Thursday, December 5, 2013

Daniel Kuehn on the Austrian Business Cycle Theory

Daniel Kuehn has an important and very interesting paper here on the Austrian business cycle theory (ABCT):
Daniel Kuehn. 2013. “Hayek’s Business-Cycle Theory: Half Right,” Critical Review 25.3–4: 497–529.
Three insightful critiques of the ABCT are these:
(1) the empirical evidence suggests that business people do not respond to interest rates in the way the ABCT predicts: interest rates do not much affect production decisions in already established firms (Kuehn 2013: 505, citing Tullock 1987 and Akerlof et al. 2000: 505), especially if they have excess capacity.

The finding of Davis, Haltiwanger, and Schuh (1996) “suggests that most job creation (and destruction) happens at large, mature establishments which are presumably primarily making capacity-utilization decisions rather than new capital-expenditure decisions” (Kuehn 2013: 506).

In fact, the overrated role of interest rates in determining investment has been known since the 1930s. Work by the Oxford Economists’ Research Group (OERG) (instituted at Oxford University in 1936) found that interest rates had considerably less influence on investment decisions than standard economic theory held, and that uncertainty was an overriding factor in the investment decision (Lee 1998: 88).

(2) Another finding that contradicts Hayek’s theory is that
“Cowen (1997) points out that over the course of the business cycle, investment and consumption move together, a phenomenon he refers to as ‘comovement.’ For at least two reasons, Hayek’s theory predicts that investment and consumption should move in opposite directions during the business cycle, with investment rising in the boom and declining in the bust.” (Kuehn 2013: 507).
As Kuehn points out, Austrian attempts to answer this still contradict Hayek’s theory and even suggest that no “rebalancing” or “bust” needs to happen in the economy at all (Kuehn 2013: 508).

(3) Kuehn also analyses some of the twenty empirical evaluations of Hayek’s ABCT listed here:
Kuehn concludes that, if lengthening of the capital structure has validity, the capital structure actually “lengthens and contracts as a consequence of the business cycle, rather than as its cause” (Kuehn 2013: 523).
Post Keynesians, I suspect, would press more strongly Sraffa’s critique of Hayek on the non-existence of the natural rate, the problems with loanable funds, the irrelevance of Hayekian versions of the theory that use a general equilibrium framework, and other problems listed here.

Nevertheless, this paper makes productive reading.

Akerlof, G., Dickens, W. and G. Perry. 2000. “Near-Rational Wage and Price Setting and the Long-Run Phillips Curve.” Brookings Papers on Economic Activity 1: 1–44.

Davis, S. J., Haltiwanger, J. C. and S. Schuh. 1996. Job Creation and Destruction. MIT Press, Cambridge, Mass.

Kuehn, Daniel. 2013. “Hayek’s Business-Cycle Theory: Half Right,” Critical Review 25.3–4: 497–529

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Tullock, Gordon. 1987. “Why the Austrians Are Wrong about Depressions,” Review of Austrian Economics 2: 73–78.


  1. Ya you have it in your bibliography, but the real strong statement on interest rates is Tullock, not Akerlof.

    The Akerlof paper is nice because it validates this point much more broadly (in their case, w.r.t. inflation). Small costs are in practice ignored. And when it comes to capacity utilization decisions interest rates are small costs.

    1. Thanks, I've added a reference to Tullock above in point (1).

  2. this is a test from my work browser

  3. Must be the browser on my ipad. Bummer.

    Over at prax Central I think we have hunted the M_F to its lair.

    M_F's many contradictions in that htread are too many to list, but this final howl, "I'm right I don't need to explain!", should convince any fair minded reader.

    Now of course that we have learned from all the praxeologist's there that the action axiom is analytic/synthetic/empirical/a priori and does/does not logically imply the laws of economics we should do penance for not finding this limpid, unambiguous, and convincng.

    1. Yes, his totally inconsistent comments and deliberate distortions of virtually every comment his opponents make it pretty clear he is incapable of rational, good faith debate.

      Just look at his parting comment:

      "These truths are not derived from observation, and formal logic is insufficient to show their truth."

      What the?? Not only is this bizarre, but also is contradicted by Mises, Hayek and Rothbard themselves:

      “Schuller maintains that Mises “provides no clear test of incorrect versus ‘correct praxeological reasoning.’” The tests are, on the contrary, clear enough. Praxeology consists of two main elements: (1) the fundamental axioms, and (2) the propositions successively deduced from these axioms. Neither the axioms nor the deduced propositions can be “tested” or verified by appeal to historical fact. …. The deductive propositions are tested according
      to the universally accepted laws of logic.
      (Laws, incidentally, which are also a priori to historical fact.) The fact that a proposition comes at the end of a “long chain of deduction” makes it no less valid than a proposition at the end of a short chain."

      Rothbard, Murray N. 1951. “Mises’ ‘Human Action’: Comment,” The American Economic Review 41.1: 181–185, at p. 181.

  4. “Cowen (1997) points out that over the course of the business cycle, investment and consumption move together, a phenomenon he refers to as ‘comovement.’ For at least two reasons, Hayek’s theory predicts that investment and consumption should move in opposite directions during the business cycle, with investment rising in the boom and declining in the bust.”

    I don't understand this. Is he saying that Cowen says that investment and consumption move together in a recession (which, by the way, was known long, long before 1997 and is implied in Keynes' own consumption function...)? Okay, I think that is what he's saying. I get that. Although, it's really just a simple consumption function argument.

    Now, what are the reasons that Hayek says that they should move in opposite directions? Okay, so in a recession Hayek thinks that some sort of "spring cleaning" is occurring where all the "malinvestment" is being cleared out. This, of course, would lead to a fall in investment. But why should consumption rise? Surely Hayek knows that when investment falls, incomes fall. So, what gives rise to this rise in consumption? Surely it cannot be drawing down savings or borrowing because in ABCT interest rates rise in a boom.

    LK, perhaps you could lay out the argument in more detail. It looks wrong to me at face value.

    1. Right - we've known this much longer than 1997. The point is Cowen (1997) is the best known critique of ABCT on those grounds. He has several criticisms of ABCT, some stronger than others.

    2. Last July some Austrians released a paper refuting Cowen's findings, just saying.

  5. Pace my comment above, I have looked this up. Some vulgar Austrians seem to try to make this case using a simple money market S-D framework. But it is completely nonsensical and incoherent and seems ignorant to how interest rates functioned in the classical model. So, let's go back to the source, shall we?

    Here is Mises in Human Action:

    "The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment. The depression, on the other hand, is the way back to a state of affairs in which all factors of production are employed for the best possible satisfaction of the most urgent needs of the consumers." (p573).

    "Out of the collapse of the boom there is only one way back to a state of affairs in which progressive accumulation of capital safeguards a steady improvement of material well-being: new saving must accumulate the capital goods needed for a harmonious equipment of all branches of production with the capital required. One must provide the capital goods lacking in those branches which were unduly neglected in the boom. Wage rates must drop; people must restrict their consumption temporarily untiI the capital wasted by malinvestment is restored. Those who dislike these hardships of the readjustment period must abstain in time from credit expansion." (pp575-576).

    My guess is that Kuehn's arguments are against some vulgar Austrians who just make stuff up and don't read the original work in the field. But I think Mises is quite clear on this point: during the boom and the depression consumption and investment move together. It looks like he anticipated Cowen (1997)! ;-)

    People should really go to the source when dealing with this stuff. The theories are bad enough as they are. No need to misrepresent them.

    1. But surely even in that quote Mises is saying after the bust consumption falls and savings rise leading to higher investment? That requires a time period of falling consumption and rising investment.

    2. We have already seen that Mises thought that consumption would fall in the bust until it returned to a more sustainable level later. But what happens to investment? Well, let's ask Ludwig...

      "As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap. Factories are closed, the continuation of construction projects in progress is halted, workers are discharged." (p562)

      Or here is a particularly clear passage where he says that consumption and investment fall together in the bust:

      "Expansion squanders scarce factors of production by malinvestment and overconsumption. If it once comes to an end, a tedious process of recovery is needed in order to wipe out the impoverishment it has left behind.
      But contraction produces neither malinvestment nor overconsumption. The
      temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of discharged wage earners and the owners of the material factors of production the sales of which drop." (p567)

      If you read this chapter in Mises (Chapter XX) it is crystal clear that his only real concern is that the boom is characterised by MALinvestment rather than OVERinvestment. That is his concern. He's not a total fool. He doesn't think that consumption rises in a recession. Nor does he think that investment rises in a depression.

      I also read a bit of the vulgar Austrian literature again and they never say that consumption rises in a slump. Rather they say that consumption rises at the pinnacle of the boom, this leads to a rise in the interest rates and then investment, incomes and presumably consumption collapses.

      So, actually, I'm not really sure WHERE Kuehn is getting his argument from. Does he provide a source in the paper?

    3. Also, Kuehn clearly said that investment falls in the bust and implies that consumption increases:

      "Hayek’s theory predicts that investment and consumption should move in opposite directions during the business cycle, with investment rising in the boom and declining in the bust.”

      Again, a source would be nice here. Where on earth is he getting this argument? For a moment I thought I found it in the vulgar Austrians but closer inspection shows otherwise.

    4. This doesn't deal with Mises or Austrians generally - it's a symposium on Hayek. And Hayek said they would not move together (I cite him in the paper, if you're interested).

      I also discuss Garrison - certainly not a vulgar Austrian - and his attempts to rescue the theory. His case makes sense, but it is not Hayek's argument and it seems to jettison the Ricardo effect (it really has to of course).

    5. I know Hayek better than I know Mises, but here he seems to be saying they don't move together.

      You don't even have to assume he ignores the paradox of thrift. After telling you savings must increase for investment, he comes out and tells you that consumption (not the rate of consumption) must be restricted.

    6. Mises and Hayek have the same theory. I looked into it and you appear to have torn Hayek completely out of context. I am pulling the following quote from a comment I made on my blog:


      Kuehn has quite clearly torn Hayek completely out of context. Ready? Here we go. Kuehn writes the following to show that Hayek thinks that Cowen’s ‘comovement’ will not take place:

      "For at least two reasons, Hayek’s theory predicts that investment and consumption should move in opposite directions over the business cycle, with investment increasing in the boom and decreasing in the bust… Hayek clearly expected a movement of consumption and investment in opposite directions: “an increase in the demand for consumer goods will tend to decrease rather than increase the demand for investment goods” (Hayek [1939]1975, 3). — (Kuehn, pp8-9)

      So, let’s trace that Hayek quote back and give it some context, shall we? Okay:

      “In this essay an attempt will be made to restate two crucial points of the explanation of crises and depressions which the author has tried to develop on earlier occasions. In the first part I hope to show why under certain conditions, contrary to a widely held opinion, an increase in the demand for consumers’ goods will tend to decrease rather than to increase the demand for investment goods. In the second’ part it will be shown why these conditions will regularly arise as a consequence of the conditions prevailing at the beginning of a recovery from a depression.” — (Hayek, p3 — My Emphasis)

      Now, remember, Kuehn said that Hayek expected “that investment and consumption should move in opposite directions over the business cycle, with investment increasing in the boom and decreasing in the bust“. But that is NOT what Hayek is saying. He is saying rather that investment and consumption will follow different paths “at the beginning of a recovery from depression“. He is quite clear about this when he says “I hope to show why under certain conditions…”. Under certain conditions, i.e. after a depression and at the beginning of a recovery. That is an entirely different argument.


      Anyway, the key point is that the point you raised entirely misses the point about ABCT.

    7. That post is very interesting, and I must say it looks like you've raised a good point that needs answering.

      However, you say:

      "But that is NOT what Hayek is saying. He is saying rather that investment and consumption will follow different paths “at the beginning of a recovery from depression“."

      But that is exactly what I said above:

      "But surely even in that quote Mises is saying after the bust consumption falls and savings rise leading to higher investment? That requires a time period of falling consumption and rising investment."

      I think my original comment -- at the least -- was vindicated, even if there may well be misunderstanding about the directions of consumption and investment during the boom and bust phases.

      However, if the economy is in equilibrium when the boom starts, doesn't this imply that consumption will eventually fall in the boom?

      This is what Garrison says:

      "Used in this way, the concept of forced saving is wholly conformable with the concept of overconsumption. The two terms taken together suggest a pattern of consumption and saving that characterize the boom-bust cycle. As the boom begins, consumption demand is high relative to the pre-expansion level. Incomes earned by workers and other factors in the early stages of production are being spent on consumer goods. To the extent that this high consumption demand is met with increased allocations to the late stages of production, then resources are being doubly misallocated. Considerations of derived demand and of time discount are sending resources in opposite directions.
      The Hayekian triangle is being pulled at both ends against the middle. Production activities in the middle stages, which have been effectively raided because of high demands in both the early and late stages, eventually reach maturity—but with yields of consumer goods that are deficient with respect to both the boom phase and the pre-expansion economy. It is at this point that consumption falls, as it must, and saving increases."

    8. I sort of agree, LK. But Hayek's argument in that particular paper is very obscure. It's really not central to the ABCT.

      The key issue here is whether consumption rises when investment falls and vice versa. We might be able to find arguments where this may occasionally happen, but it is not some sort of "law" governing the business cycle in Austrian theory. Rather the business cycle in their theory seems to assume something like a consumption function, or whatever it is that Cowen relabeled it.

    9. Here is more evidence of what I'm saying. In the very paper that Kuehn cites Hayek clearly states that after the crash investment AND consumption fall. I quote from the sub-heading "Investment and Revival":

      Prices of consumers' goods are notoriously sticky. At first, when the demand for such goods ceases to increase or even begins to fall, this will check the tendency to increase capacity and thus (by decreasing the "multiplicand" of the acceleration effect without as yet changing the" multiplier") will decrease employment also in those
      capital goods industries which till the end shared the prosperity of the consumers' goods industries. This will further intensify the decrease of incomes and of consumers' demand. (Hayek, 1939, p35)

      This process is then brought to a halt by the familiar mechanism: a deflation, a fall in prices and a consequent rise in real wages.

      What Hayek is arguing here is explicitly neo-Keynesian. He is not only using Keynesian language (he says "multiplier" and in the previous pages he discusses the "marginal propensity to consume") but he is also assuming sticky prices and falling consumption.

      Hayek's "critique" of vulgarised Keynesianism always had to do with MALINVESTMENT. That is why he was able to say that sometimes the government should intervene. That is also why the vulgar Austrians are totally off base when they say that stimulus will lead to hyperinflation etc. That is a Rothbardian argument. And whatever you think of Hayek, Rothbard was a very stupid man indeed.

  6. The “lengthening of the capital structure” idea always struck me as bizarre. The decision to increase the number of intermediate stages involved in producing something is an inherently long term decision: it cannot be implemented and reversed in line with the boom / bust cycle.

    1. Certainly in any substantial way it's an odd theory. There's some decent empirical evidence that there are marginal changes in the length of the capital structure, though. I'm willing to accept that - but I don't think it matters for the business cycle.

  7. Here we go. The theory and debate is nicely summarised. I'm surprised this went as far as it did. Isn't Critical Review full of Austrian types?

  8. It's good to know that two of my concerns about the ABCT have been resolved. First, while interest rates are probably the most important "price" for purposes of information and planning, so are the prices of finished goods (and everything else) that people are buying. Second, with the advent of consumer credit, there is no reason that a capital goods and consumer goods boom cannot occur simultaneously. What happens as the result of an artificial credit expansion is always an empirical matter but certain "rules of thumb" apply.

    None of this impairs the central importance of economic calculation nor does it benefit the Keynesian analysis in any way. That is why Keynesian analysis must suppress and ignore the self evident but empirical nature of voluntary exchange and economic calculation.

    1. (1) interest rates are not the "most important "price" for purposes of information": the post above shows you evidence that they are not for most established firms.

      Nor are many prices even performing their Hayekian function, because they are administered prices.

      (2) The notion of "artificial credit expansion" just begs the question and assumes all new money creation is immoral, which it is not.

      (3) "None of this impairs the central importance of economic calculation nor does it benefit the Keynesian analysis in any way."

      Because your stupid comments refute none of the criticisms raised against the ABCT.

      Once the ABCT is shown to be a false theory of the cycle, it follows directly that this would "benefit the Keynesian analysis".

      All in all, one wonders whether you even read the post or did anything but randomly write these sentences with your typical prize ignorance.

    2. Bob Roddis acts like we still dig our wealth out of the ground. Arguing with pathetic Internet Austrians is like trying to talk to a brick wall. It's like these loons are trying to understand how to operate a DVD or Blu-ray with outdated knowledge of how a VCR works.

      Roddis is nothing but an annoying troll and I wish that his comments would not be published on this site from this point on.

    3. Bob's also a moron if he thinks any of the nonsense he said applies to a world where people can deposit checks with their smartphones. Keep on doing what you're doing LK, destroying these dogmatic, ignorant trolls. I don't get what they have to gain by coming here all the time and getting in the way of genuine discussion on these topics.