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Can the crash in the Baltics be explained by Austrian Business Cycle Theory?

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Robert Dinero posted on Sat, Mar 31 2012 12:43 PM

On a Post-Keynsian blog, "Lord Keynes" has written about how horrible the economies of Latvia and Lithuania have been recently.  What I want to know is, can the Baltic boom of the 2000s that preceded the current bust be explained by Austrian Business Cycle theory? I don't know enough about the Scandinavian banking system or the particulars of the Baltic economies to know.

Thanks.

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Oops, here is the blog link:

socialdemocracy21stcentury.blogspot.com

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None of the 2000s real estate bubbles, the booms and busts are explained by ABCT.

(1) The Austrian Business Cycle Theory (ABCT) holds that central bank fiat money or fractional reserve banking-induced increases in credit (unbacked by commodity money) drives down the monetary rate of interest, causing it to go below the unique Wicksellian natural rate of interest. This causes malinvestment in capital goods sectors. However, the unique Wicksellian natural rate of interest does not exist, and is a pure fantasy:

http://socialdemocracy21stcentury.blogspot.com/2011/06/natural-rate-of-interest-wicksellian.html

http://socialdemocracy21stcentury.blogspot.com/2011/06/austrian-business-cycle-theory-and.html

http://socialdemocracy21stcentury.blogspot.com/2011/06/austrian-business-cycle-theory-and.html

(2) The ABCT does not explain or deal with reckless lending by banks to people for mortgages or consumer goods, and nothing about financial or real asset bubbles, and nothing about financial crises. The irrelevance of ABCT to the real estate bubble of the 2000s and financial crisis of 2008 can be seen in a passage in Rothbard’s Man, Economy, and State (2004 [1962]: 994–1008):

“What happens, however, when the increase in investment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? …. What are the consequences? The new money is loaned to businesses.110 These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original factors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the [new money is] … therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors. The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and … lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production structure is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on projects formerly unprofitable.

[footnote]
110 To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur."(Rothbard 2004 [1962]: 995–996).

-------

In other words, the mechanisms causing recession or depression as postulated by both Rothbard’s theory and the earlier Hayekian versions of ABCT do not occur if the money is mainly loaned to consumers.

ABCT assumes that newly created credit money is mainly loaned out to businesses (causing malinvestments in capital goods), and not to consumers to a significant degree. In this case, we can already see that Rothbard’s version of ABCT cannot be a serious explanation of the housing bubbles in Latvia, or indeed the US or other nations in the 2000s, nor the US financial crisis of 2008, because credit flowed to housing, a consumption good.

 

 

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As usual you spread your ignorance, Lord Keynes. Your are very impressive you know. I don't know what to say now.

the unique Wicksellian natural rate of interest does not exist (Lord Keynes)
Saying that the existence of multiplicity of interest rates disproves the ABCT is like saying that the amount of saving can’t determine the amount of money the bank could loan. Remember that : the less people consume and the more people save, the more banks loan money, and the more the production structure lengthens. That’s the core of ABCT.
The ABCT does not explain or deal with reckless lending by banks to people for mortgages or consumer goods, and nothing about financial or real asset bubbles, and nothing about financial crises. (Lord Keynes)
Really ? H de Soto wrote :
Only securities which represent the property of the companies closest to consumption will undergo a temporary, relative decline in price, as a result of the immediate, negative impact of the decrease in the demand for consumer goods that is generated by the upsurge in saving.
 
Therefore it is clear that, contrary to popular opinion [...] the stock market does not necessarily reflect mainly companies’ profits. In fact, in relative terms with the capital invested, the accounting profits earned by the companies of the different stages tend to match the interest rate. Thus an environment of high saving and low relative profits (i.e., with a low interest rate) constitutes the setting for the greatest growth in the market value of securities representing capital goods. Moreover the further the capital goods are from final consumption, the higher the market price of the corresponding securities. In contrast, growth in relative accounting profits throughout the productive structure, and thus in the market rate of interest, other things being equal, will manifest itself in a drop in the value of securities and a consequent fall in their market value.
 
If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, the boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted.
In fact the lowering of the interest rate gives the appearance of profitability and generates an excess of optimism ("animal spirits") because everything seems to increase at the same time (consumption, investment, profit, etc.). This cannot happen when the lengthening of production structure is sustained by savings. Bubble cannot inflate without credit inflation.
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Lord Keynes:
None of the 2000s real estate bubbles, the booms and busts are explained by ABCT.

Um.

Crash Proof

Meltdown

Overdose (not intended to be Austrian, but the facts presented show how the situation aligns with ABCT)

The Bubble (see the production blog for interviews with Austrians)

Austrian predictions

The Bailout Reader

 

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"Saying that the existence of multiplicity of interest rates disproves the ABCT is like saying that the amount of saving can’t determine the amount of money the bank could loan. Remember that : the less people consume and the more people save, the more banks loan money, and the more the production structure lengthens."

The non-existence of the Wicksellian unique natural rate of interest is a severe blow against the Hayekian verison of the ABCT, and if you wanted to discuss the subject with minimal honesty, you'd would admit that even Robert P. Murphy and J. G. Hülsmann  say actually what I said, and what Piero Sraffa said back in 1932:

http://socialdemocracy21stcentury.blogspot.com/2012/02/hulsmann-on-misess-business-cycle.html

http://socialdemocracy21stcentury.blogspot.com/2011/07/robert-p-murphy-on-sraffa-hayek-debate.html

The Hayekian ABCT is premised on absurd assumption of  an initial equilibrium state: no idle resources, no idle stocks of goods, no signiicant unemployment. It also ignores the role of international trade in open economies, which works to relieve relative scarcities when these do in fact occur.

Even versions of ABCT dispensing with a Wicksellian natural rate of interest fail to explain why the cycle effects would happen if factor inputs were not scarce and available through international trade. These alternative versions still show the legacy of irrelevant equilribium thinking.

 

 

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Lord Keynes:

This has to be a joke.

Your claim is that the crisis of 2008 can't be explained by ABCT, and I reference several sources doing exactly that (which you obviously didn't even look at, as you called them "articles" when only one could even be considered an "article" and the rest were entire books or feature length films dedicated to the subject.)  Your response is this link of a bunch of blog posts which, from what I can tell is nothing more than your own simple commentary on the theory in terms of differences between various thinkers.

The only link in that list that looks even remotely close to refuting anything like your claim here is the first one "Austrian Business Cycle Theory: Its Failure to explain the Crisis of 2008”.  So I clicked it.

For the first 500 words or so you're simply trying to establish what ABCT is (in an abstract sense), and the notion that there are differences held regarding it among various scholars.  Okay, fair enough, I suppose an introduction is in order.  Then you explain that you picked Rothbard's explanation from Economic Depressions to analyze, and spend the next 1000 words reproducing text from that book, followed by another 500 words basically amounting to nothing more than: "Austrians weren't the only ones to predict it!  There were some Keynesians and such who did too!  And...and...and besides!  Just because Austrians predicted it using their methodology doesn't mean their theories are accurate!"

As you can see, it could have been done in a lot less words.

Finally, in the last 200 words you basically hinge on Rothbard's emphasis of malinvestments by "businesses" to claim the entire theory can't explain anything about the 2008 crisis because people aren't businesses.

Seriously?  This is your big debunking?

Perhaps if you'd actually read the data surrounding the 2008 debacle (including the data of the boom that led up to it, of course), and would actually read any of the Austrian sources applying ABCT to the specific case, you might actually begin to have something to try and refute.

All you've done here is taken a few paragraphs-worth of abstract explanation of the theory itself from one scholar (after going to great lengths to express that there are many "different forms" of it), and then bascially said "See?  This guy says ABCT says businesses malinvest...and in the housing bubble, it was individuals!  ABCT busted!  Muuuhuhahahahah!"

Granted, you muddy it up with verbose explanations of things that are essentially irrelevant, so a typical reader would get lost and just assume you've done a good job simply because the post is so "extensive" and "detailed"—an image propped up by the completely unnecessary bibliography.

Again, if you actually have something that actually refutes an Austrian scholar's application of ABCT to the mid 2000s bubble and resulting bust, I'd be happy to see it.  But if all you ever do is just quote mine various abstract explanations of the theory and then data mine factoids that seem to not align with the quote you mined previously, then I see no reason to even have to bother with you.

 

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John James : "All you've done here is taken a few paragraphs-worth of abstract explanation of the theory itself from one scholar"

you said that better than I would have

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Do Austrians assume that there are no idle resources?

"The limits of my language mean the limits of my world." ~ Ludwig Wittgenstein
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Fool on the Hill, see my reply to LK in his blog :

Lord Keynes, you ironically give the evidence that you never read Huerta de Soto (or at least not entirely). You can only fool those who never read and learn about ABCT. See what de Soto had to say, in his book (2006) :

 
The theory of the business cycle teaches precisely that credit expansion unbacked by an increase in real saving will encourage the malinvestment of productive resources even when there is a significant volume of idle resources, specifically, unemployed labor. In other words, contrary to opinions expressed by many critics of the theory, full employment is not a prerequisite of the microeconomic distortions of credit expansion. When credit expansion takes place, economic projects which are not actually profitable appear so, regardless of whether they are carried out with resources that were unemployed prior to their commencement. The only effect is that the nominal price of the original means of production may not rise as much as it would if full employment existed beforehand.
Nevertheless the other factors which give rise to malinvestment and a spontaneous reversal, in the form of a crisis and recession, of the errors committed eventually appear, regardless of whether the errors have been committed with originally-unemployed resources.
 
An artificial boom based on bank credit expansion which reallocates previously-unemployed original means of production merely interrupts the process of readjustment of those factors, a process not yet complete. Consequently a new layer of widespread malinvestment of resources overlaps a previous layer which has yet to be completely liquidated and reabsorbed by the market.
 
Another possible effect of the use of previously-idle resources is the following: apart from the fact that their price does not increase as rapidly in absolute terms, they may make a short-term slowdown in the production of consumer goods and services unnecessary. Nonetheless a poor allocation of resources still takes place, since resources are invested in unprofitable projects, and the effects of the cycle eventually appear when the monetary income of the previously-unemployed original means of production begins to be spent on consumer goods and services. The relative prices of these goods and services rise more rapidly than the prices of products from the stages furthest from consumption, thus diminishing real relative wages and setting off the “Ricardo Effect” and the other effects which lead to crisis and recession. In any case credit expansion will always, from the outset, cause a more-than-proportional increase in the relative price of products from the stages furthest from consumption. This rise stems from the new monetary demand credit generates for these goods and from the artificial reduction in the interest rate, which makes such projects more attractive. This results in a lengthening of the productive structure, a change which cannot be maintained in the long run and which is completely independent of whether previously-idle resources have been used in some of such projects.
 
Austrian theory does not, as is often suggested, assume “Full Employment.” It assumes that in general, at any moment, some factors are scarce, some abundant. It also assumes that, for certain reasons connected with the production and planned use of capital goods, some of these scarcities become more pronounced during the upswing. Those who criticize the theory on the ground mentioned merely display their inability to grasp the significance of a fundamental fact in the world in which we are living: the heterogeneity of all resources. Unemployment of some factors is not merely compatible with Austrian theory; unemployment of those factors whose complements cannot come forward in the conditions planned is an essential feature of it. (Lachmann, Capital and its Structure, pp. 113–14)
P.S. Reply with "Quote" does not work...
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"Lord Keynes, you ironically give the evidence that you never read Huerta de Soto"

(1) I've read Huerta de Soto, thanks.

(2) My comment above about an initial full employment equilibrium state applies to Hayek's ABCT and Hayekian verisons of ABCT.

Hayek made this pefectly eplicit in correspondence with John Hicks:

"Hicks to Hayek, November 27, 1967
“... We have (a) full employment, (b) static expectations, (c) ‘equilibrium’ at every stage, so that demand = supply in every market, prices being determined by current demand and supply. ....."

Hayek to Hicks, December 2, 1967
“I accept assumption (a), full employment. .... Of (c) I can accept that at each stage in every separate market demand = supply in the sense that at the ruling price all buyers and sellers buy and sell as much as they want to buy at that market, but not in the sense that any change in the supply which a change in price will bring about in the course of time has already taken place or that prices correspond to the marginal costs at which producers now begin to produce.

Nor need there [be] at any but the initial stage an overall equilibrium between the different markets ..."

Hayek, F. A. von, 1999. Collected Works of F.A. Hayek, Volume 6: Good Money, Part II: The Standard, Routledge, London. pp.  100–102.

Full quotation of the letters here:

socialdemocracy21stcentury.blogspot.com/2012/02/economic-calculation-part-3.html

More on the collapse of Hayek's theory:

http://socialdemocracy21stcentury.blogspot.com/2012/01/hayeks-trade-cycle-theory-equilibrium.html

(3) When De Soto and Lachmann retreat from the full employment equilibrium assumption this is nothing but a concession that Hayek's critics were right.  Just like the devastating point that the Wicksellian unique natural rate of interest doesn't exist, this is a blow against the Austrian ABCT.

(4) These other versions of ABCT abandoning a full employment assumption still require relative scarcities of factor inputs is a prerequisite. What happens when these inputs are not scarce? The theory is also ridiculously flawed by its inability to model what happens in an open economy, through international trade.

If that isn't bad enough, the development of any boom in the business cycle is dependent on a myriad of factors, and whatever future profit any particular capital goods project will deliver can only be a matter of subjective expectation in the present. A rise in interest rates may decrease the demand for credit and raise the burden of servicing debt, but, if there is a mutual expectation that a particular investment might deliver future profit by the bank and business, it is normal for businesses to refinance their investment loans or have the loans rolled over by banks.

(5) As Robert Vienneau has argued, there is no necessary reason why lower interest rates would cause production to be re-oriented to higher-order capital goods anyway, and even classifying capital structure into well-defined higher orders is dubious in itself (see Vienneau 2006 and 2010).

Vienneau, R. L. 2006. “Some Fallacies of Austrian Economics,” September
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=921183

Vienneau, R. L. 2010. “Some Capital-Theoretic Fallacies in Garrison’s Exposition of Austrian Business Cycle Theory,” September 4
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1671886

(6) ABCT assumes that credit flows primarily to producers engaged in capital goods investments. It is obvious that this is a grossly simplistic and unrealistic assumption in the modern world. Credit today is a complex composite of flows to create consumer loans, loans to speculators on assets or primary commodities, and loans for capital goods investments. When booms in business cycles are primarily driven by credit flows to speculators who blow asset bubbles, the dynamics of the boom are different from those of booms in (allegedly) unsustainable high-order capital goods investments, as assumed by ABCT. Minsky's financial instability  model is a far better explantion of such business cycles.

(7) It is interesting that you reproduce a quote from Lachmann. What you don't say is that Lachmann did not believe that ABCT  was a universal theory of trade cycles:

"The Trade Cycle cannot be appropriately described by means of one theoretical model. We need a number of models each showing what happens when certain potential causes become operative. The many models that have been constructed by economists in the past are therefore not necessarily incompatible with each other. Overinvestment and underconsumption theories, for instance, are not mutually exclusive. None of them of course is the true theory of the Trade Cycle; each is probably an unduly broad generalization of certain historical facts. Once we admit the dissimilarity of different historical fluctuations we can no longer look for an identical explanation. In dealing with industrial and financial fluctuations eclecticism is the proper attitude to take. There is little reason to believe that the causes of the crisis of 1929 were the same as those of the crisis of 1873.” (Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City. pp. 100–101).

Lachman didn't even believe ABCT explained America's boom and bust in 1920s-1933.

Nor did Israel M. Kirzner regard ABCT as a universal theory of trade cycles:

“AEN: Do you accept the idea that interest-rate manipulation by the central bank can cause distortions in the structure of production?

KIRZNER: Certainly the Austrian cycle theory showed brilliantly how this can happen. But it’s one thing to develop a theory which could explain a downturn. It’s quite another to claim that historically every downturn is to be attributed to that particular theory. That does not necessarily follow. If one were asked, does this theory necessarily explain each and every cycle, I would say no.”
“An Interview with Israel M. Kirzner,” Austrian Economics Newsletter (vol. 17.1, 1997).

http://mises.org/journals/aen/aen17_1_1.asp

 

Your own big name theorists tell you that ABCT is a NOT universal theory that must explain every cycle ever seen in modern capitalist history.

Yet here you are flogging a dead horse desparately, trying to explain every cycle in history by means of the  theory.

 
 
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"I've read Huerta de Soto, thanks."

 
Good. I don't believe it.
 
"Just like the devastating point that the Wicksellian unique natural rate of interest doesn't exist"
 
Don't make me repeat myself. Saying that the existence of multiplicity of interest rates disproves the ABCT is like saying that the amount of saving can’t determine the amount of money the bank could loan. Remember that : the less people consume and the more people save, the more banks loan money, and the more the production structure lengthens. That’s the core of ABCT.
 
"As Robert Vienneau has argued"
 
 
"Lachman didn't even believe ABCT explained America's boom and bust in 1920s-1933."
 
Oh, really ?
Murray N. Rothbard calculates that the money supply in the United States grew from $37 billion in 1921 to over $55 billion in January 1929. These figures closely approximate the estimates of Milton Friedman and Anna J. Schwartz, according to whom the money supply increased from over $39 billion in January 1921 to $57 billion in October 1929.
 
Thus the price of securities increased four-fold in the stock market, and while the production of goods for current consumption grew by 60 percent throughout the period, the production of durable consumer goods, iron, steel, and other fixed capital goods increased by 160 percent. Another fact which illustrates the Austrian theory of the cycle is the following: during the 1920s wages rose mainly in the capital goods industries.
Over an eight-year period they increased in this sector by around 12 percent, in real terms, while they showed an average of 5 percent real growth in the consumer goods industries. In certain capital goods industries wages rose even more. For instance, they increased by 22 percent in the chemical industry and by 25 percent in the iron and steel industry.
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Rodolphe Topffer:
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See here.

 

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MaikU replied on Sun, Apr 1 2012 3:04 PM

As Lithuanian, yes, the country I live in experienced boom and bust. Actually it was all over the news, thing is, at that time I wasn't interested neither in economics nor anarchism to fully understand what' was wrong..

"Dude... Roderick Long is the most anarchisty anarchist that has ever anarchisted!" - Evilsceptic

(english is not my native language, sorry for grammar.)

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