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

 

Re: David Henderson: A Defense of Austrian Business Cycle Theory

At EconLog David Henderson is asking:

Question for Bob Murphy and other proponents of the Austrian Business Cycle Theory: is there any evidence conceivable that, if you believed it, would convince you that your theory is wrong?

This was in response to Robert Murphy who David quotes:

As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.

The logic that is implied by Murphy's statement, that Austrians have been warning about this for years, does not imply that they are right about the current problem. Saying "we were right" does not make it so. Murphy's story has not inspired David's confidence. Perhaps I can inspire some confidence.

The core of Austrian Business Cycle Theory proposes that changes in the money stock, whether due to gold discoveries (when that mattered) or credit expansion, alter relative prices. This leads to overproduction in some sectors and under production in others. As long as these distortions remain small, the economy will probably not be greatly destabilized. If the array of relative prices, which reflects consumer demands and existing and expected supplies, are continually pushed away from an array that actually reflects these factors, instability grows more likely and business fluctuations may increase in size or number.

Expectations may help offset the distortion; they may not. We are accustomed to thinking of expectations in macroeconomics as expectations about the price level. As long as velocity remains relatively stable, agents may form expectations that often approximate future changes in the price level. This is not the object of significance in the Austrian story. It may have features that coincide with price level movements. The argument stresses that movements in and the formation of expectations about a price level are not the prime cause of fluctuations, although high levels of expected deflation can be responsible for dysfunctional credit markets, as they were during the Great Depression. Typical monetarist analysis, despite all of its success and usefulness (i.e., the cash balance interpretation of depression) does not account for the story concerning relative prices.

We can expect that, in the short run, relative prices will be distorted and that this distortion increases as the size of the injection increases. We cannot expect a full and immediate adjustment of prices as knowledge exists only in dispersed bits. Those bits of knowledge are born from varying interpretations that have contributed to and been formed in part by the agent's interpretive (cognitive) structure. Distortion derived from interpretation increases as agents face greater uncertainty (edit 1826 EST) (Koppl 2002). We've been living in an atmosphere of elevated uncertainty for a decade.

Realist Theory and Complex Methods: The Path Toward Integration

In its purest form, economic theory describes its domain of study as it actually exists. Reality is not comprised of homogeneous agents who choose quantities of goods according to the mariginal unit of utility gained per dollar spent. If only life were so simple! In the real world, agents have no option but to make choices that confront scarcity of time and resources. These choices are often aided by some standard or algorithm. In some cases, choices appear to be random. Despite this, order in society is apparent enough to suggest to the observer with even a slight inclination toward introspection that the persons around her act with ends in mind; that there must be some process by which society organizes itself toward the ends of its agents.

James Buchanan identifies much of this order in the form of rules that govern human action and interaction. Douglas North took this a step further, arguing that the rules and order that appear in society first arise in a mind or minds. The rules of the mind come to impact the rules of the game and their structure. This may happen simply through duplication of the rule governed action by others, or may rely on a complex, iterative processes of instantiation. Herbert Simon showed us that humans are ecologically rational, using the information present in their surroundings to guide their actions. This is a process of necessity for humans to function in a world that is best described as an open system and where one's own computational power is limited both by physical and structural constraints of the mind. Hayek (1952; 1960; 2014) delved further into the nature of rules, perception, interpretation, and action, providing a general language that made many readers confuse his economics for something approaching philosophy.

The wisdom of those great economists who have come before us serves as foundation for a new framing of economics. This starts with a reconstruction of the agent along the lines suggested by the economists above mentioned, as well as researchers in the adjacent disciplines which include philosophy, sociology, cognitive science, computational and computer science. Carl Menger dreamed of building a robust economic system that integrated essential innovation in formal knowledge of mind, human action that flows from the mind, and the society that arises as a result of human action. In some ways, Mises (1949) fulfilled this dream in human action. However, unaddressed problems concerning epistemology made his contribution fodder for those who do not appreciate the implications of his argument. Hayek corrected much of this with his work from the Abuse of Reason project. It is no coincidence that he is highly cited by those who study the emergence of institutions.

Many recognize that Hayek's work in this domain is valuable, but I have yet to see a substantial integration of his ideas with the core of economic theory. Many researchers in institutional economics have picked up the torch that he passed. Elinor Ostrom credits Hayek (1937, 1945) for her understanding of the emergence of social institutions that help to govern the commons. A similar appreciation is true for North and Denzau, as well as more recent work from Boettke, Coyne, and Leeson. The latter of these note that Hayek "was among the first to emphasize these aspects of spontaneously emergent institutions (333)." Koppl (2002) advises us to consider the internal state of the economic agent with reference to his perception of the external world. He argues that agents form expectations according to types that they have constructed or borrowed from others. (When I approach a cashier, I do not necessarily expect to make a friend, but I can be nearly certain that he will facilitate my purchase.) Agents have mental maps - private ontologies - which are comprised of a mixture of anonymous and personal typifications and rules that are believed to govern the existence and interactions of objects represented by these typifications.

The work of all of these mentioned have helped move economics toward the cusp of a change that has been building throughout the last half-century. Their work is part of a line realist theories that trace their lineage back to early economists like David Hume and Adam Smith who were not afraid to recognize, and even awed at, the complexities inherent in social interaction. These contributions represent a more scientific rendition classical political economy. This is synonomous with Wagner's "entangled political economy."  Their work is integral to the resuscitation and development of a paradigm of realism to underlie the work of economists.

Not long after the Samuelsonian turn in economics, theorists on the margins of the discipline - and some like Arrow who was certainly not on the margin - began to employ a new set of tools. These tools are part of the complexity paradigm. Researchers within this practice investigate emergent processes and the objects and structures that the processes generate. Of primary concern for economic theorists are agent based models. Some popular models include Shelling's (1971) segregation model, Axelrod's (1997) conflict model, and Gode and Sunder's (1993) zero-intelligence trader model. Theoretical contributions are arising from this line of inquiry. Gode and Sunder show that the process of coordination is an outcome of simple rules governing the buying and selling of goods. Axtell (2005) demonstrates that exchange is a process of social compuation! These theorists have created a number of innovation that other economic theorists can integrate into their own practice and understanding.

Now to bring these treasures together into a cohesive framework. A robust economic theory must explicitly identify its objects of concern, relationships between objects, and processes that govern these. Emphasis on rule-based perception and coordination is critical for understanding the core of social processes. Perception is at the foundation of agent action. Agent-based modeling provides a method to which a methodologically robust rendition of economic theory can be applied. Integration of these will provide us models that not only explain and demonstrate economic theory. The same platform also allows us to produce models whose predictions take economic process into account.