Monday, June 6, 2011

Austrian Business Cycle Theory: Epicycles on Epicycles

Austrian business cycle theory does not explain the most recent disastrous cycle seen in many countries from 2001/2002–2009/2010 (“Austrian Business Cycle Theory: Its Failure to explain the Crisis of 2008,” October 18, 2010).

I can’t resist quoting the Cato Institute libertarian Tom Palmer on this as well:
“Among the many books I read during my recent travels, I strongly recommend Johan Norberg’s truly excellent diagnosis of … the financial crisis …. It’s far better than the other works I’ve read … with no religion thrown in. (As an example of the latter, the book Meltdown by Thomas Woods insists, contrary to the evidence, that the artificially induced boom resulted in a lengthening of the capital structure through overinvestment in too many ‘long-term projects.’ [p. 68] In fact, what we saw was a bubble in housing, which is not a ‘long-term project’ that will ‘bear fruit only in the distant future,’ but a speculative investment in a durable consumer good, with an additional twist: the low refinancing rates and the inducements to refinance led many to treat their homes as ATM machines and withdraw cash to finance, not ‘long-term projects,’ but consumption. But Mises and Hayek explained a previous boom-and-bust cycle in terms of a lengthening of the capital structure, so we must believe — we must, a priori! — that all boom-and-bust cycles must — they must! — follow the same process. That’s religion, not analysis.”

Tom Palmer, “Norberg on the Financial Crisis…. GREAT!!,” November 1, 2009.
Palmer is right, and his insightful comments provoked a storm of anger from Austrian ABCT supporters, caught, as it were, with their intellectual pants down by Palmer, as can be seen here:
Steve Horwitz, “The Battle of the Toms,” Coordination Problem, November 2, 2009.
Yet another thing that occurs to me is that ABCT is like the geocentric theory of the universe: the empirical evidence is inconsistent with it, and its Austrian supporters are constantly having to modify and change it – madly flogging the dead horse – to desperately make it work, like adding epicycles to the Ptolemaic geocentric theory (for people who will complain about the historical problems with “Epicycles on Epicycles”, I am using it as a metaphor only, so don’t bother to leave comments about this issue).

For example, ABCT clearly doesn’t work for the 2002–2009 cycle, when bad debts to consumers for houses or refinancing mortgages led to an asset bubble in real estate.

If we turn back to a description of ABCT by Rothbard, we have this analysis of what is supposed to happen:
“[businesses] invest more in capital and producers’ goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable now seem profitable, because of the fall of the interest charge ... They expand their investment in durable equipment, in capital goods, in industrial raw material, in construction as compared to their direct production of consumer goods” (Rothbard 2009 [1969]: 32–33).
But people taking out liars loans or NINJA loans were not making investments in lengthy and time-consuming projects: they were often just buying houses already built on secondary markets.

In fact, Rothbard in Man, Economy, and State was already clear that credit to consumers does not cause ABCT effects:
“What happens, however, when the increase in investment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? …. What are the consequences? The new money is loaned to businesses.110 These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original factors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the [new money is] … therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors. The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and … lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production structure is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on projects formerly unprofitable.

110 To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur. (Rothbard 2004 [1962]: 995–996).
So, according to Rothbard, as more money flows “to consumers rather than businesses, the cycle effects discussed in this section do not occur.” The conclusion is clear: Rothbardian ABCT as a serious explanation of the recent cycle is a joke. That seems to be reinforced (perhaps unintentionally) by comments made by Mario Rizzo:
“The first thing to keep in mind is that while [sc. ABCT] … embodies ‘Austrian’ characteristics it is not an official Austrian theory. What do I mean by that? Eminent Austrian economists have made important criticisms of the bare-bones theory. For example, Israel Kirzner has criticized the theory for not taking entrepreneurship seriously. Where are the alert entrepreneurs either in the boom phase or the recession phase? There are profits to be made from avoiding mistakes. Another eminent Austrian economist, Ludwig M. Lachmann — one of the main contributors of the development of the idea of capital heterogeneity which is an important constituent part of the cycle theory — criticized the ABCT for assuming that agents simply expand their investment whenever interest rates fall. And Ludwig von Mises agreed that we need to take account of what the agents expect about the future course of interest rates.

Second, the ABCT is only a partial theory of the cycle — specifically of the upper turning point. We should also not expect it to explain all business cycles — just those which are generated by excessive credit expansion to businesses.”

Mario Rizzo, “Austro-Wicksellian Theory of the Business Cycle: An Informed View,” Thinkmarkets, April 13, 2010.
But then what does Rizzo make of the fact that much of the credit in the recent cycle went to consumers?

What are the Austrian solutions to this? Jesús Huerta de Soto steps up to the plate: let’s just pretend durable consumer goods are capital goods! (Huerta de Soto 2006: 406–408). Here is what de Soto says:
“We are now able to identify the modifications, if any, to be made to our analysis when, as in modern economies, a significant portion of the credit expansion banks bring about without the support of voluntary saving takes the form of consumer credit. This analysis is of great theoretical and practical importance, since it has at times been argued that, to the extent credit expansion initially falls on consumption and not on investment, the economic effects which trigger a recession would not necessarily appear. Nevertheless this opinion is erroneous for reasons this section will explain. It is first necessary to point out that most consumer credit is extended by banks to households for the purchase of durable consumer goods. We have already established that durable consumer goods are actually true capital goods which permit the rendering of direct consumer services over a very prolonged period of time. Therefore from an economic standpoint, the granting of loans to finance durable consumer goods is indistinguishable from the direct granting of loans to the capital-intensive stages furthest from consumption. In fact an easing of credit terms and a decline in interest rates will provoke, among other effects, an increase in the quantity, quality and duration of so-called “durable consumer goods,” which will simultaneously require a widening and lengthening of the productive stages involved, especially those furthest from consumption” (Huerta de Soto 2006: 406; this can also be read here).
So now ABCT can work only if we radically re-define the nature of consumer goods, and make them capital goods.

But houses were not “capital goods” in any reasonable sense of that term in relation to owner occupiers: these were people who went into debt, either bought a home to permanently live in, or lived in them and expected to make money from capital gains on their asset (the home) appreciating in price. We are talking about assets and asset bubbles here, not production goods. If you earn money from the appreciation in your house’s value, then this is speculation on asset prices, not obtaining an income through production and sale of commodities. Therefore the home cannot be, and is not, a capital good: it is not used to produce a commodity. Even the person who “flips” it is selling an asset on a secondary market.

Of course, if a house was bought to rent out to other people, it is a capital good. But, as we can see perfectly well in Figure 3 of this book:
Brookings Papers on Economic Activity: Fall 2008, p. 81 (see also p. 83),
loans to non-owner-occupiers did not significantly rise in 2000s housing bubble and in fact stayed flat. It was owner-occupiers who took the majority of sub-prime loans. These people are the ones who started to default causing the subprime meltdown and crisis in the value of mortgage backed securities. Many of these people were not “house flippers”: the significant factor was subprime mortgages that went bad made to occupant-owners or subprime mortgages made to occupant-owners used to refinance existing loans.


Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.


  1. I think you're quite right in says that the Rothbard's version of the ABCT is a quite wrong, and it CANNOT explain the current crisis. And I also find De Soto's explaination quite clumsy. But I don't believe that his explaination is wrong because it implies that we "re-define the nature of consumer goods, and make them capital goods". What I interpret from him (I could be quite wrong in my interpretation) is that a boom in consumption goods such as housing (we may just consider housing a consumer good) may provoke a rise in housing prices and indirectly trigger an investment boom (in this case, in new housing production). I still find it quite stupid that nowhere in his explaination he mentions financial markets (I still haven't read his book, though).

  2. "What I interpret from him (I could be quite wrong in my interpretation) is that a boom in consumption goods such as housing (we may just consider housing a consumer good) may provoke a rise in housing prices and indirectly trigger an investment boom (in this case, in new housing production)."

    Correct. But, again, what you're saying is compatible with a Post Keynesian explanation of the recent cycle, and the Austrian solution of deflationary depression does not follow at all.

  3. Um, Austrians have considered durable consumer goods as capital goods since Hayek first fleshed out his theory of intertemporal price coordination.

  4. "To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur. (Rothbard 2004 [1962]: 995–996)."

    Then the attempt to make ABCT work over 2000-2009 by invoking that concept is STILL a revision - an epicycle - even if the consumer goods as capital goods argument was made by Hayek.

    And where does Hayek ever say that his ABCT aplies to credit extended to consumers?

    *No one ever wrote a book saying 'ABCT - here it is'. What is considered ABCT has evolved over time.
    *When Austrians say 'capital good', they use the term in an idiosyncratic way (which is probably a bad idea) to mean a higher-order good/sensitive to interest rates.
    *Just because some 'Austrians' change their views in the epicycle manner does not invalidate the notion of an ABCT which considers SOME consumer goods as (ABCT) 'capital goods'. I've noticed you do this somewhat often on your site - show a self-declared Austrian saying something that doesn't make sense, or engaging in some form of denialism, and then go 'And it just goes to show - Austrian economics and/or ABCT is false!'
    *There are a lot of people out there who use Austrian economics to argue for things inconsistent with Austrian theory (like austerity, for example, which Austrian theory is, if anything, neutral on--because austerity doesn't 'distort' the economy--so consistent Austrians should evaluate austerity measures on a case-by-case basis), so this may be one of those cases.
    *Worth thinking about (from Horwitz article): "An observer unfamiliar with ABCT might claim housing isn’t a “long-term project” and thus doesn’t fit into the Mises-Hayek story, but that would just underscore his lack of acquaintance with the Mengerian framework in which Mises and Hayek operated. Housing is a long-term consumer durable, interest rate sensitive, that is time-consuming to build and is very capital intensive."
    *Even if your post is substantively correct, ABCT is fundamentally about an unsustainable expansion of credit and/or a big increase in the money supply relative to the overall productivity of the economy, not just a bubble in housing/something similar. So even if the housing bubble isn't malinvestment according to ABCT (though I think it is), there might still be other malinvestment going on in the economy--things consistent with ABCT. In other words, Austrians argue that the unsustainable credit expansion of the early 2000s caused a lot of problems--not just a housing bubble.
    *Not to imply you think this, but just because I feel compelled to mention it, I certainly don't see anything about the housing bubble that could in any way be used as an argument against ABCT.

  6. The problem with ABCT is the problem with monetary economics in general - anyone can see what the FED is doing, and if they believe it to be inflationary, they would raise their interest rates or prices or whatever.