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.

Keynes’s Mistakes in the General Theory

Matias Vernengo raises the issue of Keynes’s errors in the General Theory in this post.

The mistakes and oversights that Keynes made in the General Theory are arguably as follows:

(1) the assumption of an exogenous money supply;

(2) the marginal efficiency of capital (MEC) idea. Keynes, in developing the MEC, failed to free himself from the neoclassical marginal productivity of capital (King 2002: 209):

“[sc. Keynes] made a fatal mistake in offering a quasi-long-period definition of the inducement to invest as the ‘marginal efficiency of capital’, that is, the profit that will be realised on the increment to the stock of capital that results from current investment and, still worse, identified the profitability of capital with its social utility. This was an element in the old doctrine from which he failed to escape. He had an alternative concept of the inducement to invest as the expected future return on sums of finance to be devoted to investment. Minsky (1976) points out that he did not seem to recognise the difference between the two formulations. If he had stuck to his short-period brief, he would have used only the second.” (Robinson 1979: 179–180).

The MEC seems to suggest that there exists a rate of interest which is low enough to induce full utilization of capital goods. But this is just smuggling in the Wicksellian natural rate of interest, when Keynes had wanted to abandon the natural rate.

A number of Post Keynesians reject the MEC, because it is based on the neoclassical or marginalist theory of distribution.

(3) Keynes did not sufficiently stress the role of uncertainty and expectations in undermining the coordinating role of interest rates (King 2002: 14). In Chapter 18 of the General Theory, Keynes played down the role of uncertainty (which he had stressed in Chapter 12) and, if he had really maintained the crucial role of uncertainty (as he did later in Keynes 1937), this would have “ruled out any stable functional relationship between investment and the interest rate” (King 2002: 14). The door was thereby left open for neoclassical synthesis Keynesians to reformulate the General Theory as a general equilibrium model where the interest rate has a pivotal role (King 2002: 14).

(4) In Chapter 2 of the General Theory, Keynes used the marginal productivity of labour concept. Later he was criticised by Lorie Tarshis and Dunlop, who invoked empirical evidence on pro-cyclical wages, and in Keynes (1939) he came to reject this marginalist idea, apparently giving some endorsement of Kalecki’s theories.

Other possible problems include:

(1) Did Keynes properly understand the heterogeneous nature of capital goods? Possibly he did (see Hayes 2007), though the Cambridge capital debates were long after he died;

(2) Did Keynes understand the extent and significance of fixprice markets? One charge against Keynes is that the General Theory does not consider fixprice markets properly. By contrast, Michał Kalecki did understand fixprices, in his ideas on cost-determined pricing. Kalecki and later Post Keynesians understood that as long as excess capacity exists in fixprice market firms, then government stimulus produces direct increases in output and employment in the latter markets, not just inflation.

LINKS
“Keynes’s Marginal Efficiency of Capital: A Mistake?,” January 1, 2012.

“Post Keynesian Policy on Interest Rates,” March 12, 2013.

“Interview with Bob Rowthorn,” March 4, 2012.


BIBLIOGRAPHY
Hayes, M. 2007. “Keynes’s Z-Function, Heterogeneous Output and Marginal Productivity,” Cambridge Journal of Economics 31.5: 741–753.

Keynes, J. M. 1937. “The General Theory of Employment,” Quarterly Journal of Economics 51: 209–223.

Keynes, J. M. 1939. “Relative Movements of Real Wages and Output,” Economic Journal 49: 34–51.

King, J. E. 2002. A History of Post Keynesian Economics since 1936. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Robinson, J. 1979. “Garegnani on Effective Demand,” Cambridge Journal of Economics 3: 179–180.