Tuesday, September 30, 2014

A Brief Outline of Mises’ ABCT

A quick summary following on from the last post of Mises’ Austrian business cycle theory (ABCT) in its successive stages, but with the version in Human Action included:
(1) a fall in the bank rate below the unique Wicksellian natural rate induces unsustainable, roundabout capital projects (Mises 2009 [1953]: 355, 360–361; Mises 2006 [1978]: 107–108). By the time of Human Action Mises replaces the unique Wicksellian natural rate with the single originary interest rate (apparently on capital goods) (Mises 2008: 547–548), but the two concepts are functional equivalents;

(2) but the new investment increases wages/aggregate income and non-labour factor prices (Mises 2008: 550), and so consumption increases in early and middle stages of the boom, and the prices of consumer goods rise (Mises 2008: 550). This increase in consumption is made more intense by the falling money rate of interest discouraging saving;

(3) the rising consumption also encourages consumer goods industries to expand production (Mises 2008: 558), further increasing demand for factor inputs.

(4) but, according to Mises (2009 [1953]: 362–363), as scarce factor inputs are bid away by the new firms engaged in more roundabout capital projects, raising the price of factor inputs, then the mature firms producing consumer goods in the last stages of production see their total quantity of output of consumer goods fall, even as inflation in consumer goods’ prices increases, and investment continues to increase. Presumably this is the point where investment and real consumption move in opposite directions.

(5) if the banks were to continue to expand the money supply indefinitely, the result will be hyperinflationary collapse of the currency, but normally banks end the process well before this (Mises 2008: 559). The boom reaches its end point when banks raise the money rate on loans, then investment falls. The capital projects that were unsustainable are folded up and liquidated, and this drives the bust (Mises 2008: 560–561; Mises 2006 [1978]: 115). The bust sees further falls in consumption and rises in saving, and liquidation of capital until bank rate and natural rate coincide and intertemporal coordination of saving and investment begins again, and investment rises.
An interesting question: did Hayek agree with point (4), that at some stage of the boom investment will continue to rise as real consumption falls?

Yet another question is: why does the law of demand (apparently) mysteriously stop working in the boom? Why doesn’t the relative degree of wage and price flexibility assumed in the theory (which, admittedly, is not perfect, but still reasonably strong) cause the Wicksellian natural rate to adjust and actually fall to the bank rate, as rising prices for consumer goods cause falls in the quantity demanded of consumer goods? Why don’t the rising prices of factor inputs cause falls in the quantity demanded of factors, so that investment is dampened?

If I am not mistaken, John Hicks (1967) wondered the same thing, and other neoclassical economists, citing Hicks, bring up the same objection (Vasséi 2010). Vasséi (2010: 213) points out that Mises (2008: 550) assumes no significant lag between the additional consumption through rising wages and the rise in the prices of consumer goods. So a serious time lag and “sticky” consumer goods’ prices cannot account for the lack of a tendency to market clearing.

Hayek’s answer, at least with respect to his version of the ABCT, was that disequilibrium in relevant product markets is not corrected because of the continuous “inflow of new money” into the system “at a given point and at a constant percentage rate” (Hayek 1969: 279). This doesn’t seem entirely convincing to me. It seems like the law of demand is asserted as a universally true law, but conveniently pushed aside when it contradicts the theory.

This also illustrates how the Austrians see market economies as incredibly feeble, fragile, unstable systems, which are thrown out of balance even by fundamental institutions of capitalism like fractional reserve banking and indeed any excessive credit money creation by private sector agents.

Under Austrian theory, capitalism isn’t some powerful Atlas, but is transformed into some hapless, puny weakling, liable to stumble and fall over at any time.

Further Reading
“Daniel Kuehn on the Austrian Business Cycle Theory,” December 5, 2013.

“John Hicks on Hayek’s Business Cycle Theory,” July 18, 2014.

“A Candid Admission from Hayek?,” Sunday, July 20, 2014.

Hayek, F. A. von. 1969. “Three Elucidations of the Ricardo Effect,” Journal of Political Economy 77.2: 274–285.

Hicks, J. R. 1967. “The Hayek Story,” in J. R. Hicks, Critical Essays in Monetary Theory. Clarendon Press, Oxford. 203–215.

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. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. 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.

Vasséi, Arash Molavi. 2010. “Ludwig von Mises’s Business Cycle Theory: Static Tools for Dynamic Analysis,” in Harald Hagemann, Tamotsu Nishizawa, Yukihiro Ikeda (eds.). Austrian Economics in Transition: From Carl Menger to Friedrich Hayek. Palgrave Macmillan, Basingstoke. 196–217.


  1. "Why doesn’t the relative degree of wage and price flexibility assumed in the theory (which, admittedly, is not perfect, but still reasonably strong) cause the Wicksellian natural rate to adjust and actually fall to the bank rate, as rising prices for consumer goods cause falls in the quantity demanded of consumer goods"

    Why would price flexibility cause the natural rate to change ? if there was perfect price flexibility then prices would adjust to the increase in the money supply while (other things equal) that natural rate would remain the same. Changes in the price level would cause the nominal bank rate and the underlying natural rate to stay aligned.

    1. I phrased that poorly. What I should have asked, as Hicks did, is why wouldn't flexible prices and wages lead to a tendency to market clearing and dampening of the excessive real investment, so that there is a “nil effect” (Hicks 1967: 207–208).

      But if rising prices induce people to save more, then that would affect the hypothetical natural rate.

    2. Hicks asks a good question - ABCT is a theory based upon monetary disequilibrium - many Austrians don't like that view.

      You may find this article interesting.


  2. Good point about the disequilibrium thing. I think that the Austrians tried to dynamise the old static equilibrium framework and then quickly found that this led to profound problems. That, I think, is what accounts for the problems that you raise above.

    In reality, when we think about dynamic economics it quickly becomes obvious that the Keynesian approach is the best because it makes no strong assumptions about, well, anything really.

  3. I don't get this unique Wicksellian interest rate. First, I think few people accept this idea at all. I see different interest rates everywhere. Interest to me is the price of borrowing. So why would one argue there is a single natural rate?
    Next, why does ABCT rely on there being a unique rate?

    1. I've tried to lay out an explanation of the Wicksellian natural interest rate step by step here:


      If you have questions, I'll do my best to explain.

    2. Maybe I should just add: this critique of the ABCT on the Wicksellian natural rate goes back to Sraffa's review of Hayek's Prices and Productions:

      Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

      Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.
      Hayek's reply was here:

      Hayek, F. A. von, 1932. “Money and Capital: A Reply,” Economic Journal 42 (June): 237–249.

      Post Keynesians would say that Hayek never came up with an answer to Sraffa.

      Astonishingly, this is a view that even Robert Murphy accepts -- he accepts that Sraffa's critique was correct, and Austrians have never answered it:


    3. Also, the Cambridge Capital controversies -- amongst its many issues -- also deals with the problems with the concept of a natural rate.

      It's a dry, technical subject for many people, but some relevant links:




    4. http://fixingtheeconomists.wordpress.com/2014/05/17/the-natural-rate-of-interest-does-not-exist/

  4. I've always wondered--does ABCT make any provision for the effects of changes in exchange rates and other exogenous variables?

    It seems to me that the logic of the cycle could be disrupted at a number of points by the effects of currency movements. For example, its claim that price rises in both wages and non-labour factor prices will follow upon the bank rate dropping below that mythical natural rate--couldn't the disinflationary pressure of a simultaneous large appreciation in the value of the currency the CB issues against other popular currencies prevent this from occurring, if the swing is big enough? And if so, wouldn't that short-circuit the series of events that's supposed to make the bust 'inevitable', thus making it, well, *not* inevitable as most vulgar Austrians are wont to claim? (that would certainly undermine the case for intervention only ever making things worse)

    I could be totally wrong, but I get the feeling that Mises was so hamstrung by the a priori methodology of praxeology that he made the ABCT almost autarkic--it doesn't account for the complexities that arise when you view economies in their natural international context, where they can be affected by developments in other economies. (and by extension their currencies) Minsky and the financial instability hypothesis don't seem to fall into this trap: because he posits that the fostering of instability by periods of financial stability is a process endogenous to the capitalist system--it's part of what capitalism IS, not what happens when capitalism is distorted--all the international dynamics (including changes in exchange rates) are already 'built into' the theory.

    By contrast, ABCT (particularly the Misesian version) is all about capitalism being distorted by central banking, and so is predicated on a very specific series of events unfolding from an exogenous 'intervention' by the central bank. Because the theory attempts to preserve the contingency of the cycle--it doesn't HAVE to happen, it's not a natural part of the capitalist system, we'd have utopia were it not for central banking--it seems to me it leaves open the door for other exogenous factors to disrupt that series of events.

    Am I missing something big or misunderstanding things? I'll admit I'm biased by my belief that Mises, Rothbard and that whole portion of the Austrian school were rather lazy thinkers demonstrating little intellectual rigor--I only read through their best-known works once, and suffered considerably while doing so, whereas I rather enjoy reading Hayek, Lachmann, and Böhm-Bawerk, even when I disagree with them, since I find them to be more disciplined, nuanced and thoughtful. (As an aside, I think it's telling that most Austrian cranks don't know much about Austrian economics outside of the work of its two most worthless figures.)

    1. I think the classic Austrian models of the ABCT (as in Hayek's work) use a closed economy assumption and seem to ignore exchange rate issues -- and as you point it: this is not very realistic at all.