Saturday, August 3, 2013

Why the Austrian Business Cycle Theory is Wrong (in a Nutshell)

The reasons why all versions of the Austrian business cycle theory (ABCT) fail, including reformulations of the theory emphasising the role of “false monetary profits,” are as follows:
(1) there is no unique Wicksellian natural rate of interest outside of a purely imaginary general equilibrium state. Hence neither private banks nor central banks can lower the money rate of interest below a single natural rate of interest to induce malinvestment when the latter natural rate does not exist. Moreover, the very idea that unfettered monetary interest rates have some fundamental and reliable role in communicating information about time preference is wrong (see point (4) below).

(2) The early Hayekian versions of the theory assume an economy starting from a general equilibrium state and returning towards one, which is an impossibility.

The alternative model where it is assumed that an Austrian business cycle will develop from a boom with full employment and a lack of resources ignores the fact that virtually all modern economies are open to international trade and even at full employment still have idle capacity in many sectors (which overcome scarcity problems for many investments made in the past). The ABCT assumes a full use of resources and a closed economy: both unrealistic assumptions.

(3) the assumptions of Austrian capital theory underlying the ABCT are wrong. The belief that capital goods can be classified into universal, clear-cut orders as removed from the final consumer goods output must be highly doubtful. Many capital goods can simultaneously belong to multiple orders at once.

Even though capital goods are heterogeneous, there can also be a significant degree of durability, substitutability, adaptability, and versatility in the capital structure of any real world market economy.

(4) the pure time preference and loanable funds model underlying the ABCT are wrong.

Interest rates do not communicate the necessary information about time preference and resource availability as required in the theory.

(5) The ABCT assumes a real-world tendency towards general equilibrium or Mises’s “final state of rest,” such as tendencies to clearing of market prices, equalisation of profits and elimination of profits, and so on. Such tendencies do not exist in the real world economies, because of shifting expectations, uncertainty, and institutional complexity.

(6) The price theory underlying the ABCT is that, while some short-term price rigidity exists, in the long run prices tend towards their flexible, market clearing values. That is false: it ignores the role of administered prices.

In alternative versions of the ABCT where the fundamental dis-coordination mechanism is presumed to be the role of “false money profits,” it is assumed that prices of goods do move flexibly in response to demand changes and induce shifts in money profits of businesses, which then cause malinvestments as capitalists exploit unsustainable profit opportunities.

In reality, a vast swathe of the market – especially industrial and service industries – is dominated by administered fixprices. Prices are relatively inflexible in these sectors. New demand simply means greater production and employment, not significant price movements.

The alleged mechanism of inducing “false profits” will be non-existent or so weak in a fixprice world that it is unlikely to cause the imagined malinvestments.
Further Reading
“Austrian Business Cycle Theory: Its Failure to explain the Crisis of 2008,” October 18, 2010.

“Kirzner on Austrian Business Cycle Theory,” May 30, 2011.

“ABCT and Idle Resources,” June 6, 2011.

“Austrian Business Cycle Theory: Epicycles on Epicycles,” June 6, 2011.

“The Natural Rate of Interest: A Wicksellian Fable,” June 6, 2011.

“Austrian Business Cycle Theory (ABCT) and the Natural Rate of Interest,” June 18, 2011.

“Mises’s ‘Evenly Rotating Economy’ (ERE) and ABCT,” June 20, 2011.

“Austrian Business Cycle Theory: The Various Versions and a Critique,” June 21, 2011.

“Mises’s ‘Originary Interest Rate’ Theory,” June 21, 2011.

“The Differences Between Mises and Hayek on ABCT,” June 23, 2011.

“Hayek and the Myth of Neutral Money,” June 23, 2011.

“Milton Friedman on ABCT,” June 24, 2011.

“There was no US Recovery in 1921 under Austrian Trade Cycle Theory!,” June 25, 2011.

“Vaughn on Mises’s Trade Cycle Theory,” June 29, 2011.

“Hayek on the Flaws and Irrelevance of his Trade Cycle Theory,” June 29, 2011.

“Mises’s Versions of ABCT,” July 1, 2011.

“ABCT and Full Employment,” July 1, 2011.

“Hayek’s Trade Cycle Theory and its Appeal to Socialists,” July 1, 2011.

“Robert P. Murphy on the Sraffa-Hayek Debate,” July 19, 2011.

“Bibliography on the Sraffa-Hayek Debate,” July 20, 2011.

“Robert P. Murphy on the Pure Time Preference Theory of the Interest Rate,” July 13, 2011.

“Lachmann on Trade Cycle Models,” August 27, 2011.

“David Glasner on Hayek versus Sraffa,” September 10, 2011.

“Hayek and the Concept of Equilibrium,” September 20, 2011.

“Hayek and Equilibrium as a Starting Point for an Austrian Trade Cycle,” September 21, 2011.

“ABCT without a Unique Natural Rate of Interest?,” September 22, 2011.

“Did Hayek Advocate Public Works in a Depression?,” September 25, 2011.

“ABCT and the Flow of Credit,” October 6, 2011.

“Michael Emmett Brady on Hayek’s Concept of Uncertainty,” October 11, 2011.

“Austrians Predicted the Housing Bubble? – But so did Post Keynesians and Marxists,” December 14, 2011.

“Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT,” December 27, 2011.

“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012

“Equilibrium Amongst the Austrians,” January 28, 2012.

“Hülsmann on Mises’s Business Cycle Theory,” February 11, 2012.

“Bloggers Debate the Austrian Business Cycle Theory,” February 12, 2012.

“Jonathan Finegold Catalán on Free Banking and ABCT,” May 14, 2012.

“Why Isn’t the Boom of 1946-1948 a Problem for Austrians?,” June 2, 2012.

“Rothbard Shoots Himself in the Foot: Why the ABCT is Anti-Capitalist,” June 25, 2012.

“Bruce Caldwell on the Flaw in Hayek’s Early Business Cycle Theory,” July 8, 2012.

“What was the Greatest Mistake of Lionel Robbins’s Life?,” August 9, 2012.

“Some Critical New Work on the Austrian Business Cycle Theory,” October 9, 2012.

“Repapis on Hayek’s Business Cycle Theory,” October 10, 2012.

“Hayek on his Simplified Capital Theory Assumptions in Prices and Production,” October 15, 2012.

“Why Did Hayek get a Nobel Memorial Prize in Economic Sciences?,” November 10, 2012.

“Critics of the Classic Hayekian Business Cycle Theory,” December 13, 2012.

“The Natural Rate of Interest in the ABCT: A Definition and Analysis,” February 26, 2013.

“Mises’s ‘Originary Interest’: Another Useless Real Theory of the Interest Rate,” June 28, 2013

“Marshall on Menger’s Orders of Capital Goods,” June 24, 2013.

“Greg Hill on ‘The Moral Economy: Keynes’s Critique of Capitalist Justice,’” June 20, 2013.

“Greg Hill versus Steve Horwitz: A Keynesian–Austrian Debate,” June 4, 2013.


  1. Bryan Caplan on the ABCT:

    "... Supposedly, since the central bank's inflation cannot continue indefinitely, it is eventually necessary to let interest rates rise back to the natural rate, which then reveals the underlying unprofitability of the artificially stimulated investments. The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account.

  2. cont.

    ...In short, the Austrians are assuming that entrepreneurs have strange irrational expectations. Rothbard states this fairly explicitly: "[E]ntrepreneurs are trained to estimate changes and avoid error. They can handle irregular fluctuations, and certainly they should be able to cope with the results of an inflow of gold, results which are roughly predictable. They could not forecast the results of a credit expansion, because the credit expansion tampered with all their moorings, distorted interest rates and calculations of capital."[48] Elsewhere, he informs us that: "[S]uccessful entrepreneurs on the market will be precisely those, over the years, who are best equipped to make correct forecasts and use good judgment in analyzing market conditions. Under these conditions, it is absurd to suppose that the entire mass of entrepreneurs will make such errors, unless objective facts of the market are distorted over a considerable period of time. Such distortion will hobble the objective 'signals' of the market and mislead the great bulk of entrepreneurs."[49]

    Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation. Even if simple businessmen just use current market interest rates in a completely robotic way, why doesn't arbitrage by the credit-market insiders make long-term interest rates a reasonable prediction of actual policies? The problem is supposed to be that businessmen just look at current interest rates, figure out the PDV of possible investments, and due to artificially low interest rates (which can't persist forever) they wind up making malinvestments. But why couldn't they just use the credit market's long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates? Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot. Moreover, even if most businesspeople don't understand that low interest rates are only temporary, the long-term interest rate will still be a good forecast so long as the professional interest rate speculators don't make the same mistake.

    It should be noted that other Austrians, particularly Roger Garrison, attempt to handle the expectational objection. Garrison astutely notes that "[M]acroeconomic irrationality does not imply individual irrationality. An individual can rationally choose to initiate or perpetuate a chain letter... Similarly, it is possible for the individual to profit by his participation in a market process that is - and is known by that individual to be - an ill-fated process."[50] This is definitely a possible scenario. But does it make sense in this particular case? It does not. Naturally, entrepreneurs will not turn down lower interest rates. Rather, the rational response to artificially low interest rates is to (a) make investments which will be profitable even though interest rates will later rise, and (b) refrain from making investments which would be profitable only on the assumption that interest rates will not later rise. If entrepreneurs followed this rule, then there would be no tendency for policy reversals to produce malinvestments."