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. 

10 comments:

  1. This is a very interesting post.

    You are right that there is something deeply suspect about the Austrian business cycle theory.

    I take a slightly different approach. I would take up Sraffa's 1932 critique of Hayek (see Sraffa 1932a and 1932b below): there is no such thing as a unique natural rate of interest outside of an equilibrium state. The concept is just meaningless and non-operational in the real world.

    Also Hayek's business cycle theory itself (from which Garrison's derived) has severe problems associated with the equilibrium framework and all the unrealistic assumptions behind it.

    More here:

    http://socialdemocracy21stcentury.blogspot.com/2012/01/hayeks-trade-cycle-theory-equilibrium.html

    http://socialdemocracy21stcentury.blogspot.com/2011/12/hayeks-natural-rate-on-capital-goods.html


    ----
    Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

    Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.


    Regards

    ReplyDelete
    Replies
    1. Yes, that's a very good point. Sraffa's critique is, of course, much deeper. How can you criticize the Fed for holding the market interest rate below "the natural rate" when there are as many "natural rates" as there are goods that persist over time?

      Delete
  2. This is wonderfully written. I was directed here by professor Mayerfeld. I have always wished to eventually write a post on this--although yours was wonderfully eloquent. Your critique of Austrian economics is spot-on. I have always found the argument involving interest rates poor. If interest rates were kept 'too low' shouldn't the hyper-rational individual stop borrowing and building houses? Some aspects of the Austrian argument in terms of structural ideas of the recession are apt, but when fully embraced it is absurd.

    I recently made a post called "Liquid Money" that focuses on the purpose of fiat vs. specie money. It wasn't a direct argument, but does focus on why fiat currency is superior. (http://schoolsandthought.com/)

    I look forward to reading more of your posts :)

    -Simon

    ReplyDelete
  3. The “no such thing as a natural interest rate” claim here sounds to me a bit like the argument against the existence of monopoly profit: since it isn’t quantifiable it doesn’t exist… What obviously does exist is large scale willingness to invest beyond realistic opportunities for profit, in Austrian terms “malinvestment.” And that accepted, one can ask what makes such malinvestments possible? It may in the age of Cantillon be a discovery of rich gold mines, or today a demand for somewhere to invest the trade surpluses of China, Norway, and Switzerland etc. And with the US, with a great saving deficit, mopping up two thirds of the global excess of savings over investment, with little beyond computer hardware/software in the way of productive innovation, the money just had to be “mal” invested.

    The unnaturally low interest rate and the investment in too roundabout methods of production is an example that fitted its time: when the easy money could realistically be seen as flowing in those riverbeds, and I think it is still a very illustrative model. But the opposition to the Keynesians lies in the denial of a general glut, with as counter theory one of wrong allocation of capital?

    ReplyDelete
  4. Anon, thanks for your thoughtful comment. I'm not sure why you think monopoly profit can't be quantified. Precision is probably out of the question, but conceptually and graphically it's pretty clear. My criticism of *the* natural rate of interest is based on Sraffa's point that the ratio at which I can trade corn today for corn next year, wheat today for wheat next year, etc., -- are different. This lack of uniformity raises a conceptual difficulty for the notion of a single "natural rate of interest."

    I'm in agreement with you that firms often invest "beyond realistic opportunities for profit," though I can't quite tell whether, in your view, this "malinvestment" can occur without being caused by some government act or policy. I suppose it's difficult to disentangle everything, and, in fact, I think the quasi-governmental rating agencies played a significant role in the financial crisis.

    Thanks for you comment, Greg

    ReplyDelete
  5. The Austrians do not claim that the Fed could have set a correct interest rate; they claim that only a market could do that. There’s nothing inconsistent in claiming that a method gives wrong results and not being able to produce better results with the same method.

    If I were to lend you some money, the interest I would demand would depend on your need for funds, and on what I had saved through foregoing my right to immediately consume for the value of my work, something which would be a “natural” rate of interest. (And it would be so whatever rate my neighbour would be willing to lend at. But competing with my neighbours banking practice, or us pooling our resources, would produce a uniform rate that could be called natural for the market?)

    If I on the other hand were a counterfeiter I wouldn’t have produced anything and I wouldn’t have foregone consumption of anything - and with the state insuring eventual losses by me - I could give you a very cheap loan. And if you were an entrepreneur with a project requiring the resources that on the basis of my low interest rate you could suppose I had refrained from consuming (just not smelling anything foul), you might not be able to finish your project. And if that happens to many entrepreneurs we have a depression, according to the Austrians.

    Now, I don’t quite buy the classic overextended “roundaboutness” in production for our current problems, as this is of course based on the supposition that the easy money goes to businessmen, and lately much of it has, as is known to all, financed private consumption. The misallocation could therefore partly be, I suggest, overproduction in what’s generally loan financed goods to the detriment of wage financed (instead of capital goods to the detriment of consumer goods). Hayek in “The Fatal Conceit” also conceded that the easy money could take other routes, without specifying any.

    (A New York taxi medallion gives you a part ownership of a monopoly, for a serious price if you do not inherit it. When, if ever, you earn more than you would if there was free entrance I suggest is difficult to calculate, as the counterfactual is not available? But no matter, the problem was the elusiveness of any natural rate of interest. And “naturalness,” whether in interest rates or anything else, is actually nonexistent– naturalness is merely unforced-ness, something close in meaning to spontaneity. And so, unlike coercive force upwards that can be contrasted with coercive force downwards, it cannot be contrasted with anything – it is by its very definition not measureable: the scale is always a falsifier. - My two-bit philosophical lecture for the evening - but I really suspect there to be some faint sense in it!)

    ReplyDelete
    Replies
    1. Anon, you write, “The Austrians do not claim that the Fed could have set a correct interest rate; they claim that only a market could do that. There’s nothing inconsistent in claiming that a method gives wrong results and not being able to produce better results with the same method.” 



      But Garrison doesn’t say this. He criticized the Fed for holding interest rates too low for too long (as many self-described Austrian economists have). And this criticism would, of course, be ridiculous if Garrison also assumed that no Fed policy could have produced better results.

      "If I were to lend you some money, the interest I would demand would depend on your need for funds, and on what I had saved through foregoing my right to immediately consume for the value of my work, something which would be a “natural” rate of interest."

      Wouldn’t the rate of interest you would charge me depend on your estimate of my creditworthiness and your estimate of whether you’d need the money during the period of the loan? (I’m trying to add risk to your time preference explanation. You won’t earn any interest just by “foregoing [your] right to immediately consume the value of [your] work,” for you must part with this money, i.e., reduce your liquidity, to earn interest.

      On your conception, there can be as many different “natural” rates of interest as there are parties willing to lend and borrow. Competition could produce a single rate of money interest, but it wouldn’t necessarily be equal to the “corn rate of interest,” i.e., the rate at which you could trade 1 bushel today for 1 bushel one year from today. I don’t care whether you call them “natural” rates of interest; the point is there are many of them, not just one.

      "If I on the other hand were a counterfeiter I wouldn’t have produced anything and I wouldn’t have foregone consumption of anything - and with the state insuring eventual losses by me - I could give you a very cheap loan. And if you were an entrepreneur with a project requiring the resources that on the basis of my low interest rate you could suppose I had refrained from consuming (just not smelling anything foul), you might not be able to finish your project. And if that happens to many entrepreneurs we have a depression, according to the Austrians.

"

      It's not clear to me how my not consuming dinner today assures that you will be able to hire construction workers to finish your project a year from now. Since the ratio of a bank’s loans to deposits is typically much greater than 1, say 10, would entrepreneurs always be running out of resources to finish their projects?

      Delete
  6. Quote: “It’s not clear to me how my not consuming dinner today assures that you will be able to hire construction workers to finish your project a year from now. Since the ratio of a bank’s loans to deposits is typically much greater than 1, say 10, would entrepreneurs always be running out of resources to finish their projects?”
    Your dinner example will do fine, as long as it is contrasted with mere money/credit. The story over again: a village lives from fishing by hand line from the shore, sustain themselves on salted fish in barrels, and decides to build a fishing boat. They count the saved barrels and decide they have enough to sustain them through the non-fishing period of boatbuilding. But the fish-into-barrels-man had cheated, the barrels were mostly filled with air and the boatbuilding came to a halt with the boat half finished. The need to produce more consumer goods and less capital goods then created a depression, which they could get out of only by getting the boat builders into hand lining from the shore. (“Wait,” said Barrel Bernanke, “I’ll spread the rest of the salted fish into more barrels!”)
    And the problem is not half full barrels in itself (banks lending beyond their reserves), but the expectation of better filled barrels. A credit fuelled boom is fuelled by more credit than as usual.
    Quote: “But Garrison doesn’t say this. He criticized the Fed for holding interest rates too low for too long (as many self-described Austrian economists have). And this criticism would, of course, be ridiculous if Garrison also assumed that no Fed policy could have produced better results.”
    Unless I read you wrongly I can only reply by restating my argument: The claim that a system is wrong implies some knowledge of what it can do wrongly, as for example set a too low interest rate which might fuel an unsustainable boom. But it is still not ridiculous to claim that only the market can set prices that correctly represent existent scarcity, and at the same time claim that a planning board cannot – it’s actually the same claim. It would rather be ridiculous to demand the end of the Fed if it could be decently run on some known economic theories. I tentatively suggest you are trying to make the Austrians compete with the Keynesians in what they claim to be able to do: give correct advice to the politicians. The Austrians want the politicians out of the market (though, admittedly, in varying degrees).

    ReplyDelete
  7. Quote: “On your conception, there can be as many different “natural” rates of interest as there are parties willing to lend and borrow. Competition could produce a single rate of money interest, but it wouldn’t necessarily be equal to the “corn rate of interest,” i.e., the rate at which you could trade 1 bushel today for 1 bushel one year from today. I don’t care whether you call them “natural” rates of interest; the point is there are many of them, not just one.”

    Pardon me going around in circles, but I don’t really see the problem (I may be too dim to get you, but I’ll temporarily discount that possibility). Forget the Fed, go back to Richard Cantillon in 1820 or thereabouts. Somebody gets hold of a lot of gold, robbing the Spaniards or digging it out of the garden. If it gets into the hands of savers then the money lenders reduce their interest rate he says. If it gets into the hands of big spenders the result is the opposite: producers of luxury goods will want to invest in enlarged capacity, resulting in competition for available credit. (Essai p. 214)

    Even if not a single pair of Cantillon’s moneylenders demanded the same interest prior to the gold influx, and their reduction/increase in interest varied between each and every one of them, and even if the interest they each demanded varied with every customer, the idea of a before and after the new money seems pretty admissible to me (as is the existence of monopoly profit). So how do I translate those incalculable sums into one calculable sum? The answer is simply that I don’t, you are asking me to translate non-coercion into coercion (some fantastic phenomenon like “market socialism” where the scarcity of every resource is calculable). Roger Garrison and Ben Bernanke alike are impotent in the matter but then in a free society you don’t have to have any dictator decide what freedom is. There is no enforced spontaneity…

    Quote: “Wouldn’t the rate of interest you would charge me depend on your estimate of my creditworthiness and your estimate of whether you’d need the money during the period of the loan? (I’m trying to add risk to your time preference explanation. You won’t earn any interest just by “foregoing [your] right to immediately consume the value of [your] work,” for you must part with this money, i.e., reduce your liquidity, to earn interest.”

    And there’s probably more influences on the price of loans as well, opportunity costs, some transaction costs beyond the indicated possible need to hire a torpedo... I’ll consider the relevance of liquidity preference here tomorrow.

    Thanks for being so polite; suggesting some “Austrianisms” on the left side of the Web usually results in a hail of invectives. The first half of my posting unfortunately lost some spacing, sorry about that, I hope it's readable. Regards from Norway.

    ReplyDelete
  8. Cantillon’s essay should have been placed in 1720 or thereabouts, for what little it matters. I’ll use the opportunity to say that you will be excused for deleting at least some of my postings: I have not been demonstrating a very close observance of the words I was supposed to be commenting, and I could have expressed myself with more economy.

    ReplyDelete