If I Believed in Austrian Business Cycle Theory, part II

Karl, a loyal man, has a request:

In your post from a few years ago, "If I believed in Austrian business
cycle theory," you made some of the most apt predictions you have made
on this blog. Nearly everything has come true. Obviously though you are
not touting these predictions because being associated with the
"intransigent" Austrians will damage your credibility as a hip, quirky
thinker. So instead, can you just give me a socio-economic cost-benefit
analysis of breast implants.

Here is my original post.  Two points:

1. What happened is best thought of as a bubble where loose monetary policy was one of several triggers but the market response was more at fault than was government.

2. Second, one important false market signal was that people thought rising asset prices could substitute for savings out of disposable income.  That is not the Misesian or Hayekian scenario.

My "predictions in the subjunctive" were largely correct — more correct than I knew at the time — but that doesn’t mean Austrian business cycle theory is largely correct.  I would, however, endorse a modified version of the theory which goes beyond the "blame the government inflation" for everything interpretation.

On Karl’s other question, it’s not just a zero-sum game, socially speaking, but my personal preference would be for Q = 0.

Addendum: Walter Block wrote a 58-page critique of my earlier writings on ABC.  He has sent it to me twice and I am happy to link to it.  Update: Here is the correct Block link.


The link in the addendum is a bad one; it should properly link to http://pcpe.libinst.cz/nppe/2_2/nppe2_2_2.pdf

"He has sent it to me twice..."

That's our Tyler, always good for the subtlest digs.

Reread original post. Not bad but what happened to #7?

Yancey, I think it is controversial because people treated a rising home value as free money. That is, if their house gained $$ in potential resale value, they treated that like a lottery ticket that had just paid $$, and spent money that was deceptively illiquid and uncertain.

Point 1 is just plain wrong. The government was entirely at fault. All the shenanigans by banks and mortgage companies were caused by the Fed's distortion of interest rates--which distorted their calculations and induced them to "play or pay." If they didn't "play," they'd lose market share and the managers might lose their jobs.
As for point 2, Mises and Hayek wrote long before the rise of credit cards, loan securitization, and even before Fannie and Frauddie, er Freddie. Their basic theory is correct, and the housing/mortgage boom and bust has followed the ABCT's outline. They would have been cognizant of this point had it been on their institutional radar at that time.

Bill, do you think the people who took second mortgages to buy large SUVs have any personal responsibility, should they now find themselves doubly under-water?

As I understand ABC theory, the malinvestment is caused by market actors being fooled by price signals, price signals which are distorted by government inflationary forces.

Given this emphasis on foolish investment caused by distorted prices, Tyler's claim that there was an "additional cause" for which the market is to blame is nonsensical. Of course market actors were fooled -- but that's the essence of ABC.

In the fantasy world of rational expectations money should not matter -- but that just means that a lot of mainstream macroeconomic theory is garbage.

Odograph and Erik,

I agree that borrowing against the asset in order to consume can be foolhardy, but that is not what Tyler and others have criticized in this case, and if it is this kind of debt they meant to criticize, then they wrote poorly.

There is nothing irrational about modifying one's saving ratio to reflect changes in value of the assets purchased.

Visually appealing, less so on contact.

"2. Second, one important false market signal was that people thought rising asset prices could substitute for savings out of disposable income. That is not the Misesian or Hayekian scenario."

This is just plain wrong. In both his Theory of Money and Credit and his Human Action, Mises emphasized the pivotal role played by the "illusory" profits generated by the falsification of accounting that occurs during the boom stage of the business cycle. (He also recognized, unlike Tyler, that since assets are alienable, saving via a rise in asset prices is indistinguishable from saving out of so-called "disposable income.") These false accounting profits result in capital consumption (i.e., a reduction in real saving) among all income classes in the economy, in particular as a result of "the in rise prices of stocks and real estate." As a result, businessmen, stock jobbers, wage earners--all "feel lucky and become openhanded in spending and enjoying life." (HA pp. 546-47).

Hayek too recognized the increase of asset prices as identical with an increase in current profits, that is, disposable income. In pointing out an error of Keynes, he wrote: "But these two functions [of capitalist and entrepreneur] cannot be absolutely separated even in theory, because the essential function of the entrepreneurs, that of assuming risks, necessarily implies the ownership of capital. Moreover, any new chance to make entrepreneurs’ profits is identical with a change in the opportunities to invest capital, and will always be reflected in the earnings (and value) of capital invested" (Hayek, “Reflections of the Pure Theory of Money of Mr. J. M. Keynes.† Part I. Economica, No. 33 (August) p. 277.

I think Yancey is correct: There isn't anything irrational about borrowing against assets that have raised in value. Whats foolhardy is treating that value as if it was permanent when its not. But how were borrowers and lenders to know what the "correct" prices should be? They were receiving false signals, and acted on them.

I also think its crazy to suggest that ABCT doesn't have some explanatory power with regard to the housing bubble. It certainly doesn't explain everything (you'd have to model tons of political, regulatory and institutional frameworks for that), such as why all the money went into housing. If you think banks don't have strong incentives to make more loans when interest rates drop, I think you're crazy.

There was no (relatively) inflation, therefore there is no realignment of consumers spending (yet) and no recession (though if one keeps predicting recessions for YEARS one will eventually be right) therefore it is not proof against Austrian business cycle theory.

The government has plenty of blame, and the businesses have blame. It's not that the market doesn't make mistakes, its that the market finds them and fixes them. And the government so far has done what? Sent out a bunch of checks. Solidified the positions of the companies that are "too big to fail." Btw, when did that phrase move from hubristic, as in the Titanic, to pejorative, as in the Titanic, to a self-reinforcing prophecy?


"As I understand ABC theory, the malinvestment is caused by market actors being fooled by price signals, price signals which are distorted by government inflationary forces.

Given this emphasis on foolish investment caused by distorted prices, Tyler's claim that there was an "additional cause" for which the market is to blame is nonsensical. Of course market actors were fooled -- but that's the essence of ABC."

I agree....at least that's how I understand the ABC Theory broadly interpreted.

I'm not sure if Tyler is sticking to a more stringent definition centered on capital goods or if there is something beyond the laymen's interpretation that we are not considering.

As I scrolled, I was hoping Tyler would have addressed your comment or others like it.

So far, not yet. Come on, Tyler. Talk economics to us. Tell us why ABC is not applicable here....if not at least incomplete.

Robert's criticism above focuses on some details of the ABC theory, about what happens to the capital structure when inflationary forces distort investment. However, I don't see the essence of ABC to be that detailed description about what happens to capital -- the essence is just that capital is mis-allocated. So the essential part of ABC is untouched by such capital theoretic criticisms.

Secondly, Sraffa's criticism -- that in intertemporal equlibrium theory there are many own rates of interest, thus it is quite dubious to talk about the "natural" rate of interest -- fails for the same reason. ABC uses the concept of natural rate of interest in order to describe what happens to the capital structure.
If you don't want to describe the mis-allocation process in detail, or accept that it is hard or impossible to do so, then Sraffa's criticism fails too.

I think that I am probably discarding more of ABC theory than most Austrian economists would -- but I see that as a small price to pay in order to have a theory that is both consistent and very relevant to explaining the real world.

Where is this crisis originating from? The financial sector.

What is closest part of the economy to the government (aside from defense contractors)? Banks.

Some associated with Austrian theory (Mike Shedlock and Bill Bonner among others) were predicting a severe housing recession. I, informed by my thin understanding of ABCT predicted the recession would not spread. Now, Austrians tend to be perma-bears, so the stopped clock criticism is fair, and I could be wrong either because my interpretation is wrong or the theory is wrong. But, right now we sit at the S&P barely tagging a 20% decline (from the top, btw), barely a bear market, so the market doesn't have visibility to a further decline. We have also had shocks such as oil prices which are external to business cycle factors. So, is the commodity bubble a bubble or not? It is an interesting thought to ponder that the increased commodity prices may be an artificial bubble which is artificially anchoring the economy.

It's fine to criticize the Austrian theory. But, when we have an economy that is heroically staying afloat despite a credit crisis brought about by home prices inflated by mortgages fueled by fractional reserve credit and cost push inflation from external competitors and supply shocks, I don't think it's a wise time to do so. I think this is the closest we can get to a pure Austrian example.

One explanation for the "market failure" of the credit crunch is the competition posed by the artificially "guaranteed" return of "safe" government debt. Purchasing power is not guaranteed or safe of course, but the flight to quality still poses a temporarily appealing alternative to some. It's not a crowding out based on rates, but a crowding out based on quality. But, the quality is under siege as the dollar declines and long-term inflation seems inevitable.

Another explanation for the market side of the failure is that all returns are relative to your competition. When others are making obscene profits the tendency is to follow the leader. The need to capture market share has been cited. But not losing it is also critical. One can put the majority of blame on the banks, but how can you say that "the market" failed when it is the banks so deeply embedded with the government and not the market as a whole. When it comes to real-estate, can there be any more visceral display of the phallic nature of the competition than this?


I was going to say something similar to reason@6:02:27, that while what happened seems somewhat simple, the inside-baseball of economic schools and beliefs seems hard.

Dear Tyler:

Please allow me to make a slight correct to what you said. You said, "Walter Block wrote a 58-page critique of my earlier writings on ABC." Not so, not so. The correction is, that I had a co author on this. Here is the full and correct cite: Barnett, William II and Walter Block. 2006. “Tyler Cowen on Austrian Business Cycle Theory: A Critique.† New Perspectives on Political Economy, Vol. 2, No. 2, pp. 26-84; http://pcpe.libinst.cz/nppe/2_2/nppe2_2_2.pdf; http://pcpe.libinst.cz/nppe/.

Best regards,


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