Austrian Business Cycle Theory: Dinosaur Economics

Fixing the Economists Article of the Week

by Philip Pilkington

Just a very quick note so as to weigh in on a debate which, frankly, I don’t really want to weigh in on. It relates to the Austrian Business Cycle Theory (hereafter: ABCT) and its relationship to the natural rate of interest.

Follow up:

The natural rate of interest was discredited by Piero Sraffa in the 1920s when he pointed out that there were actually multiple own rates of interest depending on which commodity you took as a numeraire. There have been many Austrian responses to try and iron this out — almost all of them imagine a range of financial market contracts, throw in some implicit “rational expectations” assumptions about how such contracts are priced and then claim that they can reconstruct the ABCT from here.

I don’t think that this is the case, I think that the assumptions they use to make the financial contracts produce the interest rate they wish to produce — because, let us have no doubt, this is a theory that at some base emotional level the Austrians want to be true — contradict other assumptions made elsewhere in Austrian theory; such as the assumption of Knightian uncertainty.

However, even leaving this aside we know that the ABCT will not work because, whatever way you cut it, it rests on the idea of a rate of interest that will bring the economy to full employment equilibrium. The manner in which the theory “works” is that the money rate of interest — i.e. that charged by banks — either falls above or below this full employment equilibrium rate, thus causing either inflationary or deflationary forces to generate. This view, however, is disproved by the Cambridge Capital Controversies which showed that such a rate of interest — which the Austrians take over from Knut Wicksell — cannot exist.

Here I will quote Peter Kriesler summarising the argument made by Colin Rogers in his extensive book on monetary theory, Money, Interest and Capital:

Wicksellian monetary theory relies crucially on the concept of the natural rate of interest which has logical flaws which are now recognized as having been exposed by the Cambridge capital controversies. The natural rate of interest was derived from the interaction of forces within the real sector, and determined the equilibrium monetary rate of interest. The natural rate of interest is derived from Wicksell’s capital theory on the assumption that all forms of capital must earn a uniform rate of return. The natural rate is the price which determines the equilibrium of savings and investment. By applying the results of the Cambridge critique of neoclassical capital theory to Wicksell’s concept of the natural rate of interest, Rogers is able to show that it has no rigorous theoretical foundation. Since, for Wicksell, it is the natural rate which determines the market (or monetary) rate of interest, this leaves Wicksell’s monetary theory also without foundation. (Pp52)

It also leaves the ABCT without foundation as this theory relies on the notion of an interest rate — call it the “natural rate” or the “equilibrium rate” or whatever else you want — that, as Kriesler says, “determines the equilibrium of savings and investment”. But this notion does not stand up to the results of the Cambridge Capital Controversies.

And just to wrap this all up I will quote Austrian economist Robert Garrison on the origins of the ABCT and how it relies crucially on Wicksell’s ideas on monetary theory that I have laid out above:

Grounded in the economic theory set out in Carl Menger’s Principles of Economics and built on the vision of a capital-using production process developed in Eugen von Böhm-Bawerk’s Capital and Interest, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Mises’s Theory of Money and Credit and in subsequent exposition and extension in F. A. Hayek’s Prices and Production, the theory incorporated important elements from Swedish and British economics. Knut Wicksell’s Interest and Prices, which showed how prices respond to a discrepancy between the bank rate and the real rate of interest, provided the basis for the Austrian account of the misallocation of Financial capital during the boom. The market process that eventually reveals the intertemporal misallocation and turns boom into bust resembles an analogous process described by the British Currency School, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specie flow. (My emphasis)

Put a fork in it. The ABCT has been a dead duck for years. Which leads one to wonder why Hayek received the faux-Nobel for it — which he received, ironically enough, joined with Gunnar Myrdal, Wicksell’s student who overturned the Wicksellian monetary theory!

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