My paper is a reformulation of the Austrian business cycle theory in light of the financial crisis.
And let me just read you a very short statement of the thesis of my paper.
Some, as we know, some prominent mainstream economists have not really responded kindly
to the sudden resurgence of interest in the Austrian business cycle theory.
Krugman and DeLong and even some lesser Keynesians like Brian Kaplan and Tyler Cowan at GMU have criticized it.
But rather than openly subjecting the theory to rigorous scholarly analysis in the standard research forums of academic journals and professional conferences,
they have sniped at the theory on blog sites and in the popular press.
Furthermore, in their haste to find flaws in the theory, they have disregarded the works
of its originators and leading proponents, Ludwig von Mises, Friedrich Hayek, and Murray
Rothbard. Instead, they have drawn upon a sole or solitary secondary source that portrays
the Austrian business cycle theory as a monetary overinvestment theory. The theory is thus
described this way in the influential survey of business cycle theories that was published
under the auspices of the League of Nations in 1937 by Gottfried Habeler, and this is
called Prosperity and Depression. When Mises was asked what he thought of this book, Mises
says, it's a study for the League of Nations. I mean, he just shrugged and said, you know,
what can you expect, right? Okay, so the result of the fact that they focus on this survey
by someone who was against the Austrian business cycle theory after maybe a one or two-year
flirtation with it, okay, Gottfried Habler, means that their criticisms are really aimed
at a straw man. Their criticisms really grossly misrepresent the theory. So let me just give
you the gist of their critiques. It's that the Austrian business cycle theory cannot
explain the positive correlation of consumption and investment that occurs over the course
In particular, these criticisms allege that the theory predicts a slump in investment
in capital goods industries during the recession and a corresponding boom in consumer spending
and retail sales during the recession.
In other words, they're saying, well, yeah, there should be a slump in investment, but
there should not be, or according to the Austrians, we should have wildly successful retail industry,
expansion, high profits, which of course we did not.
We had one of the deepest retail slumps since World War II, in this latest financial crisis.
So they therefore conclude that the Austrian business cycle theory is manifestly in conflict
with the stylized facts, as John called them, of the business cycle, and shouldn't be taken seriously, okay?
So my paper basically argues that, rightly understood, the Austrian business cycle theory does account for the unprecedented overconsumption
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
and the subsequent retail slump that was observed during the last cycle.
Okay, so let me just put up very quickly two or three quotes by these detractors of the
Austrian business cycle theory, who says, in the beginning an investment boom gets out
of hand, maybe excessive money creation, well how could that be?
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.
Or there's an excessive money creation or reckless bank lending drives it.
Maybe it is simply a matter of irrational exuberance on the part of entrepreneurs.
Whatever the reason, all that investment leads to the creation of too much capacity.
Here's the problem, as a matter of simple arithmetic, total spending in the economy is necessarily equal to total income.
Okay, that's not even arithmetic, that's an identity.
Every sale is also a purchase and vice versa. Thank you, Paul.
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?
Implying that an investment slump, meaning the recession, should always be accompanied by a corresponding consumption boom.
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.
People will be just shifting jobs, according to Krüger.
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.
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.
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.
and more.
There is no necessity of a transfer of resources out of investment goods producing sectors
be accompanied by high unemployment.
The business of shifting resources between sectors is pretty much orthogonal to the business
of maintaining near full employment and proper capacity utilization.
In other words, the Austrian story doesn't make any sense.
Why should we have no unemployment when resources are shifting during the boom toward investment
Goods Industries, but suddenly have unemployment when they're shifting the other way, okay,
he doesn't understand it, okay, well I'll explain that in a moment.
The last is Brian Kaplan, very quickly, he has the most trenching critique, he sums the
whole thing up.
Now they're really criticizing Habler, okay, he says the Austrian theory also suffers from
serious internal consistencies, if as in the Austrian theory, initial consumption investment
Preferences reassert themselves, why don't consumption goods industries enjoy a huge boom during the pressure?
After all, the prices of the capital goods factors are too high, are not the prices of the consumption goods factors too low.
The Austrian theory predicts a decline in employment in some sectors, but an increase in others.
Thus, it does nothing to explain why unemployment is high during the bust and low during the boom.
and I won't go on.
Okay, well what they've done is they've neglected
to read Mises, Rothbard, and I would even argue Hayek,
who's been most closely associated with the idea
that overinvestment is a characteristic of the boom.
In fact, as Mises, Rothbard, and even Hayek,
and I defend Hayek in the paper against some
of Walter, Roger Garrison's criticisms,
even Hayek point out that the characteristic
of the Boehm-Bawerk cycle is malinvestment and overconsumption. During a Boehm you have
overconsumption and malinvestment. And Mises even emphasizes overconsumption more than he
does the malinvestment.
Okay let me just read one short passage by Mises, where he vividly describes the nature
and implications of overconsumption. He says, quote, it would be a serious blunder to neglect
the fact that inflation also generates forces which tend toward capital consumption. One
of its consequences is that it falsifies economic calculation and accounting. It produces the
phenomenon of imaginary or apparent profits. If the rise in the prices of stocks and real
estate is considered as a gain, as every household considered them during our last bubble, the
illusion is no less manifest. What makes people believe that inflation results in general
Prosperity is precisely such illusory gains. They feel lucky and become open-handed in
spending and enjoying life. This is America in the late 1990s, early part of the last
decade. They embellish their homes, they build new mansions, and patronize the entertainment
business. He's writing this in the 1940s. In spending apparent gains, the fanciful result
of false reckoning, they are consuming capital. It does not matter who these spenders are.
Rothbard also emphatically rejected the overinvestment explanation of the Austrian business cycle
theory on essentially the same grounds, referring to it as, quote, a misconception given currency
by Hobbler's famous Prosperity and Depression. Now, Rothbard went on to say, superficially,
it seems that the credit expansion greatly increases capital, for the new money enters
the market as equivalent to new savings for lending. Since the new bank money is apparently
When we add it to the supply of savings on the credit market, businesses can now borrow at a lower rate of interest.
Hence, inflationary credit expansion seems to offer the ideal escape from time preference,
as well as an inexhaustible fount of additional capital.
Actually, this effect is illusory. He uses the same word as Mises.
On the contrary, inflation reduces savings and investments during the boom.
It may even cause large-scale capital consumption.
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.
Theoretically, but I also collect a lot of data to show that, in fact, we had an enormous
amount of overconsumption during the boom, which destroyed capital.
And that allowed us to live high off the hog, so to speak.
So we had a seeming increase in capital goods, which was illusory, and at the same time,
we were destroying our wealth, we were destroying capital by overconsumption of houses and using
What I want to show you is a few slides on the extent of this.
Let me just get to the household net worth, which is very interesting.
So, household net worth during this period,
Okay, I have the figures here, so
So, basically net worth consists
of the value of financial assets and the value of real estate
minus the debt that households carry. So,
they boosted household net worth, these rising prices, by over 23 trillion dollars
during the three years from 2003
2006. This drove the ratio of household net worth to annual GDP to well over 450 percent.
Now, since 1952, household net worth has been about three and a half, between three and
three and a half times of total income, household income. Look what happens first in the late
90s with the high-tech bubble and then in the early part of the last decade, okay? It
shoots up to over four and a half times of household income, meaning that households
now feel that, look, my pension fund has gone up, the value of my house has gone up, I don't
have to save as much, so saving rates decline to less than one percent.
As a result of this, they spent, they used their houses as ATM machines, okay?
They took out home equity loans and so on.
And I show also, and I'm not going to show that here, an enormous retail boom.
The biggest retail boom that we've had since the 1960-61 recession, I have statistics on
that.
Let me just go on though and show, all right, so that just shows you sort of the retail
boom and then the bust.
The personal savings rate falling below 1% by 2005, and then shooting up, which is what
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,
In the 2000-2001 recession when things were corrected, it was around 8,000.
It added almost 8 trillion dollars of capitalization to firms.
So it looked as if our capital has increased tremendously, but did really the productivity
of the U.S. economy double in five years?
Of course not.
What happened was, eventually, this false prosperity, these illusory gains, were revealed
by the collapse in the stock market and the collapse in real estate prices.
So that if you now look, it touched around 8,000 before we started with the quantitative
easing, and now it's fluctuating around 12,000.
That level was first reached in the 1990s.
What does that tell you?
Now, Fed economists use this as a proxy for the wealth of a nation.
It basically tells you that we have had no capital accumulation since the mid-90s.
That everything that we were accumulating was destroyed during those bubbles, during
the overconsumption in those bubbles.
So what I hope to show in this paper is that in fact the consumption boom and then the
consumption bust, the contraction of consumption that we're seeing, this so-called co-movement
actually reinforces the Austrian business cycle theory, when it's rightly understood.
Again, it's malinvestment. There are no new capitals being produced during the boom. They're just dead ends.
And at the same time, capital is actually being destroyed during the boom.
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.
To go back for a moment, I am even suspicious that going from 8,000 to 12,000 reflects true wealth.
It's probably lower. We probably are much poorer than is being reflected today.
I'll stop there. Thank you. Would I have two minutes?
The Austrian business cycle theory, as originally formulated, does explain the asymmetry between
the boom and bust phases of the cycle.
The malinvestment and overconsumption that occurred during the inflationary boom caused
a shattering of the production structure that accounts for the pervasive unemployment
and impoverishment that is observed during the recession.
The production structure must be painstakingly pieced back together again in a new pattern
because the intertemporal preferences of consumers have changed radically due to the redistribution
and losses of income and wealth incurred during the inflation.
This of course takes time.
In addition, the recession adjustment process is further prolonged by the fact that the
boom has wreaked havoc with monetary calculation, the very moorings of the market economy.
have discovered that their spectacular successes during the boom were merely a prelude to
a sudden and profound failure of their forecasts and calculations to be realized. Until they
have regained confidence in their forecasting abilities and the reliability of economic
calculation, they will be understandably averse to initiating risky ventures that appear profitable.
But if the market is permitted to work, this entrepreneurial malaise, now I'm actually
There is a grain of truth in Keynes, this whole idea of animal spirits and entrepreneurs becoming depressed.
But they become depressed because not only has the structure of production been shattered,
but monetary calculation has been shattered during the boom.
And you don't get that when you take the hobbler version of the Austrian theory.
So what we're in now is the secondary deflation.
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,
You are not going to get the economy being regenerated.
So it's not low interest rates that causes economic recovery.
It's high interest rates. It's sky-high interest rates reflecting the pessimism.
Because sky-high interest rates reflects the fact that we now have a huge gap between costs and prices.
And that's when the entrepreneurs jump in.
So I actually have in my paper a sort of a new theory of the secondary deflation,
which I sort of teased out of Mises and Hayek also, okay.
All right, so in fact, I'll just conclude with that.
The mislabeled secondary deflation,
whether or not it is accompanied by monetary contraction,
and this one has not been,
is an integral part of the adjustment process.
We need the secondary deflation, properly defined.
It is a prerequisite for the renewal
of entrepreneurial boldness and the restoration
of confidence in monetary calculation.
Decisions by banks and capitalist entrepreneurs to hold rather than lend or invest a portion
of their accumulated savings in employing the factors of production and the corresponding
rise of the loan and natural rates above the estimated true time preference rate does not
impede but speeds up the economy. This implies, of course, that any political attempt to arrest
or reverse the decline in factor and asset prices through monetary manipulations or fiscal
stimulus programs will retard or derail the recession adjustment process. And that's what
has happened. Thank you.