WEBVTT NOTE Teaching Austrian Business Cycle Theory and Macroeconomics 1 00:00:00.000 --> 00:00:03.080 The objectives of this presentation are twofold. 2 00:00:03.080 --> 00:00:06.160 First is to argue that Austrian business cycle theory 3 00:00:06.160 --> 00:00:08.600 offers unique pedagogical advantages 4 00:00:08.600 --> 00:00:10.880 over conventional presentations 5 00:00:10.880 --> 00:00:13.680 in mainstream principles texts. 6 00:00:13.680 --> 00:00:15.080 Second, I will make the case 7 00:00:15.080 --> 00:00:16.680 that Austrian business cycle theory 8 00:00:16.680 --> 00:00:18.960 is the logical and necessary conclusion 9 00:00:18.960 --> 00:00:21.560 which follows from a set of fundamentals 10 00:00:21.560 --> 00:00:26.040 which virtually all mainstream economists accept in isolation, 11 00:00:26.040 --> 00:00:29.440 but they are mysteriously unable to connect the dots 12 00:00:29.440 --> 00:00:34.240 to arrive at the conclusions promoted by our heretical cult. 13 00:00:34.240 --> 00:00:41.540 The presentation will consist of three elements, 14 00:00:41.540 --> 00:00:49.580 the loanable funds model, the production, and let me say 15 00:00:49.580 --> 00:00:52.580 that I agree with everything that Rayno presented. 16 00:00:52.580 --> 00:00:55.640 It's just that my point here is 17 00:00:55.640 --> 00:00:58.980 that most mainstream economists would not criticize this model. 18 00:00:58.980 --> 00:01:01.820 So it's a good foundation for them to accept. 19 00:01:01.820 --> 00:01:03.940 The production possibilities frontier 20 00:01:03.940 --> 00:01:05.820 and the Hayekian Triangle. 21 00:01:05.820 --> 00:01:07.980 The first two are not controversial, 22 00:01:07.980 --> 00:01:10.340 at least outside the Austrian School, 23 00:01:10.340 --> 00:01:12.440 and not necessarily Austrian. 24 00:01:12.440 --> 00:01:15.740 Although the Hayekian Triangle is widely rejected 25 00:01:15.740 --> 00:01:18.420 as a plausible model of production structure 26 00:01:18.420 --> 00:01:22.580 or simply considered outdated, it has particular uses 27 00:01:22.580 --> 00:01:27.820 which are amenable to conceptualizing entrepreneurship. 28 00:01:27.820 --> 00:01:30.060 This is the loanable funds model. 29 00:01:30.060 --> 00:01:33.420 We observe individual time preference varies. 30 00:01:33.420 --> 00:01:35.760 If we set the interest rates sufficiently low, 31 00:01:35.760 --> 00:01:38.020 few offer to lend much of their wealth, 32 00:01:38.020 --> 00:01:40.060 but many would want to borrow. 33 00:01:40.060 --> 00:01:42.960 This incidentally would result in the interest rate rising. 34 00:01:42.960 --> 00:01:45.860 If we set the interest rates sufficiently high, 35 00:01:45.860 --> 00:01:49.360 many would want to lend, but few borrow, 36 00:01:49.360 --> 00:01:50.520 resulting in an interest rate 37 00:01:50.520 --> 00:01:53.120 adjusting downward toward equilibrium. 38 00:01:53.120 --> 00:01:55.360 Because the supply curve slopes upward 39 00:01:55.360 --> 00:01:57.220 and the demand curve slopes downward, 40 00:01:57.220 --> 00:02:09.220 The equilibrium is stable and we have a model of the joint determination of the equilibrium interest rate R0 and the equilibrium amount loaned and borrowed L0. 41 00:02:09.220 --> 00:02:16.220 We can make the further observation that when the interest rate is zero, no one will want to lend and everyone will want to borrow. 42 00:02:16.220 --> 00:02:21.220 But if the interest rate rises enough, everyone will want to lend, but no one borrow. 43 00:02:21.220 --> 00:02:26.540 Thus, the supply and demand curves are jointly determined by the distribution or constellation 44 00:02:26.540 --> 00:02:34.300 of individual time preferences, and demand is just the mirror image of supply. 45 00:02:34.300 --> 00:02:39.300 If we increase the money supply, we increase the supply of loanable funds without changing 46 00:02:39.300 --> 00:02:40.700 the demand. 47 00:02:40.700 --> 00:02:45.020 The interest rate now falls below the original rate, which was determined by the society's 48 00:02:45.020 --> 00:02:47.460 overall time preference constellation. 49 00:02:47.460 --> 00:02:53.100 Also, investment rises, but saving falls, or in other words, monetary expansion has 50 00:02:53.100 --> 00:02:54.100 two effects. 51 00:02:54.100 --> 00:02:59.660 It A, drives a wedge between interest and time preference, and B, drives a wedge between 52 00:02:59.660 --> 00:03:01.440 investment and saving. 53 00:03:01.440 --> 00:03:08.500 This is not controversial and is widely accepted in the mainstream. 54 00:03:08.500 --> 00:03:11.460 Now we turn to the production possibilities frontier. 55 00:03:11.460 --> 00:03:15.980 This shows us different amounts of goods A and B, which we can produce depending on how 56 00:03:15.980 --> 00:03:18.740 and how we allocate productive resources. 57 00:03:18.740 --> 00:03:20.900 It is normally bowed outward as long as factors 58 00:03:20.900 --> 00:03:22.300 are heterogeneous. 59 00:03:22.300 --> 00:03:25.020 Some resources are more useful for producing A 60 00:03:25.020 --> 00:03:26.180 as opposed to B. 61 00:03:28.900 --> 00:03:31.860 We can capture the whole economy in the PPF diagram 62 00:03:31.860 --> 00:03:35.780 if we make the two goods producer goods I for investment 63 00:03:35.780 --> 00:03:39.660 and consumer goods C for consumption. 64 00:03:39.660 --> 00:03:41.540 If we graph I on the vertical axis, 65 00:03:41.540 --> 00:03:43.500 we can represent the slope of the tangent 66 00:03:43.500 --> 00:03:45.420 as the rate of time preference. 67 00:03:45.420 --> 00:03:50.700 If time preference is zero, the tangent is flat and selects the I-intercept, the maximum 68 00:03:50.700 --> 00:03:57.260 possible output of producer goods or investment expenditure. 69 00:03:57.260 --> 00:04:04.780 If time preference is infinite, the tangent is vertical and selects the consumption intercept. 70 00:04:04.780 --> 00:04:09.200 Time preference may be low, which implies a higher growth rate, which would be represented 71 00:04:09.200 --> 00:04:12.340 by shifting the PPF outward. 72 00:04:12.340 --> 00:04:19.180 Time preference may be high with a steep slope, implying a lower growth rate and possibly even a negative one. 73 00:04:19.180 --> 00:04:23.700 So far we have assumed no monetary expansion and that the market interest rate from the 74 00:04:23.700 --> 00:04:30.020 loanable funds market reflects agent time preferences. 75 00:04:30.020 --> 00:04:34.420 We've seen in the loanable funds model that monetary expansion drives a wedge between 76 00:04:34.420 --> 00:04:39.140 interest and time preference, that is that time preference is unchanged but the market 77 00:04:39.140 --> 00:04:41.900 interest rate has been lowered. 78 00:04:41.900 --> 00:05:11.900 Saving the interest rate should result in producer goods being substituted for consumer goods output. This is virtuous and should result in faster economic growth. That would be fine if that were all that happens. The lower interest rate increases investment to an expansionary level greater than the amount saved by consumers. Because saving falls in response to the lower interest rate consumer spending also rises. The economy is drawn beyond the PPF to an unsustainable point beyond it where a recession 79 00:05:11.900 --> 00:05:16.100 Sessionary Correction becomes inevitable. 80 00:05:16.100 --> 00:05:20.260 In the absence of monetary expansion, the interest rate reflects agent time preferences 81 00:05:20.260 --> 00:05:26.820 selecting the one sustainably attainable combination of consumer goods satisfying immediate wants 82 00:05:26.820 --> 00:05:35.020 and producer goods potentially satisfying future wants. 83 00:05:35.020 --> 00:05:39.340 If time preference falls, this results in a substitution of producer goods for consumer 84 00:05:39.340 --> 00:05:50.780 and as producer goods become more abundant, the economy's productive capacity grows. 85 00:05:50.780 --> 00:05:54.780 This works fine as long as it doesn't result from monetary expansion. 86 00:05:54.780 --> 00:05:59.040 As we saw from the loanable funds model, increasing the money supply lowers the interest rate 87 00:05:59.040 --> 00:06:04.220 R below the rate of time preference P0. 88 00:06:04.220 --> 00:06:10.780 I rises to IE for expansionary investment consistent with the lower interest rate as 89 00:06:10.780 --> 00:06:14.780 C rises to CE, expansionary consumption. 90 00:06:14.780 --> 00:06:19.780 This happens because savings falls in response to the lower interest rate causing consumption 91 00:06:19.780 --> 00:06:22.940 spending to rise. 92 00:06:22.940 --> 00:06:26.740 The economy is drawn unsustainably outside the frontier. 93 00:06:26.740 --> 00:06:30.960 The correction brings the economy back down under the frontier because lots of productive 94 00:06:30.960 --> 00:06:36.560 of Resources have been wasted during the unsustainable expansion. 95 00:06:36.560 --> 00:06:40.760 We can illustrate the Hayekian Triangle within the production possibilities frontier, but 96 00:06:40.760 --> 00:06:46.260 we have to note that the height of the triangle is consumption, because I've reversed the 97 00:06:46.260 --> 00:06:48.260 usual way these are shown. 98 00:06:48.260 --> 00:06:55.080 So as a result, the height of the triangle here is actually the base in most presentations. 99 00:06:55.080 --> 00:07:00.440 The unsustainability of this production structure is illustrated by its curved linear shape 100 00:07:00.440 --> 00:07:06.080 indicating that middle-stage bottlenecks prevent low-yielding early-stage investment from being 101 00:07:06.080 --> 00:07:14.320 transformed into high-yielding late-stage consumer goods. 102 00:07:14.320 --> 00:07:19.160 Following Garrison, we can use this framework to illustrate alternative explanations of 103 00:07:19.160 --> 00:07:20.880 the business cycle. 104 00:07:20.880 --> 00:07:26.880 The Keynesian otherwise inexplicable collapse of aggregate demand is illustrated here. 105 00:07:26.880 --> 00:07:31.160 Keynes' plucking model of the business cycle is formally identical. 106 00:07:31.160 --> 00:07:35.120 Interestingly in the general theory, Keynes argues that to aid recovery, interest rates 107 00:07:35.120 --> 00:07:38.120 should be lowered to restore investment spending. 108 00:07:38.120 --> 00:07:43.600 This would either move us to the left on the PPF or bring about an Austrian recession. 109 00:07:43.600 --> 00:07:46.840 Hardly a good outcome. 110 00:07:46.840 --> 00:07:51.800 Real business cycle theory operates in an interest and time preference free zone. 111 00:07:51.800 --> 00:07:57.320 Human but serially correlated shocks to factor productivity shift the PPF inward. 112 00:07:57.320 --> 00:08:02.120 Though this phenomenon can be identified as a recession, it is also a purportedly welfare 113 00:08:02.120 --> 00:08:07.840 optimal outcome, which would be news to anybody who's unemployed during a recession. 114 00:08:07.840 --> 00:08:13.320 It is hard to see these alternatives as very impressive compared with Austrian business 115 00:08:13.320 --> 00:08:17.680 cycle theory. 116 00:08:17.680 --> 00:08:23.960 Hyman Minsky's post-Keynesian financial instability hypothesis fares better in this framework. 117 00:08:23.960 --> 00:08:30.200 Factor productivity and the return on financial assets are both stochastic and serially correlated. 118 00:08:30.200 --> 00:08:35.780 As an expansion lengthens, investors and entrepreneurs lose the memory of the last collapse. 119 00:08:35.780 --> 00:08:40.640 They progressively under appraise economic risk to sigma zero, which shrinks as time 120 00:08:40.640 --> 00:08:46.880 goes by, while they're increasingly risky, over-leveraged and financially interdependent 121 00:08:46.880 --> 00:08:56.080 and Interconnected Behavior increases the unobservable actual risk to Sigma 1 until a shock disrupts 122 00:08:56.080 --> 00:09:01.380 many financial arrangements and assets are revalued downward in an effort to generate 123 00:09:01.380 --> 00:09:05.880 liquidity, a process Minsky calls debt deflation. 124 00:09:05.880 --> 00:09:11.000 Minsky does not relate his scenario to monetary expansion, but it seems clear that monetary 125 00:09:11.000 --> 00:09:18.320 expansion would both encourage, aggravate and fund the kind of irresponsible over-leveraging 126 00:09:18.320 --> 00:09:22.120 he describes in the financial instability hypothesis. 127 00:09:22.120 --> 00:09:31.880 He does not relate an unsustainable increase in investment with a reduction in saving. 128 00:09:31.880 --> 00:09:36.680 I hope I have made a persuasive case to you both for the reality and for the pedagogical 129 00:09:36.680 --> 00:09:43.480 of Austrian Business Cycle Theory for teaching macro principles and a few more advanced topics. 130 00:09:43.480 --> 00:09:48.080 There is very little in macroeconomics which has not been addressed through this model. 131 00:09:48.080 --> 00:09:53.080 It thus remains a mystery why Austrian Business Cycle Theory is not enthusiastically embraced 132 00:09:53.080 --> 00:09:54.720 by the mainstream. 133 00:09:54.720 --> 00:09:58.920 They have all the pieces, why can't they connect the dots? 134 00:09:58.920 --> 00:10:03.000 Israel Kirzner often makes the case that much of Austrian economics has been thoroughly 135 00:10:03.000 --> 00:10:05.320 assimilated into the mainstream. 136 00:10:05.320 --> 00:10:16.600 However, a coherent, integrated macroeconomics has yet to find real acceptance in spite of its holistic, consistent, integrated and thoroughly uncontroversial basis.