(1) The version of Mises in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]), pp. 349–366. The first version presumably appeared in the original German edition, the Theorie des Geldes und der Umlaufsmittel (The Theory of Money and Credit; Munich and Leipzig, 1912) and the 2nd German edition published in 1924. An English translation appeared in 1934.Hülsmann has a pertinent discussion of the flaws in the original theory of Mises in The Theory of Money and Credit:
(2) Mises’s version in Monetary Stabilization and Cyclical Policy (1928) that can be found in Mises 2006 [1978], p. 99ff.
(3) The version in Mises’s Nationalökonomie, Theorie des Handelns und Wirtschaftens (Geneva, 1940).
(4) The version in Human Action: A Treatise on Economics (Auburn, Ala., 1998 [1949]), pp. 568–583.
“In light of his theory of interest, Mises now clarified the relationship between interest and changes in the quantity of money. The Austrian (Misesian) theory of the business cycle asserts that intertemporal misallocations result from inflation-induced reductions of the interest rate. But what was the precise meaning of ‘reduction’? Mises did not mean to assert that simple changes of the interest rate would induce a business cycle. The fact that today’s interest is lower than yesterday’s does not by itself mean that a misallocation has occurred.Hülsmann is entirely correct about the non-existence of Wicksell’s natural rate of interest. Mises’s exposition of the ABCT in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]) and Monetary Stabilization and Cyclical Policy (1928) both use the Wicksellian unique natural rate of interest concept. It follows that both these expositions are severely flawed.
In his Theory of Money and Credit, Mises had based his analysis on the Wicksellian distinction between the natural rate of interest and the money rate. But this distinction was untenable in light of Mises’s work on economic calculation and on the non-neutrality of money. There is no such thing as a natural rate of interest, defined as the rate of interest that would prevail in a barter economy. And even if there were such a ‘natural’ rate of interest, it would still be irrelevant for the analysis of a monetary economy. Money is not just a veil over a barter economy.
It affects all economic relations. Prices, incomes, allocation, and social positions in an economy using money are completely different from what they would be in a society with no common medium of exchange. And so the interest rate in a monetary economy is necessarily different from what it would have been in the same economy if the market participants had decided to forgo the benefits of money. Even if one could hypothetically compare ‘natural’ and money interest rates—which is not the case—it would not follow that intertemporal misallocations would ensue whenever the ‘natural’ rate was higher than the money rate.
In Nationalökonomie, Mises gave a new exposition of his business cycle theory. He came up with a new benchmark to identify pernicious reductions of the monetary interest rate. The relevant benchmark was no longer the Wicksellian natural rate that would exist if the economy were a barter economy. It was rather the monetary interest rate that would exist in the absence of credit expansion. Any increase in the supply of credit on the market will reduce the interest rate, but if the increase comes from printing paper money or banknotes (rather than from savings) then the artificially lower interest rate falsifies the entrepreneurial profit calculus. In light of the decreased interest rate, a greater number of business projects appear to be profitable and are launched. But the material factors of production necessary for the physical completion of the greater number of projects do not exist.
Credit expansion does not mean expansion of the real factor endowment of the economy; it merely means expansion of the money supply through the credit market. It follows that it is physically impossible to sustain the new structure of production that resulted from the credit expansion. The boom must eventually end in a bust.” (Hülsmann 2007: 779–781).
But Mises’s new version of his business cycle theory in Nationalökonomie (and developed in Human Action) still has major flaws, as follows:
(1) it assumes an economy with no idle resources and no international trade. In reality, capitalist systems have historically had many periods where there are significant idle resources, like labour, raw materials, capital goods and other factor inputs. If an economy with significant idle resources has investment via fractional reserve banking or central bank creation of excess reserves, how will the inflationary pressures imagined by ABCT happen if productive resources simply do not need to be freed in the stages close to consumption? Such factor inputs will be available or quickly made available through increasing capacity utilization in the relevant industries, or even imported from overseas. Versions of ABCT dispensing with a Wicksellian natural rate of interest fail to explain why the cycle effects would happen if factor inputs were not scarce and available through international trade. And even when resources become scarce the theory still has problems.
(2) Like all versions of ABCT, it assumes that credit flows primarily or exclusively to producers engaged in capital goods investments. It is obvious that this is a grossly simplistic and unrealistic assumption in the modern world. Credit today is a complex composite of flows to create consumer loans, loans to speculators on assets or primary commodities, and loans for capital goods investments. When booms in business cycles are primarily driven by credit flows to speculators who blow asset bubbles, the dynamics of the boom are different from those of booms in (allegedly) unsustainable high-order capital goods investments, as assumed by ABCT.
As a concrete example, in the 2000s the economic effect of subprime loans (such as liar’s loans or NINJA loans), where people used their houses as ATMs, was an asset bubble in housing, from which exotic CDOs were created. These effects – essentially caused by consumer loans – are clearly very different from the alleged distortions of capital structure imagined in the ABCT. Even if we assume that alleged unsustainable capital structure distortions occurred, they would be swamped by effects coming from consumer credit expansion and debt deflation.
(3) Underlying Mises’s new theory is still the mistaken time preference theory of interest rates.
(4) As Robert Vienneau has argued, there is no necessary reason why lower interest rates would cause production to be re-oriented to higher-order capital goods anyway, and even classifying capital structure into well-defined higher orders is dubious in itself (see Vienneau 2006 and 2010).
(5) The development of any boom in the business cycle is dependent on a myriad of factors, and whatever future profit any particular capital goods project will deliver can only be a matter of subjective expectation in the present. A rise in interest rates may decrease the demand for credit and raise the burden of servicing debt, but, if there is a mutual expectation that a particular investment might deliver future profit by the bank and business, it is normal for businesses to refinance their investment loans or have the loans rolled over by banks.
(6) In the real world, even when inflationary booms occur, the causes of recession and depression are often very different from the ridiculously simple Austrian business cycle theory. The business cycle after WWII down to the 1980s was rather different from the pre-1933 business cycle. The post-war world saw downturns that were mostly “inventory recessions.” Recessions from the 19th-century to the 1930s often (though not always) conformed to a pattern of bursting asset bubbles, financial crises, bank runs and debt deflation. The Austrian trade cycle theory says nothing about asset bubbles in financial markets or real assets like housing. In the 1990s and 2000s, many nations have experienced asset bubbles and the debt deflation-type of recession once again (or balance sheet recession), after neoliberal economics introduced lax and ineffective forms of financial regulation.
BIBLIOGRAPHY
Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.
Mises, L. von. 1912. Theorie des Geldes und der Umlaufsmittel, Duncker & Humblot, Munich and Leipzig.
Mises, L. von. 1924. Theorie des Geldes und der Umlaufsmittel (2nd edn), Duncker & Humblot, Munich.
Mises, L. von. 1934. The Theory of Money and Credit (trans. H. E. Batson from 2nd German edition of 1924), J. Cape, London.
Mises, L. 1940. Nationalökonomie, Theorie des Handelns und Wirtschaftens, Éditions Union, Geneva.
Mises, L. von. 1953. The Theory of Money and Credit (enlarged, new edn), Yale University Press, New Haven.
Mises, L. 1998. Human Action: A Treatise on Economics. The Scholar’s Edition, 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.
Vienneau, R. L. 2006. “Some Fallacies of Austrian Economics,” September
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=921183
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
LK,
ReplyDeleteThis is a good article but I imagine that every Austrian will ask about those assumptions. How do you know that Mises assumed no idle resources, international trade, etc. Do you have sources?
(1) It is perfectly obvious that Mises assumes no international trade in his model. His theory is essentially that of an imaginary economy which is a closed economy.
ReplyDelete(2) It is very clear the ABCT requires scarce resources/factor inputs, as Hayek says here:
“As it is sometimes alleged that the ‘Austrians’ were unaware of the fact that the effect of an expansion of credit will be different according as there are unemployed resources available or not, the following passage from Professor Mises’ Geldwertstabilisierung und Konjunkturpolitik (1928, p. 49) perhaps deserves to be quoted: ‘Even on an unimpeded market there will be at times certain quantities of unsold commodities which exceed the stocks that would be held under static conditions, of unused productive plant, and of unused workmen. The increased activity will at first bring about a mobilisation of these reserves. Once they have been absorbed the increase of the means of circulation must, however, cause disturbances of a peculiar kind.’ In Prices and Production, where I started explicitly from an assumed equilibrium position, I had, of course, no occasion to deal with these problems.” (Hayek, F. A. von. 1975 [1939]. Profits, Interest and Investment, Augustus M. Kelley Publishers, Clifton, NJ. p. 42, n. 1).
In Prices and Production, Hayek explicitly begins from a stationary equilibrium position.
http://socialdemocracy21stcentury.blogspot.com.au/2012/01/hayeks-trade-cycle-theory-equilibrium.html
Lord Keynes,
ReplyDeleteWhile researching ABCT (and Austrian economics in general) it is important to realize that Mises and Hayek's economics could be very different. While they maybe preached to the same choir (ABCT), how they preached it (method) and some of their substance could be very different. Not everything Hayek says is applicable to Mises' business cycle theory. His discussions of Sraffa, where he couldn't answer his objections about the natural rate of interest because he lacked a pure time preference theory of interest (while the later Mises and Rothbard could, as I have tried to point out in our many discussions).
While Hayek might have said his Austrian Business Cycle Theory required full employment, the case was not for Mises and Rothbard, who both wrote explicitly in sections of Human Action and America's Great Depression (respectively) that full employment was not a prerequisite for their business cycle.
"Mises and Rothbard, who both wrote explicitly in sections of Human Action and America's Great Depression (respectively) that full employment was not a prerequisite for their business cycle."
ReplyDeleteScarcity of the factor inputs for the (alleged) unsustainable higher-order capital goods investments is a prerequisite for their business cycle.
Advocates of the Mises/Rothbard ABCT still cannot explain why the business cycle would happen if the relevant factor inputs are relatively abundant or imported.
"Scarcity of the factor inputs for the (alleged) unsustainable higher-order capital goods investments is a prerequisite for their business cycle.
ReplyDeleteAdvocates of the Mises/Rothbard ABCT still cannot explain why the business cycle would happen if the relevant factor inputs are relatively abundant or imported."
As Mises and Rothbard both explain in those sections:
It is important to remember that in any round of economic activity, factors are always trying to tend to employment and a market clearing price. The continual change in the economy provokes new profit opportunities that constantly shift factors around, in "frictional", or "speculative" unemployment. Laborers are always in the midst of looking for the most attractive job, and landowners/capital goods owners are also trying to find the most profitable market to sell their wares. Due to the non specificity of labor, labor markets have the ability to clear; since labor is scarcer than land, some submarginal land will not be used because the complimentary factors of production can be used elsewhere. Some capital will be unemployed due to prior malinvestments (and it costs to much to salvage the capital due to its specificity).
So in a given market, factors are always trying to tend to full employment. I must emphasize that due to the constantly changing conditions and entrepreneurial nature of the market, markets do not instantaneously clear at full employment, nor is speculative employment ever eliminated. Also imperative is to emphasize this can only occur the absence of government induced rigidities. However, they always tend to full employment. Credit expansion still causes malinvestment because it takes these factors, that were tending to become employed in society's currently profitable means of production, and uses them in longer production processes. It takes them away from where they would go in the absence of credit expansion and uses them in a different environment. These processes are still unsustainable because
1)They inevitably bid away complimentary factors of production, which are being used in shorter production processes, and cause a runup in costs and factor prices.
2)When capitalists try to sell their higher order product, it will be at an unprofitable price. This is because the price spread that the market always tries to equilibrate to has not become flatter (meaning relatively higher prices for higher order goods) but rather is still steeper, which implies that the selling prices of higher order goods is much lower than capitalists thought (since the expansion in those industries was based on an increased profitability). This price spread becomes steeper, because even though factor prices for unemployed goods are not bid up, factor incomes of the original factors still increase, which they will spend on consumption, raising society's rate of time preference.
"It is important to remember that in any round of economic activity, factors are always trying to tend to employment and a market clearing price." etc.
ReplyDelete1. This waffling doesn't answer my question: why would the business cycle happen if the relevant factor inputs are relatively abundant or imported?
2. the very existence of a long-term tendency to equilibrium is the thing in dispute. There is no such tendency and not even all Austrian believe so:
http://socialdemocracy21stcentury.blogspot.com.au/2012/01/equilibrium-amongst-austrians.html
When capitalists try to sell their higher order product, it will be at an unprofitable price.
How on earth would you know? If interest rates raise, it is perfectly possible a business will get to refinance their investment loans on new terms, or have the loan rolled over by the bank, if there is an expectation of future profit. Expectations are subjective.
Even if you assume such alleged capital structure distortions occur (and Vienneau 2006 and 2010 rightly dispute this), banks and businesses don't all behave in the robotic way imagined by ABCT, simply if interest rates raise.
"1. This waffling doesn't answer my question: why would the business cycle happen if the relevant factor inputs are relatively abundant or imported?"
ReplyDeleteBecause they will not be employed in the production processes that they would be employed in had the credit expansion not occurred. I wrote this above:
"Credit expansion still causes malinvestment because it takes these factors, that were tending to become employed in society's currently profitable means of production, and uses them in longer production processes. It takes them away from where they would go in the absence of credit expansion and uses them in a different environment."
"2. the very existence of a long-term tendency to equilibrium is the thing in dispute. There is no such tendency and not even all Austrian believe so:"
I know. The economy "never" equilibrates in the real world, because data is always changing. But its constantly in the process of trying to equilibrate to data that are constantly in flux. Equilibrium is just a tool to deduce ceteris paribus laws.
"How on earth would you know? "
Well I said above:
"This is because the price spread that the market always tries to equilibrate to has not become flatter (meaning relatively higher prices for higher order goods) but rather is still steeper, which implies that the selling prices of higher order goods is much lower than capitalists thought (since the expansion in those industries was based on an increased profitability). This price spread becomes steeper, because even though factor prices for unemployed goods are not bid up, factor incomes of the original factors still increase, which they will spend on consumption, raising society's rate of time preference."
The profitability of higher order goods is dependent on the price spread. A flatter price spread implies a higher capital value for longer P.P and greater profitability. Since this price spread has actually not fallen, the money that capitalists will be willing to pay to those capitalists who embarked on those P.P will be less than what would have occurred had the price spread been flatter. Unanticipated decrease in revenue=losses. Your loan comment has nothing to do with this.
"Because they will not be employed in the production processes that they would be employed in had the credit expansion not occurred."
ReplyDeleteThat does not answer my question. It merely evades it.
If there were sufficient factor inputs for these other investments, and the factor inputs that were bought by higher-order capital goods would otherwise have been idle, the inflationary process imagined in his theory would not occur.
Also, the inflation in consumer goods that ABCT posits is now a joke in a world where a vast amount of our consumer goods come from off-shored manufacturing in East Asia.
Let me try and break it down more.
ReplyDelete1)The "idle" resources were tending to their most renumerative use. Bidding them away into longer production processes prevents them from being allocated to the processes that they were trying to tend to before. They are being misallocated because they are not being employed in the production processes that they would have eventually gone to had the credit expansion not occurred.
2)The bidding of resources inevitably employes nonspecific factors of production, some/many (empirical) could be employed in shorter production processes. So the canonical "bidding" away of resources already being used would occur.
3)The drop in revenues from selling the higher order goods due to the nature of the price spread, and the realization of their unprofitability. See above.
"Also, the inflation in consumer goods that ABCT posits is now a joke in a world where a vast amount of our consumer goods come from off-shored manufacturing in East Asia."
The increase in the profitability of consumer goods industries (and shorter production processes) still occurs, because our consumer goods industries are the "retail sector" of distributing our imported products. So there is a run up in revenues and hence the profitability of switching to these production processes.