Economics Questions

Re: The Austrian Business Cycle Theory is Flawed

Rodolphe Topffer — Fri, 19 Feb 2010 02:51:54 GMT

Esuric,

The Hayekian Triangle has been rebutted.

http://mises.org/journals/scholar/block18.pdf

Re: The Austrian Business Cycle Theory is Flawed

Esuric — Mon, 15 Feb 2010 09:42:42 GMT

These questions are perfect. I don't know what school of thought you were originally interested in, but you sound like an Austrian economist to me! My responses will not be short, but I'll try to keep them as short as possible.

Duckinstein:
In any ABCT I have read, there is little to no mention of the actual resources themselves and whether they need to be specific or not, all that is said is factors of production geared towards consumption can be used to fuel earlier production. Is there mention of training for different labor, specificity of capital goods, distance between where the factors of production were freed up and where they will be used, etc? No, all that I am aware of is that the capital blob of from any saving of resources can be used to fuel the expansion of earlier industries. This seems to be the fatal flaw in the Austrian argument, what one man saves may not necessarily be the resources that another man requires. One man’s trash may really not be another man’s treasure.

Austrian capital theory is in fact the only capital theory which includes and incorporates the heterogeneity and complementarity of capital goods. The efficiency/productivity of capital is not only determined by its physical characteristics, but also by the remoteness of its employment, and how it is employed. Each capital good can be used in a myriad of ways, also known as a "capital combination;" the role of the economic system is to assure that all capital goods are used most efficiently, that is, for the most productive capital combination. Indeed, Hayek's main point is that specific capital goods and labor are diverted away from their most warranted employments towards relatively (or absolutely) unwarranted employments, which are only profitable under the guise of pseudo-profits (inflation). And the complementarity and heterogeneity of capital is the central focus of Mises' "calculation argument." I suggest "Capital and Its Structure" by Ludwig Lachmann.

Furthermore, the notion of capital as a self-replenishing blob which can "flow" from one market to another comes from the Chicago school of economics, namely, Frank Knight. If you wish to read an Austrian refutation of this position, I suggest "The Mythology of Capital" by F.A. Hayek. Your criticism is entirely valid; unfortunately, it's not aimed at the Austrian school. The point of a recession is to liquidate portions of the malformed capital structure, freeing up capital goods for more warranted employments (melting down certain capital goods for scraps). The problem of the boom is that it structures capital in a very peculiar way, and the degree of capital heterogeneity and complementarity during the boom determines the severity of the bust (as well as government intervention)--or the restructuring process.

Duckinstein:
In a similar tone in regards to “factors of production”, the Austrians make reference to the “higher stages”, and the “lower stages”. Well, what is the difference? I understand that the Austrians emphasis subjectivity in their economics, ranging from the basic fact of human action to marginal utilities and entrepreneurial decisions, but at what is the dividing point between the higher and the lower? Or in other words, when do businesses stop experiencing the derived demand effect and instead the interest rate effect? How far into the structure of production or the Hayekian Triangle will the resources be free from?

When a good is ready for final consumption then it is considered a "consumer" good, or a "present good." But the physical characteristics of the good itself is immaterial--only the intended use of the good truly matters. For example, sugar may be a producer and consumer good--it depends on its employment. Sugar used for the production of candy is an intermediate producer good, but sugar used to sweeten coffee, for example, (which you're about to consume) is a consumer good. But steel, for example, is almost always (if not always) a producer good--thus a fall in "aggregate demand" (to use clumsy mainstream terminology) should affect the price of sugar more than the price of steel (a relative increase in the price of the latter)

Duckinstein:
So where do the resources come from to move the entire triangle outward?How do consumer goods industries, which initially lose their factors of production for later stages, suddenly get factors of production and expand? The Austrians, despite their highly complex view of time,saving, and production in the economy do not reveal these answers clearly.

The original means of production are released (labor and land), while the capital goods are reallocated (again, some capital goods have to be scrapped entirely, depending on the degree of their complementarity and heterogeneity). The triangle is used for demonstrative purposes, but as savings increases (or what is called a fall in "aggregate demand") resources shift from the lower stages towards the higher stages--the triangle contracts horizontally, but expands vertically (further division of labor). The resources are allocated towards the higher stages because a fall in "aggregate demand" affects lower stages more dramatically (most sensitive to demand for consumer goods--since they produce consumer goods), leading to a relative increase in the price of "higher order goods." The relative increase in the price of producer goods, plus a lowered interest rate, is what redirects production towards higher phases of production (more capital intensive roundabout methods of production). See "Prices and Production" By F.A. Hayek

As savings increases, there is a shift in the demand for "future goods" relative to the demand for "present goods." This increases the amount of capital intensity, which yields a higher productivity of labor (more goods produced). This allows for an increase in both consumption and savings in absolute terms. If the ratio between savings and consumption remains unchanged, then the structure will continue to expand vertically and horizontally. If the savings rate, in absolute terms, remains constant (leading to a relative increase in the demand for consumer goods), then the structure will cease lengthening, and will expand horizontally. The interest rate expresses this relationship--namely the demand for consumer goods (present goods) relative to producer goods (future goods).

Hayekian triangle: (Means-ends framework with time as an endogenous variable; inter-temporal allocations of resources) on page 228. The hypotenuse represents the original means of production (labor and land). The value of the original means of production are expressed by the horizontal projection of the hypotenuse, while the vertical dimension, measured in arbitrary periods from top to bottom, expresses the progress of time, so that the inclination of the line representing the amount of the original means of production are expended continuously during the whole process of production. The bottom line represents the total output of current consumption goods, and the area of the triangle shows the totality of the successive stages through which the several units of original means of production pass before they become ripe for consumption. The area of the triangle also shows the total amount of intermediate goods which must exist at any moment of time in order to secure a continuous output of consumer’s goods. As the average period between the application of the original means of production and the completion of the consumer’s goods increases, production becomes more capitalistic, and vice versa. The brackets at every level represent the rate at which the original means of production are employed in the production process. Revenue flows from bottom up, effecting the lower stages more relative to the higher stages--but the key is that for every firm in the lowest phase of production, there are a multiple of firms which produce the various inputs required for the production of the final consumer good (final output).

(I have not read the previous comments, so all of my points may have already been touched upon/fully elucidated).

Re: The Austrian Business Cycle Theory is Flawed

pauled — Fri, 09 Oct 2009 18:18:10 GMT

Hi Duckinstein,

You make some interesting points, but an important element to your discussion that is conspicuous by its absense, is reference to Murray Rothbard's Man Economy and State. In there, you will find substantial discussions on the structure of production - Chapters 5 through 9, and then Chapter 12, Section 11.B. Credit Expansion and the Business Cycle. This represents some 300 odd pages of indispensible reading on the subject that one must assimilate prior to an attempt at accurately discusing, let alone refuting the theory of the Austrian Business Cycle.

I suspect this is going to sound like a bit of a dodge to your points, however, since Rothbard's elaboration of the theory is so good, and since I think it will allow you to reformulate your model somewhat into something valuable, I recommend it. On top of that, it will give you something to really sink your teeth into if you choose to critique it, and from there we can debate the subject on a more even playing field.

Best of luck.

Paul

Re: The Austrian Business Cycle Theory is Flawed

Nima — Fri, 11 Sep 2009 00:09:22 GMT

@Caley McKibbin:

I thought about what you said for a while and I believe we are on the same page. I just want to clarify that I do NOT propose to change the model of the ABCT itself, the theory that explains the events that ensue upon the expansion of business credit.

I am merely saying that this existing model does NOT cover the events that ensue upon the expansion of consumer credit. This is, in fact, what Rothbard himself admitted.

As I pointed out on http://www.economicsjunkie.com/the-business-cycle-revisited/:

Rothbard and Mises hold that a credit expansion that aims at expanding consumer credit will not cause a business cycle:

Mises did not deal with the relatively new post-World War II phenomenon of large-scale bank loans to consumers, but these too cannot be said to generate a business cycle. Inflationary bank loans to consumers will artificially deflect social resources to consumption rather than investment, as compared to the unhampered desires and preferences of the consumers.

But they will not generate a boom-bust cycle, because they will not result in “over” investment, which must be liquidated in a recession. Not enough investments will be made, but at least there will be no flood of investments which will later have to be liquidated. Hence, the effects of diverting consumption investment proportions away from consumer time preferences will be asymmetrical, with the overinvestment-business cycle effects only resulting from inflationary bank loans to business.

Indeed, the reason why bank financing of government deficits may be called simple rather than cyclical inflation is because government demands are “consumption” uses as decided by the preferences of the ruling government officials.

... you see?

Rothbard himself says with 100% clarity that an expansion of consumer credit does NOT create "the business cycle". But by "the business cycle" he can't be referring to anything else but the ABCT.

He calls the events that ensue upon consumer credit expansion "simple inflation". OK, very well, let's call it that. But then he still needs to clarify what exactly he means by that.

He also leaves open why the structure of production shouldn't change upon such a consumer credit expansion. Why should it be impossible for the structure of production to be aligned toward an excessive production of consumer goods, while it IS possible for it to be aligned toward an excessive production of capital goods? - There is absolutely no reason.

He clearly leaves a void right there that needs to be filled. That is all I am suggesting, that we fill that void.

Re: The Austrian Business Cycle Theory is Flawed

Caley McKibbin — Thu, 10 Sep 2009 20:10:05 GMT

So, what are you saying is that the development of consumer credit changes the model?

Re: The Austrian Business Cycle Theory is Flawed

Nima — Tue, 08 Sep 2009 08:55:39 GMT

@WisR:

You quoted my entire comment and at the same time ignored everything I said in there except for the first sentence.

"That's classic ABCT theory. If you say it isn't, you are strawmanning the theory and should read more of Mises and/or Jesus Huerta de Soto, who is a little more clear on the issue."

Where did I say that it isn't? I outlined precisely that process myself in what I call the production business cycle (http://www.economicsjunkie.com/the-business-cycle-revisited/#production). I fully agree with Mises' ABCT. I never said anything to the contrary.

I don't mean to get picky, and I assume you chose your words out of convenience, but just to be clear on what you said: "During the boom the interest rate, the price of money, is lower than it would be..." - the interest rate is NOT the price for money, it is the price for credit. But other than that, yes, you've done a fine student's job reciting Mises' brilliant ABCT ... what is unclear to me is what your comment has to do with the thesis I am proposing.

Re: The Austrian Business Cycle Theory is Flawed

WisR — Tue, 08 Sep 2009 03:47:30 GMT

Nima:

It's not about prices!!! Prices may go up or down or not change at all, but they are always merely a symptom of underlying developments. If anything you would have to look at the number of goods sold multiplied by prices, and put the two into relation.

As you can see in my chart (http://www.economicsjunkie.com/wp-content/uploads/2009/06/us-true-consumption-as-percentage-of-gdp-1929-2008.png), during the boom, production and sales of consumer goods went up relative to capital goods. Now, during the correction, production of capital goods is going up against consumer goods. This is precisely contrary to the events outlined in the classic ABCT.

Let me just ask you in very simple terms, set aside all your bias in trying to apply the ABCT to what happened:

Do you think the crisis in the US primarily came about due to an overhang in the production of industrial robots, unfinished production facilities, an excessive number of energy plants, oil rigs, and the like? Is this what you see when you walk through the streets, look at the news, read the papers?

Isn’t it rather obvious that we are primarily faced with a massive overhang in consumer goods, such as houses, cars, strip malls, Starbucks branches, nail salons, beauty salons, energy drinks, shampoos, fast food stores, kitchen appliances, flat screen TVs, etc. ?

When I talk about a shift from producing capital goods to consumer goods, I mean that, as a tendency, and within a certain period, the entire structure of production moves closer toward turning out immediate consumption goods rather than goods that are half finished or that aide in the production process. I do NOT mean that suddenly all capital goods disappear and all we have is consumer goods. This is simply not possible since the consumer goods also need to be produced by utilizing capital goods.

No, it is all about prices. During the boom the interest rate, the price of money, is lower than it would be without an artificial expansion of the money supply and given the current state of savings. Because of this, entrepreneurs or management think there is enough savings to fund long term investments (or in the case of some management know there isn't but proceed to act as if there were, knowing that they will make a lot of money through stock options before the real owners wise up), and as they bid on them the price of capital goods rises relative to consumer goods. Hence the price of the factors of good farthest from consumption go up the most (including titles to these factors, aka stocks)

When the bust comes, the price of consumer goods rises relative to capital goods (depending on what's happening to the money supply, both could be falling or rising though).

That's classic ABCT theory. If you say it isn't, you are strawmanning the theory and should read more of Mises and/or Jesus Huerta de Soto, who is a little more clear on the issue.

Again, to be clear, in an ABCT boom, the prices of capital goods rise relative to consumer goods and then this reverses when the bust sets in. This is undeniably true if you accept the idea that interest rates are lower than what they would have been otherwise thanks to an expansion of the money supply and what follows from that.

You can't really analyze this boom & bust clearly without taking into account other countries that lent us vast sums of consumer goods in exchange for future promises of something tangible (right now they are still mostly paper promises sitting on the books of central banks around the world).

Re: The Austrian Business Cycle Theory is Flawed

Paul — Tue, 08 Sep 2009 02:23:43 GMT

E. R. Olovetto:

Duckinstein:
This seems to be the fatal flaw in the Austrian argument, what one man saves may not necessarily be the resources that another man requires. One man’s trash may really not be another man’s treasure.

I don't quite understand what is going on here and don't care wasting my time on it.

Then why bother responding at all? The guy asked an intelligent question, politely, and giving every impression of wanting to learn something. I count two posts among all the replies that actually attempted to respond, and everyone else is basically just saying "don't question Holy Writ!" (except for McCloskey, who's off on some silly tangent, again).

Duckinstein: you appear to think the "factors" at the lowest (closest to the consumer) level under consideration are things like hamburgers -- but, of course, McDonalds' hamburgers are made daily: once they start losing sales, they'll cut back on their burger production, and thus on their meat and bread orders, etc., and the baker who bakes the buns will cut back on his orders for flour, eggs, etc.; ultimately, the factors being saved are mostly fairly highly "retargetable", coming from more distant lines of production (the methods of production that get extended due to saving or malinvesting are not necessarily the same ones that existed prior)

Re: The Austrian Business Cycle Theory is Flawed

Nima — Tue, 08 Sep 2009 00:01:27 GMT

azazel: TVs, cars, nail treatments, movies, shiny stovetops, etc. are consumer goods, by every criterion one could possibly apply. That one would list those as capital goods simply baffles me. That you have to bend and twist youself and call them "in essence capital goods to a consumer" (which one is it now??) indicates that you are not very comfortable with your thesis yourself. Seriously? You consider a TV, a kitchen faucet, or a Porsche Boxter a factor of production?? Come on now! :)

But let me ask you, just for the sake of your argument: What DOES pass your test as consumer good if not a TV??

I will now repeat what I already said and what I assume you may have overlooked:

"Yes a Starbucks location is a factor of production, a capital good. But it is one that immediately turns out cups of coffee, consumer goods. It is thus much closer to the consumption stage, than, say, a store that sells industrial robots, or a factory that produces metal parts, or an oil rig that drills for crude oil.

When I talk about a shift from producing capital goods to consumer goods, I mean that, as a tendency, and within a certain period, the entire structure of production moves closer toward turning out immediate consumption goods rather than goods that are half finished or that aide in the production process. I do NOT mean that suddenly all capital goods disappear and all we have is consumer goods. This is simply not possible since the consumer goods also need to be produced by utilizing capital goods."

Re: The Austrian Business Cycle Theory is Flawed

azazel — Mon, 07 Sep 2009 23:44:07 GMT

Cars, flat screen TV's, kitchen appliancies etc. are consumer durables, not consumer goods. There are in essence capital goods to a consumer. There also must exist capital to support overproduction of those goods.

Nail salons, starbucks coffe shops, shoping malls, casinos, hotels, airplanes are all capital goods. There were investments in capital goods that yielded no value to consumer.

There is massive surplus in transport capacity (trucks, ships), shipyards, steel mines and all the industries related to production of such goods. There is also surplus in construction machinery, cement factories etc.

Re: The Austrian Business Cycle Theory is Flawed

Nima — Mon, 07 Sep 2009 20:16:07 GMT

It's not about prices!!! Prices may go up or down or not change at all, but they are always merely a symptom of underlying developments. If anything you would have to look at the number of goods sold multiplied by prices, and put the two into relation.

As you can see in my chart (http://www.economicsjunkie.com/wp-content/uploads/2009/06/us-true-consumption-as-percentage-of-gdp-1929-2008.png), during the boom, production and sales of consumer goods went up relative to capital goods. Now, during the correction, production of capital goods is going up against consumer goods. This is precisely contrary to the events outlined in the classic ABCT.

Let me just ask you in very simple terms, set aside all your bias in trying to apply the ABCT to what happened:

Do you think the crisis in the US primarily came about due to an overhang in the production of industrial robots, unfinished production facilities, an excessive number of energy plants, oil rigs, and the like? Is this what you see when you walk through the streets, look at the news, read the papers?

Isn’t it rather obvious that we are primarily faced with a massive overhang in consumer goods, such as houses, cars, strip malls, Starbucks branches, nail salons, beauty salons, energy drinks, shampoos, fast food stores, kitchen appliances, flat screen TVs, etc. ?

Re: The Austrian Business Cycle Theory is Flawed

WisR — Mon, 07 Sep 2009 12:00:31 GMT

Nima:

I never said that capital formation did not happen in other parts of the workd. In fact, it is rather obvious that a big part of US consumption goods was produced abroad in China. So those export countries, too, bacame part of the consumption business cycle and are now hurting due to the fact that their consumer goods are no longer as demanded as they used to be. Hence, my theory of the consumption business cycle beautifully integrates with all that happened recently. I pointed this out in the ensuing discussion comments under that post so I assume you must have missed that.

Well, which is it?

In a capital goods boom and bust (classic ABCT theory), goods higher up in the production process fall in price much more. Did copper fall in price more than corn? How about the price of all of the capital goods in the tens of thousands of factories going out of business here in Southern China, vs the price of food at the supermarkets here (which is steadily going up, btw)

Jesus Huerta de Soto makes it clear that it is this price movement, during the inevitable bust, which is the characteristic of a classical ABCT bubble (in Money, Bank Credit, and Economic Cycles). In a true consumer goods driven bubble, the prices of consumer goods would fall relative to the price of everything else. That's not happening (with the only possible exception of housing, and only if you define the house as a consumer good instead of the rent / live in value it produces every month).

When you have China financing so much of the US's consumption (in exchange for promises of future goods), you have to take into account their capital goods industries as well, or consider both markets as one large one.

Re: The Austrian Business Cycle Theory is Flawed

Nima — Mon, 07 Sep 2009 10:50:39 GMT

I never said that capital formation did not happen in other parts of the workd. In fact, it is rather obvious that a big part of US consumption goods was produced abroad in China. So those export countries, too, bacame part of the consumption business cycle and are now hurting due to the fact that their consumer goods are no longer as demanded as they used to be. Hence, my theory of the consumption business cycle beautifully integrates with all that happened recently. I pointed this out in the ensuing discussion comments under that post so I assume you must have missed that.

Re: The Austrian Business Cycle Theory is Flawed

azazel — Mon, 07 Sep 2009 10:18:44 GMT

Nima:

I think the main problem arises from trying to apply the ABCT to an event that did not follow the course outlined in it. The traditional ABCT has validity, but it does not explain the recent real estate / consumer goods boom and the subsequent bust: I explained this at http://www.economicsjunkie.com/the-austrian-business-cycle-theory-insufficient-at-explaining-the-current-financial-crisis/

I think your scope was to narrow... The capital formation (or rather misformation) was done in other parts of the world.

Also, you could notice oversupply of steel with mines closing recently, overinvestment in shipyards etc...