by Mario Rizzo

There has been a lively debate on forecasts of high inflation made by those worried about the Fed’s recent policy of quantitative easing. For details I refer the reader to Daniel Kuehn’s excellent blog. The question to which I address myself is solely “What do these predictions have to do with core Austrian Business Cycle Theory?” This is my answer.

We must start with a few general points. First, I am talking about the Austro-Wicksellian business cycle theory as developed by Friedrich Hayek and Ludwig von Mises and as synthesized by Roger Garrison in his book Time and Money. I cannot take responsibility for versions constructed by others. It is not that I think the others are necessarily wrong (and I mean no disrespect to them), but I do not know with sufficient precision what all these others are saying in the name of “Austrian theory.”

Secondly, the Austro-Wicksellian theory begins with either an endogenous increase in credit through the banking system or with an “exogenous” increase initiated by a central bank. In the latter case, however, the theory itself has little to say about the extent to which increases in base money will manifest themselves in increases in bank credit to producers. (This may not be much of an issue during a boom but may be an issue during a recession or in a recovery.)

Third, the theory is fundamentally one about the “upper turning point” in the cycle – it is a theory about why a credit-induced boom must come to an end. It is not a theory, for better or worse, about the “secondary” factors that develop consequent on the break-up of the boom. These include possible recessionary-problems relating to bank runs (there is an Austrian inspired banking literature, but that is not the cycle theory) or what exactly will get investment expectations to turn around. As to deflation, Lawrence White has argued that the logic of the theory requires the avoidance of deflation in accordance with Hayek’s very early recommendation to keep M V from falling. (Hayek departed from this in the Depression, and later admitted he was incorrect to do so.)

Now to more specific points:

The Austrian theory rests, not on a catalyzing effect of core inflation or headline inflation, but on changes in relative prices that cause resources to be allocated in ultimately unsustainable ways. The Great Depression was not preceded by much inflation because productivity improvements allowed for increases in bank credit without increasing (by much) the price level. Hayek said repeatedly that the price level aggregate can hide the distortions basic to the cycle.

This point is especially important in the early stages of recovery when there is so much unused capacity and previous investment pessimism that expansions in bank credit (not meaning base money) may be returning to sustainable levels and inflation in the usual sense is unlikely. Nevertheless, as the recovery proceeds, there is a danger that maintenance of low interest rates by the central bank for long periods can induce a distorted character of investment, even as the total amount of investment measured throughout the economy has not recovered.

The important point is that, for Hayek, investment is not a homogeneous phenomenon. It matters where the investment is (that is, stages farther from or nearer to consumption). Not all investment should be analogized to simple inventory investment.

The policy-relevant point is that if the central bank decides not to allow interest rates to rise until aggregate investment has recovered to boom levels, it will have waited too long. The character of the investment will be distorted. Malinvestments will set in – even without inflation.

I do not think that the Austrian theory says anything unique about inflation – in the sense of increases in the aggregate price level – beyond the warning that aggregates of this sort can conceal the theoretically-relevant magnitudes for understanding business cycles.

Whether inflation precedes the upper turning point or whether it is unleashed in an effort to induce recovery is not what the Austro-Wicksellian theory is about. This is not to say that there are not compatible theories that can supplement the core theory at these points. But these are not the Austrian theory of the business cycle as Hayek, Mises, Garrison and I conceive it. (There are many others as well, but I am being extremely cautious here in not dealing with “all” that is out there.)

Finally, a point on forecasting: Most macro-monetary economists do not test their theories by making literal forecasts of future macroeconomic aggregates. What economists call “prediction” is really retrodiction or explanation of past events. The difference is crucial. All models treat important events or actions as exogenous. They do not forecast, for example, whether Ben Bernanke will die, whether he will be replaced by Brad DeLong, whether the politicians will agree on a new budget, and so forth. All of these could have a big effect on future macro-aggregates. Furthermore, most economists are happy if the model gets the direction of change correct (the sign of the variable). Making good numerical predictions has not been the forte of economists – let alone making good numerical forecasts.

Economists usually content themselves with a more modest form of testing. I see no reason to make an exception for a theory simply because it is disliked by certain economists.