Sunday, November 25, 2012

Brad Delong, Thomas Nagel, and The Relationship between Mind and World

Brad Delong has a provocative post here on Thomas Nagel’s new book, Mind and Cosmos: Why the Materialist Neo-Darwinian Conception of Nature Is Almost Certainly False.  Delong dismisses Nagel’s central argument, but that’s because Brad doesn’t really grasp Nagel’s point of view, or even the point of philosophy (at least in this post).  Delong attributes the following line of reasoning to Nagel, 
Suppose we think we are going south-southwest and see the sun rising before us. [According to Nagel] we don't think: "the heuristics of reasoning that have evolved because they tend to boost reproductive fitness make it likely that I am not in fact going south southwest". We think, instead: "I know the sun rises in the east! I must be going roughly east! I deduce this by my reason, and my reason is a mechanism that can see that the algorithm it follows is truth-preserving! My mind is in immediate contact with the rational order of the world! I don't just think I am going east! I know I am going east!
Delong evidently thinks Nagel is trying to answer the question, “why do we think we’re right when we hold a belief with great confidence?” when, in fact, Nagel is asking whether our minds are something more than mechanisms designed to “boost reproductive fitness.”
Delong proceeds to show, with understandable ease, that reasoning creatures like ourselves can be wrong even when we’re absolutely convinced we’re right.  So, Brad concludes
Any theory that provided such an account of reason becoming an instrument of transcendence and offering guarantees of grasping objective reality would be hopelessly, terribly, laughably wrong.
Now, if you think Nagel is arguing against the very possibility of mistaken belief, then I suppose you might conclude, as Brad does, that Nagel is “hopelessly, terribly, laughably wrong,” (though, if you’d read a lot of Nagel’s work, you’d probably be more charitable).

But when Delong applies the coup de grace, saying

I cannot help but think that only a philosophy professor would believe that our reason gives us direct access to reality.  Physicists who encounter quantum mechanics think very differently. . .
. . .  Brad inadvertently illuminates the question on which Nagel should have been focused, as well as Delong’s own unarticulated and debatable understanding of the relationship between philosophy and science.  The point of philosophy is, in part, to clarify what it means to have “access to reality,” a task that requires reflection on several issues central to Western philosophy from its classical beginnings in ancient Greece.

In Delong’s view, at least as it’s expressed in his post, physics is the ultimate arbiter on questions concerning the nature of reality.  And this understanding has the implication, I think it’s fair to say, that it’s up to science to tell us what counts as having “access to reality.”  W.V.O. Quine made a strong case for a conception that resembles my reading of Delong, but Quine was unsuccessful in trying to assimilate philosophy to science, and to destroy, along the way, the autonomy of philosophical (and ordinary) reason.

For Quine, the world stands to thought only as cause to effect, and, as Richard Rorty puts it in commending this view, “we understand all there is to know about the relation of beliefs to the world when we understand their causal relations to the world.”  The trouble is that this understanding rules out the possibility that our thought stands in relation to reality in such a manner that features of the world can provide reasons for a particular judgment or belief.

Here’s Wittgenstein’s way of putting it, “When we say, and mean, that such-and-such is the case, we – and our meaning – do not stop anywhere short of the fact; but we mean: this-is-so. Wittgenstein is not, of course, claiming that all our beliefs are true, but rather that there’s no conceptual gap between the sort of thing that can be thought (or said) and the sort of thing that can be the case in the world.  That things are thus-and-so is both the content of experience and (if we’re not mistaken) an aspect of the world.

From this vantage point, the “materialist neo-Darwinian conception of nature” isn’t mistaken because it has failed to produce a theory that explains the power of mind to comprehend the world as it is.  It’s mistaken because it regards the world only as the cause of beliefs and not as an object of beliefs, which can be assessed according to the standards appropriate to the particular beliefs in question.

Wednesday, September 5, 2012

How to Solve Our Massive Macroeconomic Coordination Failure

Robert J. Barro asked me here to identify the market failure that would justify the American Recovery and Reinvestment Act (aka “the stimulus”).  My answer, in brief, is that the market failure which permits sustained high unemployment is the lack of a truly comprehensive market in which workers with excess leisure, and firms with excess capacity, could make conditional commitments of the following kind, “if you’ll hire me at the going wage, I’ll promise to purchase goods from firms A, B, and C, whose new hires, in turn, will promise to buy goods from you.”

In the absence of such a market, a firm’s decision to expand employment will give rise to a positive externality insofar as the new hires buy the output of other firms.  (I assume the new hires were unemployed, and that prices exceed marginal costs, so aggregate demand rises, and firms profit from additional sales.)  Since firms don’t take account of this positive externality in their hiring decisions, total employment will be less than optimal.

At first glance, persistent unemployment looks like a coordination problem.  Imagine a two-firm economy in which the wages paid out by firm X are spent on the output of firm Y, and vice versa. If X believes Y will be hiring additional labor, then X will expand its output, and if Y believes the same about X, Y will expand, and the result will be a high-output equilibrium. If both X and Y expect the other to reduce output, then you’ve got a low-output equilibrium.  The trick, in this case, is to get X and Y to coordinate on the high-output equilibrium.

Laurence Kotlikoff has suggested that coordinating around high employment could be accomplished if President Obama urged the largest 1,000 firms to hire additional employees, then urged the next largest 1,000 firms to expand employment, and so on.   

I don't believe this approach will work for the following reason: in game-theoretic jargon, this is really a Prisoner's Dilemma Game in which each firm's dominant strategy is to wait for other firms to start hiring.  It's too risky to expand employment unless you can be assured that other firms will do likewise.  By waiting, a firm avoids the risk of expanding employment without an increase in demand.  And the losses in this scenario would certainly be greater than the profits that would be foregone "by coming late to the party," i.e., hiring after the recovery has gained momentum.  So President Obama urging thousands of firms to expand employment can only be successful if a) Obama inspires an awful lot of confidence and/or b) firms have some altruistic component in their decision-making objectives.  These are both unreasonable expectations in my view.

Nevertheless, Professor Kotlikoff is onto something.  Our current unemployment problem is a coordination problem.  But you can't solve it without converting it into an Assurance Game in which each firm is assured that, if it hires, others will also hire.  In an earlier post, I suggested that large firms submit “offers” to a central auctioneer of the following kind: I’ll increase employment at my firm by X% if the total increase in employment promised by all other firms amounts to at least Y%.  This Walrasian process of tâtonnement would continue until the greatest increase in total employment commitments were achieved.  These hiring pledges, in turn, would be enforced by levying tax penalties on firms that failed to meet their commitments, and transferring revenue from these payments to firms that met their hiring commitments.

One drawback of this process is that firms would “low ball” their hiring commitments, understating the employment commitments they would really be willing to make.  To address this problem, the government could offer tax subsidies to those firms whose employment commitments exceeded the median employment commitment, measured by (say) the percentage increase over a firm’s actual employment in the previous year.   Alternatively, you could replace the median threshold with (say) the top quartile, etc.  Finally, the government could stipulate that it would only impose the tax penalties and transfer revenues if (say) 80% of the firms made hiring commitments.

Sunday, May 27, 2012

How to Stimulate the Economy Without Increasing the Debt

John Maynard Keynes had a charming propensity to praise the unorthodox ideas of lesser known economists.  A case in point is Keynes’s tribute to Silvio Cassel’s notion of “stamped money.”  Under Cassel’s scheme, money must be periodically stamped at a small cost in order to retain its validity as legal tender.  This scheme appealed to Keynes because it was, in effect, a tax on hoarding.  The drawback, Keynes dutifully pointed out, is that a public desperate for a liquid store of wealth will find another vehicle to replace (stamped) money once its newly added “carrying cost” has diminished its appeal as a liquid asset.

This is a good argument against the introduction of stamped money as a permanent substitute for ordinary currency.  But, one might ask, could some variation of the stamped-money idea play a temporary role in getting a slumping economy going again?  The great Yale economist, Irving Fisher, thought so and even helped write legislation that would allow the U. S. Treasury to issue stamped scrip or “stamped money.”  In Fisher’s scheme, this money must be stamped every Wednesday.  The stamps, which are pasted onto the back of the scrip, are purchased from the government at a price equal to two percent of the scrip’s face value.  If you are holding scrip on Wednesday, you must affix a stamp to it in order to preserve its exchange value.  The “Wednesday stamp requirement” sets in motion a flurry of buying wherein the holders of the scrip scramble to spend it before Wednesday arrives and they incur what is, in effect, a tax on their scrip holdings.

Stamped script, or stamped money, is like ordinary currency in that it may be spent, deposited at the bank, or invested in securities.  But unlike currency, stamped money cannot be hoarded without cost.  If you are holding stamped money on Wednesday, you must pay the “stamp tax.”  As a consequence, stamped money flies through the economy, accelerating the pace of trade during a period when the public’s lack of confidence is self-reinforcing.

The Outline of a Stamped Money Plan

In the current economic circumstances, Fisher’s stamped money scheme might work in the following way: 1) the Treasury sends $1,000 in special stimulus checks (scrip) to every household; 2) each check is worth twenty dollars; 3) the checks must be stamped every two weeks to retain their validity as legal tender; 4) the stamps are sold by the government at a price of $0.80, or four percent of the scrip’s twenty-dollar face value; 5) after one year, all scrip checks bearing twenty-six stamps may be exchanged for twenty dollars in ordinary currency from the Treasury; and 6) when a twenty-dollar scrip check arrives at the Treasury, it will find waiting there $20.80, which is the sum of the twenty-six “stamp tax” payments.  Twenty dollars covers the Treasury’s outlay, and the remaining $0.80 is used to offset administrative costs.

A Tax on Hoarding

The stamped-money plan is propelled by everyone’s attempt to avoid paying the “stamp tax.”  In trying to avoid this tax, each citizen speeds the circulation of the stamped money, which is the program’s intended effect.  Moreover, the faster the stamped money moves, the smaller is each citizen’s tax burden.  For example, suppose a business takes in and pays out $600 in stamped money during a two-week period, $550 of which turned over before “tax stamp day” in the middle of the month.  In this instance, the business pays a tax, not of $24 (= 4% of $600), but a tax of $2 (= 4% of $50), which is a “sales tax” rate of only 0.33% on $600 of stamped-money sales.  Since a significant portion of these sales would not have occurred without the introduction of the stamped money and the accompanying “stamp tax,” the business is actually better off after the imposition of this temporary tax.

To be clear, the “stamp tax” is neither a sales tax, nor a tax on transactions, but rather a tax on hoarding, which aims to increase the speed at which money circulates through the economy.  Fisher estimated that stamped money with characteristics like those described above would circulate at least six times faster than ordinary currency circulates during times of depression.  Of course, this does not mean that business sales would increase six fold, for stamped money would comprise a small percentage of the total money stock, and some ordinary currency might be held for a longer period of time than usual following the introduction of stamped money.  But even if $100 billion in stamped money were to drive $50 billion of ordinary currency into idle hoards, the increase in the average velocity of money would still be sufficient to the give the economy a significant boost.

Overcoming Objections

Some conservative economists have complained that the stimulus checks sent out by the U. S. Treasury in the spring of 2008 had little effect on the economy because most households declined to spend their temporary windfall.  Realizing that the tax bill for this windfall would come due in the future, these economists claimed that people saved their stimulus checks in order to offset this liability.  Whether this explanation is true or not, it is misplaced as a criticism of the stamped-money program.  Unlike the spring 2008 stimulus package, the stamped-money program outlined above is self-liquidating.  The Treasury’s end-of-year receipts (not including administrative costs) are equal to the amount the Treasury advanced to the public at the beginning of the year.  Since there is no future tax liability associated with stamped money, households need not increase their saving on this account.

The proponent of stamped money may also expect criticism from Monetarists who insist that an injection of money into the financial system will raise prices, a view summarized in Milton Friedman’s characterization of inflation as “too much money chasing too few goods.”  In Keynes view, by contrast, when workers and equipment are idle, there is apt to be “too little money chasing too few goods.”  If more money were put into circulation, or if it changed hands at a faster clip, sales revenue would rise, factory orders would increase, additional workers would be hired, and so on.  At the end of this multiplier process, the increased volume of money would be chasing more, not fewer, goods.  Moreover, the stamped-money plan has an extra margin of safety in that the high-velocity stamped money would be extinguished after one year, replaced by its slow-footed counterpart – ordinary currency.

Economists from the Rational Expectations School will insist that households receiving stamped money will simply save an equivalent amount of ordinary currency, leaving total expenditure unchanged.  While there may be some truth in this criticism, it misses three important considerations: 1) households that are liquidity constrained will spend whatever they can; 2) since there is no future tax liability associated with stamped money, there is no reason to save on this account; and 3) people tend to maintain separate “mental accounts” for their holdings, which is one reason why some people simultaneously hold low-interest savings accounts while maintaining high-interest credit card balances.  And let us not ignore the effect that a “spend-for-the-common-good” campaign could have in encouraging citizens to refrain from hoarding regular currency so as offset the intended effect of the stamped money.

It must be acknowledged that a stamped money program would be challenging to administer.  But most of these difficulties could be avoided by eliminating the stamp requirement and replacing it with scrip that automatically lost 1/12 of its face value at the end of each month, becoming worthless at the end of one year.  Under this alternative, there would still be an effective tax on hoarding, thereby providing an inducement to spend.


It has been said that money is the root of all evil, though some would argue that lack of it is the root of many problems.  Occasionally, it is our reluctance to part with it that is the source of our difficulties.  As long as everyone waits for others to increase their spending, there will be no increase in spending.  But if the Treasury can make it costly to hoard, at least for awhile, then the circumstances that gave rise to the hoarding will themselves disappear, and we can get back to work again.

Wednesday, March 28, 2012

Further Inconsistencies in the Conservative Case Against the Individual Mandate

It's important to distinguish between 1) the conservative case against the individual mandate as a violation of individual liberty and 2) the legal case against the mandate as an unconstitutional exercise of Federal power.  If there are conservatives who slam the mandate as a violation of natural rights while supporting government-mandated trans-vaginal probes (such as the Governor of Virginia). . . well, I can only say they've got a rather idiosyncratic conception of individual liberty.

Regarding the legal issue, the U.S. Constitution does indeed constrain the Federal Government in ways that it doesn't bind state governments.  The rationale for this distinction is, roughly speaking, that states formed the United States and, in addition, are closer to "the people" than the Federal Government.  But this last argument seems much less convincing today than it was in 1787.  Perhaps, it's time for another Constitutional Convention.

George Will argues that there's no precedent for forcing individuals to enter into private contracts, and, therefore, the individual mandate is a violation of "freedom of contract," which is a guiding principle in the Constitution.  Well, here's a precedent for Mr. Will: motel owners must enter into private contracts with African Americans if they have rooms available for rent.  Granted, the rationale for civil rights laws is different than the rationale for the mandate, but people are still forced to enter into contracts, and this was the issue Mr. Will originally raised.

In addition, Will is also mistaken in characterizing the mandate as a "forced contract" in the first place.  If you don't want to buy health insurance, you can pay the fine instead. And, in this context, it doesn't matter whether you call it a tax rather than a fine.

The Conservative Critique of the Individual Health Insurance Mandate

The straightforward case for the individual mandate is that uninsured individuals will eventually impose costs on others when they're treated in the emergency room (and elsewhere), and their unpaid bills are recovered via higher health insurance rates.  Lawyers criticizing this argument before the Supreme Court, as well as a few sympathetic SC Justices, claimed that this goes on all the time in markets, e.g., if some people stop buying a particular good or service, its cost and price may rise because economies of scale are lost.

This is certainly true, but the conservatives' stress on externalities, cross-subsidies, and free riding in many markets other than health care, while it may be a good argument against the uniqueness of the health care/insurance market, it could also be read as an acknowledgement of the widespread inefficiency/ineffectiveness of real-world markets in general.  Insofar as many real-world markets fall far short of the competitive ideal, one could conclude, not that the health care/insurance market shouldn't be regulated, but that many other markets should be regulated in order to reduce cost-shifting, free riding, and the other unwanted outcomes.

Tuesday, March 20, 2012

Occupy Rousseau: a Discussion at the NYC Library

Andrew Hultkrans wrote an entertaining synopsis of the Occupy Rousseau discussion at the New York City Library for Art Forum (here).  I add a few comments to Andrew’s reporting, in quotes, below.

1. “Demos senior fellow Benjamin Barber took the stage and ebulliently outlined the evening. Rousseau thought that commerce and private property were incompatible with democracy, he said, and this problem is still with us today in an America desperately clinging to its sense of exceptionalism (‘exceptional because one in four children live in poverty’).”

I think Barber is a bit off the mark here.  Large inequalities of wealth and income, and a preoccupation with private concerns at the expense of public life, are certainly incompatible with Rousseau’s vision of democracy.  But private property is essential to that vision because personal independence is essential, and, at least during Rousseau’s time, it was hard to conceive of such independence for citizens who had to rent their homes, their land, and their tools.  Although Rousseau was a communitarian in many matters, he never advocated either Platonic or Marxian-style communism.

2. “Gourevitch threw a cold bucket of water over Barber’s enthusiasm and the premise of the entire event by saying, “’I don’t know how I fit into this program; Rousseau was a conservative, not a revolutionary.’”

I’d put it this way: Rousseau was a conservative and a revolutionary.  He was conservative in his pessimism (realism?) regarding the prospects for a good society because Rousseau doubted our ability to keep the republic, and its common good, constantly before our minds.  We’re easily distracted from our public duties by personal concerns, by the possibilities for gain and status, and we’re very good at concealing our real motives from others.  Rousseau wasn’t prepared to pin all his hopes on our capacity for virtuous self-discipline; he envisioned an extensive regime of mutual surveillance.  Yet, it’s hard to read Rousseau’s “Discourse on Inequality” and not construe it as an extended argument for the overthrow of the Ancien Regime; or to read the Social Contract and not see the existing European states as falling far short of the standards that must be satisfied if men are to exchange their natural freedom for the rights and duties of citizenship.

3. Chenevière and Keohane more effectively problematized Gourevitch’s stance by reading some pretty rad-sounding quotes from Rousseau’s writings. Gourevitch was having none of it: “Rousseau thought that the ideal form of government was a democracy of the aristocracy. He would be opposed to all trends in liberal thought today: multiculturalism, feminism, political correctness . . . ” Harsh, dude.

I don’t object too strongly to Gourevitch’s claim that Rousseau believed “the ideal form of government was a democracy of the aristocracy,” but I’d put more emphasis on the democratic element and on Rousseau’s insistence that the people can pull down their rulers at any time.  Rousseau wasn’t a multiculturalist because he thought a republic could only survive if its citizens shared a common life without too many conflicting beliefs about essentials, that is, without too much diversity.  And he wasn’t a multiculturalist because (like Brian Barry three centuries hence) he believed, implicitly at least, that cultural values were subject to critical judgment.  A culture that affirms the subordination of one segment of society to another is to be criticized, not honored.

4. “A former political philosophy student and lawyer, Husain insisted without prompting that he was not a spokesperson for the Occupy movement and said he thought Rousseau was a ‘tortured realist’ when he read him in college. ‘Occupy is presenting a structural critique,’ Husain said, ‘not limited to capitalism and wealth.’”

Rousseau, too, presented a “structural critique” if, by this phrase, we mean a thoroughgoing, root-and-branch critique of the existing order.  Although I don’t recall Rousseau writing anything about racial subordination, the First and Second Discourses do not stop at the door of “capitalism and wealth,” but aim to strike at their origin in the first interactions among human beings on their way to “civilization.”

5. “Somebody raised one of Rousseau’s most famous quotes: ‘Man is born free, and everywhere he is in chains.’  For a split second, the audience basked in the lefty resonance of this statement until ol’ bucket-brigade Gourevitch interjected, ‘Rousseau was trying to show people how to make the chains legitimate.’”

Yes, but “making the chains legitimate” doesn’t mean giving the inhabitants of the existing state a reason for obeying their current rulers.  Quite the contrary, Rousseau’s Social Contract describes a model beginning, a social contract, and a system of institutions, which could, and should, call forth the willing cooperation of men who’ve exchanged their natural rights for the rights and duties of citizenship.

6. “For my money, Kean, the type of moderate Eisenhower Republican all but extinct today, delivered the quote of the evening: ‘We used to fight our own wars and pay for them—everyone was involved. We’re now doing wars by proxy. When everyone’s involved, you have less wars.’  Word.”

Kean’s point about fighting wars “by proxy” does indeed go to the heart of Rousseau’s political philosophy.  Rousseau insisted that citizens not delegate their voices to representatives, that representatives not delegate too much to administrators, and that paying taxes – the ultimate form of “citizenship by proxy” – be replaced by the corvée, a form of compulsory public service. 

7. “All with Victor Gourevitch as the anti–Flavor Flav, a hype man in reverse who quietly debunked what everyone was saying instead of egging them on with a well-timed ‘Yeeaah, Boyeee!’  The man can rock the mic—that is, when he knows where to point it.”
Let me conclude by complimenting Andrew Hultkrans’ brilliant characterization of Gourevitch as the “anti-Flavor Flav,” a role essential to the lively discussion reported above.

Thursday, March 15, 2012

Is The Austrian View Of The Great Recession Coherent?

   There seems to be something deeply inconsistent in the Austrian view of the Great Recession (and of business cycles in general).  On the one hand, Austrian criticism of the Federal Reserve’s “easy money policy” leading up to the financial crisis and The Great Recession is sublimely self-assured.  On the other hand, the Austrian School must assume that business firms (unlike Austrian economists) can’t tell when market interest rates are well below the “natural rate” if there’s to be an Austrian business cycle.  Here’s the inconsistency: if a credit bubble can only be discerned after the fact, then it’s silly to criticize the Fed for what no one could foresee; and if a credit bubble can be discerned in its early stages, then market participants will take actions, e.g., reducing credit-financed expenditures, which will burst the bubble in its early stages.  Therefore, Austrian economists should either be more circumspect in their critique of the Fed, or they should retool their model of the business cycle.
Consider Roger Garrison's account of the Great Recession, offered in response to Brad Delong's dismissive attitude toward Hayek’s theory.  Garrison writes, “A true-to-Hayek nutshell version of the Austrian theory is not difficult to produce.  The central bank is central to our understanding of the current crisis.  The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through.”
Garrison continues, “The Austrian theory couldn’t be more tailor-made for understanding our current situation.  Dealing with the unfortunate consequences of artificially cheap credit, a memorable passage in Mises’s Human Action (3rd ed., 1966, p. 560) alludes to an overbuilt housing market: ‘The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials.  If this man overestimates the quantity of the available supply, he drafts a plan . . . [that cannot be fully executed because] the means at his disposal are not sufficient.  He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.’”
Reading this, I can’t help concluding that Mises’s “master builder” is rather dim-witted.  Why wouldn’t the Austrian Master Builder recognize that the Fed had pushed market interest rates below the “natural rate,” that the supply of artificially cheap credit couldn’t last, and that the rational course of action would therefore be to avoid undertaking too many “roundabout” projects?  If Master Builders, relying on the Austrian model to form a rational expectation of the coming collapse, were to decide to cut their investment spending, the effect of their decisions would be to bring the supply and demand for “loanable funds” into closer balance, thereby bring the credit bubble to an early end.  Thus, Garrison’s “true-to-Hayek nutshell” explanation of the Great Recession only works if either A) few businesses held the Austrian view of the credit cycle in 2003-2004, or B) the Austrian theory can only pick out artificially low interest rates after the fact, when it’s too late. 
            What’s the Austrian response to this argument?  There are two actually.  (Further elaborations can be found in the discussion (here, here, and here).  The first response was put forward by O’Driscoll and Rizzo in The Economics of Time and Ignorance and it runs as follows.  Although entrepreneurs grasp the general macroeconomics of the business cycle, they can’t predict the precise beginning and end of its boom and bust phases.  Nevertheless, the authors add, “these entrepreneurs have no reason to foreswear the temporary profits to be garnered in an inflationary episode . . . From an individual perspective, then, an entrepreneur fully informed of the Austrian theory of economic cycles will face essentially the same uncertain world he always faced. Not theoretical or abstract knowledge, but knowledge of the circumstances of time and place is the source of profits.”
            This is an ill-fitting jumble of claims.  Although O’Driscoll and Rizzo grant that entrepreneurs can make “temporary profits” during “an inflationary episode,” they don’t tell us whether these profits come by accident, or because entrepreneurs can make very rough guesses about when the “inflationary episode” will end.  Since the authors insist that possession of Austrian business cycle theory leaves entrepreneurs with no less uncertainty than they would face without this theory, it appears that the latter interpretation, i.e., that profits during inflationary episodes are a windfall, is the more consistent one.  But, if so, then shouldn’t Austrian economists be less aggressive in their criticism of the Federal Reserve?  Either it was clear that Greenspan held interest rates too low in 2003-2004, in which case rational entrepreneurs would have drawn back from the precipice before it was too late, thereby reducing the depth of the downturn, or it wasn’t clear that interest rates were too low in which case sharp criticism of Greenspan is unfair.
            What about the Austrians’ claim that “[local] knowledge of the circumstances of time and place is the source of profits,” “not theoretical or abstract knowledge”?  Let’s imagine a regional homebuilder who profits from her knowledge of local labor markets, the strength of demand for different kinds of housing, the variety of local land use regulations, and so on.  Now, even with all this local knowledge, the homebuilder must make still some assumptions about the future course of mortgage interest rates, the future availability of credit, the future price of oil  (which affects the demand for housing in different locations), and so on.  All else equal, a homebuilder who makes better-than-average forecasts of these variables will outperform one who makes worse-than-average forecasts of these variables.  Yet, it’s hard to conceive of this as “local knowledge,” and it’s just as hard to imagine that these forecasts would be constructed without any reliance on “theoretical” and “abstract knowledge,” whether it’s the Austrian theory of the business cycle or some alternative.  This brings us back to the original problem: either firms with superior forecasting ability will act in ways that defeat the Hayek-in-a-nutshell model, or these variables can’t be forecast in which case there’s no point in criticizing the Fed.
The second response to this apparent inconsistency draws upon a prisoner's dilemma defense of Austrian business cycle theory in which the dominant strategy for individual banks during the onset of a credit bubble is to continue lending even though the bankers recognize that the prevailing rate of interest is below the “natural rate.”  The argument runs as follows.  If one bank curtails its lending and other banks don’t, the prudent bank loses business and is still subject to increased liquidity risk.  If, however, the bank continues lending and other banks do likewise, the bank is subject to liquidity risk, but doesn’t lose customers to competing banks.  Hence, the dominant strategy is to continue lending no matter what other banks do.  The upshot of this argument for the rational expectations critique of Austrian Business Cycle theory is that even if banks can discern that prevailing interest rates are unsustainable, their best strategy is still to continue lending, in which case the credit bubble continues to expand. 
            Unfortunately, this argument rests on a false premise.  A bank that charges a higher interest rate and maintains a higher reserve at the beginning of a credit bubble will indeed lose market share, but the bank is not, in fact, subject to the same degree of liquidity risk as banks that continue lending at artificially low interest rates.  A conservative bank, which maintains a relatively large reserve, is simply in a better position to cope with increased defaults and withdrawals than a bank that allows its reserves to decline.  Thus, increased lending at low interest rates is not actually a dominant strategy.  Rather, banks must balance risk and expected return.  But, in this case, the prisoner’s dilemma defense of the Austrian theory collapses, and the rational expectations challenge reemerges.
            Thus, to reiterate, either Austrian Business Cycle (ABC) Theory provides a reasonably good guide to decision makers, in which case it is “expectations inconsistent” (i.e., agents acting on ABC-informed expectations would eliminate the ABC), or the theory only gives a retrospective explanation of events, in which case it’s absurd to criticize the Federal Reserve for a creating a credit bubble that can’t be recognized before the fact.