Austrian Cycle Theory: More Than a Theory of Inflation Driven Boom and Bust

Yesterday, David Henderson asked me "can you look at the stock price drops of the last week and say with much confidence that they are strongly confirming of ABCT?" I responded that we cannot know for certain. The more I thought about it, the more I thought that this is not the right question to be asking.

Austrian business cycle theory is an extension of price theory. As long as expectations are convergent, we can expect prices to tend toward an array that reflect underlying scarcities and demands. If expectations are not convergent, then we can expect increased volatility. As humans, we gain much of our knowledge by observation of others. This leads to a tendency for expectations to be subject to herding (Koppl and Yeager 1996). The more uncertain the future, the more likely expectations will be disparate. For at least as long as disagreeing agents remain solvent, this volatility will persist. Discoordination persists as relative prices fail to reflect  underlying economic reality. 

We can be certain that the mechanics of Austrian cycle theory are always in operation. 

The effect of discoordination of relative prices is always in force. Entrepreneurs and firms in the market are often able to withstand the volatility. This does not change that these agents are interacting with distorted prices. Movements in relative prices always affect the production structure. Sometimes price distortions do not greatly impact system stability. Sometimes they generate numerous insolvencies. In the current crisis, Austrian cycle theory seems to hold in China as myriad distortions have left the market in disarray. 

Confusion arises from the Austrian emphasis on inflation and inflation's relationship to the natural rate. Murphy argues that "the Federal Reserve was setting us up for another crash." How was it setting us up for another crash? Murphy points to the Fed's increased balance sheet as evidence that it has set the economy on course for a slump. He provides the traditional argument that the interest rate has been pushed below the natural rate.

However, what happens if interest rates fall not because of a genuine increase in saving by the public, but rather because central banks flood the financial sector with newly created money? According to the Austrians, this typical remedy merely sets off an unsustainable boom. Entrepreneurs still get the green light to start longer term investment projects, but the economy lacks the real savings necessary to bring them to fruition.

This version of the story is not as powerful as most Austrians think. Firms can substitute toward cheaper inputs as prices rise. Consumers can substitute away from goods that have become to expensive. Projects can be completed, but they may be completed at a loss. If losses accumulate, credit markets may seize for as long as their is a perception of high risk and/or a rate of expected deflation. The structure of production may lengthen, but discoordination occurs on more than one dimension. The story presented by Murphy is incomplete.

The core of Austrian cycle theory is not overconsumption or overproduction. Garrison's presentation with its use of the Hayekian triangle and emphasis on interest rates, demonstrate this version of Austrian cycle theory (edit 926 EST). The theory is more general than this. All relative price distortions lead to overproduction of some goods and under production of others. Inflation tends to make overproduction more common, as reflected by Garrison's movement off of the production possibilities frontier. Central bank policy contributes to this, especially when changes in the money stock are substantial and central bank action is unpredictable. 

This logic applies to more than central banks. All state intervention into the economy tends to be distortionary. The greater the magnitude of the intervention. the less sensitive is the structure of production to the actual needs of consumers. Unlike private agents, the state is not especially responsive to profit and loss as its funds derive from a different revenue stream: taxes. When relative prices are perpetually distorted by interventions and policy uncertainty, profit and loss becomes less effective in promoting expectations that reflect the underlying economic reality.

Thinking about prices and coordination:

Hayek - Socialist Calculation I, II, and III 

Hayek - Economics and Knowledge 

Hayek - The Use of Knowledge in Society 

Mises - Economic Calculation in the Socialist Commonwealth