There’s been a bit of confusion surrounding the Austrian Business Cycle Theory (ABCT) over at Lord Keynes’ blog. Regular readers of this blog will know that I try as best I can to avoid Austrian economics as it is absurdly primitive, but every now and again I get pulled into the mix. Given that I’m a bit of a history of ideas guy, it always irks me somewhat when people misrepresent ideas — even those I think nonsensical — by buying into modern presentations without going back to the sources.
The confusion surrounding the ABCT seems to stem from an article by Daniel Kuehn. Note that I have not read the article but so far as I can see the quote in question cannot really be taken out of context. Here is that quote,
Cowen (1997) points out that over the course of the business cycle, investment and consumption move together, a phenomenon he refers to as ‘comovement.’ For at least two reasons, Hayek’s theory predicts that investment and consumption should move in opposite directions during the business cycle, with investment rising in the boom and declining in the bust.
Two things should be noted. The first is slightly less important but should probably be posited for the historical record. The phenomena that Cowen apparently calls ‘comovement’ is not something that Cowen in any way identified. Rather it is just a manifestation of the basic Keynesian consumption function. In the General Theory Keynes argued that consumption is a function of income and that income is a function of investment. So, when investment falls, income falls and hence consumption falls. Cowen may place a new term on an old theory but that strikes me as being rather pretentious.
The second point, however, is far more pressing: do Austrians really think that investment and consumption move in opposite directions over the course of the business cycle? I have looked around a bit and I have not found any evidence of this — a few vague statements by vulgar Austrians that might be misunderstood aside. Since the articles by the vulgar Austrians online are vague, being the good scholars that we are, it is probably better to go to a source. I take Ludwig Von Mises’ Human Action as it was written when Austrian theory had largely been fully developed. (It is also available online in PDF form which is handy!).
Now, what happens to consumption across the business cycle according to Mises? Well, let us take a number of quotes in this regard.
“The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment. The depression, on the other hand, is the way back to a state of affairs in which all factors of production are employed for the best possible satisfaction of the most urgent needs of the consumers.” (p573, My Emphasis).
That seems rather clear to me. In the boom there is both malinvestment — which is a form of overinvestment — and overconsumption. That looks like the so-called ‘comovement’ that Tyler Cowen ‘discovered’. So, what happens in the bust?
“Out of the collapse of the boom there is only one way back to a state of affairs in which progressive accumulation of capital safeguards a steady improvement of material well-being: new saving must accumulate the capital goods needed for a harmonious equipment of all branches of production with the capital required. One must provide the capital goods lacking in those branches which were unduly neglected in the boom. Wage rates must drop; people must restrict their consumption temporarily until the capital wasted by malinvestment is restored. Those who dislike these hardships of the readjustment period must abstain in time from credit expansion.” (pp575-576, My Emphasis).
Again, Mises seems crystal clear on this point: in the bust wages fall and people consume less. Again, consumption in the bust falls, it does not rise as Kuehn seems to think. This is just like Cowen, Keynes and anyone with an ounce of sense who has lived through a recession would think. Indeed, Mises is quite clear that everyone — both producers and consumers — feel better off in the boom.
Expansion produces first the illusory appearance of prosperity. It is extremely popular because it seems to make the majority, even everybody, more affluent. It has an enticing quality. (p567)
The trade-off, for Mises, is not that consumers starve while capital goods are produced, but rather that everyone feels the pain when so-called malinvestment unwinds and reallocates resources to their supposedly more productive uses. This is made clear when Mises writes the following,
Of course, the boom affects also the consumers’ goods industries. They too invest more and expand their production capacity. However, the new plants and the new annexes added to the already existing plants are not always those for the products of which the demand of the public is most intense. (p560)
What about investment? While I think that it would be unusual for anyone familiar with the Austrian theory of the ‘purging’ of malinvestment in the bust to assume that investment rises in a recession (indeed, it is clear that Kuehn was not making this case), for the sake of completeness let us get Mises’ take on this. Conveniently enough it comes in a passage where he again discusses consumption in the boom. The following is the clearest instance showing that Mises fully agrees with Cowen’s rediscovery of the consumption function under the guise of his so-called ‘comovement’,
Expansion squanders scarce factors of production by malinvestment and overconsumption. If it once comes to an end, a tedious process of recovery is needed in order to wipe out the impoverishment it has left behind. But contraction produces neither malinvestment nor overconsumption. The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of discharged wage earners and the owners of the material factors of production the sales of which drop. (p567 — My Emphasis)
Again, Mises is quite clear: at the turn of the business cycle investment falls and so too does consumption while in the run-up of the boom both investment and consumption rise.
This seems to be well recognised by the more articulate of the internet Austrians. Paul Cwik writes,
The ABCT is a theory that contains both malinvestment at the higher stages of production and overconsumption!… When the interest rate falls it sends a signal not only to investors and entrepreneurs to invest more. It also tells consumers that the return on savings has fallen. As a result, income saved falls and income consumed rises. Thus, the structure of production is split and torn apart in two directions. For the mainstream macroeconomist, he sees C (consumption) and I (investment) increasing together, which is solid GDP growth.
So, what is this ABCT really all about then? Well, as I indicated above — and as is obvious to anyone who reads Chapter XX of Human Action — it has to do with malinvestment; that is, a mis-allocation of resources. Mises and other Austrians believe that the market allocates resources in a perfect manner, ensuring optimal outcomes. When this process is disturbed by an increase in the money supply and a fall in the interest rate entrepreneurs undertake investment in crappy goods that people do not ‘really’ want. Eventually the easy money dries up, interest rates rise and the malinvestment is shown to be what it is: investment in low-grade crap. Then a process of low production and consumption sets in where resources are gradually reallocated to accommodate what people ‘really’ desire. This is the recession or depression.
This is, in essence, a moral story. It is one of excess, of misrecognised desires and of human folly that is then followed by purging, a return to more austere desire and a sobering up. It is a nice moral story that speaks to something deep inside ourselves. One might say that it is even Catholic in its conception of the easy excesses of Sin and the uphill battle in search of Redemption.
But all this matters little to the key point: Kuehn and Cowen misrepresent Austrian Business Cycle Theory in their criticisms. Mises together with other sophisticated Austrians simply cannot be read in any other way. I would plead with economists: please, please adhere to standards of good scholarship and read sources carefully when engaging with various paradigms — opposing or otherwise. Poor scholarship has done such immeasurable damage to the profession that even misrepresentations of quasi-theological doctrines like those of the Austrians is something that should be avoided at all times.
Addendum: Hayek as a Neo-Keynesian
I thought that it might be interesting to provide a quote from the very paper that Kuehn cites as evidence that Hayek/ABCT states that there is an inverse relationship between consumption and investment across the business cycle. Here it is,
Prices of consumers’ goods are notoriously sticky. At first, when the demand for such goods ceases to increase or even begins to fall, this will check the tendency to increase capacity and thus (by decreasing the “multiplicand” of the acceleration effect without as yet changing the” multiplier”) will decrease employment also in those capital goods industries which till the end shared the prosperity of the consumers’ goods industries. This will further intensify the decrease of incomes and of consumers’ demand. (Hayek, 1939, p35)
As we can see, Hayek’s argument is neo-Keynesian and explains the sharp fall in output that accompanies a downturn not only with an appeal to price stickiness but also using the Keynesian language of the multiplier! This would, of course, baffle many internet Austrians. But it should not surprise us. As I stressed above: the ABCT is all about malinvestment. It is not about hyperinflations or any of that other gold bug nonsense.