WEBVTT NOTE A Neoclassical Argument for the Austrian Business Cycle 1 00:00:00.000 --> 00:00:05.240 Perhaps a little background would be worthwhile before I just dive right into the paper. 2 00:00:05.240 --> 00:00:11.840 I really, as an undergraduate and graduate student, wasn't exposed to Austrian theory so much. 3 00:00:11.840 --> 00:00:18.000 But I remember first coming across Keynes when a fraternity brother of mine was trying to 4 00:00:18.000 --> 00:00:25.280 take the Keynesians, teach me the Keynesian story, and over a few beers, and today the 5 00:00:25.280 --> 00:00:29.120 truth it never made any sense to me. 6 00:00:29.120 --> 00:00:34.360 You know, the paradox of thrift, as far as I could tell, the only paradox was why anyone 7 00:00:34.360 --> 00:00:37.820 would believe it. 8 00:00:37.820 --> 00:00:44.360 So at that point, you know, I knew I didn't like macroeconomics very much, but I continued 9 00:00:44.360 --> 00:00:52.320 on in my studies and in graduate school, being exposed to neoclassical price theory, you 10 00:00:52.320 --> 00:00:59.720 I was a micro guy, and so I got into graduate school, I was taking all of the econometrics 11 00:00:59.720 --> 00:01:05.600 as a field of study, as well as finance and mathematical economics, and the more I learned 12 00:01:05.600 --> 00:01:11.040 about econometrics and mathematical economics, I began to realize that it seemed like all 13 00:01:11.040 --> 00:01:17.960 economists were doing was building mathematical puzzles that they would go out and estimate 14 00:01:17.960 --> 00:01:20.200 in ways that they couldn't possibly do. 15 00:01:20.200 --> 00:01:28.120 So I became disillusioned with economic theory in graduate school, and really it was after 16 00:01:28.120 --> 00:01:36.240 graduate school that I began to be interested in Austrian, reading Austrian economists. 17 00:01:36.240 --> 00:01:45.640 I ran across Hayek's critique of the neoclassical theory and his discussion of scientism, and 18 00:01:45.640 --> 00:01:48.840 it kind of set me on a particular road. 19 00:01:48.840 --> 00:01:54.800 In the early 90s, I was able to hear Roger Garrison present business cycle theory at a 20 00:01:54.800 --> 00:02:03.000 fee conference one summer and it immediately set well with me because I was teaching finance 21 00:02:03.000 --> 00:02:04.000 at the time. 22 00:02:04.000 --> 00:02:10.240 I could easily see how artificially reducing interest rates could get business people to 23 00:02:10.240 --> 00:02:14.820 do poor or make poor choices. 24 00:02:14.820 --> 00:02:21.700 And so that's really where this particular idea came from. 25 00:02:21.700 --> 00:02:24.060 So let's get into it. 26 00:02:24.060 --> 00:02:30.420 In most finance texts, they early on will present the Fisher Separation Theorem. 27 00:02:30.420 --> 00:02:36.920 And I just stated here, this is out of Copeland and Westman's old book, Financial Theory and 28 00:02:36.920 --> 00:02:43.780 Corporate Policy, and they just say, given perfect and complete capital markets, the 29 00:02:43.780 --> 00:02:48.740 The production decision is governed solely by an objective criterion without regard to 30 00:02:48.740 --> 00:02:54.640 individuals' subjective preferences that enter into their consumption decisions. 31 00:02:54.640 --> 00:02:58.380 Well, graphically, here's what it looks like. 32 00:02:58.380 --> 00:03:07.220 You know, in other words, if we put in here a capital market, a financial market, then 33 00:03:07.220 --> 00:03:12.540 this is our production possibilities curve, then the individual is freed from making the 34 00:03:12.540 --> 00:03:19.640 The decision, the consumption and investment decisions can be separated out, or the saving 35 00:03:19.640 --> 00:03:26.660 and investment decisions can be separated out, and the individual can move in terms 36 00:03:26.660 --> 00:03:30.980 of utility theory up and down that line. 37 00:03:30.980 --> 00:03:38.260 Now the problem with this is that that might be true for the individual, that the individual's 38 00:03:38.260 --> 00:03:45.500 This decision to save or invest is not one in the same as it would be in a Robinson Crusoe 39 00:03:45.500 --> 00:03:46.500 economy. 40 00:03:46.500 --> 00:03:47.940 That much is true. 41 00:03:47.940 --> 00:03:53.780 But it's wholly untrue that that could be true in the economy as a whole. 42 00:03:53.780 --> 00:04:00.980 Because the slope of the line here, this tangency, is a slope that comes out of financial markets 43 00:04:00.980 --> 00:04:03.540 and what's going on with financial markets. 44 00:04:03.540 --> 00:04:09.620 And so there's a fallacy of composition if I think that the economy as a whole that we 45 00:04:09.620 --> 00:04:16.740 just separate out these decisions from one another because it can't be done that way. 46 00:04:16.740 --> 00:04:23.380 As a whole, there's a coordinating activity going on in the financial markets and the 47 00:04:23.380 --> 00:04:30.580 rising of the interest rate reflects something that's ultimately true about the markets going 48 00:04:30.580 --> 00:04:36.400 The same rate of time preference as it is, and that's the rate that's coordinating market 49 00:04:36.400 --> 00:04:41.940 activity and inter-temporal choices. 50 00:04:41.940 --> 00:04:46.520 So while it might be true for the financial markets to allow an individual to save without 51 00:04:46.520 --> 00:04:55.160 making the investment decision, it's certainly not true in the aggregate economy. 52 00:04:55.160 --> 00:05:00.420 Because the aggregate economy cannot easily veer off of the market clearing combination 53 00:05:00.420 --> 00:05:04.780 of Consumption in the Present and Consumption in the Future that coordinates the market 54 00:05:04.780 --> 00:05:12.740 and that's given by the market interest rate, whatever it is, whatever the market ends up 55 00:05:12.740 --> 00:05:13.740 doing. 56 00:05:13.740 --> 00:05:23.260 And in Garrison's work, you know, he has this, this is from a graph from his 1997 paper in 57 00:05:23.260 --> 00:05:28.620 the loanable funds markets where he's got, you know, this is the net supply of loanable 58 00:05:28.620 --> 00:05:34.940 Loanable Funds by Net Savers in the market, and then the demand for loanable funds, and 59 00:05:34.940 --> 00:05:40.700 this would be an increase in the supply of loanable funds, now that it comes about as 60 00:05:40.700 --> 00:05:48.380 a result of merely the Fed creating a monetary expansion, then what you end up with is you 61 00:05:48.380 --> 00:05:57.140 end up with a shortage of loanable funds, in other words, savers are actually going 62 00:05:57.140 --> 00:06:02.980 and to save less at this lower interest rate because time preferences have not changed. 63 00:06:02.980 --> 00:06:09.860 And so you're going to have a shortage and so Garrison points that out in his 1997 paper. 64 00:06:09.860 --> 00:06:21.580 Well this really conforms quite well with the, if we go back and look at that production 65 00:06:21.580 --> 00:06:25.980 possibilities curve, it's going to conform quite well with that and it's going to tell 66 00:06:25.980 --> 00:06:48.420 Notice what's happening here. We have this shortage of loanable funds. Businesses are 67 00:06:48.420 --> 00:06:54.940 trying to borrow more to invest in capital, but savers are saving less, and they're actually 68 00:06:54.940 --> 00:07:01.340 saving as if the rate of time preference were much higher in the market instead of lower. 69 00:07:01.340 --> 00:07:07.960 Why? Because there's no incentive. There's really no incentive to save. So now if I flip 70 00:07:07.960 --> 00:07:13.860 this back over and put it against the production possibilities curve, what we have going on 71 00:07:13.860 --> 00:07:21.540 is we have this mismatch. So in the mismatch, consumers are consuming as if the rate of 72 00:07:21.540 --> 00:07:27.740 time preference is very high and as if the capital markets is giving this kind of signal 73 00:07:27.740 --> 00:07:34.040 back and so they've increased their current consumption where business decision makers 74 00:07:34.040 --> 00:07:41.380 are trying to invest in capital for the longer haul and so they're trying to invest as if 75 00:07:41.380 --> 00:07:46.120 their interest rate were up here when in truth the interest rate is here so you have this 76 00:07:46.120 --> 00:07:52.080 total mismatch between what consumers are doing and what investors are doing and in 77 00:07:52.080 --> 00:07:57.520 between savings, what's happening with savings and what's happening with investment. So capital 78 00:07:57.520 --> 00:08:06.340 is being liquidated in the whole process. Well, when the reality hits, then it's exactly 79 00:08:06.340 --> 00:08:13.480 as Dr. Salerno said. You're going to have a collapse in both areas. It's going to collapse 80 00:08:13.480 --> 00:08:18.680 collapse in, and the production possibilities curve is going to be collapsing down on itself. 81 00:08:18.680 --> 00:08:22.000 There's no reason why it would be constant. 82 00:08:22.000 --> 00:08:28.180 And so as it collapses down, that's going to be the real problem area. 83 00:08:28.180 --> 00:08:34.640 In reading through Carl Menger's principles, he kind of hints at this sort of thing when 84 00:08:34.640 --> 00:08:39.880 he is talking about goods character. 85 00:08:39.880 --> 00:08:47.240 Let me just read to you a brief piece here. He's talking about this. He says, 86 00:08:47.240 --> 00:08:54.160 Suppose that the need for direct human consumption of tobacco should disappear as the result 87 00:08:54.160 --> 00:08:59.280 of a change in taste, and that at the same time all other needs that tobacco already 88 00:08:59.280 --> 00:09:05.160 prepared for consumption might serve to satisfy should also disappear. In this event it is 89 00:09:05.160 --> 00:09:10.160 It's certain that all tobacco products already on hand in the final form suited to human 90 00:09:10.160 --> 00:09:14.280 consumption would immediately lose their goods character. 91 00:09:14.280 --> 00:09:18.760 But what would happen to the corresponding goods of higher order? 92 00:09:18.760 --> 00:09:24.120 And so if you think about it, all of a sudden they begin to lose their goods character too. 93 00:09:24.120 --> 00:09:32.880 And if you can't reallocate to a higher valued use, they're a total loss. 94 00:09:32.880 --> 00:09:37.360 to become a total loss to the entire system. 95 00:09:37.360 --> 00:09:45.500 And so the recovery is the attempt to reallocate goods, which would push the production possibilities 96 00:09:45.500 --> 00:09:52.600 curve back outward, probably won't ever get back out here until economic progress or economic 97 00:09:52.600 --> 00:09:57.600 growth is sufficient to overtake it again. 98 00:09:57.600 --> 00:10:03.960 And the size of the bust, the size of the retrenchment is going to be driven by how 99 00:10:03.960 --> 00:10:11.540 great the mismatch was, which will be driven by how large the monetary expansion was in 100 00:10:11.540 --> 00:10:15.800 relation to some of these things. 101 00:10:15.800 --> 00:10:21.420 So here are some points that can be made in arguing and putting in this kind of graphical 102 00:10:21.420 --> 00:10:28.460 Analysis that might work well with neoclassical theorists, that the depth of the recession 103 00:10:28.460 --> 00:10:33.100 depends on how large the shortage was, which is caused by how great the monetary expansion 104 00:10:33.100 --> 00:10:39.540 was. When the recession comes, the production possibilities curve or trenches, and finally 105 00:10:39.540 --> 00:10:45.300 the ability to recover depends upon how quickly capital can be liquidated and put to some 106 00:10:45.300 --> 00:10:52.100 and some other use. Some capital may be lost in the process. In fact, most likely will 107 00:10:52.100 --> 00:10:58.600 be lost in the process. And really, probably what's giving the recession its length, how 108 00:10:58.600 --> 00:11:04.740 long that recession is, will just depend on how much was actually lost in the process. 109 00:11:04.740 --> 00:11:14.460 So, you know, here we go. Some scenes. This is out in Las Vegas where they have entire 110 00:11:14.460 --> 00:11:19.700 Housing Projects that have just been left abandoned. Now, I suspect part of this is 111 00:11:19.700 --> 00:11:30.140 driven by the fact that we had the Fed buying up Freddie Mac and Fannie Mae bonds and so 112 00:11:30.140 --> 00:11:34.260 nobody's, you know, the banks aren't taking the hit or else they would have tried to liquidate 113 00:11:34.260 --> 00:11:39.500 this stuff or whatever they could have gotten out of it if they had had to actually take 114 00:11:39.500 --> 00:11:43.620 the hit on it but you know since the feds gonna take the hit on it which means 115 00:11:43.620 --> 00:11:48.880 since US taxpayers are gonna take the hit on it we can just leave it to the 116 00:11:48.880 --> 00:11:53.980 rats and you know here's another one so I guess the rats are taking over because 117 00:11:53.980 --> 00:12:05.460 looks like they're setting up camp outside and yeah so anyway and that's 118 00:12:05.460 --> 00:12:12.460 That's basically the idea that I had.