Tyler Cowen and Daniel Kuehn Miss the Point of the Austrian Business Cycle Theory


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.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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25 Responses to Tyler Cowen and Daniel Kuehn Miss the Point of the Austrian Business Cycle Theory

  1. ivansml says:

    First of all, Kuehn’s article is primarily about Hayek’s version of the theory, not Mises’, and in the paper he does justify why Hayek’s theory predicts negative comovement:

    “First, Prices and Production assumed that the economy starts in a position of full employment before the unsustainable boom begins. Cowen notes that since the economy is operating at capacity any increase in capital goods production has to come at the expense of consumer goods production. The second reason for the expected differential behavior of investment and consumption concerns the upper-turning point, which accounts for the end of the boom with the Ricardian assumption that capital intensification occurs at the expense of labor income, and that this tension between capital and labor ends the boom.”

    BTW, the draft version is availible at http://danielpkuehn.files.wordpress.com/2013/07/abct-article-for-critical-review.pdf

    Second, Cowen doesn’t claim to have discovered anything. That both consumption and investment are procyclical is a well known empirical fact. Referring to Keynes is rather beside the point here, as the positive correlation can be obtained also from other theories (e.g. real business cycle model with productivity shocks).

    However, the important point is that if economy is in full employment, then it’s hard to see how both consumption and investment can rise simultaneously in response to purely nominal shock. The resource constraint looks something like C + I = F(K,L), so if K and L doesn’t change, clearly positive comovement is impossible (I know you reject this kind of models, but that’s the theory that’s implicitly assumed by ABCT). The fact that Mises writes something different just shows how easily one can fool self with “axiomatic” verbal theorizing.

    • Two points:

      (1) Kuehn’s assertion means nothing to me. It is unsourced. I require quotes to substantiate from original sources.

      (2) You still do not understand the theory. The idea is that resources are moved from ‘good’ production to ‘bad’ production. The ‘bad’ production is, presumably, easier to undertake but is ultimately rubbish. Austrians then refer to the fact that macro statistics cannot distinguish the overall quality of production. Here is Cwik from the link above:

      For the mainstream macroeconomist, he sees C (consumption) and I (investment) increasing together, which is solid GDP growth. Unfortunately, this information is misleading. The modern macroeconomist is misled due to the overaggregation of his statistics.

      • ivansml says:

        (1) If you “require” quotations to original sources, maybe read the damn paper first and look for them.

        (2) No, I’ve argued with plenty of internet austrians to understand the theory just fine. The ABCT is not about shifting resources to “bad” production, it describes a particular mechanism for doing so – lower interest rates makes project with payoffs longer into the future profitable, so investment in early stages of production increases. Explanations by Cwik are just made-up stories that don’t address the main point of full employment assumption.

      • (1) Okay, dude. I did your work for you and here’s what I’ve found: Kuehn has quite clearly torn Hayek completely out of context. Ready? Here we go. Kuehn writes the following to show that Hayek thinks that Cowen’s ‘comovement’ will not take place:

        For at least two reasons, Hayek’s theory predicts that investment and consumption should move in opposite directions over the business cycle, with investment increasing in the boom and decreasing in the bust… Hayek clearly expected a movement of consumption and investment in opposite directions: “an increase in the demand for consumer goods will tend to decrease rather than increase the demand for investment goods” (Hayek [1939]1975, 3). — (Kuehn, pp8-9)

        So, let’s trace that Hayek quote back and give it some context, shall we? Okay:

        “In this essay an attempt will be made to restate two crucial points of the explanation of crises and depressions which the author has tried to develop on earlier occasi.ons. In the first part I hope to show why under certain conditions, contrary to a widely held opinion, an increase in the demand for consumers’ goods will tend to decrease rather than to increase the demand for investment goods. In the second’ part it will be shown why these conditions will regularly arise as a consequence of the conditions prevailing at the beginning of a recovery from a depression.” — (Hayek, p3 — My Emphasis)

        Now, remember, Kuehn said that Hayek expected “that investment and consumption should move in opposite directions over the business cycle, with investment increasing in the boom and decreasing in the bust“. But that is NOT what Hayek is saying. He is saying rather that investment and consumption will follow different paths “at the beginning of a recovery from depression“. He is quite clear about this when he says “I hope to show why under certain conditions…”. Under certain conditions, i.e. after a depression and at the beginning of a recovery. That is an entirely different argument.

        (2) Yes, see comment below. There are also cases where ABCT says that the time-structure of production is messed up. There are many different mechanisms that I could imagine to ensure this. I’d imagine that I could invent one or two right now. The key is this: when the money supply is ‘artificially’ increased peoples’ expectations are shifted and this leads to distortions within the sphere of production. Thus, the Austrians will say, “you silly macro people cannot capture this in your statistics because they do not look into the structure of production”. The argument may be garbage for any number of reasons, but it is not so dumb as to make the mistakes that you attribute to it — i.e. misrecognising that at full capacity consumption must fall for investment to increase.

      • ivansml says:

        This must be a first on the internet – me, a neoclassical guy, explaining to a post-keynesian why austrian business cycle theory is a bad idea.

        Anyway – I don’t know what Hayek meant exactly. The quote you pulled out can be interpreted both ways (“regularly arise” as in “any time a recovery starts”, or as in “generally over the business cycle”).

        Either way – if the economy was at full employment before monetary expansion, comovement must be negative; if it wasn’t, one must answer the question why – and whether benefits from increase in output can outweigh any so-called distortions from changes in time structure of production (which is what I believe Kuehn was getting at, though I’ve read his paper some time ago, so I’m not sure).

        This would of course require a quantitative argument, of which austrians are incapable due to their crazy methodology – so all they do is create more stories. E.g. some (like Garrison) claims that overall output can increase but only temporarily, so economy shifts away from its PPF, but in unsustainable way – how convenient. But that’s not science. Actually, I don’t really see why you’re contradicting me, as your overall opinion about austrians seems pretty similar.

      • Actually this isn’t some massive irony or anything. Austrian theory is perfectly incoherent nonsense but all the real criticisms that can be applied to it apply to marginalist economics generally. Austrian economics is just a branch of marginalist economics that emphasises expectations and uncertainty in places where it suits their purposes (business cycle theory etc.) and ignores them in others when it runs contrary to their purposes (the idea of a natural rate of interest etc.). Marginalists criticising other marginalists is thus often going to come across as being likely incoherent — especially when both marginalists accept uncertainty and expectations to some extent (when it suits their purposes) as I know that Kuehn does. Now, back to business…

        (1) The Hayek quote is perfectly unambiguous. And if you peruse the paper in question especially you will see that it cannot be taken in the context that Kuehn puts it in unless he didn’t read or understand Hayek’s argument properly.

        We can simplify: Kuehn claims that Hayek thinks that I and C will move in opposite directions across the business cycle — i.e. the general case is for I and C to move in opposite directions. But anyone who reads the source will see that this is not Hayek’s argument: rather he is talking about a very special case that occurs when the recession is in remission and the recovery in underway.

        (2) Your criticism is now basically that the Austrians insistence that our data is flawed and that we have to “look inside the production structure” is not science because it would require a quantitative argument — i.e. empirical evidence is needed otherwise this is just fairy-tales. Again this is just cherry-picking. I would argue that buying into the entire marginalist argument in the face of overwhelming evidence on, for example, pricing and consumer preferences that contradicts this argument is just fairy-tales. So, while I agree with your second point, I think its a bit rich coming from someone who seems to buy into an awful lot of fairy-tales.

        It never ceases to amaze me when the blind criticise the blind for their blindness. But then, marginalist economics in general is just a weird metaphysics. Which is why I so often avoid going near the ring-around-the-rosy arguments that take place within it.

    • The other mechanism that I’ve come across is that malinvestment consists in production that will take too long to create new consumer goods — so the time-structure of production gets messed up. Then consumers come wanting more goods now and… pop!

  2. Bob Roddis says:

    The foundation of Austrian theory are the concepts of economic calculation and voluntary exchange. We cannot read other people’s minds but we can observe the terms of transactions in which they engage, especially prices (which are associated with the things or services being exchanged). Artificial credit expansion distorts interest rates and prices so that people in general are misled into thinking that they are richer than they really are. Whether that manifests itself in unwise investments, asset bubbles or extravagant consumer spending is a question of facts and circumstances. It is not only a moral theory, but a practical theory. The question is not about a return to a state of what people really want but to a state of what everyone can REALLY afford.

    Keynesianism always ignores the fact that any economic crisis will generally be caused by these price distortions. The Keynesian explanation is false because it starts in the middle of the story and relentlessly excludes consideration of economic calculation and miscalculation caused by prior artificial credit emissions.

    • Roman P. says:

      Define un-artificial credit expansion.

      • Bob Roddis says:

        Define un-artificial credit expansion.

        I would define a non-artificial credit expansion as loans from actual savings where the lent funds are no longer under the control or possession of the lender and thus no new money is created by the loan. Everyday citizens cannot create loans out of nothing and banks should live under the same rules. Banks are given special privileges to makes loans out of funds they conjure up out of nothing. That is an artificial credit expansion. Those funds are then employed to bid up the price of goods, services and assets at prices in excess of the prices that would have obtained without the new credit (I hope no one denies that because that is the whole point of the policy – but for the new credit, the house wouldn’t have sold at all and its sales price is certainly higher than a no sale).

        Thus, during a housing boom, prices are artificially raised by new loans out of nothing. People then anticipate even more loans out of nothing being made to bid up housing even further. These artificial prices are unsustainable and this is what causes the boom/bust cycle (when applied to investment in true capital goods). Minsky-ites purposefully ignore artificially distorted prices (the self evident cause of these problems) by suggesting these problems just happen under “capitalism”.

      • Lord Keynes says:

        “I would define a non-artificial credit expansion as loans from actual savings where the lent funds are no longer under the control or possession of the lender …”

        Which shows Roddis doesn’t even understand fractional reserve banking, because once you hand your money over it legally becomes the property of the bank, and you do not own or control it, but have a debt owed to you.

        Behold: Bob Roddis. This is what will happen when you piss your life away reading sh*t by Murray Rothbard, people.

    • Lord Keynes says:

      “Keynesianism always ignores the fact that any economic crisis will generally be caused by these price distortions.”

      So says the idiot who does not even understand that most prices are inflexible and not even intended to be market clearing prices.

      That destroys the idea that prior prices have been significantly distorted, not to mention the fact that new money creation is not immoral, and that credit expansion is not “artificial.”

      • Bob Roddis says:

        LK, your pathetic “fixprice” argument is so embarrassingly stupid and dishonest that I now can understand why you never show your face in public.

        Why should anyone care per se that a price is not a “market clearing price”? If a large firm cannot sell all of the stuff it has made, it’s a message from Buddha that (among other things) maybe a) There is no profitable market for the stuff; or b) We can make the stuff cheaper and undercut Big Firm and still make a profit; and/or c) something else.

        You still do not understand economic calculation and miscalculation. But that’s because you do not want to. I’m perfectly satisfied with your position because it’s such a loser.

      • LOL… Roddis attack! Classic!

      • Bob Roddis says:

        LOL… Roddis attack! Classic!

        Mr. Pilkington:

        You could try to refute my arguments calmly. After all, I did listen intently to your entire interview on the Alpha2Omega podcast TWICE,


      • Thanks for the interest, Bob. But you already said that I know nothing about Hayek and Austrian economics. So, I don’t think it would be worth your time debating me…

      • Bob Roddis says:

        I don’t think it would be worth your time debating me…

        1. Just think of the “progressive” street cred you are passing up on by not vanquishing me once and for all.

        2. I collect Keynesian “evasions” as a hobby, especially when they concern the fundamental topics of economic calculation and prices as information. This one from you is new and unique. Thanks.

      • Wow… yeah… having defeated the immortal Bob Roddis in a debate. It does sound tempting but frankly I’m a little scared.

      • Lord Keynes says:

        (1) “Why should anyone care per se that a price is not a “market clearing price”?”

        Well, you should. Why? Because it is a fundamental part of your Austrian theory, idiot.

        But you’re such an ignorant crazy bastard, you know virtually nothing of the Austrian theories you claim to support.

        (2) “You still do not understand economic calculation and miscalculation.”

        On the contrary, by saying “Why should anyone care per se that a price is not a “market clearing price”, you’ve just shown us that you’re the one who does not understand Misesian “economic calculation”.

        You wouldn’t understand these Austrian theories if Ludwig von Mises personally beat you to death with a copy of Human Action.

        So sod off back to Robert Murphy’s blog, there’s a good chap.

      • Bob Roddis says:

        Can you sit in an armchair and use deduction from the action axiom to determine how all prices are actually set in real world capitalist economies and with apodictic truth?


        Answer: No. People will tend to set their prices (or cut production or whatever) to maximize the outcomes of their plans, whatever those plans might be. Of course, in the long run, people may be forced to slash prices and sell off everything they own if they have no other choices. As Kirzner explained, Salerno’s statement on “market clearing prices” does not follow from basic Austrian concepts, especially as interpreted by LK.

        People will be as flexible as they want to be. Unaccepted and accepted price offers both provide essential information about the world thus facilitating those plans. Keynesian funny money emissions and government spending distort those prices and the information process while trying to cure a problem that does not exist.

        You can argue until the ends of the universe about the deep philosophical classification of the self evident nature of the action axiom but the fact remains that we cannot read minds and that observing transactions or the lack of transactions provides essential information which is absent under socialism and distorted under Keynesianism. Keynesians cannot prove that the market fails and unless the market fails, it is not in need of a Keynesian “cure”, is it?

        Lord Keynes is the true apriorist with an unfailing belief in the omniscience and benevolence of armed regulators, who will necessarily be without the essential information that would have been provided by the pricing process.

      • Lord Keynes says:

        “As Kirzner explained, Salerno’s statement on “market clearing prices” does not follow from basic Austrian concepts,”

        Kirzner says no such thing, idiot.

        You’re pulling this right out of your ass.

      • NeilW says:

        I’d really like to see nutty Austrians try to run a business on these lines.

        They’d last about five minutes.

  3. dkuehn says:

    1. Right – no one said Cowen came up with it. And that pre-dates Keynes so I don’t know why you bring Keynes. I mention Cowen because Cowen is the one that raised the phenomenon as a challenge to ABCT.

    2. “Again, consumption in the bust falls, it does not rise as Kuehn seems to think.” – how do I seem to think that? I say it’s a problem with Hayek that he thinks that.

    3. Mises is saying THE EXACT OPPOSITE of what you are attributing to him. He is saying that consumption must drop in order for investment to be restored.

    4. This article is about Hayek in a symposium on Hayek. I have no idea why you cited Mises on LK’s blog or why you continue to cite him here. They are different theories.

    5. I also don’t know why you copied Garrison’s diagram in or Cwik’s comment (which goes along with Garrison’s revision of ABCT). Yes, it includes overconsumption. Overconsumption was discussed specifically to respond to Cowen’s criticism of Hayek! Garrison’s clean up work is fine in the context of the Austrian model. There’s nothing especially un-Austrian about it. But it is not Hayek’s view.

    • 1. Renaming a well-established relationship that is taught in basic macro books is pretentious. Also, the consumption function pre-dates Keynes? Source, please.

      2. You’re taking that quote out of context. You should be careful with that. Read in context it is clear that I mean “According to Mises consumption in the bust falls, it does not rise as Kuehn seems to attribute to the ABCT”.

      3. I never stated otherwise. Please show me where I stated otherwise. My point is that in the ABCT properly understood so-called “comovement” is recognised.

      4. Fine. Check out the Hayek quote I put in the addendum. Its from the paper you cited as evidence that Hayek thought that C and I moved in opposite directions over the business cycle. Actually, you just tore the quote you used out of context. In the quote above Hayek very clearly states that C and I will move together. He even uses Keynesian language to describe this!

      5. Well, it looks to me like Hayek DID think that C and I moved in tandem over the business cycle. Again, see quote above.

  4. Patton Dog says:

    Hi all. I would like to help with the debate if you don’t mind. Maybe i arrived late 🙂

    As a starting point, from my point of view, a economic cycle theory is totally incomplete if it doesn’t have a capital theory. Using aggregates variables like C or I without resolution, is from my point of view, like a doctor saying you are ill, but not prescribing the ‘what’ (virus, bacteria, etc.). I really get scared when i see economists (neoclasics, keynesians, etc.) feeling complete defending the description of a society with just 5 variables (C, I, etc.). Its like saying to a biologist that a human body can be parametrized with ultra agregate and simplistic sums of 5 variables that are not even characterized as differential equations. To me is really scary that the world fiscal and economic policy is driven by a variable named “aggregate demand”. Just saying.

    Austrian theory can be partially right or wrong, but my point is how pretentions people are when they talk trash about other economic schools like if there is no even a remote posibility to find posible solutions or new ideas and approaches. To me is really scary how keynesians refuses to think that under variables like C or I, there is a entirely world. That is not the same capital investment in early stages of production, that in stages nearer to consumption. That if an economy grows, the simple fact of growing doesn’t necessary mean that is a healthy growth.

    If we look at how our banking system works nowdays, you can really say that economic multiplier and fractional reserve system doesn’t work anymore. Central banks do not manage the credit anymore with this two variables. They can’t control credit policy modifying interest rates (putting and sucking base money according to monetary policy). And they can not control credit creation since _real_ savings are not need anymore to create deposits (liabilities). Credit creation is what drives reserves creation. And the key in here is that when interbank do not provide reserves anymore, FED enters the system with open market operations or repos providing more cheap reserves.

    The ABCT is not about mal investment (or resource miss-allocation) in ‘crappy’ good and services that people suddenly do not really want or desire. This is a pretty basic approach. Is about unsustainable productive structure investments based on debt as a result of interest rate manipulation, that is VERY different.

    Mises and Hayek talk about a “natural interest rate”, but not all the austrians defend the existence of a natural interest rate. To me is secondary. The issue is more about the relationship between variables time and risk. Why in big liquidity crisis, banks need the support of a central bank to avoid bank runs? simple: banks by default, because of the wrong incentives provided by lenders of last resort (central banks), invest capital in the long run that is captured in the short run (debt), when not all of that capital would like to do that (time and risk mis allocation). In other words, commercial banks makes long interest rates fall under short interest rates, but not because there are more long _real_ savings accumulation (people that is really saving for real long term investment), but because the banking system is privileged to over investment in the long run, like house mortgages, or early stage production investment for long term projects. The society as an aggregate, over consume (C) and over invest (I) during the boom, because the interest rate signal is giving a false information. Is the same than inflation and prices: if you increase the monetary base, you are providing the wrong signals to corporates, so that they will increase prices.

    There are a couple of charts that can provide a clue to all of this. Both of them here:


    The first chart is the difference (blue line) between 30 years mortgage interest rates vs 6 month deposit interest rates. When interest rates (short and long) changes its values (short term interest rates are higher than long), a crisis hit (red line).

    In the second chart, again the same pattern: in blue line, 30 years Moody’s Baa corporate bonds vs 3 month deposits. When the curve changes (short term interest rates are higher than long), a crisis hit.

    If FED wouldn’t provide reserves (open market operations, repos, etc.), interbank by itself would provide the break for this sistemic long and risk over investment. If real savings exist (no consumption), and real interest rates work as it should be, you can’t invest and consume at the same time as happen in all bubbles. I am living in Spain, and i can claim that during a decade (1999-2008), I and C skyrocketed, and interest rates didn’t rised up. The same deposit bank account (electronic money) could be used for mortgages loans (I) and tv consumption (C) at the same time. Hilarious our financial system.

    So finally, once we explained what is a credit expansion (reversed interests rates curve), and how fiat banking system is not driven by real savings (banks do not wait for deposits anymore to provide credit), we can analize the “production structure distorsion”, or the miss- allocation of resources during the boom. As i said, all of this is not about products and services not desired anymore, or a society that needs to enter the purgatory, as if we were talking about a catholic story.

    In Spain, when C and I started to grow, it was thanks to credit expansion coming from Germany and France. A entirely society started to invest in real state, so a huge construction industry started to grow also. After 10 years of over investment and over consumption, whats the result in my country? a huge over production structure distorsion, it means, a entirely house building society with overcapacity based on debt, and THAT’s the key. The miss allocation refers to over investment in an industry that can not grow forever at this rates. Our entire society was driven by houses. Thousands of new enterprises started to be created (miss-allocated) like real state agencies, furnitures, plumbing, house accesories, air conditioning, interior design, thousands of new architect students finishing university … the list is endless. Why miss-allocation? obvious: once the bubble popped, we had a huge extra capacity of everything. Millions of corporations and enterprises not based in productivity, but based on debt and cheap money. Once the debt machine stopped, all this companies bankrupted. Huge amounts or resources (capital) were driven to goods and services miss-allocated, invested in unsustainable projects that couldn’t be profitable without a credit expansion. And now all this miss-allocated resources are destroyed, so have to be restored (saving again). The time-structure is really messed up. Capital used to build more houses than Germany, England and France at the same time, could be used for other stuff. And now, all this capital structure needs to me liquidated. Thats another KEY. A entire society needs to be reallocated. Not in good and services that people like or are less crappy, but in other stuff different than housing bubble. Stuff that would be profitable under ‘normal’ interest rates, and not based on debt and low productivity. We have lots of airports without passengers. Highways without cars. Overcapacity in energy production (oil, gas, etc.).

    The key issue in here is not about that private sector allocates resources perfectly. The Austrian community do not advocate for perfect markets or perfect private sector resource allocation. Bubbles exist because are based on irrationality. There are not so many schools advocating for this. How come we say that private sector allocates perfectly when all this mess is the result of huge private debt (financial, non financial and households), and not because of public investment? The key issue in here is that if goverments and central banks could provide to society with REAL interest rates (not manipulated by central banks worldwide), proto bubbles would never become bubles. If in Spain in 2001 or 2002 real interest rate would had raised up, we wouldn’t had continued investing in housing bubble until 2009, and we wouldn’t had allocated all that capital (savings) in wrong investments. But interest rates didn’t raise up. I repeat, wrong investment means not “crappy” good and services, but unsustainable projects that can not survive if the society is not living a credit expansion.

    For Keynesians, capital theory is useless, but from an Austrian perspective, is one of the cores. And the fact is Spain: 3 million new unemployees that were working in companies base on debt, low productivity, and real state (directly and indirectly). How do you re-allocate entire small, medium and big companies that invested thousand of million € in business projects? There are two possibilities:

    a) or you let them liquidate, and start new business ideas based on productivity and not debt,

    b) or you don’t let them liquidate, like is happening nowdays. In Spain thousands of corps continue surviving thanks to cheap ECB money (debt refinance). Lots of huge extra capacity that is not liquidated waiting for a miracle. Another bubble?

    The key of all of this is that according to keynesians, the issue came because of an aggregate demand suddent stop, that do not recover because of sticky prices and wages. Suddenly, people stopped consuming. Its like the bubble never existed, just a future confidence sudden stop. So the FED has to enter to stabilize the short run, to keep the long term grouth thanks to economic and fiscal policy. Ok, i am not saying that it shouldn’t be like this at all (i don’t want people starving in streets), but you can’t blame Austrians when they say that a time for re-allocation production structure has to happen (do you think Spain can continue building 1 million houses per year? according to economic mainstream, yes). Or that the society, as an aggregate, needs to increase _real_ savings (not consumption). Or FED will continue creating more bubbles because of the wrong incentives (lender of last resort, even if banks extend the risk to infinite). That interest rates manipulation for allocation, is the same than price manipulation for inflation. Or for a sustainable growth, you do not need fiat money and debt ponzi schemes when history haves us the example of the spectacular usa (and world) growth since 1945 and 1971 (http://goo.gl/lKVEBw), and minimum debt growth under semi gold standar (http://goo.gl/ZNuXwu). Or that QEs are only profitting private banks and asset owners (SP500), it means, the 1% of population that owns assets, and not 99%. Or that since 1971 is when real wages (not nominal) really started to stagnate related to productivity (http://goo.gl/WNG49x). That debt, inflation and fiat money is driving lots of bubbles in our society (http://goo.gl/2v6LCY).

    You can not blame austrians for this advices. You can’t blame the doctor for prescribing the consequences of bad habits.

    So my final thoughts is that you are right. At the end, ABCT is like a history that you can accept or not because it can make sense to you or not. There is data, charts, some nobel prize, but at the end, is not scientifically demostrated. To me it does make sense once your country suffers a real over investment and over consumption cycle, and how it contaminates the whole business network. But, isn’t it the same the keynesian explanation of cycles? At the end, nothing can be scientifically demostrated. Can our science demostrate that Ricardo’s labour theory of value is right or wrong? What are the prices? Prices are determined by costs? or marginalism?

    thanks and sorry for the length and language mistakes 🙂


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