Tuesday, June 21, 2011

Austrian Business Cycle Theory: The Various Versions and a Critique

I will set out here the various books and sources for Austrian business cycle theory (ABCT). The theory has been developed for nearly 100 years, but, nevertheless, it seems to me that all of them rely on a real rate of interest concept (whether that rate is called the natural rate of interest, originary rate, equilibrium rate, or pure rate of interest), and Wicksellian monetary equilibrium theory:
(1) The version of Mises in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]), pp. 349–366. (It is unclear to me if this appears in the original German edition, Theorie des Geldes und der Umlaufsmittel [Munich and Leipzig, 1912] or the 2nd German edition published in 1924.)

(2) Mises’s version in Monetary Stabilization and Cyclical Policy (1928) in Mises 2006 [1978], The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (Ludwig von Mises Institute, Auburn, Ala.), p. 99ff.

(3) The version of Mises in Human Action: A Treatise on Economics (Auburn, Ala., 1998), pp. 568–583.

(4) Hayek’s first version of ABCT in Prices and Production (London, 1931).

(5) Hayek’s second version of ABCT in Profits, Interest and Investment (London, 1939).

(6) Rothbard’s development of ABCT in Man, Economy, and State: A Treatise on Economic Principles (Ludwig von Mises Institute, Auburn, Ala., 2004 [1962]), pp. 994–1008; and in Economic Depressions: Their Cause and Cure (Ludwig von Mises Institute, Auburn, Ala. 2009 [1969]).

(7) M. Skousen’s interpretation in The Structure of Production (New York, 1990).

(8) Gerald P. O’Driscoll and Mario J. Rizzo in The Economics of Time and Ignorance (2nd edn; Routledge, Oxford, UK., 1996), pp. 198–213.

(9) The most recent developments of ABCT, as in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure (London and New York, 2000). A summary can be found in Garrison (1997).

(10) the exposition in Jesus Huerta de Soto, Money, Bank Credit and Economic Cycles (trans. M. A. Stroup; Ludwig von Mises Institute, Auburn, Ala, 2006), pp. 265–508.
They are all subject to these flaws:
(1) They assume a single real natural rate that does not exist in a growing, money-using economy, as Sraffa showed (1932a and 1932b). The natural rate is one that would obtain, as if loans were made in natura (that is, in real commodities). But in a barter economy not in equilibrium, there could be as many natural rates as there as commodities. As Rogers argues,
“The natural rate of interest is a real rate in the sense that it is supposedly determined in a market in which saving and investment are undertaken in natura. However, the fact is that in any but the most primitive economy no such ‘capital’ market exists, and the natural rate of interest, as envisaged by Wicksell and Robertson, does not exist either. The concept of the natural rate of interest is not merely non-operational: it is an abstract special case of no general theoretical significance. It cannot, therefore, provide the theoretical foundations for an operational loanable funds theory of the rate of interest” (Rogers 2001: 546).
(2) In Hayek’s version of ABCT in Prices and Production (London, 1931) he argued that policy should attempt to make money neutral (although by 1933 he was questioning whether monetary policy could ever approach the situation of “neutral money” [Hayek 1933: 159-162]). But money can never be made neutral, and a state in which money is neutral is nothing but a state in which money does not exist:
“The starting-point and the object of Dr. Hayek’s inquiry is what he calls ‘neutral money’; that is to say, a kind of money which leaves production and the relative prices of goods, including the rate of interest, ‘undisturbed,’ exactly as they would be if there were no money at all. This method of approach might have something to recommend it, provided it were constantly kept in mind that a state of things in which money is ‘neutral’ is identical with a state in which there is no money at all: as Dr. Hayek once says, if we ‘eliminate all monetary influences on production ... we may treat money as non-existent’” [Prices and Production, p. 109]. .... (Sraffa 1932a: 42).

“The money which he [viz., Hayek] contemplates is in effect used purely and simply as a medium of exchange. There are no debts, no money-contracts, no wage-agreements, no sticky prices in his suppositions. Thus he is able to neglect altogether the most obvious effects of a general fall, or rise, of prices” (Sraffa 1932a: 44).
(3) Wicksellian monetary equilibrium assumes an economy running at full employment, and Hayek in Prices and Production (1931) also makes this assumption. But in reality capitalist systems have historically had many periods when they are mired in underemployment disequilibria, or movements from one underemployment equilibrium to another, where there are significant idle resources, like labour, raw materials, capital goods and other factor inputs. If an economy with significant idle resources has investment via fractional reserve banking or central bank creation of excess reserves (without prior saving in loanable funds), how will the inflationary pressures imagined by ABCT happen if productive resources simply do not need to be freed in the stages close to consumption? Such factor inputs will be available or quickly made available through increasing capacity utilization in the relevant industries, or even imported from overseas. Even versions of ABCT (Huerta de Soto 2006: 440ff.) that reject the starting assumption of full employment fail to explain why the cycle effects would happen if in fact factor imputs were not scarce and available through international trade. Moreover, Mises, in “Monetary Stabilization and Cyclical Policy” (1928), is quite clear in saying that his cycle effects require that factor inputs have become scarce:
“Since it always requires some time for the market to reach full ‘equilibrium,’ the ‘static’ or ‘natural’ prices, wage rates and interest rates never actually appear. The process leading to their establishment is never completed before changes occur which once again indicate a new ‘equilibrium.’ At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under ‘static equilibrium.’ With the revival of business and productive activity, these reserves are in demand right away. However, once they are gone, the increase in the supply of fiduciary media necessarily leads to disturbances of a special kind. In a given economic situation, the opportunities for production, which may actually be carried out, are limited by the supply of capital goods available. Roundabout methods of production can be adopted only so far as the means for subsistence exist to maintain the workers during the entire period of the expanded process. All those projects, for the completion of which means are not available, must be left uncompleted, even though they may appear technically feasible—that is, if one disregards the supply of capital. However, such businesses, because of the lower loan rate offered by the banks, appear for the moment to be profitable and are, therefore, initiated. However, the existing resources are insufficient. Sooner or later this must become evident. Then it will become apparent that production has gone astray, that plans were drawn up in excess of the economic means available, that speculation, i.e., activity aimed at the provision of future goods, was misdirected.” (Mises 2006 [1978]: 110).
Mises still fails to address the issue of what would happen had the factor inputs or consumer goods not been scarce.

(4) The natural rate is conceived as an equilibrium interest rate that equilibrates loanable funds supply with demand for credit. In Wicksell’s natural rate of interest theory, this is supposed to be the interest rate where money supply is neutral, and where inflation does not occur.

But subjective expectations and the instability of investment are factors that destroy the myth of equilibrating markets, either the plan coordination imagined by Austrians or the full employment equilibrium concept of neoclassicals. These factors also destroy the basis of the view from loanable funds theory that, if there is an increase in saving, then the rate of interest would fall, which will stimulate investment in production by an equal amount. This idea that an increase in saving due to a fall in consumption would not decrease aggregate demand because there is a corresponding increase in investment in capital goods to compensate for the fall in consumption is an assumption underlying Say’s law, from which it is concluded that aggregate demand will remain the same and only its composition will alter. But subjective expectations in the investment decision destroy any such automatic process to create the necessary investment.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 23–27.

Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London

Hayek, F. A. von, 1941. The Pure Theory of Capital, Macmillan, London.

Hayek, F. A. von. 1984. Money, Capital & Fluctuations: Early Essays (ed. R. McCloughry), Routledge & Kegan Paul, London.

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 1912 Theorie des Geldes und der Umlaufsmittel, Duncker & Humblot, Munich and Leipzig.

Mises, L. von. 1924. Theorie des Geldes und der Umlaufsmittel (2nd edn), Duncker & Humblot, Munich.

Mises, L. von. 1934. The Theory of Money and Credit (trans. H. E. Batson from 2nd German edition of 1924), J. Cape, London.

Mises, L. von. 1953. The Theory of Money and Credit (enlarged, new edn), Yale University Press, New Haven.

Mises, L. 1998. Human Action: A Treatise on Economics, Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

O’Driscoll, G. P. and M. J. Rizzo, 1996. The Economics of Time and Ignorance (2nd edn), Routledge, Oxford, UK.

Rogers, C. 2001. “Interest rate: natural,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy. Volume 1. A–K, Routledge, London and New York. 545–547

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure, Ludwig von Mises Institute, Auburn, Ala.

Skousen, M. 1990. The Structure of Production, New York University Press, New York.

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.


  1. LK,

    I would argue that critique 3 is the only relevant one. Garrisons theory of ABCT relies heavily on this, but when one assumes levels of employment above or below NAIRU (or the tangent point of the PPF line for Garrison), the entire theory falls apart.

    What is ironic: Garrison allows for government interest rate "manipulation" to push unemployment below NAIRU, but never above it? This then implies that market forces can never move the level of employment above or below NAIRU, which is absurd.

    Moreover, the production possibilities frontier implies the NAIRU. Since his theory specifically uses PPF, he accepts the NAIRU, and all of its corollaries.

  2. I always thought the problem with the theory is the problem with monetary theory in general - that if the Fed pushes the interest rate lower than the natural rate for too long, banks would raise their rates (expecting inflation) and there would be no malinvestment.

    I suppose what makes the Austrian theory different is they try to get some malinvestment out the time lag that a low interest rate would produce. But controlling the discount rate doesn't have any effect on the time structure of investment - which is my interpretation of what you are saying.