The Filthy Anti-Capitalist Mentality – of Austrian Economics

And I mean the anti-capitalist mentality of the Austrian libertarian cult and certainly in its Rothbardian form, because – make no mistake – these people are anti-capitalist in their core ideological beliefs, no matter how much we have to hear of their blustering nonsense.

Let us take the crucial points which make Austrian libertarianism anti-capitalist:

(1) Opposition to fractional reserve banking
Rothbardians and many other Austrian libertarians oppose even private capitalist fractional reserve banking, but their arguments for doing so are utterly flawed, wrong or just plain ignorant. In truth, fractional reserve banking is neither inherently immoral nor fraudulent, but is a fundamental and indispensable basis of capitalism. You cannot have modern capitalism without it.

In its ignorant opposition to fractional reserve banking, Rothbardianism and other Austrian economics following the Rothbardian view are actually profoundly anti-capitalist and (on their own principles!) would require coercive violations of private property rights and free contract to ban fractional reserve banking, if they were to implement their utopian anarcho-“capitalist” system.

(2) The Austrian business cycle theory (ABCT) when we understand Point (1)
Because of their mistaken view in (1), Austrians and Rothbardians – whether they want to admit it or not – are logically committed to the view that business cycles are a core and inevitable element of capitalism. In essence, Rothbardians assert that, in order to avoid business cycles, not only central banking but also private-sector fractional reserve banking must be abolished.

However, as we have seen, fractional reserve banking is a fundamental basis of capitalism and is not fraudulent. It cannot be abolished without rejecting capitalism. Capitalism is stuck with fractional reserve banking. It follows that Austrians and Rothbardians (if they were honest) must admit that capitalism – since fractional reserve banking is at its heart – is inherently and badly flawed and naturally tends to produce business cycles in its laissez faire state. Laissez faire capitalism is therefore obviously not the best system we could have. And Austrians must therefore hold the view that capitalism is inherently bad. They are just filthy anti-capitalists like their opponents.

Now let’s expand on these points.

What is the major argument Austrians have against fractional reserve banking? The Rothbardians argue that fractional reserve banking is fraudulent because it supposedly involves two incompatible property claims to the same money “deposited” in a bank whenever one opens a demand deposit.

However, this is simply a blatant falsehood, because when you open a demand deposit, you utterly forfeit your property rights to the money and transfer the ownership rights in the money to the bank. The money becomes the bank’s property. All you get in return is an IOU or debt instrument, promising to repay the debt owed to you on demand. Therefore there are not two property claims to the same money: there is only one.

I cannot be bothered repeating all my refutations of every ignorant and absurd Austrian argument against fractional reserve banking, but you can read them here:

“Hayek’s Original View of Fractional Reserve Banking,” February 29, 2012.

“Fractional Reserve Banking, Option Clauses, and Government,” January 31, 2012.

“Are the Public Ignorant of the Nature of Fractional Reserve Banking?,” December 17, 2011.

“Why is the Fractional Reserve Account a Mutuum, not a Bailment?,” December 17, 2011.

“Callable Option Loans and Fractional Reserve Accounts,” December 16, 2011.

“Future Goods and Fractional Reserve Banking,” December 15, 2011.

“Rothbard on the Bill of Exchange,” December 11, 2011.

“Hoppe on Fractional Reserve Banking: A Critique,” December 11, 2011.

“Schumpeter on Fractional Reserve Banking,” June 12, 2011.

“If Fractional Reserve Banking is Fraudulent, Why isn’t the Insurance Industry Fraud?,” September 29, 2011.

“The Mutuum Contract in Anglo-American Law,” September 30, 2011.

“Rothbard Mangles the Legal History of Fractional Reserve Banking,” October 1, 2011.

“More Historical Evidence on the Mutuum Contract,” October 1, 2011.

“If Fractional Reserve Banking is Voluntary, Where is the Fraud?,” October 3, 2011.

“Huerta de Soto on the Mutuum Contract: A Critique,” August 11, 2012.

“A Simple Question for Opponents of Fractional Reserve Banking,” August 17, 2012.

“Chapter 1 of Huerta de Soto’s Money, Bank Credit and Economic Cycles: A Critique,” August 31, 2012.

“Huerta de Soto on Justinian’s Digest 16.3.25.1,” September 1, 2012.

“Huerta de Soto on Banking in Ancient Rome: A Critique,” September 2, 2012.

“A Critique of Rothbard on the History of English Bailment Law,” August 11, 2014.

“Fractional Reserve Banking is a Fundamental Part of Capitalism,” August 8, 2014.

“The Mutuum Contract in Henry de Bracton and English Law,” August 1, 2014.

“Coggs v. Bernard and the History of English Bailment Law,” July 31, 2014.

“A Critique of Murray Rothbard on the Origins and Legal Basis of Fractional Reserve Banking,” July 30, 2014.

“Foley versus Hill and the History of Fractional Reserve Banking,” July 29, 2014

“Mutuum versus Bailment in Banking,” July 24, 2014.

“Carr versus Carr (1811) and the History of Fractional Reserve Banking,” July 23, 2014.

“Rothbard on ‘Deposit’ Banking: A Critique,” July 22, 2014.

Every stupid and ignorant Austrian argument is dealt with above, from Huerta de Soto’s unbelievable errors on banking and the mutuum contract in ancient Rome to Rothbard’s gross misunderstanding of the court case Carr versus Carr (1811).

When we get to the essence of the matter it is this: Rothbardians and their ignorant cult leader Rothbard tried to paint fractional reserve banking as an alien, unnatural and fraudulent addition to pure capitalism in its “garden of Eden” state, which was the reason for business cycles.

We can see this in Rothbard’s attempt to do just this in his book Economic Depressions: Their Cause and Cure, in the passage as follows:

“What, then, are the causes of periodic depressions? Must we always remain agnostic about the causes of booms and busts? Is it really true that business cycles are rooted deep within the free-market economy, and that therefore some form of government planning is needed if we wish to keep the economy within some kind of stable bounds? Do booms and then busts just simply happen, or does one phase of the cycle flow logically from the other?

The currently fashionable attitude toward the business cycle stems, actually, from Karl Marx. Marx saw that, before the Industrial Revolution in approximately the late 18th century, there were no regularly recurring booms and depressions. There would be a sudden economic crisis whenever some king made war or confiscated the property of his subject; but there was no sign of the peculiarly modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions. Since these cycles also appeared on the scene at about the same time as modern industry, Marx concluded that business cycles were an inherent feature of the capitalist market economy. All the various current schools of economic thought, regardless of their other differences and the different causes that they attribute to the cycle, agree on this vital point: that these business cycles originate somewhere deep within the free-market economy. The market economy is to blame. Karl Marx believed that the periodic depressions would get worse and worse, until the masses would be moved to revolt and destroy the system, while the modern economists believe that the government can successfully stabilize depressions and the cycle. But all parties agree that the fault lies deep within the market economy and that if anything can save the day, it must be some form of massive government intervention.” (Rothbard 2009 [1969]: 12–14).

Rothbard, of course, blamed “fraudulent” and “immoral” fractional reserve banking as well as central banks for the business cycle. As we have seen, he thought fractional reserve banking was some alien and anti-market addition to a pristine, wonderful and pure form of capitalism.

Rothbard was laughably wrong here. It is particularly absurd because it never seems to have occurred to Rothbard that the idea that the cause of business cycles lies within capitalism was actually a view of Hayek!

Hayek – to his credit – admitted that if one were to take his absurd business cycle theory seriously, we are stuck with the view that capitalism is inherently flawed and doomed to produce endless endogenous business cycles:

“we can … see how nonsensical it is to formulate the question of the causation of cyclical fluctuations in terms of ‘guilt,’ and to single out, e.g., the banks as those ‘guilty’ of causing fluctuations in economic development. Nobody has ever asked them to pursue a policy other than that which, as we have seen, gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the modern organization of credit. So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them.” (Hayek 2008: 102).

According to the logic of the ABCT, since capitalism naturally has an endogenous/elastic money supply, not only from fractional reserve banking, but also from things as simple as bills of exchange and promissory notes, it will be hit by perpetual business cycles. Capitalism has an inherent and natural tendency to produce such destabilising cycles.

It is no surprise that, when Hayek was propounding his business cycle theory at the LSE in the 1930s, his theory was even attractive to socialists, as Skidelsky notes:

“Hayek, like Keynes, hoped to prevent a slump from developing by preventing the credit cycle from starting. But his method was very different. It was to forbid the banks to create credit, something which could be best achieved by adherence to a full gold standard. He was quite pessimistic, though, about this being practical politics, so his conclusion, like Keynes’s, was that a credit-money capitalist system is violently unstable – only with this difference, that nothing could be done about it. One can understand why Hayek’s doctrines attracted a certain kind of socialist: they seemed to reach Marx’s conclusions by a different route. Because of the Austrian school’s close attention to the institutional and political setting of a credit-money economy, Hayek’s picture of the capitalist system in action was altogether more sombre than that of conventional Anglo-Saxon economics, with its story of easy adjustments to ‘shocks.’” (Skidelsky 1992: 457).

In other words, Hayek’s theory in the 1930s was seen as a pessimistic criticism of capitalism as inherently flawed that naturally attracted people sympathetic to socialism – a point which splendidly confirms everything I have been arguing here.

Austrian economics has a profoundly anti-capitalist mentality, and they should admit this instead of denying the heart and soul of their theory, like the delusional idiot Rothbard.

So, to all Austrians everywhere, it seems to me you need to come out of the closet and embrace your inner and suppressed hatred of capitalism. I’m sure you’ll feel a lot better when you admit to being the filthy anti-capitalist you really are.

BIBLIOGRAPHY
Hayek, F. A. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure. Ludwig von Mises Institute, Auburn, Ala.

Skidelsky, R. J. A. 1992. John Maynard Keynes: The Economist as Saviour, 1920–1937 (vol. 2), Macmillan, London.

Further Reading
“Rothbard Shoots Himself in the Foot: Why the ABCT is Anti-Capitalist,” June 25, 2012.

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.

BIBLIOGRAPHY
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.

How Noah Smith Should Have Criticised Austrian Economics

Updated

Noah Smith and Robert Murphy have engaged in a debate on Austrian economics here:

(1) Noah Smith, “Austrian Economists, 9/11 Truthers and Brain Worms,” Bloombergview.com, July 2, 2014.

(2) Robert P. Murphy, “Noah Smith Boldly Goes Where Thousands of Austrian Critics Have Gone Before,” Mises Canada, July 4th, 2014.

(3) Noah Smith, “Austrianism, Wrong? Inconceivable!,” Noahpinion, July 17, 2014.

(4) Robert P. Murphy, “Continuing My Chats With Noah Smith,” Mises Canada, July 19th, 2014.

Certainly, Noah Smith makes some good points against Austrian economics here and there. Unfortunately, he also misunderstands Austrian theory and makes a number of errors too.

What is a better critique of Austrian economics?

And what, to begin with, is a justifiable and proper economics for modern capitalist economies anyway? I contend it is Post Keynesian economics, and my remarks below follow from Post Keynesian theory.

First, we should recognise that the broad group of economists – both today and in the past – who self-identify as “Austrians” is heterogeneous, not some homogeneous group. We should not expect complete consistency between Austrians, because not all Austrian theories are consistent.

In my view, a useful general, though not definitive or exhaustive, division of modern Austrians would be as follows:

(1) The Anarcho-capitalists
E.g., Murray Rothbard, Hans-Hermann Hoppe and Jörg Guido Hülsmann;

(2) The minimal state/classical liberal Austrians in the tradition of Mises
This variety often supports praxeology and utilitarianism;

(3) Moderate subjectivist Austrians
E.g., Israel Kirzner and Roger Garrison;

(4) Hayek’s economics, with a minimal state, and with an empirical (or Popperian) approach to economic method, in place of praxeology;

(5) Radical subjectivists like Ludwig M. Lachmann (1906–1990), and Austrians influenced by him.

Some Austrians hold theories that are far more objectionable than others (and it is also an open question whether many free bankers really self-identify as Austrians), and not all Austrians agree on all fundamental points: for example, the Austrian school is divided even on the issue of methodology.

Some like Hayek and certain moderate subjectivist Austrians accept a broadly empiricist method for economics and reject Misesian apriorism. Others, following Mises, adopt an apriorist praxeological method.

Before we get to the critique, are there are any points of agreement? Indeed there are.

The Radical subjectivist group of Austrians following Ludwig M. Lachmann is the least objectionable and I suspect Post Keynesians can appreciate Lachmann’s work and even respect certain aspects of it.

It is even possible to point out that both Austrians and Post Keynesians share a number of common beliefs about economics, as follows:

(1) both think money is always non-neutral, whereas neoclassical economists think that money is neutral in either (a) both the long-run and short-run (as in the fantasy world models of the New Classical Chicago school) or (b) at least in the long-run (as in New Keynesian and monetarist theory);

(2) both Post Keynesians and (at least some) Austrians have criticisms of the quantity theory of money; while the Austrians criticise the quantity theory on the basis of Cantillon effects, the Post Keynesian critique is much more radical;

(3) both Post Keynesians and Austrians reject rational expectations and think expectations are subjective;

(4) both Post Keynesians and Austrians stress the role of irreversible time and fundamental uncertainty in economics, and the limitations of probability theory in economic decision making (indeed some Austrians see Keynes’ and Mises’ views on probability as complementary);

(5) both Post Keynesians and Austrians have criticisms of the neoclassical theory of capital, though they part company on exactly what that the critique is.

So what are the serious problems with Austrian theory?

Let us present a case below of some issues point by point:

(1) Misesian apriorist praxeology
Misesian apriorist praxeology as a method for economics is severely flawed.

Mises needed synthetic a priori knowledge and a type of Kantian epistemology to justify his praxeology, but the arguments for synthetic a priori knowledge are unconvincing and must be rejected. Misesian praxeology does not yield universally and necessarily true empirical statements about economic reality.

Furthermore, not even the human action axiom can be known a priori: it is clearly a synthetic a posteriori proposition.

In addition, the very idea that Mises in Human Action succeeded in deducing all his theories by deductive logic is manifestly untrue, and Misesians and Rothbardians have never answered the challenge of George J. Schuller to set out Human Action in a formal symbolic form in which all axioms, premises, and deductions are shown formally and proven.

Even modern Kantians have rejected Mises’ attempt to ground his praxeology on Kant’s epistemology.

There has also arisen amongst modern Austrians a feeble and ignorant belief that Mises was not really using a synthetic a priori epistemology. This is simply untrue, as I have shown here and here, and even if it were true and praxeology were simply analytic a priori, then it would follow logically that praxeology cannot give necessary truth about the real world.

Further Reading
“Limits of the Human Action Axiom,” February 28, 2011.

“Hayek on Mises’ Apriorism,” May 23, 2011.

“What is the Epistemological Status of Praxeology and the Action Axiom?,” July 27, 2013.

“Barrotta’s Kantian Critique of Mises’s Epistemology,” July 28, 2013.

“David Friedman versus Robert Murphy,” August 4, 2013.

“Mises Fails Philosophy of Mathematics 101,” August 30, 2013.

“Bob Murphy All At Sea on Geometry and Economic Epistemology,” August 31, 2013.

“Mises’s Non Sequitur on synthetic a priori Knowledge,” September 2, 2013.

“Hoppe’s Caricature of Empiricism,” September 10, 2013.

“Hoppe on Euclidean Geometry,” September 11, 2013.

“Robert Murphy gets Mises’s Epistemology Wrong,” September 13, 2013.

“Hoppe on Euclidean Geometry, Part 2,” September 14, 2013.

“Mises on Kant and Praxeology,” September 15, 2013.

“Mises was Confused about the Analytic–Synthetic Distinction,” September 15, 2013.

“Schuller’s Challenge to Misesian Apriorists has never been answered,” December 7, 2013.

“Mises versus Ayer on Analytic Propositions and a priori Reasoning,” March 16, 2014.

“David Gordon on Praxeology and the Austrian Method: A Critique,” March 13, 2014.

“Why Mises’s Praxeological Theories are not Necessarily True of the Real World,” March 15, 2014.

“Mises and Empiricism,” April 17, 2014.

“Why Should we reject the Existence of Synthetic a priori Knowledge?,” May 23, 2014.

(2) the Rothbardian interpretation of fractional reserve banking
The Rothbardian interpretation of fractional reserve banking is flawed and ignorant.

The idea that fractional reserve banking is inherently fraudulent or results in two property titles to the same money is false. Demand deposits and indeed all callable loans in the legal systems of Western civilisation are based on the mutuum contract, which is not, and has never been, the same thing as a bailment (or depositum regulare).

The callable mutuum (or loan for consumption) consists of a contract in which a lender transfers ownership of goods/money to a borrower, who then becomes the sole legal owner of that good/money and has the right to dispose of it in whatever way they wish. In return, the lender gets a debt/credit/IOU owed to them by the borrower: the promise to repay the debt on demand. This rules out any situation where the money is jointly owned by two people, as the Rothbardian ignorantly claim.

The anti-fractional reserve banking Austrians also have a horrendously poor and shoddy understanding of history and legal history. Jesús Huerta de Soto utterly misunderstands the historical definitions of mutuum, depositum regulare, and depositum irregulare, and is wrong to claim that the Romans banned fractional reserve banking.

The hostility of Rothbardians to fractional reserve banking via their ignorance of its legal nature arguably makes Rothbardians highly anti-capitalist ideologues, for they wish to ban a non-fraudulent practice which is at the heart of all developed capitalist economies and financial systems.

Further Reading
“Why is the Fractional Reserve Account a Mutuum, not a Bailment?,” December 17, 2011.

“Hoppe on Fractional Reserve Banking: A Critique,” December 11, 2011.

“If Fractional Reserve Banking is Fraudulent, Why isn’t the Insurance Industry Fraud?,” September 29, 2011.

“The Mutuum Contract in Anglo-American Law,” September 30, 2011.

“Rothbard Mangles the Legal History of Fractional Reserve Banking,” October 1, 2011.

“More Historical Evidence on the Mutuum Contract,” October 1, 2011.

“What British Law Says about the Mutuum Contract,” October 2, 2011.

“If Fractional Reserve Banking is Voluntary, Where is the Fraud?,” October 3, 2011.

“Huerta de Soto on the Mutuum Contract: A Critique,” August 11, 2012.

“A Simple Question for Opponents of Fractional Reserve Banking,” August 17, 2012.

“Chapter 1 of Huerta de Soto’s Money, Bank Credit and Economic Cycles: A Critique,” August 31, 2012.

“Huerta de Soto on Justinian’s Digest 16.3.25.1,” September 1, 2012.

“Huerta de Soto on Banking in Ancient Rome: A Critique,” September 2, 2012.

(3) The Austrian business cycle theory
The Austrian business cycle theory (ABCT) is intellectually bankrupt.

First, the ABCT requires the untenable Wicksellian loanable funds theory. In this theory, the unique Wicksellian natural rate of interest has a crucial coordinating role: if the bank rate falls below the natural rate and monetary inflation continues on a large enough scale, this is supposed to cause an unsustainable lengthening of the structure of production.

But the Wicksellian natural rate cannot even be defined or identified outside of a world with one commodity, as Piero Sraffa long ago pointed out (Sraffa 1932a and 1932b; Rogers 1989: 32 with n. 6; 43). The only viable model in which the Wicksellian interest theory is possible is one which assumes a one commodity world where that single commodity can function both as a capital good or a consumption good, such as the “corn” economy model (Rogers 1989: 32, n. 6).

That is, the natural rate can only be defined in a one commodity world, but not in a world with heterogeneous capital goods (Rogers 1989: 32, 43). The consequence is that only the monetary rate of interest in the loanable funds model is left after the untenable natural rate is cut out, and that the money rate of interest is cut free of the real forces of productivity and thrift (Rogers 1989: 43).

What is especially strange here is that Robert Murphy – one of the popular Austrian bloggers – not only understands Sraffa’s critique but concedes that it is true. Hardly any other Austrians seem even aware of it, or the devastating consequences it has for their business cycle theory.

I direct readers to these fascinating writings by Murphy:

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.
https://files.nyu.edu/rpm213/public/files/Dissertation.pdf

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”
http://consultingbyrpm.com/uploads/Multiple%20Interest%20Rates%20and%20ABCT.pdf

Murphy’s paper “Multiple Interest Rates and Austrian Business Cycle Theory” makes candid remarks about Hayek’s debate with Piero Sraffa:

“In his brief remarks, Hayek certainly did not fully reconcile his analysis of the trade cycle with the possibility of multiple own-rates of interest. Moreover, Hayek never did so later in his career. His Pure Theory of Capital (1975 [1941]) explicitly avoided monetary complications, and he never returned to the matter. Unfortunately, Hayek’s successors have made no progress on this issue, and in fact, have muddled the discussion. As I will show in the case of Ludwig Lachmann—the most prolific Austrian writer on the Sraffa-Hayek dispute over own-rates of interest—modern Austrians not only have failed to resolve the problem raised by Sraffa, but in fact no longer even recognize it.

“Austrian expositions of their trade cycle theory never incorporated the points raised during the Sraffa-Hayek debate. Despite several editions, Mises’ magnum opus (1998 [1949]) continued to talk of ‘the’ originary rate of interest, corresponding to the uniform premium placed on present versus future goods. The other definitive Austrian treatise, Murray Rothbard’s (2004 [1962]) Man, Economy, and State, also treats the possibility of different commodity rates of interest as a disequilibrium phenomenon that would be eliminated through entrepreneurship. To my knowledge, the only Austrian to specifically elaborate on Hayekian cycle theory vis-à-vis Sraffa’s challenge is Ludwig Lachmann.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 11–12).

Murphy then discusses Lachmann’s (1994: 154) solution to Sraffa’s critique, but finds it wanting:

“Lachmann’s demonstration—that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest—does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to ‘the’ real rate of interest.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 14).

How Murphy can continue to defend the classical Austrian business cycle theory using the Wicksellian natural rate remains a profound mystery, for clearly Sraffa’s critique alone is sufficient to refute it.

But, as it happens, there are also numerous other problems with the ABCT: with the collapse of the natural rate as a viable concept, all that is left of Wicksellian loanable funds theory is the monetary rate of interest, and that – contrary to Austrians – is not explained by time preference, nor does it communicate reliable information about future consumption plans.

The decision to investment – especially in new or more lengthy capital projects – cannot be reduced to some simplistic function of interest rates, and one can only laugh at how crude and stupid the Austrian models underlying the ABCT are, given the extremely important role of expectations and uncertainly in the investment decision.

Above all, the empirical evidence shows us that business people do not really 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). That is, capitalist business cycles are driven mainly by changes in capacity utilisation, which in turn are driven by changes in aggregate demand.

Furthermore, the assumptions of Austrian capital theory underlying the ABCT are wrong. The belief that capital goods can be classified into universal, clear-cut orders as removed from the final consumer goods output must be highly doubtful. Many capital goods can simultaneously belong to multiple orders at once. Even though capital goods are heterogeneous, there can also be a significant degree of durability, substitutability, adaptability, and versatility in the capital structure of any real world market economy – and this makes any modern capitalist economy considerably more robust then the Austrian view.

As for the lengthening of the capital structure concept, although this has some validity, the empirical evidence suggests that the capital structure actually “lengthens and contracts as a consequence of the business cycle, rather than as its cause” (Kuehn 2013: 523).

Further Reading
“The Natural Rate of Interest: A Wicksellian Fable,” June 6, 2011.

“Austrian Business Cycle Theory: The Various Versions and a Critique,” June 21, 2011.

“Mises’s “Originary Interest Rate” Theory,” June 21, 2011.

“Robert P. Murphy on the Sraffa-Hayek Debate,” July 19, 2011.

“Robert P. Murphy on the Pure Time Preference Theory of the Interest Rate,” July 13, 2011.

“Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT,” December 27, 2011.

“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012

“Some Critical New Work on the Austrian Business Cycle Theory,” October 9, 2012.

“Repapis on Hayek’s Business Cycle Theory,” October 10, 2012.

“Hayek on his Simplified Capital Theory Assumptions in Prices and Production,” October 15, 2012.

“The Natural Rate of Interest in the ABCT: A Definition and Analysis,” February 26, 2013.

“Marshall on Menger’s Orders of Capital Goods,” June 24, 2013.

“Why the Austrian Business Cycle Theory is Wrong (in a Nutshell),” August 3, 2013.

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

(4) Austrian price theory
The problem with the failed and hysterical Austrian predictions of hyperinflation is that their underlying price theory is obsolete and intellectually bankrupt too, just like their business cycle theory.

First, many Austrians subscribe to a naïve exogenous theory of money supply and the money multiplier myth. In reality, modern money supply is endogenous: the central banks normally just accommodate the demand for high-powered money from banks. To that extent, they are passive, with respect to the quantity of money a capitalist economy creates. Central banks do not directly control the broad quantity of money, and the conventional money multiplier idea is also utterly flawed.

Instead, the primary cause of money supply growth is demand for credit and the creation of credit and “demand deposit money” by banks. But even the demand for credit is not a simple nor straightforward function of interest rates, nor of market clearing of some mythical loanable funds market.

Banks do not lend out your money as in loanable funds theory: the banks use it in their fund of reserves for clearing their obligations to depositors/creditors, other banks and financial institutions, and central banks, and simply create “demand deposit money” whenever they grant credit. Loans create new “demand deposits,” and such “demand deposits” constitute new broad money. But of course such new loans also require that there be demand for credit, and that is determined by many factors, not just interest rates.

Hence, when central banks in the UK and the US engaged in their unprecedented experiments in quantitative easing, they were able to increase the quantity of high-powered money and reserves to a great extent, but they could not induce a corresponding demand for credit by these actions, nor cause the banks to vastly increase lending and spending throughout the economy.

But even if there had been a great increase in spending it is still unlikely that this would have led to uncontrollable inflation, and here we must look at how flexible prices are in the real world.

The fact that the satisfaction or utility that humans derive from consuming goods is indeed subjective, and that there is a great deal of empirical evidence that subjective utility diminishes as a person consumes each additional unit of the same good does not prove that prices are therefore naturally or normally set in a flexible manner and are highly responsive to demand, by mutual haggling or in auction-like markets where the prices have a tendency to move to market clearing levels.

Most prices are not set in this manner, but by a very different method.

Virtually all Austrians, apart from a few like Lachmann (1986: 134; 1994: 165–166) and Reisman (1996: 167–169, 200–201, 414–417), have utterly failed to understand the reality and nature of administered prices/mark-up prices, and how the prevalence of such prices is utterly devastating to their economic theories.

Most prices are set by sellers or producers on the basis of their total average unit costs plus a profit mark-up at some estimated or projected sales or production quantity, and are, generally speaking, not responsive to demand changes. Demand-side inflation is consequently an overrated source of inflation in the modern world. The more important type of inflation is supply-side inflation caused by changes in firms’ total unit costs.

At this point, the empirical evidence is in, and it shows us that most prices in modern developed market economies are administered prices/mark-up prices.

For example, Govindarajan and Anthony (1986) and Shim and Sudit (1995) are two marketing surveys that found that from the 1980s to the 1990s mark-up pricing accounted for roughly 70% to 85% of US industrial prices.

Blinder et al. (1998: 200–201) found that 56.8% of the firms they surveyed said that the idea that prices and price changes depend mainly on costs of production ranked as “very important” (38.8%) or moderately important (18%).

The wide-ranging survey of Fabiani et al. (2006 and 2007) on prices in the Eurozone from many central bank studies finds that the average for mark-up pricing throughout the Eurozone is 54% – a majority of firm prices.

In industrial goods markets in Germany, the largest economy in Europe, a strikingly high 73% of firms have administered prices (Fabiani et al. 2006: 18, Table 4).

A survey of Canadian firms found that an impressive 67.1% of firms surveyed attributed price inflexibility to “cost-based pricing” – that is, to mark-up pricing (Amirault, Kwan, and Wilkinson 2004: 21).

Have Austrians come to grips with this important reality of real world price setting? They have not, and the sole exception, as far as I can see, was Ludwig Lachmann.

Lachmann understood the extent and significance of mark-up pricing and said the following:

“Hence, while Marshall’s was a world of flexible prices, even though not of ‘perfect competition,’ ours is a ‘fixprice world’ with prices set on a ‘cost plus’ basis and wage rates as ultimate price determinants. …. Hence we have to look for another method of dynamic analysis. To find it we must move nearer to Keynes and his successors who are here given credit for having understood, earlier than others, that a fixprice world requires a fixprice method of analysis.” (Lachmann 1977: 238–239).

(5) Misesian economic coordination and prices
The flexible price and wage system is the fundamental equilibrating mechanism in Misesian economics:

“Mises conceives the market process as coordinative, ‘the essence of coordination of all elements of supply and demand.’ This means that the structure of realized (disequilibrium) prices, which continually emerges in the course of the market process and whose elements are employed for monetary calculation, performs the indispensable function of clearing all markets and, in the process, coordinating the productive employments and combinations of all resources with one another and with the anticipated preferences of consumers.” (Salerno 1993: 124).

But following from (4), the Austrian view that modern market economies have some natural or normal tendency to supply and demand equilibrium via flexible prices is untrue.

In reality, supply and demand in most markets is not equated by price flexibility, but by direct changes to production and output: increases in aggregate demand cause greater production and employment, and falls in aggregate demand cause reduced production and employment. This supports the Keynesian view of modern economies, not the Austrian one.

A detailed discussion of problems for Austrian theory caused by the reality of administered prices is given here.

Further Reading
“Salerno on Mises’s View of Coordination in Market Economies,” March 23, 2013.

“Hayek on the ‘Use of Knowledge in Society,’” March 30, 2013.

“Misesian Economic Calculation and Coordination in Market Economies: An Overview and Critique,” May 11, 2013.

“Kaldor on Economics without Equilibrium,” March 9, 2013.

“Administered Prices Discredit the Austrian Economic Theories of Mises,” December 10, 2013.

(6) The definition of inflation
This is, in the grand scheme of things, really a minor point, but I raise it because it is relevant to the original debate.

The Austrians have an obsession with the definition of the word “inflation.” They claim that the original and legitimate definition of “inflation” is as an increase in the money supply, instead of (as people normally use it) a general increase in prices.

In reality, there is precious little evidence for this view. The word “inflation” began to be used in an economic sense from the early 19th century: but it was nearly always qualified by additional words such as “inflation of the currency,” “inflation in (the) currency,” “inflation of credit,” “inflation of prices” or “inflation in prices.”

It is extremely difficult to see how either sense was the “original” or formally correct usage.

In fact, the expressions “inflated prices” and “inflated price” seem to appear at the same time, so that the word “inflate” and its derived forms were clearly connected with prices from an early date.

There are explicit examples of this usage in the 1821 English translation of Jean Baptiste Say’s A Treatise on Political Economy:

“We have hitherto regarded the inflated price of grain as the only evil to be apprehended. But England, in 1815, was alarmed by a prospect of an opposite evil; viz, that its price would be reduced too low, by the influx of foreign grain.”
Say, Jean Baptiste. 1821. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (vol. 1; trans. by C. R. Prinsep from 4th French edn.). Longman, Hurst, Rees, Orme, and Brown, London. p. 296.

“The experience of English commerce has, however, proved, that a casual inflation of the price of domestic, and depression of that of external products, may be the basis of permanent commerce.”
Say, Jean Baptiste. 1821. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (vol. 1; trans. by C. R. Prinsep from 4th French edn.). Longman, Hurst, Rees, Orme, and Brown, London. p. 176.

If we turn to a major 19th-century economist like William Stanley Jevons, we find that he used “inflation” in both senses in his writings too:

“While the elasticity of credit, then, may certainly, as it seems, give prices a more free flight, the inflation of credit must be checked by the well defined boundary of available capital, … .”
Jevons, William Stanley. 1863. A Serious Fall in the Value of Gold Ascertained, and its Social Effects Set Forth. E. Stanford, London. p. 13.

“A revulsion occasioned by a failure of the national capital must, cause, not only a collapse of credit, and of any inflation of prices due to credit;”
Jevons, William Stanley. 1863. A Serious Fall in the Value of Gold Ascertained, and its Social Effects Set Forth. E. Stanford, London. p. 14.

Admittedly, this was also one of the points where Noah Smith was wrong.

Smith asserted:

“The Austrians’ next defense [after 2011] was to redefine reality. Inflation doesn’t mean a rise in prices, they said -- it means an increase in the monetary base. QE wasn’t causing inflation, it was inflation itself.”

Of course, the Austrians did not turn to this definition in the early 2010s: they have been peddling this pedantry for decades, but, as we have seen, the evidence does not support them.

Further Reading
“Austrians and the Definition of ‘Inflation’ Again,” July 8, 2014.

“Austrians and the Definition of ‘Inflation,’” August 8, 2013.

Finally, the above is hardly an exhaustive list, and the indeed Austrian theory shares many errors with mainstream neoclassical theory, such as the following:

(1) belief in a real world tendency to some kind of equilibrium state (in Austrian theory, this tends to be Mises’ final state of rest), via flexible wages and prices and competition supposedly driving prices towards marginal cost, and profits towards zero;

(2) the belief that, if only prices and wages were perfectly flexible, then economies would adjust to full employment equilibrium.

(3) the gross substitution axiom;

(4) the law of demand as a universal law;

(5) the law of diminishing marginal utility as a universal law;

(6) the law of diminishing marginal productivity as a significant limit on real world firms;

(7) the belief that firms equate price with marginal cost or move price towards marginal cost, and the associated marginalist explanation of why and how much firms produce, and

(8) the belief that involuntary unemployment is fundamentally caused by inflexible wages and that the wage is itself determined by marginal product of labour.

BIBLIOGRAPHY
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.

Amirault, D., Kwan, C. and G. Wilkinson. 2004. “A Survey of the Price-Setting Behaviour of Canadian Companies,” Bank of Canada Review 2004/2005: 29–40.
http://www.bankofcanada.ca/2006/09/publications/research/working-paper-2006-35/

Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.

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

Fabiani, S., M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias, F. Martins, T. Mathä, R. Sabbatini, H. Stahl and A. Stokman. 2006. “What Firms’ Surveys tell us about Price-Setting Behavior in the Euro Area,” International Journal of Central Banking 2.3: 3–47.

Fabiani, Silvia, Suzanne Loupias, Claire, Monteiro Martins, Fernando Manuel and Roberto Sabbatini. 2007. Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.

Govindarajan, V. and R. Anthony. 1986. “How Firms use Cost Data in Price Decisions,” Management Accounting 65: 30–34.

Jevons, William Stanley. 1863. A Serious Fall in the Value of Gold Ascertained, and its Social Effects Set Forth. E. Stanford, London.

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

Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. Walter E. Grinder). Sheed Andrews and McMeel, Kansas City.

Lachmann, Ludwig M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford. 134.

Lachmann, Ludwig M. 1994. “The Salvage of Ideas: Problems of the Revival of Austrian Economic Thought,” in D. Lavoie (ed.), Expectations and the Meaning of Institutions: Essays in Economics. Routledge, London. 159–178.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.
https://files.nyu.edu/rpm213/public/files/Dissertation.pdf

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”
http://consultingbyrpm.com/uploads/Multiple%20Interest%20Rates%20and%20ABCT.pdf

Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

Salerno, Joseph T. 1993. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6.2: 113–146.

Say, Jean Baptiste. 1821. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (vol. 1; trans. by C. R. Prinsep from 4th French edn.). Longman, Hurst, Rees, Orme, and Brown, London.

Shim, Eunsup, and Ephraim Sudit. 1995. “How Manufacturers Price Products,” Management Accounting 76.8: 37–39.

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

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

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:

http://danielpkuehn.wordpress.com/empirical-analyses-of-hayekian-business-cycle-theory/

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.


BIBLIOGRAPHY
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.

Response to Jonathan Finegold Catalán on the Austrian Business Cycle Theory

Jonathan Finegold Catalán has a response to me on the Austrian Business Cycle Theory here:

“Producers’ Goods Prices,” Economic Thought, 3 August, 2013.

First, regarding Catalán’s graphs, that movement in the prices of capital and intermediate goods occurs is not in doubt! These graphs are not necessarily showing us that prices are moving in response to demand changes. I suspect Catalán has misunderstood the meaning of “administered fixprices.” That expression does not mean prices never or rarely change.

The point is that, in administered fixprice markets, prices generally change because of changes in factor input costs, not because of short or medium term changes in demand. That should be perfectly apparent in the spikes in prices in these graphs from the mid and late 1970s, at times when the Western world was in recession, but which saw supply side inflation from the oil shocks.

These graphs do not refute my assertion about the importance and widespread existence of administered fixprices in any modern capitalist economy.

I respond to Catalán’s specific points below:

(1) Catalán says that there is “such [sc. a] thing as an equilibrium rate that we can conceptualize” (my emphasis). Yes, there is, but it is only marginally more significant to economics than the fact that we can conceptualise magical unicorns, flying dragons, or any number of other non-existent imaginary things or entities.

An imaginary Wicksellian natural rate existing only in a fictitious world of general equilibrium or Mises’s “final state of rest” is effectively worthless and irrelevant to real world economics. Why? The reason is that (1) general equilibrium cannot exist and (2) it is real rate applicable only to a barter world.

Catalán asserts that we “can use this equilibrium rate as a reference point when judging policy.” No, we cannot.

The mythical rate is irrelevant to policy. Only if Catalán posits and defends the view that the real world has a tendency towards such a rate would the natural rate have some relevance to economics. But Catalán has proven no such thing.

(2) Catalán says:

“Early versions of ABCT are movements between equilibria: Yes, LK, welcome to the world of modeling, where you abstract from certain realities to be able to focus on the aspects that you want to explain.”

But not at this level of inaccurate abstraction: Catalán wants to explain the real world by reference to non-existent transitions between equilibrium states that do not occur in the real world.

I contend that such models have no worthwhile application to the real world in explaining real world business cycles.

(3) With Austrian capital theory, we are back to the question of unrealistic “ideal types” and models.

For a more detailed demonstration of flaws in Austrian capital theory and problems with the alleged “lengthening” of the capital structure, I refer readers to these discussions:

Vienneau, R. L. 2006. “Some Fallacies of Austrian Economics,” September
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=921183

Vienneau, R. L. 2010. “Some Capital-Theoretic Fallacies in Garrison’s Exposition of Austrian Business Cycle Theory,” September 4
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1671886

(4) On loanable funds theory, I appear to get this concession:

“I agree that interest should play less of a role in ABCT than it does in a lot [sc. of] narratives. But, if you read, say, The Pure Theory of Capital, you’ll see that the rate of interest is actually not vital to ABCT, at all.”

Then why does the loanable funds theory appear in so many modern versions of ABCT today like Roger Garrison’s?

And even appeals to Hayek’s later versions of the ABCT where he switched to “false profits” simply beg the question by assuming the truth of this new model. It must face serious problems precisely because of the issue of administered prices.

(5) On the tendency to equilibrium, Catalán says:

“Again, take equilibrium as a reference point. What people mean when they say there’s a tendency towards equilibrium is that entrepreneurs are interested in chasing profits and liquidating unprofitable investments (except under certain conditions).”

It is very difficult to see how this is not a fallacy of equivocation.

No, a tendency towards equilibrium is simply not a state where “entrepreneurs are interested in chasing profits and liquidating unprofitable investments.” This is a bizarrely thin definition of a “tendency towards equilibrium.”

Catalán has changed the definition of “equilibrium” away from what Austrians normally mean by it. The Austrian view of a tendency towards equilibrium would at least stress:

(1) flexible prices moved toward their market clearing levels to equate demand with supply;

(2) a tendency towards the equalisation of profits, and

(3) a tendency toward the equalization of the “originary interest” rate for all commodities.

But I have had this discussion with Catalán before.

In his in previous posts, he implies that he himself does not think there is a real world tendency towards a general equilibrium state (whether Walrasian GE or Misesian “final state of rest”), and at one point implied that Mises was almost a radical subjectivist.

Now it is obvious that a tendency towards market-clearing prices is at least one fundamental element of the Austrian idea of a tendency towards equilibrium and economic coordination, yet this is precisely the element that is grossly unrealistic, given the wealth of data on modern administered prices.

Catalán then says this of my original criticisms:

“these are very weak criticisms of ABCT and they shouldn’t be taken seriously. Some of the ‘criticisms’ raised are actually strong points in the theory, because they’re issues that Austrian capital theorists have dealt with at length before.”

Oh, really?

So there are versions of the ABCT that take account of fixprices? Of the severe problems in thinking that loanable funds theory is accurate in its assumptions about the information communicated about time preference?

Why, then, does the major exposition of the ABCT in recent times by Roger Garrison use a natural rate?

Finally, I get no real discussion of why fixprices would render the “false profits” version of ABCT highly unlikely, given that the alleged price movements causing these “false profits” would be largely non-existent.

Update: Response to Catalán’s Comments

My response to Catalán’s new criticisms in the comments section:

(1) No, I said that the single Wicksellian natural rate, a real rate, it is rate applicable only to a barter world in equilibrium. And I have a hard time seeing how that is not true.

I most emphatically do not deny the importance of good models. What is being asserted above is that these general equilibrium models are effectively irrelevant to the real world as explanations or guides to real world business cycles. This is a different thing from what you are accusing me of.

(2) Once the equilibrium conditions of Hayekian ABCT are lifted and all the other unrealistic assumptions I have discussed in the original post are taken account of, the relevance of ABCT to the real world becomes effectively zero. There is little reason to expect business cycles to be explained by ABCT.

(3) No, the Austrian capital theory literature has not responded to Vienneau.

(4) So Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure (2000), which Austrians (I am fairly sure) regard as one of the fundamental treatments of the ABCT in modern times, has “an interpretation of the theory” that is incorrect? Is Catalán aware of what a stunning concession to me this is? It validates his claim that my original criticisms were “weak” and “shouldn’t be taken seriously” for one.

(5) If Catalán agrees with accepted Austrian views of a tendency to equilibrium, then he has still not proven this tendency. In fact, his statements in (6) clearly recognise the existence of administered prices, and that must mean the real world has a fairly strong impediment to equilibrium in the Austrian sense by failure of adjustment to market-clearing prices in so many markets.

(6) The existence of both flexprice and fixprice markets in the primary commodities sector and others is not in doubt. Perhaps I have not made myself clear: of course, flexprice markets exist.

My comments at the beginning of this post question to what degree these capital markets are flexprice, in the sense of being rapidly flexible in response to demand changes. The graphs do not answer that question. A good many manufactured capital goods, for example, are likely to be fixprice.

Reply to Juan Ramón Rallo on the Austrian Business Cycle Theory

A criticism of my points in the last post is available here:

“Seis malas críticas a la teoría austriaca del ciclo económico,” Juanramonrallo.com, 3 August, 2013.

The author is Juan Ramón Rallo, a PhD in Economics from the University of Valencia and a Masters in Austrian economics from the Universidad Rey Juan Carlos (Madrid). He blogs here.

Some responses:

(1) Juan Ramón Rallo’s first criticism is that the Austrian business cycle theory need not assume the existence of the unreal Wicksellian natural rate of interest. Thus Juan Ramón Rallo seems to agree that the natural rate of interest does not exist.

That is a fascinating concession. Why? It is tacit admission that all versions of the ABCT that do use the Wicksellian natural rate of interest are unsound. Unfortunately, it means that the versions of ABCT by Mises (1934, 2006 [1978]), Hayek, (1931, 1935), Rothbard (2004 [1962], 2009 [1969]), and Garrison (2000) and many others must be wrong, because they all use the natural rate. That is a devastating conclusion.

Indeed, it is the conclusion one must draw from the work of the Austrian Robert P. Murphy on the non-existence of the natural rate and the failure of Austrian attempts to refute Sraffa.

Only versions that dispense with the natural rate would evade such a criticism.

But even Mises’s version of ABCT in Human Action uses the “originary interest rate,” which is effectively the same thing as the Wicksellian natural rate. Certainly, in Mises’s equilibrium world called the “evenly rotating economy” (ERE) this would be the same as the Wicksellian natural rate of interest. Mises asserts that there is “a tendency toward the equalization of this ratio for all commodities,” but this is unconvincing, and just as worthless as any other alleged tendency of the real world to a general equilibrium state. It is hard to see how Mises’s version of ABCT is any better than the other versions that use the Wicksellian natural rate of interest.

Rallo speaks of “maturity mismatches” between savers and borrowers being a sufficient condition for an ABC. But this merely begs the question by assuming time preference and loanable funds.

(2) Juan Ramón Rallo argues that the ABCT need not assume the existence of the full employment of resources. Instead, malinvestment might generate localised bottlenecks and differences in the time preferences of savers and capitalists. But, yet again, as in (1), all this just begs the question by assuming the truth of time preference and loanable funds theory, when these very theories are unsound. See also point (4) below.

(3) The difficulties of classifying capital goods into universal, well defined orders is not irrelevant, despite what the author says. In fact, if these well structured orders are flimsy or non-existent, then whole notion of the capital structure lengthening in response to overexpansion of credit is also highly questionable.

Furthermore, Rallo’s assertion that capital is not plastic or homogenous is a straw man argument. I never asserted this.

These articles by Robert Vienneau provide further discussion of this:

Vienneau, R. L. 2006. “Some Fallacies of Austrian Economics,” September
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=921183

Vienneau, R. L. 2010. “Some Capital-Theoretic Fallacies in Garrison’s Exposition of Austrian Business Cycle Theory,” September 4
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1671886

(4) I have difficulty understanding criticism (4) at all. Rallo asserts that interest rates do not seek to coordinate new savings decisions with new investment, which appears to be a strange denial of the loanable funds theory that is certainly used in the ABCT.

(5) Rallo says it not necessary to assume any tendency toward equilibrium or the equalization of profit. He then cites Lachmann in support of this and Lachmann’s version of the ABCT.

But Lachmann denied that universality of the ABCT:

“The Trade Cycle cannot be appropriately described by means of one theoretical model. We need a number of models each showing what happens when certain potential causes become operative. The many models that have been constructed by economists in the past are therefore not necessarily incompatible with each other. Overinvestment and underconsumption theories, for instance, are not mutually exclusive. None of them of course is the true theory of the Trade Cycle; each is probably an unduly broad generalization of certain historical facts. Once we admit the dissimilarity of different historical fluctuations we can no longer look for an identical explanation. In dealing with industrial and financial fluctuations eclecticism is the proper attitude to take. There is little reason to believe that the causes of the crisis of 1929 were the same as those of the crisis of 1873.” (Lachmann 1978:100–101).

So is Rallo willing to say, with Lachmann, that the ABCT is not a universal theory, but compatible with other theories (for example, debt deflation theory or a demand side explanation)?

Moreover, I still doubt that Lachmann’s version of the ABCT is better than any other: if anything, Lachmann’s radical subjectivism and rejection of any strong real world tendency to equilibrium makes it even more likely that the ABCT is false.

(6) In his last point, Rallo seems to concede the existence of administered prices. Yet, for some unexplained reason, he still thinks the “false profits” version of ABCT will work. Again, his argument depends on an economy experiencing real shortage of resources and capital. This ignores the empirical reality that, even in most real world booms, capitalist economies still have significant idle resources and are open to international trade.

Finally, Rallo also tries to conflate asset price bubbles with the capital goods distortion postulated by the ABCT. Yet the classic versions of the ABCT do not postulate asset bubbles as the source of discoordination.

BIBLIOGRAPHY
Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure., Routledge, London and New York.

Hayek, F. A. von, 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Lachmann, L. M. 1978. Capital and its Structure. S. Andrews and McMeel, Kansas City.

Mises, L. von. 1934. The Theory of Money and Credit (trans. H. E. Batson from 2nd German edition of 1924), J. Cape, London.

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.

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

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure. Ludwig von Mises Institute, Auburn, Ala.

Why the Austrian Business Cycle Theory is Wrong (in a Nutshell)

The reasons why all versions of the Austrian business cycle theory (ABCT) fail, including reformulations of the theory emphasising the role of “false monetary profits,” are as follows:

(1) there is no unique Wicksellian natural rate of interest outside of a purely imaginary general equilibrium state. Hence neither private banks nor central banks can lower the money rate of interest below a single natural rate of interest to induce malinvestment when the latter natural rate does not exist. Moreover, the very idea that unfettered monetary interest rates have some fundamental and reliable role in communicating information about time preference is wrong (see point (4) below).

(2) The early Hayekian versions of the theory assume an economy starting from a general equilibrium state and returning towards one, which is an impossibility.

The alternative model where it is assumed that an Austrian business cycle will develop from a boom with full employment and a lack of resources ignores the fact that virtually all modern economies are open to international trade and even at full employment still have idle capacity in many sectors (which overcome scarcity problems for many investments made in the past). The ABCT assumes a full use of resources and a closed economy: both unrealistic assumptions.

(3) the assumptions of Austrian capital theory underlying the ABCT are wrong. The belief that capital goods can be classified into universal, clear-cut orders as removed from the final consumer goods output must be highly doubtful. Many capital goods can simultaneously belong to multiple orders at once.

Even though capital goods are heterogeneous, there can also be a significant degree of durability, substitutability, adaptability, and versatility in the capital structure of any real world market economy.

(4) the pure time preference and loanable funds model underlying the ABCT are wrong.

Interest rates do not communicate the necessary information about time preference and resource availability as required in the theory.

(5) The ABCT assumes a real-world tendency towards general equilibrium or Mises’s “final state of rest,” such as tendencies to clearing of market prices, equalisation of profits and elimination of profits, and so on. Such tendencies do not exist in the real world economies, because of shifting expectations, uncertainty, and institutional complexity.

(6) The price theory underlying the ABCT is that, while some short-term price rigidity exists, in the long run prices tend towards their flexible, market clearing values. That is false: it ignores the role of administered prices.

In alternative versions of the ABCT where the fundamental dis-coordination mechanism is presumed to be the role of “false money profits,” it is assumed that prices of goods do move flexibly in response to demand changes and induce shifts in money profits of businesses, which then cause malinvestments as capitalists exploit unsustainable profit opportunities.

In reality, a vast swathe of the market – especially industrial and service industries – is dominated by administered fixprices. Prices are relatively inflexible in these sectors. New demand simply means greater production and employment, not significant price movements.

The alleged mechanism of inducing “false profits” will be non-existent or so weak in a fixprice world that it is unlikely to cause the imagined malinvestments.

Further Reading
“Austrian Business Cycle Theory: Its Failure to explain the Crisis of 2008,” October 18, 2010.

“Kirzner on Austrian Business Cycle Theory,” May 30, 2011.

“ABCT and Idle Resources,” June 6, 2011.

“Austrian Business Cycle Theory: Epicycles on Epicycles,” June 6, 2011.

“The Natural Rate of Interest: A Wicksellian Fable,” June 6, 2011.

“Austrian Business Cycle Theory (ABCT) and the Natural Rate of Interest,” June 18, 2011.

“Mises’s ‘Evenly Rotating Economy’ (ERE) and ABCT,” June 20, 2011.

“Austrian Business Cycle Theory: The Various Versions and a Critique,” June 21, 2011.

“Mises’s ‘Originary Interest Rate’ Theory,” June 21, 2011.

“The Differences Between Mises and Hayek on ABCT,” June 23, 2011.

“Hayek and the Myth of Neutral Money,” June 23, 2011.

“Milton Friedman on ABCT,” June 24, 2011.

“There was no US Recovery in 1921 under Austrian Trade Cycle Theory!,” June 25, 2011.

“Vaughn on Mises’s Trade Cycle Theory,” June 29, 2011.

“Hayek on the Flaws and Irrelevance of his Trade Cycle Theory,” June 29, 2011.

“Mises’s Versions of ABCT,” July 1, 2011.

“ABCT and Full Employment,” July 1, 2011.

“Hayek’s Trade Cycle Theory and its Appeal to Socialists,” July 1, 2011.

“Robert P. Murphy on the Sraffa-Hayek Debate,” July 19, 2011.

“Bibliography on the Sraffa-Hayek Debate,” July 20, 2011.

“Robert P. Murphy on the Pure Time Preference Theory of the Interest Rate,” July 13, 2011.

“Lachmann on Trade Cycle Models,” August 27, 2011.

“David Glasner on Hayek versus Sraffa,” September 10, 2011.

“Hayek and the Concept of Equilibrium,” September 20, 2011.

“Hayek and Equilibrium as a Starting Point for an Austrian Trade Cycle,” September 21, 2011.

“ABCT without a Unique Natural Rate of Interest?,” September 22, 2011.

“Did Hayek Advocate Public Works in a Depression?,” September 25, 2011.

“ABCT and the Flow of Credit,” October 6, 2011.

“Michael Emmett Brady on Hayek’s Concept of Uncertainty,” October 11, 2011.

“Austrians Predicted the Housing Bubble? – But so did Post Keynesians and Marxists,” December 14, 2011.

“Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT,” December 27, 2011.

“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012

“Equilibrium Amongst the Austrians,” January 28, 2012.

“Hülsmann on Mises’s Business Cycle Theory,” February 11, 2012.

“Bloggers Debate the Austrian Business Cycle Theory,” February 12, 2012.

“Jonathan Finegold Catalán on Free Banking and ABCT,” May 14, 2012.

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

“Rothbard Shoots Himself in the Foot: Why the ABCT is Anti-Capitalist,” June 25, 2012.

“Bruce Caldwell on the Flaw in Hayek’s Early Business Cycle Theory,” July 8, 2012.

“What was the Greatest Mistake of Lionel Robbins’s Life?,” August 9, 2012.

“Some Critical New Work on the Austrian Business Cycle Theory,” October 9, 2012.

“Repapis on Hayek’s Business Cycle Theory,” October 10, 2012.

“Hayek on his Simplified Capital Theory Assumptions in Prices and Production,” October 15, 2012.

“Why Did Hayek get a Nobel Memorial Prize in Economic Sciences?,” November 10, 2012.

“Critics of the Classic Hayekian Business Cycle Theory,” December 13, 2012.

“The Natural Rate of Interest in the ABCT: A Definition and Analysis,” February 26, 2013.

“Mises’s ‘Originary Interest’: Another Useless Real Theory of the Interest Rate,” June 28, 2013

“Marshall on Menger’s Orders of Capital Goods,” June 24, 2013.

“Greg Hill on ‘The Moral Economy: Keynes’s Critique of Capitalist Justice,’” June 20, 2013.

“Greg Hill versus Steve Horwitz: A Keynesian–Austrian Debate,” June 4, 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.