A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis

0:00My paper is a reformulation of the Austrian business cycle theory in light of the financial crisis. And let me just read you a very short statement of the thesis of my paper. Some, as we know, some prominent mainstream economists have not really responded kindly to the sudden resurgence of interest in the Austrian business cycle theory. Krugman and DeLong and even some lesser Keynesians like Brian Kaplan and Tyler Cowan at GMU have criticized it. But rather than openly subjecting the theory to rigorous scholarly analysis in the standard research forums of academic journals and professional conferences, they have sniped at the theory on blog sites and in the popular press.

0:50Furthermore, in their haste to find flaws in the theory, they have disregarded the works of its originators and leading proponents, Ludwig von Mises, Friedrich Hayek, and Murray Rothbard. Instead, they have drawn upon a sole or solitary secondary source that portrays the Austrian business cycle theory as a monetary overinvestment theory. The theory is thus described this way in the influential survey of business cycle theories that was published under the auspices of the League of Nations in 1937 by Gottfried Habeler, and this is called Prosperity and Depression. When Mises was asked what he thought of this book, Mises says, it's a study for the League of Nations. I mean, he just shrugged and said, you know, what can you expect, right? Okay, so the result of the fact that they focus on this survey by someone who was against the Austrian business cycle theory after maybe a one or two-year flirtation with it, okay, Gottfried Habler, means that their criticisms are really aimed at a straw man. Their criticisms really grossly misrepresent the theory. So let me just give

2:02you the gist of their critiques. It's that the Austrian business cycle theory cannot explain the positive correlation of consumption and investment that occurs over the course In particular, these criticisms allege that the theory predicts a slump in investment in capital goods industries during the recession and a corresponding boom in consumer spending and retail sales during the recession. In other words, they're saying, well, yeah, there should be a slump in investment, but there should not be, or according to the Austrians, we should have wildly successful retail industry, expansion, high profits, which of course we did not.

2:54We had one of the deepest retail slumps since World War II, in this latest financial crisis. So they therefore conclude that the Austrian business cycle theory is manifestly in conflict with the stylized facts, as John called them, of the business cycle, and shouldn't be taken seriously, okay? So my paper basically argues that, rightly understood, the Austrian business cycle theory does account for the unprecedented overconsumption that we had during the boom, okay? When you would think that resources are leaving the consumption industry and you're having a shrinkage of consumption and the subsequent retail slump that was observed during the last cycle. Okay, so let me just put up very quickly two or three quotes by these detractors of the Austrian business cycle theory, who says, in the beginning an investment boom gets out of hand, maybe excessive money creation, well how could that be?

3:57And the Fed increased MZM by one billion dollars per day for five years, ending in 2001 through 2005, it's one billion per day. Or there's an excessive money creation or reckless bank lending drives it. Maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity. Here's the problem, as a matter of simple arithmetic, total spending in the economy is necessarily equal to total income. Okay, that's not even arithmetic, that's an identity. Every sale is also a purchase and vice versa. Thank you, Paul. So if people decide to spend less on the investment goods, doesn't that mean that they must be deciding to spend more on consumption goods?

4:46Implying that an investment slump, meaning the recession, should always be accompanied by a corresponding consumption boom. And if so, why should there be a rise in unemployment, i.e. the Austrian theory cannot explain the recession, which also drags down the consumption industries, nor can it explain unemployment. People will be just shifting jobs, according to Krüger. DeLong says something similar, he also goes on about, you know, it could be a rational exuberance, a fractional reserve banking, they all say the same things, basically. The second part there, there is generally no period of high unemployment when resources are transferred out of consumption producing sectors into investment goods producing sectors.

5:31So he's saying in the normal course of capital accumulation, we don't get high unemployment when people decide to consume less and invest more. and more. There is no necessity of a transfer of resources out of investment goods producing sectors be accompanied by high unemployment. The business of shifting resources between sectors is pretty much orthogonal to the business of maintaining near full employment and proper capacity utilization. In other words, the Austrian story doesn't make any sense. Why should we have no unemployment when resources are shifting during the boom toward investment Goods Industries, but suddenly have unemployment when they're shifting the other way, okay, he doesn't understand it, okay, well I'll explain that in a moment. The last is Brian Kaplan, very quickly, he has the most trenching critique, he sums the whole thing up.

6:25Now they're really criticizing Habler, okay, he says the Austrian theory also suffers from serious internal consistencies, if as in the Austrian theory, initial consumption investment Preferences reassert themselves, why don't consumption goods industries enjoy a huge boom during the pressure? After all, the prices of the capital goods factors are too high, are not the prices of the consumption goods factors too low. The Austrian theory predicts a decline in employment in some sectors, but an increase in others. Thus, it does nothing to explain why unemployment is high during the bust and low during the boom. and I won't go on. Okay, well what they've done is they've neglected to read Mises, Rothbard, and I would even argue Hayek, who's been most closely associated with the idea that overinvestment is a characteristic of the boom.

7:20In fact, as Mises, Rothbard, and even Hayek, and I defend Hayek in the paper against some of Walter, Roger Garrison's criticisms, even Hayek point out that the characteristic of the Boehm-Bawerk cycle is malinvestment and overconsumption. During a Boehm you have overconsumption and malinvestment. And Mises even emphasizes overconsumption more than he does the malinvestment. Okay let me just read one short passage by Mises, where he vividly describes the nature and implications of overconsumption. He says, quote, it would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption. One of its consequences is that it falsifies economic calculation and accounting. It produces the phenomenon of imaginary or apparent profits. If the rise in the prices of stocks and real estate is considered as a gain, as every household considered them during our last bubble, the illusion is no less manifest. What makes people believe that inflation results in general Prosperity is precisely such illusory gains. They feel lucky and become open-handed in

8:31spending and enjoying life. This is America in the late 1990s, early part of the last decade. They embellish their homes, they build new mansions, and patronize the entertainment business. He's writing this in the 1940s. In spending apparent gains, the fanciful result of false reckoning, they are consuming capital. It does not matter who these spenders are. Rothbard also emphatically rejected the overinvestment explanation of the Austrian business cycle theory on essentially the same grounds, referring to it as, quote, a misconception given currency by Hobbler's famous Prosperity and Depression. Now, Rothbard went on to say, superficially, it seems that the credit expansion greatly increases capital, for the new money enters the market as equivalent to new savings for lending. Since the new bank money is apparently When we add it to the supply of savings on the credit market, businesses can now borrow at a lower rate of interest.

9:29Hence, inflationary credit expansion seems to offer the ideal escape from time preference, as well as an inexhaustible fount of additional capital. Actually, this effect is illusory. He uses the same word as Mises. On the contrary, inflation reduces savings and investments during the boom. It may even cause large-scale capital consumption. Inflation therefore tricks the businessman. It destroys one of his main signposts and leads him to believe that he has gained extra profits when he is just able to replace capital. Hence, he will undoubtedly be tempted to consume out of these profits and thereby unwittingly consume capital as well. Thus, inflation tends at once to repress saving investment and to cause consumption of capital.

10:21Theoretically, but I also collect a lot of data to show that, in fact, we had an enormous amount of overconsumption during the boom, which destroyed capital. And that allowed us to live high off the hog, so to speak. So we had a seeming increase in capital goods, which was illusory, and at the same time, we were destroying our wealth, we were destroying capital by overconsumption of houses and using What I want to show you is a few slides on the extent of this. Let me just get to the household net worth, which is very interesting.

11:07So, household net worth during this period, Okay, I have the figures here, so So, basically net worth consists of the value of financial assets and the value of real estate minus the debt that households carry. So, they boosted household net worth, these rising prices, by over 23 trillion dollars during the three years from 2003 2006. This drove the ratio of household net worth to annual GDP to well over 450 percent. Now, since 1952, household net worth has been about three and a half, between three and three and a half times of total income, household income. Look what happens first in the late 90s with the high-tech bubble and then in the early part of the last decade, okay? It shoots up to over four and a half times of household income, meaning that households now feel that, look, my pension fund has gone up, the value of my house has gone up, I don't have to save as much, so saving rates decline to less than one percent.

12:22As a result of this, they spent, they used their houses as ATM machines, okay? They took out home equity loans and so on. And I show also, and I'm not going to show that here, an enormous retail boom. The biggest retail boom that we've had since the 1960-61 recession, I have statistics on that. Let me just go on though and show, all right, so that just shows you sort of the retail boom and then the bust. The personal savings rate falling below 1% by 2005, and then shooting up, which is what This is the Wilshire 5,000 index. Despite its name, it includes over 6,000 firms that are incorporated in the US and what's happened with that index is that it's risen from, if you look at the end of the 20th century, In the 2000-2001 recession when things were corrected, it was around 8,000.

13:34It added almost 8 trillion dollars of capitalization to firms. So it looked as if our capital has increased tremendously, but did really the productivity of the U.S. economy double in five years? Of course not. What happened was, eventually, this false prosperity, these illusory gains, were revealed by the collapse in the stock market and the collapse in real estate prices. So that if you now look, it touched around 8,000 before we started with the quantitative easing, and now it's fluctuating around 12,000. That level was first reached in the 1990s. What does that tell you?

14:19Now, Fed economists use this as a proxy for the wealth of a nation. It basically tells you that we have had no capital accumulation since the mid-90s. That everything that we were accumulating was destroyed during those bubbles, during the overconsumption in those bubbles. So what I hope to show in this paper is that in fact the consumption boom and then the consumption bust, the contraction of consumption that we're seeing, this so-called co-movement actually reinforces the Austrian business cycle theory, when it's rightly understood.

15:07Again, it's malinvestment. There are no new capitals being produced during the boom. They're just dead ends. And at the same time, capital is actually being destroyed during the boom. So we are impoverished when all of this comes to a head and prices are then, again, free to reflect the true state of scarcity in our economy. To go back for a moment, I am even suspicious that going from 8,000 to 12,000 reflects true wealth. It's probably lower. We probably are much poorer than is being reflected today. I'll stop there. Thank you. Would I have two minutes?

15:54The Austrian business cycle theory, as originally formulated, does explain the asymmetry between the boom and bust phases of the cycle. The malinvestment and overconsumption that occurred during the inflationary boom caused a shattering of the production structure that accounts for the pervasive unemployment and impoverishment that is observed during the recession. The production structure must be painstakingly pieced back together again in a new pattern because the intertemporal preferences of consumers have changed radically due to the redistribution and losses of income and wealth incurred during the inflation. This of course takes time.

16:39In addition, the recession adjustment process is further prolonged by the fact that the boom has wreaked havoc with monetary calculation, the very moorings of the market economy. have discovered that their spectacular successes during the boom were merely a prelude to a sudden and profound failure of their forecasts and calculations to be realized. Until they have regained confidence in their forecasting abilities and the reliability of economic calculation, they will be understandably averse to initiating risky ventures that appear profitable. But if the market is permitted to work, this entrepreneurial malaise, now I'm actually There is a grain of truth in Keynes, this whole idea of animal spirits and entrepreneurs becoming depressed. But they become depressed because not only has the structure of production been shattered, but monetary calculation has been shattered during the boom.

17:33And you don't get that when you take the hobbler version of the Austrian theory. So what we're in now is the secondary deflation. Secondary deflation is a result of the fact, as Mises points out, it's not because demand for money has increased, rather it's the other way around, because of all the government interventions that is preventing the adjustment of wages and other costs and of asset prices, you get diminishing of the prospects for profitability, you have depressed entrepreneurs, pessimistic entrepreneurs, and until they see a rise in the natural interest rate, until they see a big fall in costs in relation to prices, You are not going to get the economy being regenerated.

18:18So it's not low interest rates that causes economic recovery. It's high interest rates. It's sky-high interest rates reflecting the pessimism. Because sky-high interest rates reflects the fact that we now have a huge gap between costs and prices. And that's when the entrepreneurs jump in. So I actually have in my paper a sort of a new theory of the secondary deflation, which I sort of teased out of Mises and Hayek also, okay. All right, so in fact, I'll just conclude with that. The mislabeled secondary deflation, whether or not it is accompanied by monetary contraction, and this one has not been, is an integral part of the adjustment process. We need the secondary deflation, properly defined. It is a prerequisite for the renewal of entrepreneurial boldness and the restoration of confidence in monetary calculation.

19:08Decisions by banks and capitalist entrepreneurs to hold rather than lend or invest a portion of their accumulated savings in employing the factors of production and the corresponding rise of the loan and natural rates above the estimated true time preference rate does not impede but speeds up the economy. This implies, of course, that any political attempt to arrest or reverse the decline in factor and asset prices through monetary manipulations or fiscal stimulus programs will retard or derail the recession adjustment process. And that's what has happened. Thank you.