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.