Sunday, September 28, 2014

Another Problem with the Austrian Business Cycle Theory

A devastating range of problems with the Austrian Business Cycle Theory (ABCT) are sketched here and here, but another problem relates to what happens in the bust under the ABCT.

In the bust, the ABCT says that new unsustainable capital projects initiated in the boom are liquidated: capital projects that were unsustainable are folded up and liquidated, and this drives the bust (Garrison 1997: 25).

The empirical evidence, however, does not support this. A great deal of the fluctuations in output and employment during recessions are caused by changes in capacity utilisation at mature firms and businesses (Kuehn 2013: 506, citing Davis, Haltiwanger, and Schuh 1996: 56–81), often connected with the need to liquidate inventory. This is what often characterises and drives the fall in investment, not liquidation of new projects.

And once we understand too that
(1) the loanable funds model as used and required in the ABCT is wrong, given that the unique Wicksellian natural rate of interest cannot be defined outside a one commodity world, and

(2) interest rates do not provide the necessary inter-temporal coordination of real saving and investment
we can see how flawed and wrong the ABCT is.

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

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds.), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 23–27.

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


  1. even if there was such a thing as a structure of interest rates which maintained optimal equilibrium over time (and there isn't), I see absolutely no reason why any real-world market economy (be it 'laissez-faire' or any other form) would necessarily hit upon that optimal structure of interest rates rather than any other.

    1. As well as being unknowable, a natural rate would also be an aggregate yet the central bank rate is not an aggregate. Therefore some bizarre theory of arbitrage would be needed to explain why central bank rates are not mispriced at the micro level even when optimal. If someone borrows money to buy a house, is there complex arbitrage involved to discover a natural micro rate? I don't think so. Last time I checked the banks offer the same deals to everybody. Even the banks use mark up pricing.