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Monday, June 20, 2011

Mises’s “Evenly Rotating Economy” (ERE) and ABCT

Mises’s early work on the Austrian business cycle theory (ABCT) uses the Wicksellian natural interest rate concept and Wicksell’s monetary equilibrium analysis. This can be seen here:
“[Mises] surely made use of the natural and market rate concepts, developing Wicksell's analysis of the upward price spiral caused by a too low market rate into a theory of the business cycle” (Horwitz 2000: 77).

“Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about.
Up to this point Wicksell commands assent; but his further argument provokes contradiction. According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upwards or downwards. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur ‘which would naturally cause the banks sooner or later to raise their rates of interest.’ Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest ... ” (Mises 2009 [1953]: 355).

“In conformity with Wicksell’s terminology, we shall use ‘natural interest rate’ to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. ‘Money rate of interest’ will be used for that interest rate asked on loans made in money or money substitute.” (Mises 2006 [1978]: 107–108).

“The ‘natural interest rate’ is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing ‘natural interest rate’” (Mises 2006 [1978]: 109; from Monetary Stabilization and Cyclical Policy [1928]).
So as late as 1928 in Monetary Stabilization and Cyclical Policy (1928), Mises is still using the Wicksellian natural interest rate concept.

I have recently seen this attempt to defend Mises’ early versions of ABCT, by invoking his later concept of the “evenly rotating economy”/stationary economy concept:
“The point Mises is making in the [sc. quotes] ... is that the natural interest rate is the rate of interest that would arise in the [“evenly rotating economy”]... It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate.”
But a reading of the earlier work of Mises in works cited above does not support this:
(1) There is not one reference to the concept of the “evenly rotating economy” (ERE) in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]). On pages 349–366 where Mises sets out his trade cycle theory, he uses the Wicksellian natural interest rate concept and Wicksellian monetary equilibrium analysis.

(2) There is not one reference to the concept of the “evenly rotating economy” in Monetary Stabilization and Cyclical Policy (1928), and again Mises is still using the Wicksellian natural interest rate (p. 99ff.).
The “evenly rotating economy” just like the “originary interest rate” appears in Human Action, not in these earlier works. The concept of the “evenly rotating economy” needs clarification:
“In Human Action, Mises advanced the Austrian theory of money by delivering a shattering blow to the very concept of Walrasian general equilibrium. To arrive at that equilibrium, the basic data of the economy—values, technology, and resources—must all be frozen and understood by every participant in the market to be frozen indefinitely. Given such a magical freeze, the economy would sooner or later settle into an endless round of constant prices and production, with each firm earning a uniform rate of interest (or, in some constructions, a zero rate of interest). The idea of certainty and fixity in what Mises called “the evenly rotating economy” is absurd, but what Mises went on to show is that in such a world of fixity and certainty no one would hold cash balances. Everyone’s demand for cash balances would fall to zero. For since everyone would have perfect foresight and knowledge of his future sales and purchases, there would be no point in holding any cash balance at all.” (Rothbard 2011: 697).

“The Evenly Rotating Economy is a fictitious system in which there are no price changes whatever – i.e., there is perfect price stability. The concept is used to illustrate the function of entrepreneurship and to demonstrate meaning of profit and loss by hypothesizing a system where they are absent.”
http://wiki.mises.org/wiki/Evenly_Rotating_Economy

“… this line of argument makes it necessary to clarify the precise meaning of general equilibrium, as well as its role in economic analysis. Mises argued that general equilibrium—which he called the stationary economy (stationäre Wirtschaft)—is a purely methodological device. It is an imaginary construct (Gedankenbild) that has no counterpart in the real world. Its only purpose is for the definition of profit and loss.” (Hülsmann 2007: 773).
If Mises really believed that “the natural interest rate is the rate of interest that would arise in the ERE. It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate,” then ABCT has no application to real world capitalism. Why?

In the real world, economies are growing, and there can never be an “endless round of constant prices and production.” This would require an economy without growth, frozen in time, for a single natural rate of interest to even exist. As Sraffa showed, even in a barter economy with growth, there can be as many natural rates of interest as there are commodities.

Yet ABCT requires a single natural rate of interest in the real world for the market/bank rate to coincide with, in order that we can avoid the cycle effects allegedly caused by ABCT.

BIBLIOGRAPHY

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. 1998. Human Action: A Treatise on Economics, Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Rothbard, M. 2011. Economic Controversies, Ludwig von Mises Institute, Auburn, Ala. p. 697.

25 comments:

  1. An excellent post.

    ReplyDelete
  2. LK,

    I've dismantled you and your hero Sraffa sufficiently at http://krugman-in-wonderland.blogspot.com.

    Your attempt at defending yourself is rather pathetic. Go hide in your whatever-Keynesian echo chamber.

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  3. "This would require an economy without growth, frozen in time, for ABCT to work."

    Rubbish. ABCT explains how manipulation of interest rates causes malinvestment and the business cycle starting from the conception of natural interest rate as it would occur in the ERE at equilibrium. It does not require an economy without growth, frozen in time. On a free market without meddling, forces operate (which Mises has explained in TTMC) that will force the interest rate towards the natural rate of interest. It is only meddling such as artificially depressing the interest rate that prevents this natural process causes the business cycle.

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  4. "Yet ABCT requires a single natural rate of interest in the real world for the market/bank rate to coincide with for Austrian business cycle effects not to occur."

    False again and more rubbish. Austrian economic theory explains why there would be a single natural rate of interest in the ERE at equilibrium. However, it recognises that the real world could have multiple interest rates that would, however, all tend towards the natural rate of interest. It is the deliberate and artificial meddling in this process (the kind that happens with fractional reserve banking, for instance) through interest rate suppression and credit expansion beyond the available pool of real savings that causes the business cycle. That is what ABCT says. Not the straw-man you posit out here.

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  5. "However, it recognises that the real world could have multiple interest rates that would, however, all tend towards the natural rate of interest."

    Confused nonsense.
    Even in a barter economy with growth, there can be as many natural rates of interest as there are commodities.
    You repeat the same mistaken belief that there would be one natural rate of interest, even in a 100% reserve banking system.

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  6. "Even in a barter economy with growth, there can be as many natural rates of interest as there are commodities. "

    LK, You really are dense. I said "tend to". That's all they would do in the real world. It is only in the ERE at equilibrium that they would be equal.

    "You repeat the same mistaken belief that there would be one natural rate of interest, even in a 100% reserve banking system."

    Firstly, it is not a belief, genius. In the ERE at equilibrium, there would only be one rate of interest be cause there CAN be only one in that condition - the natural rate of interest. Further, in the ERE at equilibrium, it does not matter whether the banking system is 100% reserve or fiat because money would be rendered redundant by the equilibrium in the ERE.

    But I guess all this is too much for whatever-Keynesian economic chroniclers who have no understanding of economics. Sorry if I burnt your brain.

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  7. By the way, your statments on http://krugman-in-wonderland.blogspot.com.

    Your statement 1:
    Quotation of me:
    Since real-world economies can NEVER fall into a state imagined by the ERE, this single natural rate occuring in an ERE is a total myth, that will never exist in the real world.

    You: That's exactly what the use of the ERE is meant to show, genius.

    So we have established that you agree that "this single natural rate occuring in an ERE is a total myth, that will never exist in the real world."

    Your Statement 2:
    On a free market without the creation of fiduciary media or fiat money, the natural interest rate would drag all real world interest rates towards itself. Only meddling can keep real world rates of interest from tending towards the natural rate of interest.

    You have contradicted yourself completely and destoyed your argument. Statement 2 CANNOT be true, as you have just DENIED the existence of the single natural rate occuring in the real world in statement 1.

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  8. My response verbatim

    "So we have established that you agree that "this single natural rate occuring in an ERE is a total myth, that will never exist in the real world.""

    It is not a myth, my dear genius. Therein lies the flaw you keep ignoring. That it does not "exist" does not mean that it is a myth. Abstractions do not "exist" but that does not mean they are myths. What a dork!!

    "You contradicted yoruself compeltely and destoyed your argument. Statement 2 CANNOT be true, as you have just DENIED the existence of the single natural rate occuring in the real world."

    I said it does not exist in the real world, but the ERE is a concept that exists side by side with the real world. How did you become this dense? By birth or did years of indoctrination in Keynesian gobbledygook cook your brain?

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  9. "I said it does not exist in the real world, but the ERE is a concept that exists side by side with the real world."

    This is quite a claim.
    So what we have is this:

    (1) in an abstract and imaginary world of barter with no money, with a stable population, no growth, with an “endless round of constant prices and production,” frozen in time, where there is no uncertainty at all about the future, where there is full employment, there exists a single natural rate of interest.

    (2) In the real world where we have growth, rising population, uncertainty about the future, money, changing prices and production, a market rate of interest will converge to an abstract rate, if we abolished government and had a 100% reserve banking system?

    Is that what you are saying?
    Yet any economy with growth and multiple commodity markets can have multiple natural rates of interest. How will a monetary interest rate in a 100% reserve banking system converge to multiple, differing rates? Do tell...

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  10. "How will a monetary interest rate in a 100% reserve banking system converge to multiple, differing rates? Do tell..."

    Once again, genius, they will not converge to multiple differing rates. Rather, all these multiple, differing rates will converge to the natural rate of interest that would exist in the ERE at equilibrium. Your attempt at showing convergence towards multiple points is plain idiotic and shows your complete lack of understanding of the ERE and its role in the formulation of economic theory. Why am I not surprised that a whatever-Keynesian economic chronicler with no understanding whatsoever of economics is demonstrating his utter vacuity in matters economic.

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  11. "Once again, genius, they will not converge to multiple differing rates. Rather, all these multiple, differing rates will converge to the natural rate of interest that would exist in the ERE at equilibrium."

    NO system with growth, money and uncertainty can converge to a single abstract natural rate in the ERE, as it will never fall into conditions that are prerequisites for that ERE state: it will always have multiple rates in periods of growth.

    You have hit the same problem identified by
    Lachmann:

    “What is much less clear to us is to what extent Hayek was aware that by admitting that there might be no single rate he was making a fatal concession to his opponent. If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium?” (Lachmann 1994: 154).

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  12. Lachmann is making the same mistake that you are making.

    "If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others."

    This is in the real world and not in the ERE at equilibrium. Your list of fallacies extends into argument by appeal to authority.

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  13. "NO system with growth, money and uncertainty can converge to a single abstract natural rate in the ERE, as it will never fall into conditions that are prerequisites for that ERE state: it will always have multiple rates in periods of growth."

    Where did I say I disagree with this? My only point is that your 'scathing attack' on ABCT was just a demonstration of your utter vacuity in matters of economic theory.

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  14. ""NO system with growth, money and uncertainty can converge to a single abstract natural rate in the ERE, as it will never fall into conditions that are prerequisites for that ERE state: it will always have multiple rates in periods of growth."

    Where did I say I disagree with this? "


    LOL... So all your comments are in vain.

    A monetary interest rate in a 100% reserve banking system will NOT converge to multiple, differing rates: Lachmann is entirely right.

    And I don't ask you to "believe" him at all or "believe" him because he is some kind of authority, only consider his argument. Absloutely no logical fallacy is involved.

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  15. As the above illustrates, fanboys of the Austrian school of economics are typically ignorant of economics, including of the literature of the Austrian school.

    The supposedly unique "natural" rate of interest is defined in an Evenly Rotating Economy abstracting from different lengths of loans and "risks". (The standard time period might be Hicks' week in Value and Capital or the period of the yearly harvest in classical economics.) This logically false claim about an unique "natural" rate of interest is not overthrown by pointing out the structure of interest rates arising in an ERE when one accounts for differences in risks and time time periods.

    As any fool knows, neither the non-uniqueness of the "natural" rate in an ERE nor the full structure of interest rates in an ERE have anything to do with the variation in interest rates among commodities that Sraffa pointed out and Hayek accepted. Sraffa was writing about the different own interest rates for, say, lending strawberries or ice from December to January.

    As far as I am concerned, an ERE is a stationary state without any (slow) variation in technology, tastes, or demographics. I suspect our how is mistaken in claiming that Mises was not using this concept in different expositions of the "natural" rate and the ABCT, even if he did not use the term. The ERE is the standard concept for later expositions of ABCT, such as by Garrison and by Skousen. And all these expositions, as I have proven, are logically mistaken about the relationships between differences in levels of the "natural" interest rate in the ERE and the structure of production. So much for the ABCT.

    Hayek, in claiming Sraffa's different own rates to be "natural" rates, was transitioning from his acceptance of the ERE as the equilibrium concept in Prices and Production to an equilibrium concept of intertemporal equilibrium. I suppose Hayek's concept differs from the Arrow-Debreu model in that, although both consider an equilibrium in which all agents have expectations and plans that mesh, Hayek does not require the existence of most forward markets. Hayek's adoption of this concept in his response to Sraffa left his policy guidance, as Sraffa and our host point out, utterly incoherent.

    The above is about logical relations and cannot be challenged by noting that equilibrium - whether an ERE, an intertemporal equilbrium, or a temporary equilibrium - never exists in reality. By the way, nobody has ever been able to show that tendencies would exist in a market process to approach an intertemporal equibrium. The noted Austrian school economists Kirzner and Lachmann disagreed whether equilibrating or dis-equilibrating tendencies predominate in typical market processes.

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  16. "LOL... So all your comments are in vain."

    Only inside your whatever-Keynesian echo chamber. In the real world, your arguments have been torn to shreds.

    "Lachmann is entirely right."

    Lachmann is making the SAME mistake that Sraffa made and which you are now busy making. Lachmann has completely missed the point that THE natural interest rate emerges ONLY in the ERE at equilibrium. At that point, it is impossible to have multiple rates in multiple lines or stages of production or on multiple commodities. Any discrepancy will attract capital from OTHER stages/lines/commodities into the stage/line/commodity which has a higher interest rate and drive the interest rate down.

    Your argument gets no credibility by your repeating Lachmann's mistake.

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  17. LK,

    One good thing about you is that you do not moderate comments even if they destroy your arguments. On that count, hats off to you. Whatever I may have said about you, you aren't dishonest. You are only wrong.

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  18. "And I don't ask you to "believe" him at all or "believe" him because he is some kind of authority, only consider his argument."

    OK. Fair enough. But then I have already shown that his argument is a product of a serious error of omission. Lachmann's mistake provides you no support.

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  19. Robert,
    Thanks for your comment.
    I am just reading your article:

    Vienneau, R. L. 2010. “Some Capital-Theoretic Fallacies in Garrison’s Exposition of Austrian Business Cycle Theory,” September 4
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1671886

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  20. Robert,

    I too downloaded your paper and started reading it and found this.

    "According to ABCT, a certain natural interest rate would arise in an unregulated barter economy. Entrepreneurs, responding to prices and this interest rate, would adopt a technique of production in which definite proportions of resources are direction towards producing capital goods of specified orders, in contrast with resources directed towards producing first-order consumer goods. For Austrians, the boom is a consequence of the monetary authority artificially setting the money interest rate below the natural rate."

    If this is what your paper proves to be without foundation (I should confess I haven't read your full paper yet), then I am afraid you are totally off the mark. Every statement of yours in the segment I have copied above is wrong. Like LK, you too seem to have pounced upon a straw-man version of ABCT that you are able to refute and then claiming victory at having done so.

    Still, I will read the entire paper and respond in more detail.

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  21. "Every statement of yours in the segment I have copied above is wrong."

    Garbage. Robert is right, but he may expressed it the first sentence better.
    He should have said:

    ABCT, in the versions propouned by Mises (2009 [1953]: 349–366; Mises 2006 [1978]: 99ff.) and Hayek (1931) uses Wicksellian monetary equilibrium and the natural rate of interest concept. This posits a natural rate of interest as if loans were made in natura, and that money-using economies can have a monetary interest rate that can deviate from the rate by banks' use of fiduciary media.

    By the way, you were challenged above to say where in these:

    The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]).

    Monetary Stabilization and Cyclical Policy in Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

    there is a reference to the concept of the “evenly rotating economy.”

    You haven't, which suggests you can't.

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  22. "but he may have expressed the first sentence better."

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  23. "Garbage. Robert is right"

    Nonsense. All I can see is a mountain of errors. I'll just give one example.

    "Into what orders25, 26 would this entrepreneur classify goods?"

    Since when did entrepreneurs start worrying about which 'order' a good is? I thought it is something economists do.

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  24. I'm curious: what do you think the prospects are for a modified version of ABCT where there isn't a single natural interest rate?

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  25. Ah, nevermind. http://socialdemocracy21stcentury.blogspot.com/2011/09/abct-without-unique-natural-rate-of.html

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