WEBVTT NOTE A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis 1 00:00:00.000 --> 00:00:08.000 My paper is a reformulation of the Austrian business cycle theory in light of the financial crisis. 2 00:00:08.000 --> 00:00:14.000 And let me just read you a very short statement of the thesis of my paper. 3 00:00:14.000 --> 00:00:20.000 Some, as we know, some prominent mainstream economists have not really responded kindly 4 00:00:20.000 --> 00:00:24.000 to the sudden resurgence of interest in the Austrian business cycle theory. 5 00:00:24.000 --> 00:00:36.000 Krugman and DeLong and even some lesser Keynesians like Brian Kaplan and Tyler Cowan at GMU have criticized it. 6 00:00:36.000 --> 00:00:46.000 But rather than openly subjecting the theory to rigorous scholarly analysis in the standard research forums of academic journals and professional conferences, 7 00:00:46.000 --> 00:00:50.000 they have sniped at the theory on blog sites and in the popular press. 8 00:00:50.000 --> 00:00:54.400 Furthermore, in their haste to find flaws in the theory, they have disregarded the works 9 00:00:54.400 --> 00:00:59.120 of its originators and leading proponents, Ludwig von Mises, Friedrich Hayek, and Murray 10 00:00:59.120 --> 00:01:07.400 Rothbard. Instead, they have drawn upon a sole or solitary secondary source that portrays 11 00:01:07.400 --> 00:01:15.080 the Austrian business cycle theory as a monetary overinvestment theory. The theory is thus 12 00:01:15.080 --> 00:01:19.240 described this way in the influential survey of business cycle theories that was published 13 00:01:19.240 --> 00:01:25.280 under the auspices of the League of Nations in 1937 by Gottfried Habeler, and this is 14 00:01:25.280 --> 00:01:29.320 called Prosperity and Depression. When Mises was asked what he thought of this book, Mises 15 00:01:29.320 --> 00:01:36.360 says, it's a study for the League of Nations. I mean, he just shrugged and said, you know, 16 00:01:36.360 --> 00:01:45.360 what can you expect, right? Okay, so the result of the fact that they focus on this survey 17 00:01:45.360 --> 00:01:50.000 by someone who was against the Austrian business cycle theory after maybe a one or two-year 18 00:01:50.000 --> 00:01:55.720 flirtation with it, okay, Gottfried Habler, means that their criticisms are really aimed 19 00:01:55.720 --> 00:02:02.520 at a straw man. Their criticisms really grossly misrepresent the theory. So let me just give 20 00:02:02.520 --> 00:02:08.600 you the gist of their critiques. It's that the Austrian business cycle theory cannot 21 00:02:08.600 --> 00:02:12.600 explain the positive correlation of consumption and investment that occurs over the course 22 00:02:12.600 --> 00:02:29.240 In particular, these criticisms allege that the theory predicts a slump in investment 23 00:02:29.240 --> 00:02:37.680 in capital goods industries during the recession and a corresponding boom in consumer spending 24 00:02:37.680 --> 00:02:39.360 and retail sales during the recession. 25 00:02:39.360 --> 00:02:43.200 In other words, they're saying, well, yeah, there should be a slump in investment, but 26 00:02:43.200 --> 00:02:51.200 there should not be, or according to the Austrians, we should have wildly successful retail industry, 27 00:02:51.200 --> 00:02:54.440 expansion, high profits, which of course we did not. 28 00:02:54.440 --> 00:03:03.600 We had one of the deepest retail slumps since World War II, in this latest financial crisis. 29 00:03:03.600 --> 00:03:08.280 So they therefore conclude that the Austrian business cycle theory is manifestly in conflict 30 00:03:08.280 --> 00:03:15.280 with the stylized facts, as John called them, of the business cycle, and shouldn't be taken seriously, okay? 31 00:03:15.280 --> 00:03:23.280 So my paper basically argues that, rightly understood, the Austrian business cycle theory does account for the unprecedented overconsumption 32 00:03:23.280 --> 00:03:31.280 that we had during the boom, okay? When you would think that resources are leaving the consumption industry and you're having a shrinkage of consumption 33 00:03:31.280 --> 00:03:37.280 and the subsequent retail slump that was observed during the last cycle. 34 00:03:37.280 --> 00:03:44.240 Okay, so let me just put up very quickly two or three quotes by these detractors of the 35 00:03:44.240 --> 00:03:51.160 Austrian business cycle theory, who says, in the beginning an investment boom gets out 36 00:03:51.160 --> 00:03:57.280 of hand, maybe excessive money creation, well how could that be? 37 00:03:57.280 --> 00:04:11.280 And the Fed increased MZM by one billion dollars per day for five years, ending in 2001 through 2005, it's one billion per day. 38 00:04:11.280 --> 00:04:15.280 Or there's an excessive money creation or reckless bank lending drives it. 39 00:04:15.280 --> 00:04:19.280 Maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. 40 00:04:19.280 --> 00:04:24.280 Whatever the reason, all that investment leads to the creation of too much capacity. 41 00:04:24.280 --> 00:04:31.280 Here's the problem, as a matter of simple arithmetic, total spending in the economy is necessarily equal to total income. 42 00:04:31.280 --> 00:04:34.280 Okay, that's not even arithmetic, that's an identity. 43 00:04:34.280 --> 00:04:40.280 Every sale is also a purchase and vice versa. Thank you, Paul. 44 00:04:40.280 --> 00:04:46.280 So if people decide to spend less on the investment goods, doesn't that mean that they must be deciding to spend more on consumption goods? 45 00:04:46.280 --> 00:04:53.280 Implying that an investment slump, meaning the recession, should always be accompanied by a corresponding consumption boom. 46 00:04:53.280 --> 00:05:03.280 And if so, why should there be a rise in unemployment, i.e. the Austrian theory cannot explain the recession, which also drags down the consumption industries, nor can it explain unemployment. 47 00:05:03.280 --> 00:05:05.280 People will be just shifting jobs, according to Krüger. 48 00:05:05.280 --> 00:05:18.280 DeLong says something similar, he also goes on about, you know, it could be a rational exuberance, a fractional reserve banking, they all say the same things, basically. 49 00:05:18.280 --> 00:05:31.280 The second part there, there is generally no period of high unemployment when resources are transferred out of consumption producing sectors into investment goods producing sectors. 50 00:05:31.280 --> 00:05:41.280 So he's saying in the normal course of capital accumulation, we don't get high unemployment when people decide to consume less and invest more. 51 00:05:41.280 --> 00:05:42.280 and more. 52 00:05:42.280 --> 00:05:47.640 There is no necessity of a transfer of resources out of investment goods producing sectors 53 00:05:47.640 --> 00:05:49.800 be accompanied by high unemployment. 54 00:05:49.800 --> 00:05:54.800 The business of shifting resources between sectors is pretty much orthogonal to the business 55 00:05:54.800 --> 00:05:58.280 of maintaining near full employment and proper capacity utilization. 56 00:05:58.280 --> 00:06:01.840 In other words, the Austrian story doesn't make any sense. 57 00:06:01.840 --> 00:06:08.720 Why should we have no unemployment when resources are shifting during the boom toward investment 58 00:06:08.720 --> 00:06:13.240 Goods Industries, but suddenly have unemployment when they're shifting the other way, okay, 59 00:06:13.240 --> 00:06:16.100 he doesn't understand it, okay, well I'll explain that in a moment. 60 00:06:16.100 --> 00:06:24.840 The last is Brian Kaplan, very quickly, he has the most trenching critique, he sums the 61 00:06:24.840 --> 00:06:25.840 whole thing up. 62 00:06:25.840 --> 00:06:30.900 Now they're really criticizing Habler, okay, he says the Austrian theory also suffers from 63 00:06:30.900 --> 00:06:36.440 serious internal consistencies, if as in the Austrian theory, initial consumption investment 64 00:06:36.440 --> 00:06:43.940 Preferences reassert themselves, why don't consumption goods industries enjoy a huge boom during the pressure? 65 00:06:43.940 --> 00:06:51.240 After all, the prices of the capital goods factors are too high, are not the prices of the consumption goods factors too low. 66 00:06:51.240 --> 00:06:57.380 The Austrian theory predicts a decline in employment in some sectors, but an increase in others. 67 00:06:57.380 --> 00:07:02.680 Thus, it does nothing to explain why unemployment is high during the bust and low during the boom. 68 00:07:02.680 --> 00:07:04.240 and I won't go on. 69 00:07:04.240 --> 00:07:08.380 Okay, well what they've done is they've neglected 70 00:07:08.380 --> 00:07:13.380 to read Mises, Rothbard, and I would even argue Hayek, 71 00:07:13.500 --> 00:07:16.620 who's been most closely associated with the idea 72 00:07:16.620 --> 00:07:20.860 that overinvestment is a characteristic of the boom. 73 00:07:20.860 --> 00:07:23.140 In fact, as Mises, Rothbard, and even Hayek, 74 00:07:23.140 --> 00:07:25.260 and I defend Hayek in the paper against some 75 00:07:25.260 --> 00:07:27.820 of Walter, Roger Garrison's criticisms, 76 00:07:27.820 --> 00:07:31.420 even Hayek point out that the characteristic 77 00:07:31.420 --> 00:07:36.220 of the Boehm-Bawerk cycle is malinvestment and overconsumption. During a Boehm you have 78 00:07:36.220 --> 00:07:40.700 overconsumption and malinvestment. And Mises even emphasizes overconsumption more than he 79 00:07:40.700 --> 00:07:47.140 does the malinvestment. 80 00:07:47.140 --> 00:07:54.340 Okay let me just read one short passage by Mises, where he vividly describes the nature 81 00:07:54.340 --> 00:07:59.540 and implications of overconsumption. He says, quote, it would be a serious blunder to neglect 82 00:07:59.540 --> 00:08:05.100 the fact that inflation also generates forces which tend toward capital consumption. One 83 00:08:05.100 --> 00:08:09.980 of its consequences is that it falsifies economic calculation and accounting. It produces the 84 00:08:09.980 --> 00:08:15.340 phenomenon of imaginary or apparent profits. If the rise in the prices of stocks and real 85 00:08:15.340 --> 00:08:22.020 estate is considered as a gain, as every household considered them during our last bubble, the 86 00:08:22.020 --> 00:08:26.540 illusion is no less manifest. What makes people believe that inflation results in general 87 00:08:26.540 --> 00:08:31.780 Prosperity is precisely such illusory gains. They feel lucky and become open-handed in 88 00:08:31.780 --> 00:08:36.860 spending and enjoying life. This is America in the late 1990s, early part of the last 89 00:08:36.860 --> 00:08:42.220 decade. They embellish their homes, they build new mansions, and patronize the entertainment 90 00:08:42.220 --> 00:08:48.820 business. He's writing this in the 1940s. In spending apparent gains, the fanciful result 91 00:08:48.820 --> 00:08:54.380 of false reckoning, they are consuming capital. It does not matter who these spenders are. 92 00:08:54.380 --> 00:09:03.460 Rothbard also emphatically rejected the overinvestment explanation of the Austrian business cycle 93 00:09:03.460 --> 00:09:09.640 theory on essentially the same grounds, referring to it as, quote, a misconception given currency 94 00:09:09.640 --> 00:09:15.340 by Hobbler's famous Prosperity and Depression. Now, Rothbard went on to say, superficially, 95 00:09:15.340 --> 00:09:19.300 it seems that the credit expansion greatly increases capital, for the new money enters 96 00:09:19.300 --> 00:09:24.300 the market as equivalent to new savings for lending. Since the new bank money is apparently 97 00:09:24.300 --> 00:09:29.300 When we add it to the supply of savings on the credit market, businesses can now borrow at a lower rate of interest. 98 00:09:29.300 --> 00:09:34.300 Hence, inflationary credit expansion seems to offer the ideal escape from time preference, 99 00:09:34.300 --> 00:09:37.300 as well as an inexhaustible fount of additional capital. 100 00:09:37.300 --> 00:09:41.300 Actually, this effect is illusory. He uses the same word as Mises. 101 00:09:41.300 --> 00:09:46.300 On the contrary, inflation reduces savings and investments during the boom. 102 00:09:46.300 --> 00:09:51.300 It may even cause large-scale capital consumption. 103 00:09:51.300 --> 00:10:21.300 Inflation therefore tricks the businessman. It destroys one of his main signposts and leads him to believe that he has gained extra profits when he is just able to replace capital. Hence, he will undoubtedly be tempted to consume out of these profits and thereby unwittingly consume capital as well. Thus, inflation tends at once to repress saving investment and to cause consumption of capital. 104 00:10:21.300 --> 00:10:27.000 Theoretically, but I also collect a lot of data to show that, in fact, we had an enormous 105 00:10:27.000 --> 00:10:32.780 amount of overconsumption during the boom, which destroyed capital. 106 00:10:32.780 --> 00:10:36.580 And that allowed us to live high off the hog, so to speak. 107 00:10:36.580 --> 00:10:42.060 So we had a seeming increase in capital goods, which was illusory, and at the same time, 108 00:10:42.060 --> 00:10:48.500 we were destroying our wealth, we were destroying capital by overconsumption of houses and using 109 00:10:48.500 --> 00:10:57.500 What I want to show you is a few slides on the extent of this. 110 00:10:57.500 --> 00:11:07.500 Let me just get to the household net worth, which is very interesting. 111 00:11:07.500 --> 00:11:11.500 So, household net worth during this period, 112 00:11:11.500 --> 00:11:15.500 Okay, I have the figures here, so 113 00:11:15.500 --> 00:11:19.500 So, basically net worth consists 114 00:11:19.500 --> 00:11:23.500 of the value of financial assets and the value of real estate 115 00:11:23.500 --> 00:11:27.500 minus the debt that households carry. So, 116 00:11:27.500 --> 00:11:31.500 they boosted household net worth, these rising prices, by over 23 trillion dollars 117 00:11:31.500 --> 00:11:35.500 during the three years from 2003 118 00:11:35.500 --> 00:11:43.500 2006. This drove the ratio of household net worth to annual GDP to well over 450 percent. 119 00:11:43.500 --> 00:11:51.500 Now, since 1952, household net worth has been about three and a half, between three and 120 00:11:51.500 --> 00:11:58.060 three and a half times of total income, household income. Look what happens first in the late 121 00:11:58.060 --> 00:12:04.660 90s with the high-tech bubble and then in the early part of the last decade, okay? It 122 00:12:04.660 --> 00:12:12.780 shoots up to over four and a half times of household income, meaning that households 123 00:12:12.780 --> 00:12:18.860 now feel that, look, my pension fund has gone up, the value of my house has gone up, I don't 124 00:12:18.860 --> 00:12:22.660 have to save as much, so saving rates decline to less than one percent. 125 00:12:22.660 --> 00:12:27.100 As a result of this, they spent, they used their houses as ATM machines, okay? 126 00:12:27.100 --> 00:12:30.540 They took out home equity loans and so on. 127 00:12:30.540 --> 00:12:34.500 And I show also, and I'm not going to show that here, an enormous retail boom. 128 00:12:34.500 --> 00:12:42.180 The biggest retail boom that we've had since the 1960-61 recession, I have statistics on 129 00:12:42.180 --> 00:12:43.180 that. 130 00:12:43.180 --> 00:12:49.180 Let me just go on though and show, all right, so that just shows you sort of the retail 131 00:12:49.180 --> 00:12:52.140 boom and then the bust. 132 00:12:52.140 --> 00:12:58.620 The personal savings rate falling below 1% by 2005, and then shooting up, which is what 133 00:12:58.620 --> 00:13:28.620 This is the Wilshire 5,000 index. Despite its name, it includes over 6,000 firms that are incorporated in the US and what's happened with that index is that it's risen from, if you look at the end of the 20th century, 134 00:13:28.620 --> 00:13:34.180 In the 2000-2001 recession when things were corrected, it was around 8,000. 135 00:13:34.180 --> 00:13:41.060 It added almost 8 trillion dollars of capitalization to firms. 136 00:13:41.060 --> 00:13:46.620 So it looked as if our capital has increased tremendously, but did really the productivity 137 00:13:46.620 --> 00:13:50.600 of the U.S. economy double in five years? 138 00:13:50.600 --> 00:13:52.920 Of course not. 139 00:13:52.920 --> 00:14:00.160 What happened was, eventually, this false prosperity, these illusory gains, were revealed 140 00:14:00.160 --> 00:14:04.680 by the collapse in the stock market and the collapse in real estate prices. 141 00:14:04.680 --> 00:14:09.360 So that if you now look, it touched around 8,000 before we started with the quantitative 142 00:14:09.360 --> 00:14:14.480 easing, and now it's fluctuating around 12,000. 143 00:14:14.480 --> 00:14:18.840 That level was first reached in the 1990s. 144 00:14:18.840 --> 00:14:19.920 What does that tell you? 145 00:14:19.920 --> 00:14:26.800 Now, Fed economists use this as a proxy for the wealth of a nation. 146 00:14:26.800 --> 00:14:32.680 It basically tells you that we have had no capital accumulation since the mid-90s. 147 00:14:32.680 --> 00:14:37.880 That everything that we were accumulating was destroyed during those bubbles, during 148 00:14:37.880 --> 00:14:40.480 the overconsumption in those bubbles. 149 00:14:40.480 --> 00:14:51.880 So what I hope to show in this paper is that in fact the consumption boom and then the 150 00:14:51.880 --> 00:15:00.960 consumption bust, the contraction of consumption that we're seeing, this so-called co-movement 151 00:15:00.960 --> 00:15:07.480 actually reinforces the Austrian business cycle theory, when it's rightly understood. 152 00:15:07.480 --> 00:15:15.480 Again, it's malinvestment. There are no new capitals being produced during the boom. They're just dead ends. 153 00:15:15.480 --> 00:15:20.480 And at the same time, capital is actually being destroyed during the boom. 154 00:15:20.480 --> 00:15:31.480 So we are impoverished when all of this comes to a head and prices are then, again, free to reflect the true state of scarcity in our economy. 155 00:15:31.480 --> 00:15:42.480 To go back for a moment, I am even suspicious that going from 8,000 to 12,000 reflects true wealth. 156 00:15:42.480 --> 00:15:47.480 It's probably lower. We probably are much poorer than is being reflected today. 157 00:15:47.480 --> 00:15:54.480 I'll stop there. Thank you. Would I have two minutes? 158 00:15:54.480 --> 00:16:10.200 The Austrian business cycle theory, as originally formulated, does explain the asymmetry between 159 00:16:10.200 --> 00:16:12.340 the boom and bust phases of the cycle. 160 00:16:12.340 --> 00:16:16.720 The malinvestment and overconsumption that occurred during the inflationary boom caused 161 00:16:16.720 --> 00:16:21.040 a shattering of the production structure that accounts for the pervasive unemployment 162 00:16:21.040 --> 00:16:24.480 and impoverishment that is observed during the recession. 163 00:16:24.480 --> 00:16:29.640 The production structure must be painstakingly pieced back together again in a new pattern 164 00:16:29.640 --> 00:16:34.480 because the intertemporal preferences of consumers have changed radically due to the redistribution 165 00:16:34.480 --> 00:16:37.960 and losses of income and wealth incurred during the inflation. 166 00:16:37.960 --> 00:16:39.640 This of course takes time. 167 00:16:39.640 --> 00:16:43.480 In addition, the recession adjustment process is further prolonged by the fact that the 168 00:16:43.480 --> 00:16:50.040 boom has wreaked havoc with monetary calculation, the very moorings of the market economy. 169 00:16:50.040 --> 00:16:55.240 have discovered that their spectacular successes during the boom were merely a prelude to 170 00:16:55.240 --> 00:17:01.500 a sudden and profound failure of their forecasts and calculations to be realized. Until they 171 00:17:01.500 --> 00:17:06.360 have regained confidence in their forecasting abilities and the reliability of economic 172 00:17:06.360 --> 00:17:12.600 calculation, they will be understandably averse to initiating risky ventures that appear profitable. 173 00:17:12.600 --> 00:17:17.320 But if the market is permitted to work, this entrepreneurial malaise, now I'm actually 174 00:17:17.320 --> 00:17:24.320 There is a grain of truth in Keynes, this whole idea of animal spirits and entrepreneurs becoming depressed. 175 00:17:24.320 --> 00:17:28.320 But they become depressed because not only has the structure of production been shattered, 176 00:17:28.320 --> 00:17:33.320 but monetary calculation has been shattered during the boom. 177 00:17:33.320 --> 00:17:40.320 And you don't get that when you take the hobbler version of the Austrian theory. 178 00:17:40.320 --> 00:17:44.320 So what we're in now is the secondary deflation. 179 00:17:44.320 --> 00:18:14.320 Secondary deflation is a result of the fact, as Mises points out, it's not because demand for money has increased, rather it's the other way around, because of all the government interventions that is preventing the adjustment of wages and other costs and of asset prices, you get diminishing of the prospects for profitability, you have depressed entrepreneurs, pessimistic entrepreneurs, and until they see a rise in the natural interest rate, until they see a big fall in costs in relation to prices, 180 00:18:14.320 --> 00:18:18.560 You are not going to get the economy being regenerated. 181 00:18:18.560 --> 00:18:22.640 So it's not low interest rates that causes economic recovery. 182 00:18:22.640 --> 00:18:26.560 It's high interest rates. It's sky-high interest rates reflecting the pessimism. 183 00:18:26.560 --> 00:18:32.960 Because sky-high interest rates reflects the fact that we now have a huge gap between costs and prices. 184 00:18:32.960 --> 00:18:35.200 And that's when the entrepreneurs jump in. 185 00:18:35.200 --> 00:18:40.320 So I actually have in my paper a sort of a new theory of the secondary deflation, 186 00:18:40.320 --> 00:18:45.320 which I sort of teased out of Mises and Hayek also, okay. 187 00:18:48.040 --> 00:18:50.520 All right, so in fact, I'll just conclude with that. 188 00:18:50.520 --> 00:18:52.280 The mislabeled secondary deflation, 189 00:18:52.280 --> 00:18:55.120 whether or not it is accompanied by monetary contraction, 190 00:18:55.120 --> 00:18:56.640 and this one has not been, 191 00:18:56.640 --> 00:18:58.400 is an integral part of the adjustment process. 192 00:18:58.400 --> 00:19:00.880 We need the secondary deflation, properly defined. 193 00:19:01.800 --> 00:19:03.400 It is a prerequisite for the renewal 194 00:19:03.400 --> 00:19:05.920 of entrepreneurial boldness and the restoration 195 00:19:05.920 --> 00:19:08.240 of confidence in monetary calculation. 196 00:19:08.240 --> 00:19:13.420 Decisions by banks and capitalist entrepreneurs to hold rather than lend or invest a portion 197 00:19:13.420 --> 00:19:18.040 of their accumulated savings in employing the factors of production and the corresponding 198 00:19:18.040 --> 00:19:22.720 rise of the loan and natural rates above the estimated true time preference rate does not 199 00:19:22.720 --> 00:19:27.640 impede but speeds up the economy. This implies, of course, that any political attempt to arrest 200 00:19:27.640 --> 00:19:32.800 or reverse the decline in factor and asset prices through monetary manipulations or fiscal 201 00:19:32.800 --> 00:19:38.000 stimulus programs will retard or derail the recession adjustment process. And that's what 202 00:19:38.000 --> 00:19:45.000 has happened. Thank you.