Russ Roberts

Don Boudreaux on Macroeconomics and Austrian Business Cycle Theory

EconTalk Episode with Don Boudreaux
Hosted by Russ Roberts
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Don Boudreaux, of George Mason University, talks with EconTalk host Russ Roberts about the microfoundations of macroeconomics and the Austrian theory of business cycles. Boudreaux draws on Erik Lindahl's distinction between microeconomics and macroeconomics, emphasizing the difference between individual choices and the coordination of economic activity. Other topics include the Austrian view of capital and investment, the Austrian view of monetary policy, the issue of aggregation, and the intellectual successes of the Keynesians.

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0:36Intro. Austrian view of business cycles and macroeconomics. What does micro have to do with macro? There is only one kind of economics--microeconomics. All economics is microeconomics. There are just different questions asked--macro: what causes inflation, sustained unemployment? To understand them we shouldn't depart from the micro-analytics, the way people respond to incentives, the way markets equilibrate and disequilibrate, theories of creative destruction. What a strange historical episode we find ourselves in the middle of. Chief interest monetary theory and macroeconomics, but hard stuff. Anti-trust economics, international trade, traditionally micro. [Recording April 2009.] What is the role of money, what does aggregate demand mean, what is the proper role of fiscal stimulus versus monetary policy? Microeconomists educating themselves on macroeconomics: find yourself starting to think about these things again. 1930s in economics--no coincidence that it is considered one of the most fruitful for economics: Hayek, later John Maynard Keynes, also advances in public goods theory, theory of competition with Chamberlin and Robinson--years of high theory. Economy was front and center, real economic problems, not theoretical abstractions. What will be different in the classroom, textbooks?
6:07Micro/macro distinction: 2001, Boudreaux returned to GMU. Dick Wagner: familiar distinction: macro is about employment, inflation rates, etc., micro about consumer behavior and firm behavior, wasn't the original distinction. Distinction traced back to Erik Lindahl: microeconomics is that branch of our discipline that examines how individuals respond to incentives. E.g., Gary Becker. Macroeconomics is that branch that examines how all these microeconomic decisions hang together: how the pencil comes about. That is a macroeconomic issue. How does the price system coordinate the efforts of individuals, unintended consequences? Micro: given how humans are motivated, how will people react when the constrains they face--the costs and benefits--change? Coordination problem: different kinds, producing a pencil, labor market, how the money supply runs through a whole economy. Teach through convention the microeconomics of the pencil market: graphite, aluminum, labor market, etc. not talked about in traditional macro, but go up to the next level, how all the markets work together in macro. In Lindahl's view, macro explains how coordination takes place and hence how it might break down. Disagree about going to next level in traditional macroeconomics: don't see attention paid to coordination in traditional macroeconomics. It's about aggregates. Will come back to this. We do talk about "the" labor market, implicitly suggesting that there are a lot of things going on.
12:11In the Austrian view, what's the cause of the business cycle? System-wide disruption in pattern of relative prices. Resources don't coordinate automatically. When consumers, entrepreneurs, and investors respond they do so chiefly through nominal prices. They don't look out in the world and see the real underlying economic phenomena. Window of economic prices, but it's a cloudy window. Responding to prices, and expectations of what future prices will be. To the extent that the pattern of relative prices reflect as accurately as possible the underlying real economy--preferences, resource constraints, technology, costs of production--the economy is going to work pretty well. No reason to believe there will be systematic, system-wide major problems. But if those relative prices get out of whack in a significant way, they will respond to the relative prices. The money supply is the single largest force in an economy that can cause relative prices to become systematically out of whack. If the system that creates the money supply creates billions more dollars and happens to give those dollars to people who have an especially high demand for apples, the recipients will be better off; they spend their money on apples, driving up the relative price of apples. Resources shift into apple production. Looks like there has been an underlying change in economic reality. More apples and less of other things get produced. But ultimately the system restores itself when money flow from central bank stops. Apple market has to slough off all the extra production capacity; takes time, economic downturn. Can have secondary effects--people who lose jobs lose their optimism; further depressing effect on the economy. Austrian view: artificial boom created by monetary expansion affects relative prices and caused the bust. Mises and others focused on one particular relative price--the interest rate. Banking system gets more money from the monetary authority, causing the nominal interest rate to fall entrepreneurs see that investments that previously weren't profitable to become profitable. New pattern, more investment relative to consumption and different kinds of investment relative to consumption. Interest rate falls; response is same as if savings preference had increased. But real situation hasn't changed, so when monetary authority stops injecting the money, the investment plans that were made on the artificially low rate of interest, so plans have to be undone. Takes time for resources to find their way back--that's the bust.
21:17In traditional monetarist theory of inflation, not a lot of attention paid to who gets the money first. Helicopter drop doubles money in the economy. Useful simplification to understand the effect of a change in money on the overall price level. Austrian theory is going to try to look at what actually happens. Money doesn't go to apple lovers, but to banks first. But you wouldn't expect the banks to lend to any one sector disproportionately. But there is one sector: people who want to look to the future, expanding their future consumption by investing. Critical to the Austrian theory of business cycles is the Austrian theory of capital, dating back to Bohm-Bawerk: roundabout theories of production. Austrian capital theory takes specifics of production plans--capital structure, which is not just K (which stands for the aggregate quantity of capital in the economy). Structure is important. If you tie up real resources in creating a certain kind of machine that can't do anything else, and that machine is going to coordinate with certain kinds of workers who are trained, it takes time. Specific nature of capital. Impossible to appreciate the insights of the Austrian theory without understanding that Austrians take the specifics of the capital structure very seriously. Capital goods and services are structured together in nuanced, specific, granular ways. If this arrangement doesn't work out--proves not to be profitable--then that capital structure will be rearranged. Won't just be reduced; the structure of K changes. Getting K back into a pattern that fits together that not only works technologically, but works to enable the owners of that capital to enjoy a normal level of profits for a considerable period of time is the structure in line with consumer preferences including the preferences of income earners to save. But that happens all the time, without monetary disruption. Entrepreneurs start factories, make mistakes, close the factory. One man's K is another man's uselessness. If pencils go out of style and pens come along, machinery not useful. Can't be melted for scrap. But that happens all the time, not just with monetary increases. Theory of the downturn is necessary. Hayek theorized that it was the money supply, which is system-wide. Successes in economy tend to wash out the failures in ordinary times. But money and banking system are system-wide; system-wide distortion in investment.
30:07Historical context; why not also fan of Hayek in business cycle theory? Don't know much about it. In mid-1970s at the U. of Chicago, no discussion of Austrian business cycle theory. Maybe dropped off the map because of Great Depression; maybe alternative theories had taken over, marketed better. Keynes's efforts of the 1930s, Schumpeter's work on business cycles, 1939; hard to read, but Keynes triumphed. Austrian school was major alternative and went into hibernation. Milton Friedman's view has elements of this conversation in it: how nominal prices mislead, can have inflation but individuals may not realize it's system-wide, manager sees own price rising and mistakes it for increase in demand. Friedman argued for a steady growth in the money supply rather than an erratic growth and fine-tuning as currently, roughly equal to the rate of productivity; would lead to stable price level; would lead to allowing people to make plans consistent with underlying reality. Did Friedman and the Austrians see eye-to-eye on that? Yes and no, but mostly no. As a policy matter, Austrians like most people would argue that a steady rate of increase in the money supply is better than an erratic money supply. Monetarists, like Austrians, have a greater appreciation for the ability of markets to coordinate than the Keynesians. Not so worried as the Keynesians about price stickiness downwards. But monetarists and Keynesians share a focus on aggregates: talking about the price level. If you expect price level to go up 10% in a year, and interest was 3%, you are going to ask 13% in your loan contract to lend for the coming year. But Friedman, in his macroeconomics, unlike the Austrians, doesn't focus on the way individual prices in individual markets can cause distortions in resource allocations. Scholars of Friedman say he had no real capital theory; capital theory for Friedman was a K. Maybe K will increase a little too much, but if you look it as a glob, rearranging a glob from its suboptimal shape into its optimal shape is easier than rearranging different fixed forms of capital, which takes time.
37:09Logical point: Every theory is a simplification. Aggregation is by definition simplified. If you don't like the theory, you are going to say it is too simplified; but every theory is simplified. Labor, L, is obviously not an aggregate. Isn't it sufficient to say that it will be hard to rearrange both K and L if they've been artificially increased by price signals from the Fed and the money supply? What am I missing? What subtlety is missed by making the simplification? Doesn't matter if it's simplified--it gets at the main point. Cannot theorize without simplifying; good theorist has the wisdom of what to extract away from. Just because all theory is simplification doesn't mean that all simplification is consistent with good theorizing. To the extent that Friedman and anyone else abstracted away from the capital structure, from the issues involved in how many pieces of capital fit together in production plans is to abstract away from a vital part of how economic coordination takes place over time. If that's right, then when you get these distortions in the capital structure, caused by whatever, then to abstract away from the structure of capital is to abstract away from a potentially important variable. Hard time on different aspect: agree on value of Schumpeterian competition and creative destruction. New product or innovation comes along, puts pressure on substitutes for that good, and those resources are going to be unemployed. Dynamic nature of a modern economy--going back last 150 years. Example: some people decide they want to be healthier, want certain type of exercise equipment. Nobody sends a memo saying they are going to want less meat, want certain kind of shoe. We don't minimize or ignore that some people are going to be harmed--ice cream maker, couches for watching TV are going to struggle. New allocation of resources occurs. Kind of cheating, we don't worry about the fact that making high end ice cream aren't good at making tofu and therefore there will be this big disruption. Economy absorbs these kinds of changes all the time, relatively painlessly. Don't need government to coordinate. Austrian story but it seems to conflict with the Austrian business cycle story. There is that tension. First response: Austrian theory focuses as a practical matter on the system-wide distortion stemming from the nominal interest rate--the entire economy ultimately has to contract. But there is an inconsistency to say there is no need to worry about changes from one industry to another, rosy story for trade patterns, etc., and Austrian story of it's taking time. Too cavalier in not worrying about changes in trade patterns. Other countries may not be as dynamic as the United States.
48:00Historical point: Austrian theory lost the intellectual battle to the Keynesians and then to the monetarists, but are coming back. Different possibility: if you asked somebody in the 1960s-1990s, Austrian theory was a backwater. Standard answer of professor in a graduate program would have been: They were wrong. They did not explain the business cycle well. Methodology, marketing. Austrian theory does not lend itself well to modern tools. Neither does Keynesian model. Hicks made Keynesian model popular with IS-LM models. "Sir John Hicks's excursion into ISLAmic art," Ludwig Lachmann. IS-LM, aggregate supply and demand curve, touted as a form of Keynesian economics. Nothing in Keynes had IS-LM in it, though. Keynes in QJE article in 1937, acknowledged Hicks's apparatus as consistent with what he was trying to get across. But Hicks himself abandoned it before he died. Also, there is an industry still going on in what Keynes meant. Keynes was a very clear economist, but The General Theory is a muddle. Suggests that the ideas he was trying to get across were not well worked out in his own mind. Writing it in 1936, extraordinary human suffering; he understood at the time that Hayek's Austrian theory of the time was the main alternative theory, not so much monetarism. Hicks is on record as saying that there was a time when no economist knew which economist would win out, Hayek or Keynes. Hayek in Nobel Lecture, "Pretence of Knowledge," argues that Keynesian model does lend itself to modern econometrics--you can regress aggregates on each other. Austrian theory is inherently difficult to test. Good introductions: Roger Garrison book, Steve Horwitz book, Gerry O'Driscoll, UCLA dissertation, Economics as a Coordination Problem: when we look at aggregates we miss the coordination problem. Hayek: explaining macroeconomics in this Lindahlian way, as a coordination problem.
56:59Debate: how we got into the mess we are in: monetary problem, Greenspan or the Fed; Wall Street greed; housing sector grew too big too fast--people disagree. Debate about how to get out of it. Regardless of the cause, people are homing in on particular solutions: monetary authorities have to be more aggressive; collapse in aggregate demand can only be solved by government. Underlying all these views is the idea that we have to do something, better to do something than nothing. Seductive nature of idea that we have to do something as opposed to letting economy heal itself. Psychology: we have to do something. Not just Austrian, Chicago, Swedish perspective: price system coordinates actions, so the only way the economy can be restored to health is to let that take place, and intervening, throwing money at it, will only distort these prices further, prevent the coordination from taking place. That is doing something, but you are not seeing it: letting people use their knowledge of time, place, and circumstances. If you have government doing something, you are substituting one big doer for the millions of small doers on the ground. It's not clear that if the government does nothing that nothing is being done. Millions of people are doing things. Many will make mistakes, but better than a giant making one enormous mistake. Imagine going back to 1809, convince people you are from the 21st century and describe an automobile. You are describing the mundane, but to them it's a barely imaginable wonder. What would most impress is when you tell them that the industry started to evolve in the early 20th century, and entirely without coordination. Just because an individual can't imagine how successful and productive coordination can emerge doesn't mean it doesn't happen and we should say that it doesn't happen, so we should increase the money supply or do other centrally planned things. Compared to structuring an auto industry, getting consumer spending up doesn't seem like something that must be planned or stimulated by the state. In the 1930s, that's exactly what Hoover advocated; but he was a very interventionist president by the standards of his day. When you have an historical and unique as the Great Depression was, we still don't have a lot of good data on what caused it still. Huge economic downturn in 1920. Warren G. Harding was more of a do-nothing President. By 1921 it was history.

COMMENTS (28 to date)
Floccina writes:

I have a theory that if a thing is too simple to be taught in a rigorous class, academia will not teach it because the goal of academia is not to teach useful truth but to test. In order to be an effective test of the intelligence and diligence the subject matter must be sufficiently rigorous so that the weaker students will fail. IMO this often gets in the way of teaching students what would be most useful in life outside of school.

Russ, you mentioned economists who believe that down turn in the economy was mostly cause by the housing price collapse, I would like to suggest that you have Dean Baker on to discuss this because that is his position. Also Dean Baker is far to the left so it might make a good discussion.

Jake Russ writes:

Towards the end of the podcast when Dr. Boudreaux starts talking about not being able to imagine the coordination of resources required to spring up a new industry.

Hearing him talk about this phenomena made me think about religion. The idea of religion (at least in part) is that people can't imagine the possibility that life emerged from a coordination of occurrences outside of a Supreme Being's action. We're drawn to the explanation that someone (something?), call that being God if you want, exerted direct influence and the result was this miracle of life. Especially in times of crises, people tend to attribute events to a master plan.

In the same vein, when we can't imagine how a system like our economy operates without direct control, we're fearful of it. And should that system experience a crisis we look towards an authority figure, say our Federal Government, to exert its influence and bring about a recovery.

There's a certain uneasiness we have about things we can't explain/imagine. Our attitudes about uncertainty have probably evolved with direct links to our religious beliefs.

Lee Kelly writes:

An economic bubble is a destroyer of knowledge.

When a single industry fails, its resources are easily reallocated. But when many industries begin to fail at once, it is difficult to discern just where resources should be reallocated to. Who is part of the bubble? Where will demand return to? What do people really want? Nobody knows because the price signal has been corrupted throughout the economy.

Its like getting lost: it is easier to find your way back to the correct path when you took fewer wrong turns to begin with. The longer the government tries to "stimulate" the economy, the more difficult it will be to ever find the right path again.

Greg Ransom writes:

Great discussion.

I want to second Don's recommendation of Gerald O'Driscoll, Jr.'s great book _Economics as a Coordination Problem_.

Eric writes:

I still feel like you’ve only scratched the surface of Austrian business cycle theory and you need to do a thorough interview with someone like Roger Garrison who is intimately familiar with original Austrian source material and Keynes’s works, and can offer more nuances including major criticisms of ABCT. Boudreaux’s interviewed seemed redundant since Boettke already gave a nice summary; they both admitted they weren’t experts on ABCT, so it would be nice to get someone like Garrison who apparently has formalized the theory in his book, Time and Money.

Sam writes:

Very educational discussion.

One comment I have is that individuals do make their choices based on government actions, or lack thereof, to say that government should not intervene is one thing, but to ask what the government should do to solve the coordination problem along with all the individuals seems more realistic and important given that government is a integral part and has huge influence on individuals' decisions.

Sergei Vavinov writes:

I second Eric's comment above -- this discussion was quite good, but there's not much point in discussing the basics so much, when there're many deeper issues worth explaining. For example, the relevance of the full employment issues (it comes up quite often in the discussions), the explanation of why the interest rates must inevitably rise at some point as the result of the credit expansion (there's a series of specific microeconomic processes that occur at different stages of the boom-bust cycle), etc.

Some points I'd like to make:

1. Don Boudreaux spoke several times of the "monetary authorities" expanding the money supply; another source of money supply that wasn't (I think) mentioned is credit expansion by commercial banks within a fractional-reserve system. It helps to explain business cycles that occured in the absence of central bank-like instutitions.

2. At some point you asked: so what if Milton Friedman's model doesn't include capital structure, why is this kind of simplification unappropriate? Well, for one thing, we need good explanations to make good economic policies. ABCT suggests that throwing money at the problems not only won't help the economy out of depression, but will make it much worse because it will prevent the old, unsustainable structure of production from readjusting, and lead to the further losses of capital.

Adam writes:

This theory always seems very plausible to me, in terms of the mechanics of how it works, but always falls short for me in its marketing. That is to say, why does it have to be called the theory of the business cycle? Why can't it just be treated as a theory of the effects of expanding the money supply, in particular when it is done by a central bank through the fractional reserve banking system?

The larger question I have, though, concerns the ability of people to adapt. It seems to me that the Austrian Business Cycle theory explains a cost that is imposed by expanding the money supply. Now, correct me if I'm wrong, but when the same cost is imposed from the same source repeatedly for a long stretch of time, people tend to find ways to reduce its impact.

Speculation makes it possible to get certain food year round even though it only comes to harvest once a year, because speculators realize that there will be a long period of time between each harvest during which the price of that good would be quite high. After enough speculators take advantage of this, however, the price across time, correcting for inventory costs, tends to be very stable.

It may be that the discretionary nature of the Fed is not as stable and cyclical as a harvest. But you would think that, the money supply being something measured and on public record, people and institutions would adapt to minimize the impact of dramatic growth of the money supply.

So my question is: do we see this occur? Why or why not?

Christos Kitromilides writes:

One subtle point missed in your very intelligent discussion.

Real savings express consumer time preferences.

Consumers decide to consume less now (releasing some resources)and consume more in the future, when the investments bear their fruits.

With enforced low interest rates, we have (artificially induced) investments for future goods AND high current consumption patterns, going after the same scarce resources, leading to the unavoidable conflict and bust.

Some firms make good predictions and make profits, others make wrong predictions and go bust.

The only way for ALL businesses in one or more sectors to be wrong AT THE SAME TIME, is when the government through legislation tranfers resources from their natural market use to meet political objectives (e.g. 'affordable housing')

JQuest writes:

I liked the discussion with Don Boudreaux.

How about other Austrian economist, like
Joseph Salerno from the Mises Institute to have as a guest.

Roland writes:

In spite of his self-stated lack of expertise, Don Boudreaux in my view managed to give a fuller picture than Peter Boettke. Still, I join those other commentators who feel the issue deserves further discussion on EconTalk, with more depth and criticisms and their counter-arguments. And/or opponents - more Keynesians, mainstream IS/LM folks or monetarists, why not.

Neil West writes:

I have one small correction to make. In the podcast it was said: "If you have government doing something, you are substituting one big doer for the millions of small doers on the ground." This is not a substitution but an augmentation. The millions of people still act but they also must act relative to the actions of the one big doer. This moves the argument in the direction of whether the one big doers actions result in greater benefit taking into account the resulting small doers responses relative to actions only being taken by the small doers. In other words, do the big doer's actions help. This is where public choice takes over and the can of worms is open.

Great podcast!

Mark writes:

Hi Russ, am a believer in ABCT and seek to actively monitor it for investment advantage (http://www.business-cycle-monitor.com).

About your query on K, and how relative price movements affect it. I think of it like this. Let us break the economy into its 10 GICS sectors, and further assume that monetary policy results in relative price changes that lead some entrepreneurs to invest. To ignore the effect of systemic changes assume total K is unchanged. What happens to the 10 sectors individual K's? Some sectors K will fall as investment is drawn away to other sectors K that rise. At the end of stage one we have say 100 units of K same as at T=0.

In stage two, the price moves prove illusory leading to some of the K in specific sectors being liquidated. So at T=2, K now equals

So my point. All major relative price changes will destroy K, that is a creative destruction process. Monetary operations add to relative price movements which result in greater K destruction, without the economic benefits that new innovation brings. Pain but no gain.

Then consider the case where total K wasn't stable, but infact increased. Now we have K loss as a result of relative and absolute price movements. As K=capital, and capital=wealth, this makes our country poorer.

The business cycle inst going anywhere, so need to understand, monitor and exploit it!

Brad Hansen writes:

I would have liked to have heard more about empirical analysis. Not necessarily what has been done but what could be done. What evidence would be consistent with the Austrian approach and inconsistent with the Keynesian and Monetarist emphasis on aggregate demand. Empirical analysis is more difficult when one moves away from the aggreagates but it is possible. One might look at Michael Bernstein's The Great Depression: Delayed Recovery and Economic Change in America, 1929-1939 (Cambridge 1987) He examines producation, employment and investment in different sectors of the economy and basically argues that we had the wrong capital stock. Though he argues that we had the wrong capital stock because of long term structural changes rather than faulty price signals caused by inflation. His analysis is probably closer to Schumpeter than Hayek.

gringo writes:

This is a fantastic discussion. I do have to wonder how Dr. Boudreaux ignored certain aspects of the Keynesian model in that it was actually employed during the 1930's and worked very well (Japan's economic stimulus into its military comes to mind as a prime example). I very much admire his attempt at bridging microeconomics and macroeconomics - this is a very challenging endeavor. Another notion that kept coming into my head listening to this podcast, was that however an artificial (a quantitative increase without a reserve) money supply distorts demand (in making the demand temporary), so does artificial (ostensibly overvalued) investment. In other words, I would propose that the housing bubble was caused similarly, I was surprised that neither of you seemed to reach that point in the discussion.

Russ Nelson writes:

Austrian Economists can explain this recession in the same way that all the other ones are explained:


  • Government inflates the currency.
  • Businesspeople think business is expanding, and invest and hire.
  • Because the currency increase isn't a result of saving, but instead a result of inflation, there are no savings to spend to buy the products the businesspeople created.
  • Businesspeople have to sell their capital goods at a loss and fire people.
  • Economy stays in the doldrums until there's enough savings to justify business expansion OR until the government inflates "the hair of the dog".

This is why it's so painful when government stops inflating. But if government doesn't stop inflating, you have Turkey, or Zimbabwe, or Germany in the 30's. What is our government doing right now? Inflating. But inflating doesn't fix anything -- it just postpones the pain. The only fix is if people save money to fund the business expansion. What is Krugman (the moron) telling us that we need to do? Spend, spend, spend, don't save! Except for the fact that every REAL economist will tell you that that's stupid, everyone believes Krugman because back before his brain failed, he got a Nobel Prize.

Robbie Clark writes:

"Its statements and propositions are not derived from experience. They are, like those of logic and mathematics, a priori. They are not subject to verification or falsification on the ground of experience and facts. They are both logically and temporally antecedent to any comprehension of historical facts." - Mises

I think that's what Austrians would have to say in response to your question if I understood it correctly, Brad Hansen.

Jorge Borlandelli writes:

The changes in the capital structure produced by changes in preferences are more gradual than those produced by a distorted interest rate. Before you question gradual, each sector is adapted to the graduality of changes in demand.

Jorge Borlandelli writes:

the Keynesian explanation and recipes were the justifications politicians and beuraucrats were needing to justify their increase in power and command of resources.

Robert writes:

Why no discussion of Bryan Caplan's objection to the ABC? Why are businesses so stupid to invest in questionable projects when there are low interest rates when they know from experience that the day of reckoning will come!

AC writes:

As noted above, we really need a semi-sympathetic critic of the theory to have a full discussion, since mainstream economists have no interest in it. I'm still puzzled as to why that is -- it can't be just the lack of equations.

It does seem we are just repeating the basics, but honestly I don't think there are really many complications that you need an "expert" on ABCT to explain it.

George writes:

Robert said: "Why are businesses so stupid to invest in questionable projects when there are low interest rates when they know from experience that the day of reckoning will come!"

Because most wouldn't even be able to tell the difference. If you are a person operating a business, all you notice is that there's more sales than previously. You can't tell that the money or credit in question came from Fed action or market action. All you see is money coming in. That means that you do one of three things: increase prices to reflect the current demand, increase production/inventory to reflect current demand or both.

But say you know there is a credit expansion. You want to act prudently but there is something adding pressure to your business decisions, namely your competition. Some of your competitors that don't see a bubble use the new credit and new money to expand and overtake you and everybody else in the market. And then some competitors see a bubble and are only interested in riding it, profiting quickly and getting out before the collapse. Either way, you face a choice, losing business to competitors that are riding the bubble (either knowingly or unknowingly) or staying small and possibly overtaking the ones over-extended. But how many will be over-extended? You can't know, your information isn't perfect. Also, there's a psychological aspect. When you see your competitors getting huge amounts of money that you could be getting, it can't be easy.

Most economists, who, by the way, should know better, didn't see the bubble. So why would you expect the rest of the market to?

The Austrians are far from perfect. But with that said, I think their theory is sound and deserves more respect.

Eric writes:

If there is an issue that mainstream economists seem to agree on, it’s that price controls have serious economic consequences such as shortages and surpluses. Question- since the Federal Reserve strongly influences the price of credit, what do mainstream economists believe are the consequences of fixing the federal funds and discount rates? Is the Austrian narrative not accepted because the “mainstream” narrative points to other negative results (are there empirical studies on this topic?), or do mainstream textbooks not consider Federal Reserve interest rates a form of price controls that result in negative consequences?

Dmitry writes:

I think, that it is not right to suggest, that "There is only one kind of economics--microeconomics. All economics is microeconomics".
It seems to me, that this approach overlooks essence of the law of large numbers and some aspects of synergetics. By sinergetics I mean synergetic effect in particular, when in a system with lots of elements there are some features, which are extrinsic to the elements taken separately.

Consider such an approach in physics: "there is only one kind of physics- nuclear physics, all physics is nuclear..." Ofc this is true, but physics (or mechanics) of macro bodies, macro objects is very useful in everyday life.

Or I didn't understand what Don Boudreaux meant?

Ethan writes:

I am a macroeconomist with, unfortunately, very little familiarity with the Austrian Theory of the Business Cycle. If the purpose of the podcast was to introduce listeners to the Austrian Theory, I think there was a missed educational opportunity. The discussion ranged from (what seem to me) a misunderstanding of basic macroeconomic principles, to multiple reiterations Schumpeter's already familiar theory of creative destruction. I would have liked to learn something new about the theories of the Austrian school, and to confront them not only with Keynes' General Theory, which 70 years old, or Friedman's ideas that are over half a century old, but with modern macroeconomics. I think it is telling that Profs. Boudreaux and Roberts did not confront the ideas presented with the theories of even one living macroeconomist.

There were a few very confusing statements made in the discussion, and I'm not sure whether the confusion is mine or that of the discussants.


1) Boudreaux appeared confused about the difference between real and nominal interest rates. He claimed that monetary policy could create wedges between the “real” rate of time preference and the interest rate that determines investment behavior. The latter is the REAL interest rate, which monetary policy is unable to affect unless some other friction is present. An increase in the supply of money (or a change in the nominal interest rate) translates one-to-one into the price level and leaves the real interest rate unchanged at the rate of time preference. Some explanation is required as to why changes in the nominal interest rate could cause (temporary) deviations in the real interest rate. The most common explanation, to which Boudreaux is unsympathetic, is price stickiness. Boudreaux then needs to explain why the classical dichotomy is broken in his theoretical universe.

2) I am not sure why there was so much discussion on monetary policy as a cause for business cycles, and how this relates to creative destruction. Empirical macroeconomic advancements of the past few decades show that over 99% of changes in the money supply are forecastable using a very simple linear regression. So beyond the the "confusion" hypothesis of monetary policy (which Prof. Roberts incorrectly attributes to Friedman--it is actually due to Robert Lucas) is empirically very difficult to support. Are investors, who have used complex mathematical models to create MBSs and CDOs, unable to run a simple regression to forecast the trajectory of the nominal interest rate? Your Bloomberg terminal will tell you whether when the "Taylor rule" is being violated at any point in time.

3) On the other hand, creative destruction does not require monetary policy to explain a recession. The re-adjustment due to the advent of a new technology is likely to be much more disruptive to existing forms of installed capital than a small change in the supply of money. So why the emphasis on money?

Eric writes:

"I am not sure why there was so much discussion on monetary policy as a cause for business cycles, and how this relates to creative destruction."

Here are some essays by Garrison that might be of interest:

http://www.auburn.edu/~garriro/b4mismac.htm
http://www.auburn.edu/~garriro/a1abc.htm
http://www.auburn.edu/~garriro/b6time.htm

Ethan writes:

Thanks for the references, Eric. I found them very informative.

My question, however, still stands. As I understand it, the theory is that temporary decreases in the interest rate that are misconstrued by the private sector as permanent cause them to "mal-invest": invest in projects that require a longer time horizon than savers truly have. This causes an unsustainable boom, as the investors ultimately learn that interest rates were only temporary low. Fair enough--interesting theory.

But is monetary policy the primary source of confusion for private investors? Perhaps that was the case with the Austrian Central Bank of the early 20th century, but is it true today? Or perhaps it must be the case if the source of all economic ills is the government, by assumption.

Does the government have any comparative advantage in confusing investors? The Fed expends an enormous effort communicating whether changes in interest rates are temporary or permanent. Private forecasts of the Fed's policy rate tend to be rather accurate. In fact, more often than not, the Fed reacts to private forecasts rather than the other way around.

The argument that Greenspan confused the private sector into believing interest rates would be low more permanently sounds appealing. But what about the UK? They are currently suffering from a larger recession than the US. They have an inflation target, so that it should have been very clear to the private sector what the path of interest rates would be. What about Spain and Ireland? They don't even have a central bank! Am I to believe that the Spaniards were more confused by the ECB than the French?

So I would draw the opposite conclusion from the Austrians. A credit expansion created by the government is predictable. Increases in private saving are less so. This is because aggregate private savings is the sum of millions of private decisions. Even if these decisions are individually rational, how are we to know the underlying motivation? The Austrian theory seems to assume that changes in savers time horizon must be permanent. Why must this be the case? And how are investors to know?

Thus the Austrian boom-bust cycle doesn't require a monetary authority (or money for that matter). In fact, it might even be the case that there is a need for government to provide a public good (coordinating investors' expectations) in the absence of perfect information.

Eric writes:

Ethan,

More from Garrison (http://www.auburn.edu/~garriro/c4refah.htm):

"First, assume that some—but not all—market participants know that credit expansion triggers an artificial boom and that such an expansion is currently under way. They rationally expect, then, that the boom will eventually end and that widespread economic losses will be suffered. (Not even the economists can predict just when the bust will occur and just who will suffer the losses.) Yet, for the individual market participants (especially for the ones who understand the economics of booms and busts), there are profits to be made by responding to the distorted prices in near-conventional ways. The fact that production processes are not characterized by complete vertical integration gives scope for profiting from the early stages of production processes even if each production process taken as a complete sequence of stages turns out to be unprofitable. Resources can be profitably misallocated in response to a distorted price so long as the resources are sold before the bust. To argue that the expectation of an eventual bust would prevent the boom from materializing is analogous to arguing that similar expectations with regard to a chain letter would prevent the chain letter from being initiated.

Second, even if all market participants understood the economics of booms and busts, they would have no method of accurately correcting for money-induced distortions. Here the analogy between the price system and a communications network—between price signals and radio signals—can be pushed further: Knowing that a signal is being jammed is not the same thing as knowing what the unjammed signal is. During a monetary expansion the price of iron ore, for instance, may rise by eight percent. This eight percent rise may consist of an increase in the real price of iron ore (due to coincidental changes in the underlying real factors) of two percent plus a money-induced price rise of six percent. Or it may consist of some other combination of real and money-induced changes whose algebraic sum is eight percent. Possibly the most plausible assumption that market participants could make is that there have been no changes in the underlying real factors since the beginning of the monetary expansion. Economic activity based upon this assumption is analogous to a 'dead reckoning' on the basis of the most recent unjammed signal. After a protracted period of monetary manipulation, the economy may well find itself considerably off course. The ensuing readjustments would conform in the large—if not in the small—to those that Hayek originally envisioned.

Third, the claim—based on a weak form of the rational-expectations assumption—that there would be no systematic undercompensation or overcompensation for money-induced distortions across markets, even if true, is no basis for complacency. Resources are allocated—or misallocated—on the basis of price differences, not price averages. Resources would be allocated away from activities in which there was an overcompensation for money-induced price changes and into activities where there was an undercompensation.

Further, even if the market-clearing price in a particular market reflects the 'correct' amount of compensation (such that the total volume of trade is unaffected by monetary manipulation) there is still an element of discoordination. The market process imposes a certain uniformity of price for a given good. Each market participant pays the same price. But during monetary disturbances, each market participant has a different idea about how changes in the price are divided between real and money-induced changes. The market process imposes no uniformity here. The absence of uniformity of perceived real price changes gets translated by market participants acting on the basis of differing perceptions into a discoordination of economic activity."

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