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Repositioning Austrian Monetary Business Cycle Theory

Submitted by PragmaticIdealist on 08/19/2010 19:34 -0400

As nations around the world experiment with monetary policy and flimsy financial systems, it is more important than ever before to fully analyze monetary policy within an Austrian framework.

However, the Austrian monetary cycle theory (ABCT) put forth by the founders of Austrian economics fails to adequately explain a variety of business cycle phenomena and, consequently, will probably never be fully accepted by "mainstream" economists. ABCT does not incorporate the very real fact that investors and consumers will and always have been swept up in waves of euphoria or severe panic (i.e., tulip mania or thousands upon thousands of convincing behavioural finance case studies and papers). ABCT does not explain why rational economic agents (in the Austrian sense) make irrational investment decisions en masse just because a government entity purchases some treasuries. After all, such activity is highly transparent and quantifiable. Recent Austrian economics studies have realized these downfalls of ABCT and have tried to use game theory and other mechanisms to prove that interest rate policy can, in and of itself, cause financial bubbles and excessive malinvestment, but the fact remains that agents in a perfectly rational environment (i.e., represented by systems of equations) could never cause such disequilibria. Instead, monetary policy is nothing but a transfer payment from savers and past investors to future investors. It is also a tax on wage-earners since wages are sticky and unlikely to adjust as rapidly as businesses earn extra profit from increases in the money supply.

It is argued that manipulation of the interest rate obscures the rate of time preference and therefore causes over or under investment and consumption. However, if economic agents were absolutely rational and calculative, any tinkering of the interest rate by the printing of money and purchasing of treasuries and other assets should, in theory, be able to accounted for. Banks should, as they are doing now, hoard most of the money printed by the central bank and only lend out the portion that would allow them to absord the expected future increase in the default rate as savers/investors are able to make less money due to lower returns on investment and shift temporal consumption habits accordingly. All of these effects are produced by a known amount of monetary inflation and could be rationally accounted for.

The truth is that economic agents, both consumers and banks, are not rational. They are driven by waves of greed and panic at varying times. They are driven by moral hazards (partially created by regulation and also by management-shareholder-employee conflicts). And when free money is proferred to the large, powerful banks in the form of "open market operations", they will pass some savings onto lenders, pay out larger bonuses, and, while swept up in a period of euphoria, utilize the discounted cost of capital to increase leverage and make irrational investments.

Although Austrian economics is far ahead of modern-day Keynesianism in many ways, it must recognize the importance of human irrationality in the formation of business cycles, as well as in other economic phenomena. That being said, the Austrian perscription of disbanding the central bank and free the monetary system of its influence is, of course, the correct one. However, in order to win mainstream approval, the point that government tampering only reinforces existing irrational practices must become a central tenet in any Austrian position on monetary policy.

The other subject that Austrian economists need to become more lenient about is welfare economics. It is undoubtedly true that some level of transfer of wealth from the rich to the poor is not only the right thing to do, but it also increases the total utility in society as well as counteracts the regressive taxes that exist in any laissez-faire society (i.e., children that grow up in better environments can succeed due to networks and other "unfair" advantages not attributed to working other than their peers or even contributing more value to society (inheritence)). Not to mention that the "state" is democratically elected and has the responsibility to not only grow the economic "pie" but to make sure that slices are not being obscenely distributed such that total utility of society is maximized and is pareto optimal. If a rich, greedy person doesn't like that they are free to leave the state. But that's a topic for a different conversation.

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Fri, 08/20/2010 - 12:49 | 533109 Wyndtunnel

I don't know where you live but here in Cankuistan people gnerally trust government to do the right thing. Note I said generally. That trust has been eroding of late for sure. But given we're next to a Nation that preaches democracy and free market capitalism while having one of the most bloated and inefficient polotical economic systems in the World we're sticking to our British bred conservative values pretty well. Canadians believe in helping each other out. Yeah it's boring and it may seem retarded to Austrians that the less fortunate deserve a bit of help to improve their chances of success but guess what? Done even somewhat properly it leads to a narrower gap between rich and poor which fosters political and economic stability. Canada is more likely than the US to get through this crisis left with something resembling the country that went into it.

If Austrians or so damn sure of themselves why don't they all give up their citizenship and move to a country that doesn't tax or regulate anything...oh right...such a place doesn't exist and never will. Or maybe you can convince some US generals of your brilliance and they will overthrow the current regime and install a Rayndian paradise. I'm sure Greenspan would love to be involved. Good luck!

The big problem with America is that everyone cries for free markets and no guv interventon until the shit hits the fan then suddenly evryone turns on the government and bitches that it can't do anything right. America...make up your mind: social democracy, fascismt, representative democracy or Austrian School free for all...right now you just draw on the worst from all the paradigms!

Fri, 08/20/2010 - 09:24 | 532525 Wyndtunnel

So in an Austrian system criminals are free to kill and steal all they want from whoever cannot afford a private security force to shoot back? Fuck anyone who is too poor to afford medical services... Exploit the dimwitted for they are too dumb to know any better? Keynesism might be dead as it's been practiced for the past century or so but please give some example of some successful polities throughout history (can't call them States right because that would assume that some group of powerful people actually DARE to try and draw up some rules to the game...) that came close to this magical system of Austerian economics you are all waiting for like the next coming of Jesus. Seems to me what it comes down to is this: Only people who have a knack for exploiting others deserve anything. Everyone else can just fuck off and die! Keynesians might be severely misguided but hardcore Austrians are equally out to lunch. Collective problems need collective solutions. What Austrians are dreaming of is every man for himself. Basically anyone who is a devout Austrian sees HIMSELF and his like-minded Brofriends as the Feudal lords and everyone else who doesn't measure up to theirs ideals of productiveness as potential serfs. Nice.

Fri, 08/20/2010 - 15:53 | 533527 Insert witty title

Hi, Austrian school as i have read it doesn't advocate anarchy, or absence of government. Some people like to interpret it as such - Rothbard fans i guess, but its not all like that - like most schools a spectrum exists.

Read Hayek the constitution of liberty - he's quite positive on government institutions.

Fri, 08/20/2010 - 10:24 | 532726 DutchZeroPrinter

The division of labor proves that your statement is absolutely wrong. A free society is not based on exploitation. Yeah it will happen, but there will be less exploitation than a socialistic government exploiting people, who they think they should exploit.

Fri, 08/20/2010 - 09:25 | 532494 Wyndtunnel

Duplicate post deleted.

Fri, 08/20/2010 - 05:24 | 532280 Insert witty title

I’ll begin in broad strokes, just like my friend Keynes
His theory conceals the mechanics of change,
That simple equation, too much aggregation
Ignores human action and motivation

And yet it continues as a justification
For bailouts and payoffs by pols with machinations
You provide them with cover to sell us a free lunch
Then all that we’re left with is debt, and a bunch

If you’re living high on that cheap credit hog
Don’t look for cure from the hair of the dog
Real savings come first if you want to invest
The market coordinates time with interest

Your focus on spending is pushing on thread
In the long run, my friend, it’s your theory that’s dead
So sorry there, buddy, if that sounds like invective
Prepare to get schooled in my Austrian perspective

Grade you an F. You failed to grasp even the slightest difference between the austrian school, and 'mainstream' economics.

Rational decision makers assumption was needed to shoehorn human behaviour into elegant economic models. Its not part of the Austrian school.

FFS just go to youtube and type in Hayek v Keynes.

Unreal

Fri, 08/20/2010 - 02:23 | 532228 piceridu

Can you junk a whole article?

Fri, 08/20/2010 - 01:42 | 532205 Arm

Austrian theory does not assume rational actors, it assumes free actors. It does not actually judge whether the actors decisions are optimal. Like a chaotic system, a large group of free actors seeking self gain will arrive at prices through trial and error over extended periods of time.

The evil of FRB is that it makes this process near impossible because it distorts the real pricing of labor. It is these distortions, coupled with whatever human biases exist that can generate bubbles. Like all fractal systems, even a small breeze can turn into a hurricane, but with leverage it will just happen more often.

PS: Austrians do not see money as an exchange between savers and borrowers. That is the Keynesian perspective. Austrians see it as an atemporal exchange of human labor

Fri, 08/20/2010 - 00:21 | 532139 Fishhawk

Turns out the PragmaticIdealist is not pragmatic, and his ideals are mostly anti-science and pro-socialist. And his understanding of Austrian economic theory may be sufficient, but if so then this puff piece is primarily propaganda; ie, a backhanded apology for Keynesianism. And he still owes Its the V a pair of sneakers...

I am heartened, but not surprised, that most of the ZH commenters could have written this piece at least as well, and would have left out the obvious socialist errors.

Fri, 08/20/2010 - 00:21 | 532137 Reese Bobby

Huh? Your logic seems cloudy to me:

"And when free money is proferred to the large, powerful banks..."

The point is free money should not be proferred to the large, powerful banks."

"...some level of transfer of wealth from the rich to the poor is not only the right thing to do, but it also increases the total utility in society as well as counteracts the regressive taxes that exist in any laissez-faire society."

Welfare to able bodied people has been proven to perpetuate behavior that traps people in poverty.

There is nothing touchy feely about Austrian Economics. If human behavior results in irrational bubbles then let them pop.

Thu, 08/19/2010 - 22:46 | 532038 Chris88

My comments in italics.

As nations around the world experiment with monetary policy and flimsy financial systems, it is more important than ever before to fully analyze monetary policy within an Austrian framework.

Contrary to what the author claims, ABCT does indeed incorporate real people for the exact reason the author believes the theory to be flawed. ABCT does account for the fact that human beings are not omniscient and thus are prone to mistakes. Austrian economics itself is based upon praxeology, or the science of human action. This science is not concerned with why people act, it merely examines the consequences of such action. Due to the fact nobody can predict the future people act in a manner in which they believe will ex ante remove uneasiness in the future. Acting rational is precisely that; acting in a way you think will alleviate the concern that induced you to act in the first place. Rational is not always correct; if it was the world would be near perfect.

Monetary policy isn’t merely just a “transfer payment” it distorts the entire rate of originary interest which comes about due to the fact that people prefer the same good in the present to the future. Considering the length of the entire production structure is essentially determined by time preference due to the fact that the price spreads between these stages represent interest rates, these benign “transfer payments” essentially distort the entire process of production.

The first sentence of the previous paragraph demonstrates a complete lack of understanding of ABCT. The credit expansion and thus subsequent artificially suppressed interest rates do not cause over investment, they cause malinvestment. It’s not that people are allocating too many resources to somewhere, it’s that they are allocating resources to where they are not profitable. There is a substantial difference between the two.

By using the author’s reasoning, if economic agents were absolutely rational (which the author does not properly define, what he really means is omniscient) then any price change and its effects would be known in advance already by every single person instantly and everything would adjust accordingly. However, this would be an evenly rotating economy where there is no change. This is merely an economic model only useful for isolating the theoretical effects of one thing changing while holding everything else the same and is not representative of human beings acting in the real world; which is what ABCT attempts to explain.

The “known amount” of newly created money and credit doesn’t mean people will know the effects at any given point in time. For example, prices in relation to each other will vary in ways that nobody can predict with absolute certainty. The author is saying essentially that if the monetary base increases by 5% in August 2010 and then 10% in August 2011 he will know exactly where production should be allocated based upon what he knows about the central bank’s actions without realizing that this is absurd. He cannot know what this will due to wheat, soybeans, iron ore, equities, etc. at any given time.

Being greedy isn’t being irrational. In a market economy greed can be quite rational if somebody’s goal is to attain as much wealth as possible and they act in a manner that they ex ante will lead them to accumulate wealth this is perfectly rational. How is somebody in that scenario not acting purposefully to attain specified ends?

See the entire refutation above.

What is “welfare economics”? I know that economics studies human action in relation to coping with scarcity (thus the real world). Suddenly some emotive plea about the poor and downtrodden is supposed to induce people to throw a science created by logical deduction from a universal axiom out the window? Who defines what is “right”? The reality is that any deviation from permitting human beings to act freely and thus induce entrepreneurs/capitalists to allocate resources and organize the productive process to meet their most urgent needs is necessarily illogical. Economics is a science that doesn’t seek to empathize with those who are “disadvantaged” it merely explains the consequences of acting within a world of scarcity. Sure, people are born into various circumstances and with different skills; that’s why we have the division of labor which is what created society to begin with. The State is a group of people that threaten others with violence and use violence to expropriate their property and use it in a manner that the individuals would not voluntarily use it. Free to leave the State and get extorted by another one? It’s time for you to look at reality.

Fri, 08/20/2010 - 05:06 | 532307 DutchZeroPrinter

Whoa, this spared me some time. I want to add something about the tulip mania. This mania was caused because there was an explosive growth in the money supply in Amsterdam. This is explained by Douglas French from the Mises Institute in "Early speculative bubbles and increases in the supply of money":

As kings throughout Europe debased their currencies, through clipping, sweating, or by decree, the Dutch provided a sound currency policy which called for money to be backed 100 percent by specie. This policy, combined with the occasional seizure of bullion and coin from Spanish ships on the high seas, served to attract coin and bullion from throughout the world. The end result was a large increase in the supply of coin and bullion in 1630s Amsterdam. Free coinage laws then served to create more money from this increased supply of coin and bullion than what the market demanded. This acute increase in the supply of money served to foster an atmosphere that was ripe for speculation and malinvestment, which manifested itself in the intense trading of tulips.

Fri, 08/20/2010 - 04:00 | 532291 Insert witty title

I want your brain.

was all the code supposed to be something?

Fri, 08/20/2010 - 02:25 | 532229 ThreeTrees

+100

This man has read his Mises.

Thu, 08/19/2010 - 22:38 | 532025 Its the Vatican...

Gimme some o' your shit, Pragma-- I deserve it.

I'm obviously not smart enough to grasp the complex reasoning behind your socialistic literary diarrhea, so therefore you owe me on account of I'm an idiot.

I mean it-- up your sneakers, college boy..

Hand 'em over... punk.

Thu, 08/19/2010 - 22:30 | 531995 Catullus

I don't imagine Austrian economists are looking for the approval from "mainstream" economics departments. It is the endless pursuit of truth, not acceptance that drives the very best in Austrianism.

The last paragraph is about libertarianism in general, not Austrian economics. Austrian economics takes only a normative view of human action. Libertarianism is also a normative structure but is based solely on the position of either non-violence or voluntary society. That being said, you have not outlined what "some" confiscation of property is morally righteous, nor have you defined the ethic that supports the violent capture of property regardless of the ends. Just because the thugs have been elected, does not mean that taxation is a voluntary event.

And give up the social utility theory garbage. Austrians didn't even need to disprove that. Kenneth Arrow did.

Thu, 08/19/2010 - 22:22 | 531984 skippy9

Sounds like Obama got to you too. The idea of giving to those who will not help themselves is a communistic ideal and we all know how that ended. Our capitalistic system is not perfect. But I'd take it any day over the rhetoric that 'blacks are underprivileged or some other "minority" created by the liberal media can't succeed because of their background.

Thu, 08/19/2010 - 21:57 | 531918 Willie McVoid

It's quite simple, government propaganda causes false price signals, and ergo, poor rationality. Austrian theory is so complete, it even explains the failures of Austrian theory.

Thu, 08/19/2010 - 22:10 | 531954 Dr. Acula

>government propaganda causes false price signals

Yes. Look at this

http://www.shadowstats.com/alternate_data/unemployment-charts

"reflects current unemployment reporting methodology adjusted for... long-term discouraged workers, who were defined out of official existence in 1994."

Also, if you share Bernanke's fears about deflation, look at this

http://mises.org/content/nofed/chart.aspx?series=TMS

Fri, 08/20/2010 - 08:02 | 532368 harveywalbinger

Worse yet

http://research.stlouisfed.org/fred2/series/SBASENS?cid=124

Thu, 08/19/2010 - 22:36 | 532014 Willie McVoid

Mises never dreamed of a corporate, facist, 24/7 news cycle stuffed full of economic nonsense. He did, however, theorize about malinvestments made from false price signals. The fact that businesses are buying the government propaganda , and believing the lies about unemployment , creating more malinvestent, and not understanding the amount of inflation that is out there, proves the irrationality of the markets, not because of greed or fear as the author proposes, but because of false price signals.

Thu, 08/19/2010 - 21:24 | 531860 Wyndtunnel

I It is undoubtedly true that some level of transfer of wealth from the rich to the poor is not only the right thing to do, but it also increases the total utility in society as well as counteracts the regressive taxes that exist in any laissez-faire society

Do people who categorically refuse to even consider this statement assume that their kids and grand kids will always be as hardworking and uptight as they are? There are plenty of people out there who could not earn their cost of living. Wealthy, hardworking folks over the centuries figured out that if you help them a bit they are less likely to shoot you dead and steal your money outright or end up corpses rotting in the driveway or in the alley out back. It has nothing to do with altruism... In fact my experience has been that the most generous people are more often than not the most self-absorbed self righteous assholes. It has EVERYTHING to do with making the "giver" feel power over the "receiver". Charity my ass!

What it is about type A libertarians that they think everyone has to work as hard as they do to have a decent quality of life? No one is asking to put a Bentley in everyone's driveway. Instead TPTB decided to "lend" the fantasy lifestyle to people in exchange for what? There are no jobs left for people to enslave themselves to for two generations to pay it all back. Citizens in supposedly free countries are essentially permitted to get filthy rich by the grace of the State and its ruling structure. When the State is under control of greedy Capitalists it giveth but when the monopoly of violence is broken up amongst the people, the State brutally taketh away. The Elite just can't get it through their thick skulls that in the end when the small peoples' illusions are shattered and there is nothing left to live for the masses will stop at nothing until the ruling Elite are for the most part jailed, exiled and for the worst offenders hanging in the public square. They just don't get it until the gallow's floor opens beneath their feet.

Thu, 08/19/2010 - 21:56 | 531880 Dr. Acula

"What it is about type A libertarians that they think everyone has to work as hard as they do to have a decent quality of life?"

Libertarians are opposed to theft. If A wants to gift money to B, that's charity. But if C comes along and forces A at gunpoint to give the money to B, then that's theft. Even if C is backed by a million people, it's still theft. Even if A is a billionaire and B is a starving beggar, and A is forced at gunpoint to give B a breadcrumb, then it is still theft. Even if A is a taxpayer and B is General Motors, it is still theft.

All the other things you are saying are just diversions to avoid facing this one issue: either theft is always wrong, or sometimes it's OK to commit thefts. If you choose the latter, then I'm curious what other kinds of crimes can be rationalized away.

Thu, 08/19/2010 - 21:01 | 531822 lookma

Maybe more time on learning the basics of AE, like praxeology, aka the study of human action.

AE rejects rational actors, your whole premise is nonsense.

Thu, 08/19/2010 - 21:02 | 531820 lookma

double

Thu, 08/19/2010 - 21:23 | 531808 Dr. Acula

>ABCT does not incorporate the very real fact that investors and consumers will and always have been swept up in waves of euphoria or severe panic (i.e., tulip mania

Yes, ABCT is a specific theory that predicts an economic bust when interest rates are artificially lowered, ceteris paribus. It does not explain all imaginable bubbles or busts.

>if economic agents were absolutely rational and calculative, any tinkering of the interest rate... should, in theory, be able to accounted for

Sorry, economic agents are not absolutely rational, do not have perfect information, and cannot perfectly predict future tinkering of interest rates. Austrian economics deals with real people and the real world, not your imaginary superhumans. Mises' book - arguably the most important work in AE - is titled "Human Action". It is not called "Robot Action".

>It is undoubtedly true that some level of transfer of wealth from the rich to the poor is not only the right thing to do

You have left the realm of science and are preaching morals or ethics now. Science cannot tell you what is "the right thing to do". Personally, I would use the word "theft" and not "transfer", e.g. some level of theft of wealth from the rich to the poor. And if attempting to retain your wealth results in gunmen showing up at your door, then the correct word is "robbery": some level of robbery of wealth from the rich to the poor

>but it also increases the total utility in society

What is "utility"? And how do you "total" it?

Thu, 08/19/2010 - 20:46 | 531800 Conrad Murray

No taxes, no legal tender laws, no transfers of wealth. Step aside and watch magic happen.

Thu, 08/19/2010 - 22:36 | 532017 goodrich4bk

"No taxes, no legal tender laws, no transfers of wealth. Step aside and watch magic happen."

You are hopelessly naive. There won't be magic, there will be Greece. When the transfers of "wealth" stop the recipients start playing a new game, one that is more rigged in their favor. Guns and ammo, my friend, guns and ammo.

Thu, 08/19/2010 - 20:29 | 531767 SWRichmond

Oh my goodness.

It's my understanding that Austrian School economics relies on rational action, and merely stands aside while some market participants become irrational and then proceed to reap what they have sown, without any expectation of being prevented from feeling the pain they have coming. This also has the desireable effect of "teaching", an effect which is totally lost in a society where opportunities to learn from failure or inaction are thwarted by bailouts and welfarism.

Save for retirement, or take a cruise?

Buy a retail franchise during a boom selling two pounds of shit in a one pound bag (e.g., "Build-A-Bear"), or start a business that's known to weather downturns?

Save for medical expenses, or buy a widescreen TV?

Buy you own children a good education or training, or watch them fail as adults and fall back into poverty?

Work harder to get a raise, or have another baby / move to a state with better benefits?

Why is it evil or even merely undesirable if my children get a head start, by virtue of my lifetime of work, my parents' lifetimes of work? You wanna see pictures of "coming from nothing?" My parents grew up during GD 1.0; my dad was the youngest of three and never owned a new piece of clothing until he enlisted in the military. Did he bitch about the advantages rich kids had, demand a leg up, special help because of his "disadvantgage"? No, he and mom worked their asses off. Guess what? IT WORKED.

Thu, 08/19/2010 - 21:52 | 531905 nmewn

Thanks SWR...I'm tired.

Apparently "someone" must give away a few more fish instead of teaching someone else to fish for themselves, in order that it might make their final meal less strenuous or fulfilling.

An unbroken circle of Keynesian nonsense it seems.

SeeYa

Thu, 08/19/2010 - 21:05 | 531827 lookma

A core tenet of AE is the study of human action, which means a rejection of assumptions about rationationality.

Thu, 08/19/2010 - 20:36 | 531776 nevadan

amen

Thu, 08/19/2010 - 20:26 | 531762 shinola

Would someone who is less technically ignorant than I please bring this article to the attention of Mish?

Thu, 08/19/2010 - 22:41 | 532034 Nihilarian

I'm officially dumber having read Pragma's article. Would have preferred to kill brain cells with drugs instead, at least those make you feel good.

Repositioning Austrian Monetary Business Cycle Theory

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