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.