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.

Daniel Kuehn on Loanable Funds

Daniel Kuehn has a nice response to me on loanable funds:

Daniel Kuehn, “Keynes and Loanable Funds,” Facts and Other Stubborn Things, August 5, 2013.

First, I am happy to fold on a number of issues where I was wrong.

It is completely right to say that modern Keynesian economics should not be about who is more “faithful” to Keynes. Keynes made mistakes. He was not always right, and a proper Keynesian economic science must move beyond Keynes. I agree.

I was also wrong to imply that Daniel just self-identifies as a strict New Keynesian. Sorry about that!

Nor, when I cited an article in a previous post that happened to be called “Bastard Keynesianism,” did I mean to insult New Keynesians. On reflection, the term “Bastard Keynesianism” that was coined by Joan Robinson in 1962 to refer to the neoclassical synthesis (in addition to being rude!) gives the unfortunate impression that Keynesian economics is just about blindly following Keynes, which it certainly should not be.

And, yet, when it comes to the other issues I fear we may be talking past one another. Obviously, there is a flow of money into banks that represents funds people want to save, and in return they get an asset: either (1) the credit money we call demand deposits (or checking accounts or saving accounts) or (2) financial assets called time deposits.

But surely classical loanable funds theory is, fundamentally, a theory of interest rates, saving and investment. It makes many more claims than the simple observation that there is an annual flow and stock of savings.

Now I am sure Daniel is perfectly familiar with Keynes’s critique of loanable funds.

So the remarks that follow are really more for my benefit and other readers of this post.

Keynes’s critique of the loanable funds theory is summed up by Bill Mitchell:

“… the Classical belief [sc. was] that the household decision to save was determined by the preferences for current and future consumption mediated by the interest rate (the price that consumers traded current consumption for future consumption). Instead, … [sc. Keynes] considered aggregate saving was a positive function of national income.

So when national output and income rises, aggregate saving will rise. The amount of extra saving per dollar of additional disposable income is called the Marginal Propensity to Save (MPC). If the MPC = 0.20, then households will save 20 cents of every extra dollar of disposable income they receive.

The interest rate might have some influence on saving but Keynes considered the influence of changes in national income to the dominant factor determining the aggregate level of savings in any period.

The other consideration is that investment spending is a component of aggregate demand, which in turn, drives total national income in each period.

Taken together, these insights undermines the concept of a loanable funds market in the way conceived by the Classical economists. There could not be independent saving and investment functions brought together by movements in the interest rate as required by the loanable funds doctrine because investment drove income which influenced saving.

In Chapter 14 … of his General Theory of Employment, Interest and Money, he produced a diagram to illustrate his contention that this interdependency meant the loanable funds doctrine was a ‘nonsense theory.’”
Bill Mitchell, “Keynes and the Classics Part 6,” Billy Blog, January 24, 2013.

There is also the question of what information, if anything reliable, is communicated to businesses through interest rates about time preference.

And then we have more complicated issues about money and banking, such as endogenous money theory, relevant to the classical loanable funds.

Money saved adds to a bank’s reserves. But even at this point the standard story is flawed. Bank lending is not constrained in the way the standard theory requires. Loans create deposits (or new money), and most of the broad money stock is bank money held in the form of demand deposits. Prior monetary saving is not strictly necessary for investment. Then there is the issue of the mythical money multiplier.

At this point, however, we are simply revisiting some of the issues of the Krugman versus Keen debate on endogenous money from about a year ago, which I discussed here:

“Keen versus Krugman: The Great Debate!,” April 4, 2012.

Keen also gives a talk below that addresses some of these points.





Further Reading
“Keynes and the Classics Part 6,” January 24, 2013.

“Scott Fullwiler: Krugman’s Flashing Neon Sign,” Naked Capitalism, April 2, 2012.

Daniel Kuehn on the Austrian Business Cycle Theory

Daniel Kuehn has written an insightful and thought-provoking comment on the Austrian Business Cycle Theory (ABCT) here, which I reproduce below:

“For what it’s worth, I think Hayek has a more useful set of ideas on the business cycle than Mises anyway. Keynes even made basically the point in Ch. 16 of the [General Theory] that Hayek does in Prices and Production – that a lower interest rate will make production processes longer (and also more capital intensive – but the elongation is the main point). Hayek’s business cycle theory hinges on the fixed [and specific] nature of those investments in longer production processes. That guarantees that adjustment is not costless. I’m not that familiar with Mises, but I don’t think he has that mechanism that Hayek does.

My concern with all the Austrian work is that while it may be a very interesting description of what happens to what they call the ‘time structure of production’ in response to the interest rate, there’s no obvious reason to tie that to the business cycle. Their story is ‘during the boom interest rates are artificially low, and during the bust they go back to their natural rate’. In a loanable funds world, that makes sense. But in a liquidity preference world, the story is ‘interest rates are too high for full employment’. In a liquidity preference world where those interest rates are kept too high by a zero lower bound, you of course have even more trouble.

So the whole Hayekian story is predicated on the assumption that we move below Wicksell’s natural rate during the boom, and return to it in the bust. Our best understanding of macroeconomics (from Hicks et al.) says that we’re at Wicksell’s natural rate during periods of full employment, and are above it during the bust.

In other words, the Hayekian mechanism should produce a capital structure that is just right during the boom and too short during the bust – exactly the opposite of their normal story.

So while all the fluctuations of the ‘temporal structure of capital’ are quite interesting to me, I don’t think they offer much in the way of a business cycle theory.’”
Daniel Kuehn, “A Comment I Left on Brad DeLong’s Post which may be of Interest...,” November 16, 2011.

It also well worth reading the comments on that post.

Some quick comments:

(1) I think Daniel concedes too much when he says:

“Their story is ‘during the boom interest rates are artificially low, and during the bust they go back to their natural rate’. In a loanable funds world, that makes sense.”

It is better to say: if the natural rate of interest actually existed and loans were made in natura.

(2) This reminds me of Nicholas Kaldor’s different critique of Hayek’s ABCT. In 1942, Kaldor published “Professor Hayek and the Concertina-Effect” (Economica n.s. 9.36 (1942): 359–382), which was an attack on Hayek’s new version of his trade cycle theory in Profits, Interest and Investment (London, 1939). Kaldor focussed on Hayek’s Ricardo effect (or what Kaldor preferred to call the “Concertina-Effect,” since Ricardo had the examined the relative prices of labour and capital), and argued that in fact Hayek’s postulated mechanism to explain a decrease in capital goods investment when an increase in demand for consumer goods occurred during a period of full employment was not credible (for a short analysis, see Kyun 1988: 37–38 and Kaldor 1996: 156–157). Hayek argued that rising demand for consumer goods during full employment raises the prices of consumer goods and reduces real wages. Capitalists increase investment, but use less “capitalistic methods of production” (Kyun 1988: 37) by more labour intensive methods and less capital goods. The decrease in investment in capital goods overwhelms the use of labour and an overall decrease in investment results. Kaldor debunked this “Concertina Effect,” arguing instead that an increase in consumer goods demand increases overall investment.

BIBLIOGRAPHY

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London.

Hayek, F. A. von, 1942. “Professor Hayek and the Concertina-Effect: A Comment,” Economica n.s. 9.36: 383–385.

Kaldor, N. 1939. “Capital Intensity and the Trade Cycle,” Economica n.s. 6.21: 40–66.

Kaldor, N. 1940. “The Trade Cycle and Capital Intensity: A Reply,” Economica n.s. 7.25: 16–22.

Kaldor, N. 1942. “Professor Hayek and the Concertina-Effect,” Economica n.s. 9.36: 359–382.

Kaldor, N. 1996. Causes of Growth and Stagnation in the World Economy, Cambridge University Press, Cambridge.

Kyun, K. 1988. Equilibrium Business Cycle Theory in Historical Perspective, Cambridge University Press, Cambridge.