating economic distress cannot allow for the economy to gradually destabilize itself as the boom progresses. Alternatively, real business cycle adherents have the opposite misgiving because in their view, in the absence of exogenous shocks the economy should quickly return to its sustainable equilibrium. Both views leave little room for endogenous deteriorations in the economy throughout the boom, and instead focus their attention on how to exit the bust once it is underway, instead of avoiding it in the first place.
Second, Borio laments that mainstream models fail to adequately explain the role of “debt and capital stock overhangs.” Specifically, he wishes to explain why it is that credit, which is generally seen as playing a facilitating role in the economy, actually allows for the “misallocations of resources, notably capital but also labor, typically masked by the veneer of a seemingly robust economy.”
The misallocation of resources along the temporal structure of production is a significant result of an Austrian business cycle. In the Austrian view, interest rates serve the important role of coordinating intertemporal consumption and production activities. By artificially lowering interest rates below their natural level, central banks skew the productive undertakings of firms, and facilitate the discoordination of the capital structure. Overinvestment in specific areas of the economy implies relative underinvestment in others. The bust requires these misallocations of capital to be reallocated to a more sustainable allocative mix. As Borio correctly states, most mainstream models are unable to account for these misallocated capital stocks because, (1) by assumption disequilibrium capital stocks do not occur, or (2) when disequilibrated capital stocks do exist, they are the result of exogenous shocks and not because of the preceding boom.
Finally, and perhaps most importantly, Borio brings up the need for modern macroeconomists to redefine the “potential output” of an economy as “sustainable output” instead of the more common noninflationary output. Since its original formulation, Austrian business cycle theory has stressed that a boom can be destabilizing regardless of whether it has low and stable inflation. Indeed, periods of low and stable inflation have typically masked the discoordinations occurring and brought an aura of sustainability to the economic advance.
Instead of being caused by the gap between actual and potential output, as is the case in most modern macroeconomic models of the business cycle, price inflation is a result of money growth relative to economic growth in the economy. Low and stable price inflation need not coincide with sustainable economic growth, if newly created money is being sopped up by an increased amount of goods being produced in patterns that are not consistent with the underlying preferences of consumers or producers in the economy.
Where to now?
Borio, in an attempt to rectify the three aforementioned misgivings, offers three alternative directions for modern macroeconomics to head.
First, modern macroeconomics must move away from rational expectations and allow for “fundamental uncertainty” to be a “key driver of economic behavior.” One common stocktaking during the crisis has been for macroeconomists to retain a rational expectations-based approach, while allowing for the economic boom in the form of a buildup of resources followed by a subsequent unwinding of these erroneous positions. As Borio makes clear, such an approach is highly artificial. Instead, macroeconomists must accept that knowledge is fundamentally incomplete, and in some cases, unknowingly so.
A second correction would be to allow for state-varying risk tolerances. While this recommendation is not specifically Austrian in its goals, it does allow one to recognize that low-interest-rate environments may incentivize risky behavior, while financial busts create the opposite effect. (In his Risk and Business Cycles, Tyler Cowen recouches traditional Austrian business cycle theory in terms of increased risk-taking through interest rate manipulations.)
Finally, Borio makes a plea that modern macroeconomics must try harder to “capture more deeply the monetary nature of our economies.” In the real economy money matters, unlike in various modern macro models where economies are constructed in real terms and then given a veil of money. Yet in distinction to these prevailing approaches, money does not provide a friction within a model but is a necessary ingredient for the advanced economy to exist.
Above all else, economists of the Austrian School should welcome this final point. The Austrian theory of the business cycle is unable to be disjointed from monetary phenomenon. More importantly, within the Austrian business cycle theory it is impossible to delink monetary effects on the real economy. Just like in real life, our rendition of the business cycle allows for changes in the money supply to affect shifts in the real capital structure of the economy.
These points provide a good foundation for mainstream economists to keep in mind as they continue practicing their craft over the coming year. January is also the time to set more singular goals for the coming twelve months. Your broken pledge to give up sweets for the next year will leave you needing a new pair of pants by next Christmas, but a broken pledge by macroeconomists will spell continued hardship for everyone. Let's hope that this pledge for better scholarship is not one that needs to be repeated next January.