Are People Really Fooled? Rational Behavior, Misleading Signals, and the ATBC

0:00When I talk about the rational expectations, I think it's more of, I think, kind of in line with Bob Higgs when he talks about vulgar Keynesianism. And I think this is sort of really more vulgar rational expectation, a very simplistic view. I mean, I haven't gone into Muth and I haven't gone really into Sargent or Lucas and that. I'd actually like to do more of it down the road because they do try to do things like bring in shocks and all and all that to the system. But nonetheless, as you can see, this is the famous proverb, every October we would get this, right, that Lucy would promise Charlie Brown that she would hold the football for him and he could go kick it.

0:46And, of course, every year Lucy would pull up the football. And so every year she would rationalize it somehow, I know that in the end, Charlie would believe her, this time he would trust her, and he would run down to kick the football, and boom, losing it, always picking it up, and there goes Charlie Brown. Ah, no, I did not get the copyright on that, so I hope nobody turns me in. Ah, I'm sure that's probably a Federal crime worth at least 30 years in prison, but nonetheless, you know, answers, you know, and so what I do is I first remember Gordon Tullock's article, Walter hadn't answered to it years and years ago, and I've not used that in this, but I should have, I know Walter, but I know it just, but nonetheless, I'm aware of it, I just kind of ran out of time, but anyway, he says that Rothbard's apparent belief that business people never learn, okay, in other words, this is the Charlie Brown problem, that the business people would be, they would have been misled maybe the first time, maybe even the second time, okay, but third time, they're not going to let Lucy pull up the football, and because they're going to say,

1:50They're going to tell Lucy where to go because they're going to look at this, you know, the Fed has lowered interest rates and they're going to say, ah, we know what's going on here, no problem, all right, so we're not going to take the bait, okay? And in fact, that would also be, to a certain extent, in the rational, remember, if you understand the rational expectations literature, It'd be like, I think that Hunter talked about earlier today, where the Fed would, they run deficits, but that did not lead to more savings. Remember in the whole rational expectations idea that, okay, the government runs up, now people are going to, in order to pick up aggregate demand, but people are going to save more in order to avoid all that.

2:39So, I think that this is kind of in line with that. Again, it's more of a vulgar, it's not the sophisticated technical stuff that you get from Lucas and Sargent and others. This is now Brian Kaplan. You know, you got to go to Brian's website, you know, and this is from, you know, why I'm not an Austrian economist. But he says, you know, what I deny is that artificially stimulated investments have any tendency to become malinvestments. That supposedly, since it cannot continue indefinitely, it's eventually necessary to let interest rates rise back to the natural level, which then reveals profit, which is what we Austrians believe.

3:25Okay, why would any businessman make his profitability calculations based on the assumption that low interest rates will prevail indefinitely? And no, that would happen. Entrepreneurs would realize that interest rates are only temporarily low and take this into account. Again, it's an RE point. In other words, in short, the Austrians are assuming that entrepreneurs have strange, irrational expectations. So, in other words, that the ATBC is actually an irrational thing, but you know, we, and even though I don't have it up here, I looked for it on YouTube, but if you remember that, you know, one of the greatest movies ever made, Animal House, and that important scene there at the end where the band is trying to walk through the wall, and the, and I forget the name of the character leads him into the wall, the only thing I think he said the entire movie was, He called Blutarsky a moron, but his only line.

4:26But nonetheless, again, this is this whole view that what we believe is that the band can really walk through the wall. But then also Richard Wagner, and I actually got this from Walter's article. But again, it ignores elementary requirements of rationality, in other words, it's an irrational thing. But here's what I think is important. The situation might have had plausibility when the Austrian cycle theory was initially formulated. The collection of economic statistics was primitive, central banks were committed to to exchange in their notes for specie, there was no developed community of financial observers and fed watchers.

5:16Now this is, I think this is really interesting as well because what he's saying is that everybody else is going to look towards the same statistics that we do. Of course, notice that not a lot of economists figured out that we were in a housing bubble even though they're looking at the same things. But again, what I want to try to do as much as possible is keep this in a systematic way as opposed to stating the obvious, that they're saying that malinvestments can't happen and they happen. And the reason I want to do that is because people often write about Say's Law, a couple years ago I did a presentation on Say's Law and one of the assumptions was that the Say's Law claims that recession never can happen, which isn't true. And if you read that chapter you can see that that's not true.

6:04But nonetheless, I want to avoid that particular prob, but nonetheless, I think what Wagner is saying is very, very important. Now, okay, then go on, he talks about, we've been coming, looked about statistics, observers and pundits are everywhere. Cycle theory that depends on the inability of people to distinguish in the aggregate between increase in personal saving and increase in central bank holdings of government debt must be dismissed on the ground that it fails to incorporate any reasonable requirement of individual rationality and economic action. Okay, all right, and so again, that he's saying, well look, this stuff is available and we can all interpret these things, except for the small fact, of course, that people interpret these things very differently.

6:53And even in hindsight, I remember once David Henderson and somebody else had that paper a while back that claimed that the Fed really hadn't done any artificial lowering of interest rates at all. And so, I mean, and there's always, and then there's always Paul Krugman. But, alright, and so in other words that what you have is a syllogism, alright. Entrepreneurs, and if you want to put the major premise, entrepreneurs make rational decisions and Generally are correct about business conditions, some random errors are committed, and because business information is readily available, entrepreneurs are able to make rational decisions. Furthermore, business decision makers are fully aware of the theory of rational expectations, or at least act as though they're aware of it.

7:42Even if they don't know the formal theory, their actions would imply that they're aware of it. Second, the minor premise, the ATBC requires entrepreneurs to be systematically fooled by economic conditions. Therefore, all right, the conclusion, therefore the ATBC requires irrational behavior by rational decision makers, which invalidates the Austrian theory of the business cycle. That's the, you know, okay, and I want to answer it, I mean, there's lots of ways to answer it. What I've done is, and I've tried not to plow the same ground, I think that Walter, that Dempster and Carilli did back about ten years ago, I think Bob Murphy did a paper, counter paper on that, and I actually have all those in my files, and I think when I want to expand this paper, do some work on it, I want to bring all that in, this was much more of a hurried type job.

8:44But nonetheless, you've got to keep in mind though, what they're saying first is that errors are irrational. What they want to do is operate on the perfect information hypothesis when in fact, even that hypothesis was counteracted by the mainstreamers 50 years ago with George Stigler in 61. They have to admit that obviously entrepreneurs do make errors about the future, but what they deny is that they can make a cluster of errors, except of course, what do we see at the end of the boom and beginning of the crisis?

9:34be in essence the evidence for this cluster of errors, okay? And now the question is why, okay, I make a point here that entrepreneurs are not responding to economic theories. I mean, I might guess that typically an entrepreneur doesn't know who the heck Gordon Tulloch or they might know who George Lucas is, but they don't know who Robert Lucas is. but they respond to relative prices, all right? The other thing is that, and I bring this in, in my second called time is of the essence that errors occur over time and in fact what's going on is that in fact the, in the system that you can't tell the difference as an entrepreneur.

10:30Sure, you're looking at relative prices and present factors of production and what you would estimate to be future prices for consumer goods or those final goods that would be the lower order goods. And in the early stages, there's no way entrepreneurs can tell the difference. I mean, they're not going, you know, the number one, the typical entrepreneur is not a Fed watcher. Number two, the typical Fed watcher can't tell either. It's not something that the Fed watchers pick up automatically. It's not like the Fed hoist something out. And in fact, people are not even aware of the concept of a natural rate of interest. They can't tell the difference. And they assume, here's another thing. In typical neoclassical economics, the use of time is such that it's compressed. If you If you look at a typical neoclassical model of the firm, whether it's a firm in imperfect competition or perfect competition, what do you assume?

11:35You assume that the process is instantaneous from when you dig the first spade of whatever minerals out of the ground to selling the final product. That everything is compressed into that one amount of time. And I dealt with that, Murray dealt with that in looking at the whole issue of profit maximization because, again, that you have to look at the issue of time. And I had a paper a couple of years, about, no, gosh, eight years ago, I guess, in the QJAE dealing with that. And when you bring real time into the model, however, that what you, which is not done in your typical neoclassical model, you're going to, what you're going to see are sets of relative prices that change over time, all right?

12:23Well, I call them the vulgar, The other thing is that they also look into the issue of, they're looking to think of risk, and this is what, you know, I think Peter, and he's done a real service by really kind of resurrecting Frank Knight and his whole view of risk and uncertainty, and the other thing is that they're making the assumption that entrepreneurs face risks, and risks have real live numerical possibilities, and this way you can put them in Mathematical Form, and have your nice symbols there. Okay, but Mises and others point out that, in fact, what entrepreneurs face is uncertainty. And this is important too, because you not only have real time, but the issue of uncertainty is that you don't know what the outcomes are going to be.

13:15It's not, I have a whole set of outcomes, and here are the probabilities that if this is repeated over and over again, this is what would happen. That instead what we have is uncertainty, all right, and but in the relative prices play out in real time. And so you have, as I point out, that I think that what we have to keep in mind in this is that the criticisms, Not only are they based on unreal assumptions, and a lot of neoclassical is very comfortable, of course, unreal assumptions, but the problem is that by ignoring both the issue of uncertainty and also the role of real time, that what the end, also for that, and really not understanding what entrepreneurs do regarding relative prices, that in fact that these critics actually get it wrong, that the ATBC can actually stand up against a view that entrepreneurs are making rational decisions.