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A Critique of the Austrian Business Cycle Theory… by an Austrian Economist

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I do not believe your credentials as "Austrian economist".

From one perspective, money is neutral

And do you ever address the Austrian perspective?

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I understand the Austrian perspective. If money is printed there is a redistribution of wealth from savers to borrowers even if the inflation increases evenly throughout the economy. Of course, the inflation is always uneven which causes further distortions.

My point though, is that typically Austrians state that the ultra-low interest rates created by the central bank confuses businessmen into making malinvestment. I agree. But why do they ignore all the other government interventions? Low interest rates encourage consumers to spend more instead of saving. What about programs like social security, and government guarantees? Those create capital consumption too, yet they are not part of monetary policy.

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Wheylous replied on Thu, Jan 5 2012 10:00 PM

So you agree that money is neutral?

Also, can you label the other curves for me and explain what type of firm has this graph?

 

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Lawrence replied on Thu, Jan 5 2012 10:06 PM

You're not listening. I am not saying money is neutral. I was simply illustrating how the overemphasis on money is too much of a narrow view. You should read the whole article.

It's a monopoly firm. Marginal revenue. Marginal cost. Economic profit. Why do you ask?

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Wheylous replied on Thu, Jan 5 2012 10:09 PM

Alright then, you pass :P

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Jargon replied on Thu, Jan 5 2012 10:29 PM

Wheylous could you explain the graph?

Land & Liberty

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Lawrence replied on Thu, Jan 5 2012 10:48 PM

Why are you asking Wheylous? What do you want to know? The photo is a neoclassical representation of a monopoly. In perfect competition the demand curve is horizontal, so price is equal to marginal revenue. For a monopoly, the more it sells the less it can get for the marginal/incremental unit because of the elasticity of demand. The upward sloping curve is the marginal cost, the cost to produce each additional unit.

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Gero replied on Thu, Jan 5 2012 11:30 PM

“The Austrian analysis is correct but it is lacking in scope. The reason I make this point is because it is absolutely possible for a business cycle, characterized by the boom and bust, to occur even when there is no monetary expansion.”

Austrian business cycle theory explains inflation-induced recession, not all recessions. War or natural disaster can cause a recession, but those are more understandable causes. Money supply growth fueling malinvestment, boom, and then bust is more complicated, so ABCT explains it.

“Any coercion, namely from the government, will distort the free market and, by logical deduction, destroy wealth.”

Nitpicking point: anyone heard of the kill-your-TV theme? Maybe destroying one’s television will cause one to be happy and to destroy wealth, so your claim is falsified in one case.

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Gero:
Nitpicking point: anyone heard of the kill-your-TV theme? Maybe destroying one’s television will cause one to be happy and to destroy wealth, so your claim is falsified in one case.

I'll nitpick right back.  If the destruction of a television brings personal satisfaction to the owner, then its destruction is merely the owner consuming a good.  If not, drinkning milk or lighting a fircecracker would also be destruction of wealth.  You can't have your cake and eat it too, so to speak.

Further, if one views one's television as garbage, then its destruction is certainly not the destruction of wealth, any more then throwing used coffee grounds and banana peels into the trash to be carted to a landfill.


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Lawrence,

Having skimmed your article you are in general correct. Guido Hulsmann wrote a paper on this entitled a General Theory of Error Cycles and this paper on the Calculation debate gives a deeper theoretical base for the General Theory.

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Wheylous replied on Fri, Jan 6 2012 10:15 AM

Sorry Lawrence, I was just tired of arguing with some people about economics who had never taken a class in it and then transfered the resentment into this thread.

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Wheylous:

Sorry Lawrence, I was just tired of arguing with some people about economics who had never taken a class in it and then transfered the resentment into this thread.

 

Isn't Neo-Classical monopoly theory a bit of a poor litmus test for economic understanding?

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Seeing as this is an Austrian Economics forum, quite obviously it is.

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Neodoxy replied on Fri, Jan 6 2012 11:44 AM

Lawrence. I believe that your analysis in the artical is mostly incorrect. Particularly I think you

A. Misunderstand Austrian Business Cycle Theory in terms of the mechanisms which cause it

B. Misunderstand the difference between the boom bust cycle and capital consumption/falling living standards

C. Slightly simplify the process of capital accumulation.

Specfically, I believe that every government interference that you list, with the exception of the fifth one, would not bring about a bust or boom, with the possible exception of the fifth that you list. With this being said, depending upon the timing of the interventions they exacerbate or hasten the process. I realize that I could be wrong about any of this so if what I state is not the case then feel free to challenge it.

Now for my first claim. It doesn't seem as though you understand exactly what causes ABCT, although you certainly understand the basic idea. Now you start off your artical with:

"Austrian business cycle theory(ABCT) narrowly states that it is monetary stimulus that creates the boom. A misallocation of resources occurs, as a result of artificially low interest rates brought on by loose monetary policy, leading to an inevitable bust. The bust occurs as the free market corrects the imbalances, brought on by government-distorted price signals, within the economy."

This is absolutely correct, but it is incredibly dumbed down. Someone reading this couldn't say why this actually occured. It is quite comparable to me saying "price controls are negative because they prevent prices from reaching equilibrium". Once again, perfectly true, but the person making the statement might not even understand why it is because it's shorthand for a much more complicated process.

For instance you go on to say:

"Business cycles occur because of government interventions that force the free market to stray from its optimal outcome."

Technically true but this doesn't really mean anything. Indeed this might be the source of your error in failing to realize that the BBC is caused, not by intervention involving capital per se, but rather a specific type of intervention involving capital. In one of the few passages where you seem to directly address one of the mechanisms of the business cycle you state:

"The source of the boom is not monetary policy but the effect of monetary policy which is capital consumption"

This is incorrect. This may well be an affect of the boom but it is certainly not the cause, and one could see a world in which no actual net capital accumulation occured although this is unlikely. The cause of the boom is misallocation caused by temporary monetary disequilibrium, which is a fancy way of saying that investors think that they have more money than they actually have and so they invest on projects that will not result in fruition because of the scarcity of capital which in turn leads to an increase in the price of capital and factors of production so that investors don't have enough money to buy all of what they need in order to complete their projects, which means that there is mass firm failure. It has nothing inherently to do with capital consumption as much as capital "misinterpretation"

For instance let's take a world in which there are two investors. These investors normally spend 10 dollars on long term projects. Suddenly they find that over night each one of them has 20 dollars to spend. What they don't realize is that this money is new money, reflecting no actual increase in the amount of resources available to them.

So they see projects which used to be priced at the old levels. So for instance it might have taken 16 dollars to build a car factory before, but of course they could not afford it before (we'll assume that they don't like cooperating). So now they each begin to invest in a car factory, but the problem is that they have to spend money to do this. They are each competing over the same resources, the same capital, and so they each keep bidding the capital up and up in price until neither one of them can afford it. Now this might have been fine if there was the corrusponding decrease in consumer spending like there is when there's an increase in natural time preference, leading to a period of time over which more capital could be produced, but  the problem comes in that they have also bid up the price of labor and land. Labor in particular is important because this means that laborers have more money to spend and consumer prices also rise which in turn forces the structure of production back to current production. This means that the projects our investors are trying to fulfill won't work because of the fact that prices in general have finally risen to equlibrium levels, and they're trying to invest without enough funds that will bid away capital and labor from the task of providing current goods for future goods. Mass business failure results.

Captial consumption has nothing to do with our equation, the boom might go on long enough, should more and more money be created, to diverge the structure of production enough to actually result in slight net capital creation.

So for instance your assertion:

"If the economy decides not to replenish it’s capital stock then it has a lot more resources to enjoy in the current period, and of course a lot less in the future. A simple example would be selling your cow for some milk. Feels good today, but not tomorrow."

Is entirely false. The boom is actually caused by an attempt to increase the number of cows, as it were, when really people desire current prices to be fulfilled rather than future ones, which is the free market level. What you are describing are the effects of inflation if it was all spent on current consumption and not a dime of it spent, which diverges capital accumulation from its actual height and results in a decrease in investment. It is a different type of boom and bust cycle usually described by the austrian school. It would not lead to an actual misallocation of capital which is the usual standpoint of the cycle. We also can't determine a priori whether or not this will lead in actual capital consumption. It will lead to a decrease in living standards, but there will be no bust as such. There would be misallocation but this would lead to direct investment because the entire point about investment is that it is a process that takes time, whereas current production takes very little, so the transition from current to future production would take very little time at all.

With this in mind let's see what you claim aid in the BBC

"Social Security discourages saving for retirement by telling citizens that their money is being saved by the government.(Social Security is a Ponzi scheme)"

This leads into capital consumption, not a boom or bust. It would end in a long term decrease in living standards, however.

"The high taxes and regulations on the manufacturing industry make the industry less competitive in the global market. If the government erects barriers to entry in the manufacturing industry then capital flows towards the service sector."

This has nothing to do with the boom or bust cylce

"Heavily taxing the rich people and then redistributing the wealth to poor people encourages capital consumption."

See above

"When the government guarantees loans it artificially lowers interest rates(by removing the risk premium) which is similar to the effects of monetary policy"

Now this one I agree with, although this once again does not fit in exactly with traditional BBC, I'm not sure if Mises ever specifically addressed it. Governement makes unsafe loans look more secure than they actually are, this leads to an increase in investment into unsafe ventures. This could well lead to mass firm failure, especially if there is already a misallocation of resources towards capital accumulation. This is what I personally attribute the severity of the current depression for.

Does all of this make sense to you?

As for my final assertion it's not a point of major failure but it's still important to point out

 "If the government passed a law forbidding capital accumulation (specifically factories, and not retail stores, restaurants, etc.) then capital would flow towards the service sector and away from the manufacturing sector. This law would have the result of encouraging consumer spending and would clearly inflate a large service sector, an identical consequence to what foolish monetary policy has accomplished."

Capital accumulation does not just mean factory investment. Capital accumulation is a very wide topic, but realistically it is an investment into anything that increases the number of different things which can be produced or the magnitude of things whch can be produced. So for instance investments in human capital and research are both things off the top of my head which lead to this. 

Sorry if this was TL;DR

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Lawrence replied on Fri, Jan 6 2012 11:51 AM

"War or natural disaster" is an interesting point. Although, there isn't always a "bust" that follows wars and natural disasters. After WWII, there was a huge boom in the economy, not a bust as the Keynesians predicted. A natural disaster would create an increase in GDP for reconstruction, but no bust would follow.

There is something unique about the boom-bust cycle characterized by unpredictable upward and then downward fluctuations in GDP. Politicians always want to trade short-term gain for long-term pain. So they encourage capital consumption. But it's not just a monetary phenomena like the Austrians claim, there is so much more.

"Nitpicking point: anyone heard of the kill-your-TV theme? Maybe destroying one’s television will cause one to be happy and to destroy wealth, so your claim is falsified in one case."

No, you misunderstood me. I use the word "wealth" as purely subjective. A "television" is not wealth. A television is just a piece of metal and plastic. Wealth is what people value. Let me rephrase:

“Any coercion, namely from the government, will distort the free market and, by logical deduction, destroy [utility].”

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Gero replied on Fri, Jan 6 2012 12:04 PM

“I'll nitpick right back.  If the destruction of a television brings personal satisfaction to the owner, then its destruction is merely the owner consuming a good.  If not, drinkning milk or lighting a fircecracker would also be destruction of wealth.  You can't have your cake and eat it too, so to speak.

Further, if one views one's television as garbage, then its destruction is certainly not the destruction of wealth, any more then throwing used coffee grounds and banana peels into the trash to be carted to a landfill.”

Point conceded, JackCuyler.

“there isn't always a "bust" that follows wars and natural disasters.”

I view the business cycle as the chronology of all recessions, regardless of how they occurred whereas you view it as strictly ABCT explained recessions which is understandable since ABCT explains many of them.

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Lawrence replied on Fri, Jan 6 2012 12:17 PM

It wasn't too long, I did read it. Thank you for replying. Unfortunately for you, I disagree with you almost completely.

The reason I mention capital consumption is because typically the Keynesians ask why the boom has an increase in GDP. If it's artificial then why are more consumer goods being produced? The answer is that capital consumption allows the economy to temporarily produce more but only at the expense of producing less in the future.

"This is absolutely correct, but it is incredibly dumbed down." I didn't want to waste time re-explaining what ABCT is.

The real source of the boom seems to stem more from consumers using the low interest rates to spend like crazy. I agree that artificially low-interest rates can also lead to mistakes among businessmen. However, doesn't it make more sense to see look at the situation from the consumers side. If there are low interest rates then consumers spend more, which tricks businessmen into thinking there is increased demand which prompts them to expand then the interest rates rise, consumers begin to save, so the business doesn't have customers and the bust occurs.

Social security obviously encourages people to spend which makes them feel wealthier. As they spend more and save less businessmen invest in retail stores. Eventually, the bust will come when consumers recognize that social security is a ponzi scheme. The consumers will rush to save which will mean they arent spending which will crush the retail stores(bust).

 

 

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Neodoxy replied on Fri, Jan 6 2012 12:34 PM

The real source of the boom seems to stem more from consumers using the low interest rates to spend like crazy. I agree that artificially low-interest rates can also lead to mistakes among businessmen. However, doesn't it make more sense to see look at the situation from the consumers side. If there are low interest rates then consumers spend more, which tricks businessmen into thinking there is increased demand which prompts them to expand then the interest rates rise, consumers begin to save, so the business doesn't have customers and the bust occurs.

Then I'm sorry but you're not talking about ABCT, which is entirely about malinvestment. I would reccomend chapter 20 section 6 of Human action and chapter 12 section 11 in Man, Economy, and State.

I will write a critique on your theory later.

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Lawrence replied on Fri, Jan 6 2012 12:58 PM

It's still similar to ABCT because I agree that monetary policy is one method of creating the business cycle, as a result of both the consumer AND producer errors. Otherwise, ABCT is simply wrong, or at best, largely incomplete.

"I will write a critique on your theory later."

I can't wait.

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"Then I'm sorry but you're not talking about ABCT, which is entirely about malinvestment."

Oh also, I am talking about "malinvestment". The malinvestment stems from producers thinking there is an increase in demand for their retail-store business when consumers use the low interest rates to spend more and save less. Eventually interest rates rise, since there is less real savings in the economy, which prompts consumers to spend less and the malinvestment in retail-stores(or restaurants, anything service-related) is revealed.

 

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Just because it's neoclassical doesn't mean it's wrong (not saying it's right either). Plus, if you want to critique the mainstream you should at least know what it teaches.

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