Tags

Among the great contributions of Austrian economic theory, Austrian business-cycle theory (ABCT) explains the previously inexplicable reoccurring boom-bust cycles experienced throughout economic history. By increasing the supply of money through loans in excess of savings, banks lower interest rates, sending a false signal that tricks investors into making expansive long-term investments unjustified by the supply of savings. After interest rates rise and prices in the economy adjust to the new supply of money, these investments experience widespread losses — a collection of errors that send the economy into a recession. Through ABCT, Austrian economists have a clear and compelling explanation of the boom-bust cycle.[1]

Of the many critiques of ABCT, rational-expectations theory provides one of the most cogent arguments. According to this view, ABCT could possibly explain the first boom-bust in history, and it could perhaps explain the next few. Nevertheless, it could not continue to explain its reoccurring nature for hundreds of years because market participants would learn to respond rationally to bank-credit expansions rather than continually fall prey to the same trick. Instead of continuing to make the same mistake over and over again, individuals would alter their actions in response to the reoccurring governmental interventions, preventing them from falling for the same trick repeatedly.

A large variety of critics with very different economic views have responded to ABCT along these lines. For example, Gordon Tullock, Bryan Caplan, Tyler Cowen, John Quiggin, and Matt Yglesias, among others, have criticized ABCT for allegedly ignoring rational expectations. For a representative defense of this position in the words of one of its proponents, Bryan Caplan remarked,

Since the central bank's inflation cannot continue indefinitely, it is eventually necessary to let interest rates rise back to the natural rate, which then reveals the underlying unprofitability of the artificially stimulated investments. The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account. In short, the Austrians are assuming that entrepreneurs have strange irrational expectations.… The ABC requires bizarre assumptions about entrepreneurial stupidity in order to work: in particular, it must assume that businesspeople blindly use current interest rates to make investment decisions. (emphasis in original)

At a glance, this critique seems to have a lot of merit. If anything, the thoughtful criticism of ABCT from Caplan and other proponents of rational expectations makes too limited of an argument, confining it to a subset of economic actors whose rational expectations should in their view deter business cycles. In particular, they confine their inquiry to entrepreneurs who borrow money from banks, declaring that they would not be tricked repeatedly. In contrast, they should broaden their fundamental question: Why don't the rational expectations of economic actors in general negate the significance of ABCT?

To respond to this broader critique, as well as its subset, we will divide economic actors into three general categories: bankers, speculators, and entrepreneurs. For the purposes of this essay, we will define bankers as individuals who loan money at a rate of interest,[2] speculators as individuals who buy and sell existing products with the intent to make money through price differences over place and time, and entrepreneurs as the individuals who attempt to coordinate production based on their expectations of future demand. As will be shown below, rather than ending the significance of ABCT, economic actors within any of these three categories rationally responding to knowledge of ABCT will exacerbate the boom-bust cycle.

Bankers

Curiously, although the banking sector itself appears to be the natural starting place for inquiring about the effects of rational expectations on ABCT, the supporters of rational expectations rarely address the question of why bankers would loan the money in the first place. If bankers would simply rationally expect that easy credit results in widespread malinvestments that punish the bankers through the associated losses, then the business cycle would not occur. Why do the rational expectations of bankers fail to prevent them from loaning easy credit in the first place?

In his excellent book What Has Government Done to Our Money?, Murray Rothbard provides a lucid account of how government interventions in the banking sector have developed.[3] As explained by Rothbard, the government over time removed the natural checks on inflation within the banking sector, eliminating the free-market regulations that would otherwise restrain easy credit. Among the many governmental interventions into the banking sector important in relation to rational expectations, the government allowed banks to ignore their contractual obligations via "bank holidays," created a central bank as a lender of last resort that manages inflation, and created the Federal Deposit Insurance Company (FDIC) to insure deposits at banks.[4] All of these interventions reduced the risks of easy credit, enabling for bankers to provide it without fear of its consequences.

By instituting bank holidays since the War of 1812, the federal government trained bankers to expect rationally the existence of future bank holidays, convincing them that expanding credit would be a safe venture protected by the government. Whereas the strict enforcement of contractual obligations would have resulted in the bankruptcies of banks that had significantly expanded credit and would have taught bankers to be cautious when expanding credit, the instituting of bank holidays ingrained the opposite rational expectation, leading to greater credit expansions as time passed. Bank holidays convinced bankers to expand credit more recklessly, knowing full well that the government would institute bank holidays when needed.

Further expanding the impetus for easy credit, the creation of the Federal Reserve in 1913 constructed a federal agency designed to manage inflation through the banking system while acting as a lender of last resort. Prior to the Federal Reserve, banks with tighter credit checked banks with easier credit by redeeming the notes of the easy-credit banks, necessarily restraining the volume of loans that banks could make in excess of the amount of liquid cash they had. By institutionalizing a banking cartel, the Federal Reserve ended this free-market regulation, transforming banks into cooperating inflationary agents. Additionally, by acting as a lender of last resort, the Federal Reserve provided banks direct access to money in case of emergencies, continuing to remove concerns bankers had of a lack of liquidity. Primarily for these two reasons, the formation of the Fed continued to mold the rational expectations of bankers so that they would not concern themselves with the bust phase of the business cycle.

With the creation of the FDIC, the federal government removed one of the final free-market checks on the banking sector, eliminating most of the remaining inhibitions of bankers. Prior to the FDIC, bankers needed to maintain sufficiently large reserves so as to maintain the confidence of depositors. If a bank ever lost their confidence, then it would suffer from a bank run, leading to the bankruptcy of the bank. Bank runs acted as a powerful check on the credit expansion of banks. Following the formation of the FDIC, depositors were ensured that any banking problems would not affect them. Banks no longer had to fear bank runs, enabling them to expand credit further without this fear.

As Rothbard explained, these measures taught bankers that the government would protect them from problems associated with easy credit. Due to special governmental privileges and through bailouts from the Fed, bankers learned to expect rationally that they would receive the benefits of easy credit while being protected from the costs.

Since the publication of Rothbard's book, the governmental interventions have only expanded. In particular, the federal government has deemed entities "too big to fail" and shown a willingness to bail them out. For example, the federal government bailed out Amtrak and New York City in the 1970s, savings-and-loans institutions in the '80s, Long-Term Capital Management (LTCM) in the '90s, and most recently American International Group (AIG), the large automobile companies, and the largest banks that made poor and reckless investment decisions. As long as a company is large enough, employs enough people, relates significantly to the financial system, or in some way qualifies as "too big to fail," the federal government has clearly signaled that it will bail it out in hard times. The largest banks now know that their profits can be privatized and their losses can be socialized, removing the checks associated with risk and creating perverse incentives among bankers.

Given this structure, how would bankers who believe ABCT rationally react? Due to the combination of a removal of the checks on easy credit and the socializing of any large losses, the rational expectations of bankers incentivize them to expand easy credit with neither fear of any of the free market checks on this expansion nor significant concern of the risks associated with the investments. In fact, bankers who believed ABCT would exacerbate the recession since they would know that they would receive very large short-term profits during the boom without having to suffer from the socialized long-term losses during the bust. By insulating bankers from the costs of easy credit, the federal government has created an institutional structure within which bankers reap large rewards for expanding and profiting from the boom phase of the business cycle.

Speculators

In a free society devoid of a trade cycle, speculators serve very important social purposes. By buying undervalued resources or shorting overvalued resources, speculators alter prices to reflect future consumer preferences better. Due to the actions of speculators, these new prices communicate information to entrepreneurs, helping them expand or contract production in line with future demand and thus assisting them in producing the most valuable products for society. Despite the condemnations they often receive for "villainously" driving up prices to the harm of honest Americans or of benefiting from downturns through the "malicious" process of short selling, speculators aid greatly in coordinating production over time in line with consumer demand, making their services a nearly indispensable prerequisite of a prosperous society.[5]

Despite the benefits of speculators in a society without a central bank or fractional-reserve banking, speculators who know ABCT exacerbate the malinvestments that occur during booms, fueling larger and worse bubbles. A speculator aware of ABCT would know to focus closely on the interest rates and the supply of money, noting that a rapid increase in the supply of money in the form of loans along with artificially low interest rates create bubbles in the sectors that the newly created money enters. With this rational expectation that a bubble will form, a speculator will speculate in the bubble sector, further driving up the prices of that sector. For example, by predicting in advance that a bubble would form in housing, a speculator would invest more in housing, further increasing the prices of housing and the profitability of housing construction. Rather than attempt to deter the bubble by shorting the sector that experiences malinvestments, speculators would realize the potential for profits in the booming sectors of the economy and act accordingly, expanding the bubble. Therefore, due to the easy-credit-induced separation of profits from consumer demand, the pursuit of profits by speculators during a boom increases the malinvestments in the economy.

Whereas the rational expectations of bankers lead them to create bubbles due to the laws that reduce or eliminate various risks to them, speculators aware of ABCT in an economy experiencing a boom naturally pursue profits in the booming sectors, needing no additional institutional incentives to make money. Unlike bankers, whose rational expectations exacerbate bubbles due to the institutional framework within which they invest, speculators who act based on their knowledge of ABCT inherently exacerbate bubbles. Far from irrational, the expectations-induced actions of these speculators represent rational exuberance.

Interestingly, though speculators primarily receive rampant condemnations from society during the bust phase of the trade cycle, the much-needed actions of speculators during the bust phase greatly aid the economy. While speculators with knowledge of ABCT exacerbate booms by expanding them, these same speculators expedite busts by quickly realizing which sectors experienced malinvestments and shorting those sectors, sending signals to entrepreneurs to reduce production in those sectors. Therefore, during the bust phase when economic resources need to be reallocated, speculators who quickly realize the presence of widespread malinvestments necessarily promote a quicker and less painful economic recovery. Paradoxically, speculators receive praise (or at least not condemnations) when they harm the economy during booms and condemnations when they aid the economy during busts, directly contrasting with their contributions to a prosperous economy.

Entrepreneurs

Unlike bankers and speculators, entrepreneurs repeatedly engaging in a collection of errors seems to contrast starkly with the view that entrepreneurs are those best able to predict the future. As both Ludwig von Mises and Rothbard repeatedly stated, the market process acts as a testing ground for entrepreneurial talent, with those best able to predict future demand rewarded with profits and those least able punished with losses. In the words of Rothbard,

Profits and losses … perform the function of getting money out of the hands of the bad entrepreneurs and into the hands of the good ones. The fact that good entrepreneurs prosper and add to their capital, and poor ones are driven out, insures an ever smoother market adjustment to changes in conditions.[6]

Given that entrepreneurs represent the class of individuals trained to study market phenomena and predict future demand, it does seem at first unlikely that they would continually make the same mistakes in response to artificially low interest rates and an expansion of easy credit.

Indeed, among other reasons, this realization led Rothbard to reject Joseph Schumpeter's seemingly appealing theory of the business cycle. In Schumpeter's view, the business cycle ensued from new technology replacing old technology over time with bursts of technological innovation causing booms and the end of that innovative burst resulting in a bust, a process he termed creative destruction. Among other problems with this business-cycle theory, Rothbard notes that it fails to explain the cluster of errors. Simply put, why don't entrepreneurs predict the changing states of technology and invest accordingly? As Schumpeter has no convincing reason to explain this lack of foresight among the class of individuals trained in foreseeing future demand, Rothbard correctly concludes that Schumpeter's theory inadequately explains the business cycle.[7]

Whereas Schumpeter had no reason to explain why entrepreneurs should continually make the same mistakes related to innovations, Austrian economists have determined two very compelling reasons to explain why the boom-bust cycle continues despite (or because of) the rational expectations of entrepreneurs. Firstly, the artificially low interest rates create a Nash equilibrium in which the dominant strategy of every individual entrepreneur creates collective misfortune. Secondly, even entrepreneurs who wanted to act based on their knowledge of artificially low interest rates would have no way of knowing the free-market rate in order to make future predictions, meaning that the low interest rates disrupt their knowledge of market phenomena and disrupt their ability to perform their entrepreneurial functions.[8] By combining these two reasons with the analysis above on bankers and speculators, both of these reasons can be expanded to make the entrepreneurial errors even more understandable.

Entrepreneurial Error 1: Business Cycles as Nash Equilibriums

Regarding the first reason, Austrian economists have shown that the artificially low interest rates create a deleterious Nash equilibrium. Providing a particularly thoughtful account of this phenomenon, Gene Callahan remarks,

Let us, for simplicity, divide entrepreneurs into classes A and B.… Class A entrepreneurs are those who are currently profitable, i.e., those most able to interpret the current market conditions and predict their future. Class Bs are struggling, money-losing, or, indeed, unfunded "want-to-be" entrepreneurs, less capable at anticipating the future conditions of the market. Now, let us go to the start of the boom. It is 1996, and the Fed begins to expand credit. To where does this new supply flow? The As are not necessarily in need of much credit. If they wish to expand, they have available their cash flow.… The situation for the Bs is quite different, however. Their businesses are marginal, or perhaps nonexistent.… Even if they could tell that they are witnessing an artificial boom, it might make sense for them to "take a flier" anyway.… As the Bs create and expand businesses, the boom begins to take shape.… Although the most skilled [Class A] entrepreneurs suspect that the expansion is artificial, most can't afford to shut down their business for the duration of the boom. But if they can't, they must increasingly compete with Bs for access to the factors of production.… However, in order to do so, [Class A] must take advantage of the same easy credit that [Class B] is using to back its bids.… So the A entrepreneurs, willy-nilly, are forced to participate in the boom as well. Their hope is that, in the downturn, the basic soundness of their business and the fact that they have expanded less enthusiastically than the Bs will see them through, perhaps with only a few layoffs.[9]

As can be seen from Callahan's excellent analysis, the artificially low interest rates and the easy credit create a calamitous Nash equilibrium. Although the ideal state of affairs would be for every entrepreneur to forego the benefits of easy credit, the presence of any entrepreneurs who use the easy credit to their advantage compels other entrepreneurs to use it to compete with this advantage, creating a situation in which individuals pursuing their own interest conflicts with the collective good. Whereas Adam Smith correctly pointed out centuries ago that entrepreneurs in a free market act as if guided by an invisible hand such that their individual interest corresponds with the collective interest, the interventions in the credit market distort this fundamental harmony, creating a situation in which individual interest harms the collective interest.

Despite the general veracity of his statements, Callahan's descriptions seem to suggest that the Class A entrepreneurs restraining themselves mitigates the bubble at least somewhat. In his view, although the Class B entrepreneurs drag the Class A entrepreneurs into expanding the bubble, the hesitance of the skilled class would make the downturn at least less disastrous. Nevertheless, as can be inferred from a more complete analysis of this event combined with some of the reasoning listed above on bankers, Callahan does not take his argument far enough. In fact, the rational expectations of the Class A entrepreneurs exacerbate the crises.

As Callahan correctly remarks, increasing the supply of money and lowering the interest rates draws marginal entrepreneurs into production — specifically the entrepreneurs who would not have received access to credit without this intervention. If Class A entrepreneurs restrain themselves from borrowing money to any extent due to their rational expectations, then the demand for loanable funds falls, resulting in even lower interest rates. As a result, a greater number of marginal entrepreneurs receive access to credit which they otherwise would not receive, making the overall skill of the entrepreneurs in society worse. Consequently, with less skilled entrepreneurs managing the economy, the malinvestments and losses in the economy would be greater than without the restraint of the Class A entrepreneurs.

To clarify, let Class A continue to represent the skilled entrepreneurs who would receive credit regardless of the artificially low interest rates, and let us redefine Class B entrepreneurs and introduce Class C entrepreneurs. We shall redefine Class B entrepreneurs to be a specific subset of marginal unskilled entrepreneurs. They represent the entrepreneurs who would not receive credit (or as much credit) without the artificially low interest rates but would receive credit regardless of the rational expectations of Class A entrepreneurs. Representing the rest of the unskilled entrepreneurs, Class C shall be defined as the unskilled entrepreneurs who only receive credit during a bubble if Class A entrepreneurs respond to their rational expectations of a bubble by restricting the credit they obtain.

Clearly, if Class A fails to predict the bubble and responds to artificially low interest rates as if they represent the true savings of society, then only Class A and B will receive access to credit. However, consider the case in which Class A does respond to the artificially low interest rates by reducing their demand for credit somewhat due to rational expectations that the policy contributes to a bubble. As a result of the rational expectations of Class A, the demand for loanable funds falls, reducing the interest rates on the loan market. As a result of the even lower interest rates, Class B entrepreneurs receive even more credit than they otherwise would, and Class C entrepreneurs receive credit they would not receive at all — even during a period of easy credit. Consequently, by adjusting their behavior to the expectations of a bubble, Class A entrepreneurs partially reverse the process described in the above Rothbard quotation of allocating capital to those entrepreneurs best able to use it, thus exacerbating the bubble by expanding credit to even more unskilled entrepreneurs.

A possible objection to this point would be to note that the less skilled entrepreneurs have a greater risk premium than more skilled entrepreneurs, meaning that the increased risk associated with their loans may deter the expansion of credit to them. Yet, upon examination, this counterargument proves unsatisfactory for two reasons.

Firstly, as seen in the banking section above, the institutional framework within which banks function substantially reduces their personal risk of losses associated with making risky loans. As a result, the risk premium on the interest rate would be lower than without the institutional privileges granted to banks even though the actual risk of default has not changed. Consequently, the institutional framework again divorces the collective benefit of society from the individual benefit of market actors — in this case bankers — by incentivizing them to provide loans with higher default rates without any meaningful change in the market economy to justify it. Whereas a high risk premium would deter the expansion of credit to unskilled entrepreneurs, the comparatively lower risk premium further expands the number of Class C entrepreneurs who receive access to credit.

Secondly, even with a high risk premium, the total interest rate would still be lower than if it were not for the artificially low interest rates and the rational expectations of Class A entrepreneurs. For example, consider three different interest rates for the different circumstances. Without easy credit, Class C may have a 5 percent rate plus a 3 percent risk premium for a total of 8 percent. With easy credit and without entrepreneurial restraint among Class A, the rates of Class C may be reduced to a 3 percent rate plus a 3 percent risk premium for a total rate of 6 percent. Finally, with easy credit and the rational expectations of Class A, the rates of Class C may reduce further to a 2 percent rate plus a 3 percent risk premium for a total rate of 5 percent. The total interest rate of the Class C entrepreneurs falls notably regardless of the risk premium, thus incentivizing an expansion of credit to unskilled entrepreneurs.

Whereas an unexpected boom-bust creates malinvestments throughout the economy, a boom-bust expected by skilled entrepreneurs exacerbates the harm. Motivated by their rational expectations of a bubble, Class A entrepreneurs restrain their access to easy credit, thus inadvertently leading to less-skilled entrepreneurs receiving even more credit and ensuring that more malinvestments and errors occur. By weakening the link between entrepreneurial skill and access to credit, the rational expectations of Class A entrepreneurs set the foundations for a bust led by less capable entrepreneurs.

Entrepreneurial Error II: Distorted Prices Disrupting Knowledge

Regarding the second reason that rational expectations do not prevent the bubble, Austrian economists have noted that entrepreneurial awareness that the interest rate does not reflect the free-market rate provides little information about the unhampered interest rate. Indeed, Austrian economists and many entrepreneurs have known that the Federal Reserve has been keeping interest rates artificially low for much of the last 15 years. Nevertheless, it would not have been possible in 2002 to determine what rate would have existed without Federal Reserve interventions. In fact, with rates constantly increasing and decreasing, there are times it may not even be possible to determine if the rate is too high or too low. Entrepreneurs who know that the interest rate does not reflect the free-market rate and who wish to use the free-market rate to guide their actions cannot do so since the information cannot be determined with any accuracy.

Despite the validity of this line of reasoning, it confines itself unnecessarily to the interest rate. By doing so, it represents an incomplete account of the full effects described by ABCT. Two primary features bring about the results described by ABCT: artificially low interest rates and an increasing supply of money. Although Austrians have correctly focused on how the former denies entrepreneurs important knowledge, both features hinder the ability of entrepreneurs to coordinate production.

Just as the artificially low interest rates remove entrepreneurial knowledge of the free-market interest rate, the increasing supply of money disrupts entrepreneurial knowledge by distorting relative prices throughout the economy, most notably increasing the prices where the newly created money flows. Due to this flow of money, the prices of products sold to consumers and of the costs of production change. Resulting from this disruption in prices, entrepreneurs have a much greater difficulty knowing the appropriate prices of the factors of production they purchase and the prices of the products they sell.

Combined with the artificially low interest rates, entrepreneurs must thus guess as to the natural interest rate, the natural prices of the products they sell, and the natural costs of their factors of production. Although perhaps not as insurmountable as the socialist-calculation problem, all of these distortions certainly make the job of entrepreneurs very difficult, leading them to make widespread errors. Indeed, by disrupting the prices of both costs and products, these price distortions would make the entrepreneurial job difficult even for Class A entrepreneurs who refuse to partake in any of the easy credit. Given this economic climate, it is unclear how an entrepreneur with rational expectations could reasonably use them to coordinate production effectively.

As if these problems were not enough, speculators as explained above add another layer of disturbance to entrepreneurial actions. Whereas speculators in a free market provide entrepreneurs essential knowledge of future demand through prices, speculators who rationally expect a bubble exacerbate the price distortions, further misleading entrepreneurs. As a result, entrepreneurs need to determine the appropriate prices within an economy in which speculators communicate misinformation to entrepreneurs about future consumer demand. Rather than an ally of the entrepreneurs as in a free market, speculators during a boom make the functions of entrepreneurs all the more difficult.

In an economy in which all of the most important prices to entrepreneurs have been distorted by easy credit and further distorted by speculators, it is natural that even entrepreneurs with rational expectations would be unable to act in line with future consumer demand. Far from being gods among men, entrepreneurs represent humans prone to error. In a free economy, they use the information communicated to them through prices to organize production as well as they can. With all of their signals for coordinating production disrupted, they will necessarily make mistakes that result in malinvestments and losses.[10]

Conclusion

ABCT often receives condemnations for ignoring rational expectations and foolishly believing that entrepreneurs will continue to fall for the same tricks. As has been shown, market participants with knowledge of ABCT can do little to combat it. In fact, bankers, speculators, and entrepreneurs who rationally expect a bubble will exacerbate it.

In the case of bankers, the institutional structure that substantially reduces the risks of easy credit and enables them to privatize profits and socialize losses incentivizes their role in forming the bubble.

For speculators, their knowledge that prices and profits will rise during a boom incentivizes them to profit through speculations in the booming sectors, further expanding the bubble.

For entrepreneurs, the easy credit creates a harmful Nash equilibrium in which the dominant strategy for entrepreneurs incentivizes a collective failure, and the distorting effects of easy credit on the interest rate and relative prices disrupts their ability to anticipate future demand effectively.

Additionally, the institutional framework of bankers and the role of speculators increase the errors of entrepreneurs, with the former reducing risk so as to facilitate less-skilled entrepreneurs gaining access to credit and the latter further distorting the price signals necessary for entrepreneurs.

Instead of an argument against ABCT, market actors rationally expecting a bubble would make it much worse. Therefore, rather than hoping for market actors to adapt to easy credit in a way that ends the business cycle, the government interventions that enable easy credit itself should be discontinued, and the economy should be allowed to grow, free from central planning.