Wednesday, January 30, 2013

The Natural Rate of Interest and the Austrian Business Cycle Theory: A Reply

One Guillermo Sanchez has a post here defending the Austrian business cycle theory (ABCT):
“Sraffallacies: A Misesian Defense of ABCT (II),” Econo-Mia [y Tuya], January 29, 2013.
If I am not mistaken, Guillermo Sanchez already acknowledges that Sraffa’s critique of Hayek on the non-existence of the Wicksellian natural rate of interest is sound.

Sanchez states:
“Robert P. Murphy’s great paper “Multiple Interest Rates and Austrian Business Cycle Theory” (2010) takes the subject directly as Lachmann did. The enormous merit of this paper is that even if Sraffa was right, his critique does not refute ABCT. In other words he was able (after criticizes Lachmann’s solution) to ensure the validity of ABCT in Sraffa’s own terms (a multiple rates environment). ABCT is still valid even in the circumstances in which Sraffa said it would not be valid. He managed to do it using a Dynamic Equilibrium simple model. Maybe the best refutation is not to demonstrate that Sraffa was wrong, but to demonstrate that even if he was right, the theory still holds logically”
What Sanchez is trying to argue here is that ABCT can be reformulated by purging it of its use of the natural rate of interest, and that such a reformulated ABCT can be defended against Sraffa’s critique on the basis of the mythical natural rate.

That is perfectly true, of course, and I have never denied this. The problem is that such a theory is not a Hayekian theory, it requires real world tendency to a general equilibrium state, and it is still subject to a host of other problems, such as subjective expectations, uncertainty, capital theory, unrealistic assumptions about use of resources, and so on.

But let me turn to the specific criticisms Sanchez has of my arguments:
(1) First, Sanchez points out a red herring:
“Lord Keynes” does not mention the fact that Mises was not the only one whose theory relied on the [W]icksellian natural interest rate concept. Keynes himself confessed that he also relied on it on the same time (early 30s) that Sraffa accused Hayek of using that unique rate concept …. As everybody knows, in the early 30s (and before that) Keynes was a [W]icksellian and a quantitative [= “quantity” – LK] theorist.
Yes, before the General Theory Keynes was indeed a quantity theorist and used the natural rate. But so what? Keynes was wrong.

Let me repeat that: Keynes was as wrong and misguided as any neoclassical in these years in his use of these concepts.

But, in the end, Keynes abandoned the natural rate idea between the Treatise on Money and his writing of the General Theory. Keynes came to see that the “natural rate” does not equate investment with savings, that savings can be much higher than investment, and that subjective expectations can shatter business confidence.

(2) Next, Sanchez asks me this:
“Why did ‘Lord Keynes’ accuse Mises (or Hayek) of using Wicksell’s natural rate and did not say anything about Keynes who was using it too two years after Mises and at the same time that Sraffa was accusing Hayek of using that [W]icksellian concept? Has he the guts to refute his ‘master’’s Treatise and his previous books because he was using the [W]icksellian natural rate concept? Can LK write ‘Keynes’s early theory is a complete nonsense because he relied on [W]icksellian theory of natural rate of interest’ or ‘All Keynes’s pre-GT writings on monetary and interest theory are worthless because he relied on [W]icksellian natural rate’? I doubt it. But let’s assume LK admits it and says “yes, all what Keynes wrote before GT is garbage because he relied on Wicksell natural rate. But obviously later on he did not used that faulty concept.”, however he himself has confessed that Mises in his later treatments abandoned that concept too. So in order to be intellectually honest he must say that Mises-ABCT is as immune to Sraffa’s criticism as it is the monetary and interest theory of Keynes in GT.”
The answer is “yes.” A great deal of what Keynes wrote before the General Theory is wrong, because of his use of neoclassical theory. (Although not all of it is wrong, for Keynes was, for example, receptive to the Chartalist theory of money and wrote some quite insightful though things about the history and nature of money).

In fact, I am surprised that any knowledgeable Austrian really thinks he has scored any points here. And, as I have admitted above, yes, a version of the ABCT purged of the Wicksellian natural rate of interest can be defended against Sraffa.

(3) The third issue is that Mises’s originary interest rate is still a flawed, real theory of interest. Interest is a monetary phenomenon, not explained by time preference.

If Mises’s originary interest rate is false, it follows that his later version of the ABCT (without the natural rate) still has a severe flaw.

(4) The objection that an economy where factor inputs are relatively abundant still poses a serious problem to the Austrian business cycle theory, despite what Sanchez says.

Instead of dealing with this issue, he merely distorts the issue, by attributing a straw man to his opponents. Keynesians and even Marxists do not deny that insufficient resources are often a problem in the real world.

The word “scarce” can have two meanings: (1) finite, and (2) insufficient quantities available in relation to demand. When I say that something is “relatively abundant,” I mean that it is available in a quantity that exceeds the demand for it.

But relative scarcity and relative abundance in these senses exist, and an economy can have a relative abundance of certain goods in any time outside a boom. International trade also provides goods even when domestically there might be shortages.

Nor do I deny that as an economy expands and reaches a boom, inflationary pressures build up as resources become less available.
Critics of my posts on the ABCT have simply misunderstood my critique. The non-existence of the natural rate of interest is one of the reasons why Hayek’s early business cycle theory is wrong. That critique applies to all Hayekian forms of the theory that use the natural rate, and even these Austrian critics are admitting this point.

The other versions of ABCT are flawed for other reasons. One of these is the unrealistic assumption of a economy that converges to a general equilibrium state:
“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012
An unrealistic capital theory is yet another problem, as I have shown here:
“Hayek on his Simplified Capital Theory Assumptions in Prices and Production,” October 15, 2012.

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


  1. The Murphy rehash of the theory and all those resembling it (i.e. all general equilibrium formulations) are basically just the same as the natural rate hypothesis embodied in the Taylor rule that is used in New Consensus Models and even estimated by (gasp!) central banks all over the world. The Taylor rule -- and the stronger form inflation-targeting rule -- basically state that if the central bank miscalculates the interest rate there will be inflation/deflation. This is exactly what Murphy et al are implying.

    Because if we assume a known equilibrium and all that then what the central banks are doing is perfectly legitimate when they go to put together inflation-targets and Taylor rules. This means that the juvenile tendencies that Murphy et al have of criticising the Fed have no theoretical basis any longer. They should inform their legions of followers straight away. But they won't, of course, because this is an exercise in political propaganda first and an exercise of economics second.

    If we go with Murphy then the neo-Austrians are just neoclassicals that can't do mathematics. But we all had our suspicions that this was the case anyway, didn't we?

  2. I don't think ABCT is dependent upon a Wicksellian single natural rate of interest.

    ABCT can be shown to be a specific case of monetary dis-equilibrium theory. An increase in the supply of money unmatched by an increase in its demand and combined with price stickiness will result in the structure of interest rates having a tendency to move lower in the short run. This lowering will cause distortions to the price structure that lead to the unsustainable investment and consumption patterns described by ABCT. If increases to the money supply continue over a long enough period then this can lead to a boom/bust scenario.

    Clearly underlying this theory is a concept of a set of interest rates that would maintain monetary equilibrium but when this is understood in terms of the demand and supply to hold money and not in terms of stabilizing prices I think it avoids Straffa's criticism of Hayek.

    1. "I don't think ABCT is dependent upon a Wicksellian single natural rate of interest...

      Hayek's original business cycle theory is (in Prices and Production), as is Mises's first two major expositions of the theory.

      And even the Austrian I have responded to above tacitly admits this.

      And, furthermore, a number of other Austrian versions of the ABCT also follow Hayek: both those of Rothbard and Roger Garrison.

      Garrison's version of the ABCT is basically the modern "go to" exposition. Yet it is as unsound as Hayek's version in 1931 was.

  3. "Hayek's original business cycle theory is (in Prices and Production), as is Mises's first two major expositions of the theory."

    I agree that this is a true statement. I would however be interested in your views on the monetary dis-equilibrium based versions of ABCT (such as that held by Horwitz) which I think could be shown not to depend upon a single natural rate of interest assumption.

  4. Bravo, Lord Keynes. A very clear article which should clear the air a bit.

    As a former Austrian who now tends to be more Marxian/post-Keynesian, I ask you and your readers the following question in a tongue-and-cheek jest: To what extent can a monetary, dis-equilibrium, non-Wicksellian, etc. based versions of ABCT still be called "Austrian"?

    It appears that any remains of ABCT from all of these powerful critiques, have required a certain escapism from standard Austrian theory. If we take the example of Horwitz, as Rawlings suggests, it is noticeable that "Austrians" have begun to move (read: 'retreat') in the direction of Virginia School, public choice theory, and George Mason University whereby New Institutional considerations have been blended with Austrian ones. Indeed, this is a stronger mutant to encounter. Yet, is it the case that the original "Austrian" tradition seems to have been lost in the back-peddling marathon?

    And, to be certain, there is at least one major critique incoming, granted this scenario (at least from my humble perspective), and this is against the fundamentalist belief that "in the beginning was the Market!"

    Thank you, and best wishes going forward.

    1. The essence of the theory is that inappropriate policy by the monetary authorities can have distortionary effects on the economy. An understanding of this can lead to the adoption of a better monetary regime.

      Discussions of the natural rate of interest v other theories of the rate of interest are a sideshow to the bigger theory.

      I don't see why the "Austrianness" of the theory is relevant. Either it helps us understand reality better or it doesn't.

    2. Yes, the recognition by, for example, Jonathan Catalan that the number of anti-fractional reserve banking, "deflation-is-always-good" Austrians is declining is a serious admission that Austrians are retreating into a more mainstream point of view.

      Monetary disequilibrium dynamics represent yet a further retreat and concession, a retreat to positions consistent with Keynesianism.

    3. "retreating into a more mainstream point of view."

      This isn't really fair, as opposition to fractional reserve banking is really a tenet of Rothbardianism and not an inherently Austrian idea. Were it not for Rothbard's insistence, I doubt it would have become part of the Mises Institute's canon.

      Re: "deflation is always good"--Selgin addresses this here on Glasner's blog:

      "Finally, it’s quite incorrect to assume that to assert that there’s merit to the Austrian view is to deny that busts can also be caused by monetary contraction–as if the Fed and other CB’s weren’t capable both of encouraging booms with overly easy money and of contributing to busts by making money overly tight.

      A man is rescued from drowning, his lungs full of water. He is revived, but then given nothing to drink. Must we say of such a man either that he is suffering from having taken in too much water, or that he is suffering from taking in too little? Can we not say that he has suffered first from one thing and then from the other?"

      "Monetary disequilibrium dynamics represent yet a further retreat and concession, a retreat to positions consistent with Keynesianism."

      This isn't a "retreat"; some Austrians have embraced monetary disequilibrium ideas for a long time. Here's White in 1983 addressing an Austrian audience (including Rothbard); the talk includes a support for both FRB and a quick nod to monetary disequilibrium ("monetary policy mistakes"):

      Monetary disequilibrium theory isn't Keynesian, it's a combination of Leland Yeager and Austrian macro.

    4. John S@January 30, 2013 at 12:11 PM

      "Monetary disequilibrium theory isn't Keynesian, it's a combination of Leland Yeager and Austrian macro.

      Yet even a quick look at the basic history of it shows it stems from ideas from Wicksell and Gunnar Myrdal - both economists have diverse intellectual heirs, including Keynesians.

      Stripped of the natural rate, it has affinities with Keynesianism, e.g.,

      "...Monetary-disequilibrium theory states that output, not (or not only) prices and wages, fluctuate with a change in the money supply. To that degree, prices are represented as sticky. It is this “monetary disequilibrium,” that, the theory contends, affects the economy in real terms.

    5. "The essence of the theory is that inappropriate policy by the monetary authorities can have distortionary effects on the economy. An understanding of this can lead to the adoption of a better monetary regime."

      This is basically just monetarism or New Keynesian economics. As I said, its just inflation-targeting. Move along folks, nothing to see here. It's all taught in graduate level macro. And all the Austrian nutters and gold bugs on the internet are just being bamboozled.

    6. Inflation targeting is the same thing as NGDP targeting? This alone is a shockingly bad misrepresentation. But how on earth is New Keynesian econ "basically just" the same as Selgin-White-Horwitz Free Banking? (which is the ultimate policy recommendation of most Post-White Austrians who have incorporated monetary disequilibrium theory)

      Are you familiar with Free Banking at all? I'm reading your literature (Debunking Econ)--please have the courtesy to at least attempt to understand something before you criticize it.

      Informative links:

      Selgin Sound Money Project Interview:

      Selgin Ron Paul lecture on the Fed (btw this addresses 19th cent. deflation--US money supply growth was bounded by the supply of fed debt, which shrank with Post-Civil War surpluses):

      Larry White with a good overview of Free Banking:

      As much as you despise Rothbard, you ought to be grateful for his obsession with fractional reserve banking. Insistence on 100% reserve banking has been the biggest barrier to mainstream acknowledgement of the Austrian school. But that barrier is crumbling--even if it's 30 years overdue.

    7. "Inflation targeting is the same thing as NGDP targeting?"

      When did I say that? They are different policies, but part of the same mainstream policy framework. Monetarists and New Keynesians both can advocate either inflation-targeting or NGDP targeting or any other array of nonsense policies**. All of it is in the same theoretical framework (a Quantity Theory of Money framework). The neo-Austrian stuff, in trying to hold the ABCT together, have become close enough to these positions as to have rendered the distinction meaningless from my point-of-view. It's all just neoclassical theory characterised by monetary policy being a stabalising force and a panacea. Yawn. Boring. Learned it in university in a variety of different guises and never gave any of it an ounce of credibility. Only brainwashed people with no real world analytical experience believe this stuff.

      The original Austrian position was "different" because it advocated abolition of the central bank, or at least hinted at it. The new framework, which banishes uncertainty etc. in favour of some dynamic equilibrium framework, can no longer make this case coherently. Plain vanilla economics. Those who adhere to it are boring neoclassicals. But, it would seem, neoclassicals who can't do mathematics and try to make up for their shortcomings by posturing about their knowledge of outdated texts from the 1930s. Neoclassical hipsters, one might say.

      As the "barrier" breaks down you will see that many "edgy" Austrians are absorbed into the mainstream. They'll be the inflation hawks on the boards of central banks and the bears in the T-bill market. They won't have anything new or original to say, but Lord knows they'll try.

      **I should clarify that there are a couple of New Keynesians that could be moving in a different direction using Taylor rules, but I doubt they will get very far because of their neoclassical foundations.

    8. Should clarify: yeah, you can be idiosyncratic and support free banking, but this becomes a political choice. When you accept all the above you have no theoretical reason to oppose the Fed because you've given up on uncertainty and hence you have given up on the idea that market agents process information better than an institution of trained economists. Welcome to the mainstream, pal. You can hold all the idiosyncratic views about banking that you like, but you're still in the mainstream.

  5. I suppose the W key on Sanchez's keyboard is not working?

  6. I "predict" a shift among the agitators of pure free market from Austrian school to some other form of Neoliberalism.It is simply to many flaws in the theory and it could not really reach out to more than minor fringe groups.I guess the think tanks recognize this fact and find other "schools" they put their money on.For only some years ago it was a heavy promoting of Milton Friedman´s ideas.Suddenly the all over internet trolls that promoted Friedman,almost dissapeared,
    and instead it was a large groups of Austrian´s.It has fascinated how fast the shift happened,and it made me wonder why that could be? How do such paradigm shift happen?It must be some sort of organisational structure behind it,i could hardly believe that such happen by pure occasition.

    1. Were you listening to that interview I did on Hayek and Mont Pelerin by any chance? What you're saying sounds awfully familiar. [].

      But yes, the Austrian stuff is "underneath" all the neoliberal stuff. I call it a "founding myth". The neoliberal responses are just a means to translate it into a practical form. Much like the above commenters seem to be doing with ABCT. It's just inflation-targeting with an Austrian twang. Adherents would fit in perfectly in an FOMC meeting. They'd be the annoying hawk in the corner of the room ruminating on hyperinflation and insisting on tight monetary policy. Their understanding of policy levers would be identical to everyone elses', but they'll have a deflationary bias built into their cognitive make-up.

    2. Jan:Thank you Philip.A wonderful interview that explain a lot!And it´s a pleasure to hear some fine Irish accent to! Sla´n!

    3. Philip Pilkington@January 31, 2013 at 5:09

      That was an insightful interview. I might put a link up to it in the next days.


  7. I "predict" a shift among the agitators of pure free market from Austrian school to some other form of Neoliberalism.

    They probably will not shift (Rothbardian-Austrians have bulletproof resistance against logic when it comes to fractional reserve banking). But if any do shift, I think it will likely be toward Free Banking Austrians like White and Horwitz--since they advocate a pure free market in money, credit, and banking.

    The other alternative might be left-libertarianism (, although I think the Libertarian party's future has better prospects among Republicans, judging from the results of the Liberty for All Super PAC:

  8. Paul Krugman on gold buggism – so right, so right