Edmund Phelps of Columbia University writing in the WSJ (June 3, 2003) critiques the Austrian (Mises-Hayek) theory of the business cycle with no reference at all to the central-bank induced artificiality of the boom phase, which is the very core of the theory:
One of the most unreasoning fears, yet pervasive, is the nightmare of interwar Austrian cycle theory: “over-investment.” Wall Street gurus say that the investment boom, with its extra purchases of capital goods (and extra jobs to make them), caused capital stock to get “ahead of itself,” with the result that capital-goods spending (and output) will for years be below its normal path -- to give wear & tear and obsolescence the chance to work off some of the excess capital and to permit the economy to grow into the rest. If that is right, employment will also stay for years below its normal path. A slump after the boom.
But, first, what if only a small part of ‘90s investment is proved to be overinvestment? No slump should follow an investment boom inspired by new expectations of some outsize future productivity gain if they prove correct -- a sort of rational boom. The capital stock surges up only in proportion to the expected rise of productivity, and when the productivity gain is realized annual investment drops back to its normal ratio to (increased) output -- never below its trend-path -- and employment falls back to normal.
On overinvestment, the Austrians really had no argument. Imagine a sudden addition of capital was heaped on the world. The growth rate of capital stock would have to drop. But, for that, it would be more than enough that gross investment not increase as a ratio to the (increased) capital stock; it wouldn’t require a decrease of investment or of jobs, let alone collapse. Indeed, a model of mine says world markets would react to the addition of capital with a sharp drop of interest rates, a skyward jump of capital goods prices, and an immediate lift of real wages and jobs! The saving point for the Austrian contention is that if the overinvestment is concentrated in the U.S., the U.S. alone cannot achieve the full drop in interest rates required because it is just one part of the world economy. But that won’t wash if overinvestment was not much less important in Europe and Asia.
Before finishing with overinvestment, consider a related fear. It is that, with the capital stock pushed far higher in the last decade than will be justified by productivity gains in this one, expected rates of return on business assets must have fallen, so the rates of interest required for unemployment to attain and stay at its natural rate must have fallen similarly. The worry is that, if a recession were to arise, the economy would be faced with the need for interest rates of close to zero, even below zero. Should that come to pass, vast parts of the financial system would go under, unable to provide a return competitive with that of good old cash. Then disinflation would pick up and lead to deflation, intensifying the problem.
