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New attempt to debunk ABCT

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myhumangetsme Posted: Wed, Sep 5 2012 10:55 PM

Happened to see this link posted on Wenzel's blog to a very recent research paper from Notre Dame University:

Here's the abstract:

Austrian Business Cycle Theory, as espoused by Mises (1912,1949) and Hayek
(1935), predicts changes in the economy's structure of production following an unex-
pected change in monetary policy. In particular, the theory predicts that following a
credit expansion the production and price of goods further away from nal consumption
increase relative to the production of other goods in the economy. Despite the emphasis
on the importance of relative prices and the structure of production, most of the existing
empirical work discussing the relevance of the theory uses aggregate data. We rectify
this, by using stage-of-process data to illustrate the relevance of the theory. We fi nd that
mechanisms emphasized by the theory are either not supported by the empirical results
or are of second order importance in explaining the e ffects of monetary policy.

I haven't had a chance to read it, but my skim of the paper says faulty interpretation(s) of ABCT, but I thought I'd put it out for the forum to dissect.

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Jargon replied on Thu, Sep 6 2012 8:40 AM

Just noticing a few things from the abstract:



"Unexpected change in monetary policy."
It's my understanding that whether the change is expected or not is irrelevant. What is of importance is the direct effect on credit conditions, cheapening the costs of business. The business cycle may still occur when CEO's predict a rate cut in the future because, alas, they will put that rate cut to use just as they would had they not foreseen it.


"Most of the existing empirical work discussing the relevance of the theory uses aggregate data. We rectify this, by using stage-of-process data to illustrate the relevance of the theory."
So... still using aggregated data? I don't know but 'stage-of-process' sounds like aggregate data along the timeline of the structure of production, but I'm not sure. But how are the stages of production classified?


I'll probably give it a read soon.

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Autolykos replied on Thu, Sep 6 2012 11:24 AM

The ABCT predicts that a central bank expansion leads to a misalignment between the natural and the market rate of interest with the latter decreasing relative to the former. Entrepreneurs mistakenly believe that consumers have shifted demand in favor of future consumption relative to current consumption and, consequently, move factors of production into earlier stages of production. While more resources are allocated to stages early in the production process, consumers simultaneously raise their demand for current goods due to the decrease in the market rate of interest. Mises (1912) referred to these phenomena as malinvestment and overconsumption and noted that these characteristics represent the boom phase of the business cycle. Since the new entrepreneurial time pattern of production is inconsistent with consumer preferences, this structure of production is unsustainable and eventually must be corrected. Entrepreneurs running up against increasing binding resource constraints realize the errors in their plans and liquidate projects. The bust phase is characterized by declining income paid to factors, including labor, as well as a contraction in investment and consumption.

I don't think this is quite right. In the case of the US, the Federal Reserve directly sets the interest rate at which member banks borrow from it (called the "discount rate") as well as the reserve requirement for member banks; and indirectly sets the interest rate at which member banks borrow from each other (called the "federal funds rate") through what are called "open-market operations". Open-market operations involve the Federal Reserve either purchasing US government securities from financial institutions which possess them (called "primary dealers") or selling US government securities that it possesses to those financial institutions. Importantly, whoever is on the selling side of the transaction also agrees to buy back the securities after some period of time, typically within one to seven days.

When the Federal Reserve is on the buying side of an open-market operation, the seller's bank reserves increase, enabling it to make more loans than it otherwise would've been able to (due to fractional-reserve banking). Conversely, when the Federal Reserve is on the selling side, the buyer's bank reserves decrease, with a subsequent decrease in its ability to make loans. As a result, the primary dealers' abilities to make loans are affected by whether the Federal Reserve is purchasing more US government securities from them than it's selling to them, or vice-versa. This has derivative effects on other financial institutions that are tied into the Federal Reserve System, but aren't primary dealers.

Generally speaking, banks can make loans to producers and consumers. I'll define a "producer loan" as a loan that's used largely (if not entirely) for operating a business, and a "consumer loan" as a loan that's used largely (if not entirely) for financing consumer purchases. All other things being equal, people will become more willing to take out producer and/or consumer loans if the interest rates on those loans decrease. This is a result of the supply of loanable funds increasing. Note that the demand for loanable funds has not changed - this is important.

Some producer loans will go to starting new businesses, while others will go to maintaining/expanding existing businesses. In the case of the former, this will lead to new goods and services appearing in the market. In the case of the latter, this will lead to increased supply of at least some existing goods and services. Both also amount to increased (business) income for the borrowers, which will increase their demand for various inputs for their goods and/or services. Consumer loans also amount to increased income for the borrowers, which will increase their demand for consumer goods. (Ceteris paribus applies to all of this, of course.) The important thing here is that demand could well increase more or less evenly across all stages of production.

What, then, causes the inevitable bust? I'd say it's the adjustment of prices to the increased money supply, which can only happen after the money supply has increased. All other things being equal, price inflation leads to increased demand for loanable funds. If the lenders want to make the same amount of profit as they did before, they'll now need to loan out even more money. This would require additional expansion of the money supply by the central bank (in this case, the Federal Reserve), and so on, and so forth. As Mises wrote 100 years ago, this leads to either a "crack-up boom" in which the money supply expands to the point where people no longer have any confidence (i.e. hyperinflation occurs), or the central bank stops expanding the money supply in order to forestall such a crack-up boom from happening (as it would unravel the whole game).

In other words, distortion of the production structure doesn't actually seem to be required by the ABCT. The monetary expansion carries the seed of economic malaise even if the production structure remains exactly the same.

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