And Now Here’s a Kind Word for Austrian Business Cycle Theory

I recently wrote two posts (this and this) about the Austrian Theory of Business Cycles (ABCT) that could be construed as criticisms of the theory, and regular readers of this blog are probably aware that critical comments about ABCT are not unprecedented on this blog. Nevertheless, I am not at all hostile to ABCT, though I am hostile to the overreach of some ABCT enthusiasts who use ABCT as a justification for their own radically nihilistic political agenda of promoting the collapse of our existing financial and monetary system and the resulting depression in the expectation that the apocalypse would lead us into a libertarian free market paradise. So, even though I don’t consider myself an Austrian economist, I now want to redress the balance by saying something positive about ABCT, because I actually believe that the Austrian theory and approach has something important to teach us about business-cycle theory and macroeconomics.

The idea for writing a positive post about Austrian business-cycle theory actually came to me while I was writing my latest installment on Earl Thompson’s reformulation of macroeconomics. The point of my series on Earl Thompson is to explain how Thompson constructed a macroeconomic model in many ways similar to the Keynesian IS-LM model, but on a consistent and explicitly neoclassical foundation. Moreover, by inquiring deeply into the differences between his reformulated model with IS-LM model, Thompson identified some important conceptual shortcomings in the Keynesian model, perhaps most notably the downward-sloping IS curve, a shortcoming with potentially important policy implications.

Now to be able to construct a macroeconomic model at what Thompson called “a Keynesian level of aggregation” (i.e, a model consisting of just four markets, money, output, capital services and labor services) that could also be reconciled with neoclassical production theory, it was necessary to assume that capital and output are a single homogeneous substance that can either be consumed or used as an input in the production process for new output. One can, as Thompson did, construct a consistent model based on these assumptions, a model that may even yield important and useful insights, but it is not clear to me that these minimal assumptions provide a sufficient basis for constructing a reliable macroeconomic model.

What does this have to do with ABCT? Well, ABCT seeks to provide an explanation of business cycles that is built from the ground up based on how individuals engage in rational goal-oriented action in market transactions. In Austrian theory, understanding how market actions are motivated and coordinated is primarily achieved by understanding how relative prices adjust to the market forces of demand and supply. Market determined prices direct resources toward their most highly valued uses given the available resources and the structure of demand for final outputs, while coordinating the separate plans of individual households and business firms. In this view, total aggregate spending is irrelevant as it is nothing more than the sum total of individual decisions. It is the individual decisions that count; total spending is simply the resultant of all those individual decisions, not the determinant of them. Those decisions are made in light of the incentives and costs faced by the individual decision-makers. Total spending doesn’t figure into their decision-making processes, so what is the point of including it as a variable in the mode?

This mistaken preoccupation of Keynesian macroeconomics with aggregate spending has been the central message of Austrian anti-Keynesianism going back at least to Hayek’s 1931 review of Keynes’s Treatise on Money in which Hayek charged that “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.” But the assertion that aggregates are irrelevant to individual decisions is not necessarily valid. Businesses decide on how much they are going to invest based on some forecast of the future demand for their products. Is that forecast of future demand independent of what total spending will be in the future? That is a matter of theoretical judgment, not an issue of methodological malpractice. Interest rates, a quintessential market price, the rate at which one can transform current commodities or money units into future commodities or future money units, are not independent of forecasts about the future purchasing power of the monetary unit. But the purchasing power of the monetary unit is another one of those illegitimate aggregate about which Austrians complain. So although I sympathize with Austrian mistrust of overly aggregated macroeconomic models, I am not sure that I agree with their specific criticisms about the meaningfulness and relevance of particular aggregates.

So let me offer an alternative criticism of excessive aggregation, but in the context of a different kind of example. Suppose I wish to explain a very simple kind of social interaction in which a decision by one person can lead to a kind of chain reaction followed by a rapid succession of subsequent, but formally, independent, decisions. Think of a crowd of people watching a ball game. The spectators are all seated in their seats. Suddenly something important or exciting happens on the court or the field and almost instantaneously everyone is standing. Why? As soon as one person stands he blocks the vision of the person behind him, forcing that person to stand, causing a chain reaction. For some reason, the action on the field causes a few people to stand. If those people did not stand, no one else would have stood. In fact, even if the first people to stand stood for reasons that had nothing to do with what was happening on the field, the effect would have been the same, because everyone else would have stood; once their vision is blocked by people in front of them, spectators have to stand up to to see the action. But this phenomenon of everyone in a crowd standing when something exciting happens on the ball field happens only with a crowd of spectators of some minimum density. Below that density, not everyone will be forced to stand just because a few people near the front get up from their seats.

A similar chain reaction, causing a more serious inefficiency, results when traffic slows down to a crawl on an expressway not because of an obstruction, but just because there is something off to the side of the road that some people are slowing down to look at. The effect only happens, or is at least highly sensitive to, the traffic density on the expressway. If the expressway is sufficiently uncrowded, some attention-attracting sight on the side of the road will cause only a minimal slowdown in the flow of traffic.

The point here is that there is something about certain kinds of social phenomena that is very sensitive to certain kinds of interactions between the individuals in the larger group under consideration. The phenomenon cannot be explained unless you take account of how the individuals are interacting. Just looking at the overall characteristics of the group without taking into account the interactions between the individuals will cause you to miss something essential to the process that you are trying to explain. It seems to me that there is something about business-cycle phenomena that is deeply similar to the crowd-like effects in the two examples I gave in the previous paragraph. Aggregation in economic models is not necessarily bad, even Austrians routinely engaging in aggregation in their business-cycle analyses, rarely, for example, discussing changes in the shape of the yield curve, but simply assuming that the entire yield curve rises or falls with “the interest rate.” The question is always a pragmatic one, is the increased tractability of the analysis that aggregation permits worth the impoverishment of the model, by reducing the scope for interactions between the remaining variables. In this respect, it seems to me that real-business cycle models, especially those of the representative-agent ilk, are, by far, the most impoverished of all. I mean can you imagine, a representative spectator or representative-driver model of either of the social interactions described above?

So my advice, for whatever it’s worth, to Austrians (and non-Austrians) is to try to come up with explanations for why aggregated models suppress some type of interaction between agents that is crucial to the explanation of a phenomenon of interest. That would be an more useful analytical contribution than simply complaining about aggregation in the abstract.

PS Via Mark Thoma I see that Alan Kirman has just posted an article on Vox in which he makes a number of points very similar to those that I make here. For example:

The student then moves on to macroeconomics and is told that the aggregate economy or market behaves just like the average individual she has just studied. She is not told that these general models in fact poorly reflect reality. For the macroeconomist, this is a boon since he can now analyse the aggregate allocations in an economy as though they were the result of the rational choices made by one individual. The student may find this even more difficult to swallow when she is aware that peoples’ preferences, choices and forecasts are often influenced by those of the other participants in the economy. Students take a long time to accept the idea that the economy’s choices can be assimilated to those of one individual.