Edmund Phelps’s “False Hopes for the Economy-and False Fears” (WSJ 6/3/03) attempt to undermine the current resurgence of interest in Austrian cycle. He states, “One of the most unreasoning fears, yet pervasive, is the nightmare of interwar Austrian cycle theory: ‘overinvestment’. But in truth, what should be real is the fear of the consequences unsustainable boom and what is blatantly false if Phelps’s characterization of the Austrian cycle theory.
The Austrian cycle theory is a theory of the misdirection of production-malinvestments-which may be accompanied by overinvestment and overconsumption. Most ‘Austrians’ would agree with Phelps that “world markets would react to the addition of capital with a sharp drop of interest, a skyward jump of capital goods prices, and immediate lift of real wages and jobs.”
But Phelps, unlike the Austrian, fails to realize that a sudden addition of capital is not heaped on the world; it comes from increased saving. The boom-bust cycle develops because credit creation through central bank intervention in the economy causes markets ro respond as if more ‘capital’ was available when in fact it is not. The bust and necessary readjustments develop when the misdirections of production of the economy and the relative scarcity and possible consumption of capital are discovered.
