A Neoclassical Argument for the Austrian Business Cycle

0:00Perhaps a little background would be worthwhile before I just dive right into the paper. I really, as an undergraduate and graduate student, wasn't exposed to Austrian theory so much. But I remember first coming across Keynes when a fraternity brother of mine was trying to take the Keynesians, teach me the Keynesian story, and over a few beers, and today the truth it never made any sense to me. You know, the paradox of thrift, as far as I could tell, the only paradox was why anyone would believe it. So at that point, you know, I knew I didn't like macroeconomics very much, but I continued on in my studies and in graduate school, being exposed to neoclassical price theory, you I was a micro guy, and so I got into graduate school, I was taking all of the econometrics as a field of study, as well as finance and mathematical economics, and the more I learned about econometrics and mathematical economics, I began to realize that it seemed like all

1:11economists were doing was building mathematical puzzles that they would go out and estimate in ways that they couldn't possibly do. So I became disillusioned with economic theory in graduate school, and really it was after graduate school that I began to be interested in Austrian, reading Austrian economists. I ran across Hayek's critique of the neoclassical theory and his discussion of scientism, and it kind of set me on a particular road. In the early 90s, I was able to hear Roger Garrison present business cycle theory at a fee conference one summer and it immediately set well with me because I was teaching finance at the time.

2:04I could easily see how artificially reducing interest rates could get business people to do poor or make poor choices. And so that's really where this particular idea came from. So let's get into it. In most finance texts, they early on will present the Fisher Separation Theorem. And I just stated here, this is out of Copeland and Westman's old book, Financial Theory and Corporate Policy, and they just say, given perfect and complete capital markets, the The production decision is governed solely by an objective criterion without regard to individuals' subjective preferences that enter into their consumption decisions.

2:54Well, graphically, here's what it looks like. You know, in other words, if we put in here a capital market, a financial market, then this is our production possibilities curve, then the individual is freed from making the The decision, the consumption and investment decisions can be separated out, or the saving and investment decisions can be separated out, and the individual can move in terms of utility theory up and down that line. Now the problem with this is that that might be true for the individual, that the individual's This decision to save or invest is not one in the same as it would be in a Robinson Crusoe economy.

3:46That much is true. But it's wholly untrue that that could be true in the economy as a whole. Because the slope of the line here, this tangency, is a slope that comes out of financial markets and what's going on with financial markets. And so there's a fallacy of composition if I think that the economy as a whole that we just separate out these decisions from one another because it can't be done that way. As a whole, there's a coordinating activity going on in the financial markets and the rising of the interest rate reflects something that's ultimately true about the markets going The same rate of time preference as it is, and that's the rate that's coordinating market activity and inter-temporal choices.

4:41So while it might be true for the financial markets to allow an individual to save without making the investment decision, it's certainly not true in the aggregate economy. Because the aggregate economy cannot easily veer off of the market clearing combination of Consumption in the Present and Consumption in the Future that coordinates the market and that's given by the market interest rate, whatever it is, whatever the market ends up doing. And in Garrison's work, you know, he has this, this is from a graph from his 1997 paper in the loanable funds markets where he's got, you know, this is the net supply of loanable Loanable Funds by Net Savers in the market, and then the demand for loanable funds, and this would be an increase in the supply of loanable funds, now that it comes about as a result of merely the Fed creating a monetary expansion, then what you end up with is you end up with a shortage of loanable funds, in other words, savers are actually going

5:57and to save less at this lower interest rate because time preferences have not changed. And so you're going to have a shortage and so Garrison points that out in his 1997 paper. Well this really conforms quite well with the, if we go back and look at that production possibilities curve, it's going to conform quite well with that and it's going to tell Notice what's happening here. We have this shortage of loanable funds. Businesses are trying to borrow more to invest in capital, but savers are saving less, and they're actually saving as if the rate of time preference were much higher in the market instead of lower.

7:01Why? Because there's no incentive. There's really no incentive to save. So now if I flip this back over and put it against the production possibilities curve, what we have going on is we have this mismatch. So in the mismatch, consumers are consuming as if the rate of time preference is very high and as if the capital markets is giving this kind of signal back and so they've increased their current consumption where business decision makers are trying to invest in capital for the longer haul and so they're trying to invest as if their interest rate were up here when in truth the interest rate is here so you have this total mismatch between what consumers are doing and what investors are doing and in between savings, what's happening with savings and what's happening with investment. So capital is being liquidated in the whole process. Well, when the reality hits, then it's exactly as Dr. Salerno said. You're going to have a collapse in both areas. It's going to collapse

8:13collapse in, and the production possibilities curve is going to be collapsing down on itself. There's no reason why it would be constant. And so as it collapses down, that's going to be the real problem area. In reading through Carl Menger's principles, he kind of hints at this sort of thing when he is talking about goods character. Let me just read to you a brief piece here. He's talking about this. He says, Suppose that the need for direct human consumption of tobacco should disappear as the result of a change in taste, and that at the same time all other needs that tobacco already prepared for consumption might serve to satisfy should also disappear. In this event it is It's certain that all tobacco products already on hand in the final form suited to human consumption would immediately lose their goods character.

9:14But what would happen to the corresponding goods of higher order? And so if you think about it, all of a sudden they begin to lose their goods character too. And if you can't reallocate to a higher valued use, they're a total loss. to become a total loss to the entire system. And so the recovery is the attempt to reallocate goods, which would push the production possibilities curve back outward, probably won't ever get back out here until economic progress or economic growth is sufficient to overtake it again. And the size of the bust, the size of the retrenchment is going to be driven by how great the mismatch was, which will be driven by how large the monetary expansion was in relation to some of these things.

10:15So here are some points that can be made in arguing and putting in this kind of graphical Analysis that might work well with neoclassical theorists, that the depth of the recession depends on how large the shortage was, which is caused by how great the monetary expansion was. When the recession comes, the production possibilities curve or trenches, and finally the ability to recover depends upon how quickly capital can be liquidated and put to some and some other use. Some capital may be lost in the process. In fact, most likely will be lost in the process. And really, probably what's giving the recession its length, how long that recession is, will just depend on how much was actually lost in the process.

11:04So, you know, here we go. Some scenes. This is out in Las Vegas where they have entire Housing Projects that have just been left abandoned. Now, I suspect part of this is driven by the fact that we had the Fed buying up Freddie Mac and Fannie Mae bonds and so nobody's, you know, the banks aren't taking the hit or else they would have tried to liquidate this stuff or whatever they could have gotten out of it if they had had to actually take the hit on it but you know since the feds gonna take the hit on it which means since US taxpayers are gonna take the hit on it we can just leave it to the rats and you know here's another one so I guess the rats are taking over because looks like they're setting up camp outside and yeah so anyway and that's That's basically the idea that I had.