I have been in contact with a self-proclaimed “socially moderate and economically left-leaning” young writer on economics who fancies himself a post-Keynesian. In our brief exchanges, which have pleasant and interesting, I have come to notice he has been debating an Austrian elsewhere on social media, and has made several posts critiquing Austrian business cycle theory (ABCT). I wanted to take this opportunity to address his points, not as a refutation per se, but as a reminder to Austrians to be aware of their opponent’s position, not just their own. I will look over his two latest articles on ABCT and a related piece attacking pure-time-preference theory.

Part One: A Rejoinder

The first article is a rejoinder to a criticism of his original article dissecting ABCT. He makes a point about the purpose of increasing aggregate demand through government stimulus,

the purpose of government stimulus isn’t meant to produce a certain good that people want in the future. It’s meant to increase aggregate demand, boosting production to all firms that are providing goods that consumers want. By increasing general employment, you increase demand for goods that people actually want/need, which means firms that provide those things start producing more and hiring more. (My bold)

One of the main differences between our two perspectives is John Stuart Mill’s Fourth proposition on capital: “Demand for commodities is not demand for labor.” It’s debated heavily what Mill really meant here, but what is true is that when consumer goods are demanded, there is not some automatic mechanism for labor to be demanded at a commensurate rate. In other words, there are constraints that occur that can prevent the increase in employment our Keynesian friend describes. One example is the capital-labor ratio. Just because a good is demanded, does not mean the major input to increase the supply of that product will be labor.

In fact, when looking at government stimulus during a recession, one should look at the specific firms most affected by that stimulus. An increase in stimulus will tend to go to companies that are already operating and are typically larger in scale. New businesses on the other hand that are just starting with new ideas and methods typically use higher amounts of labor and longer hours worked when starting out. Start-ups are a good example of this. Human capital is more useful in experimentation with production techniques in the early days of a firm, and as these techniques improve and economies of scale rise, less labor is necessary as automation and capital are appropriately allocated to an industry that requires large scale production. The purpose of stimulus is to increase aggregate demand and this cannot be done without already-existing businesses that are more capital-intensive receiving the funds.

Thus, we can see that the money from stimulus mostly does not go to firms that require larger amounts of workers, but to businesses that can increase production without hiring labor because they can acquire more capital, increase the machines’ capacity, or use older, more depreciated capital (This poses more problems). Another example is the temporary nature of consumer demand when artificially stimulated. From my upcoming book Monetary Kaleidics:

Professor Fiona Maclachlan, a post Keynesian, mentions this in her book Keynes’ General Theory of Interest: A Reconsideration (2013). Since the future is uncertain and production has a significant time element, the Ricardo effect proper, as Maclachlan calls it, leads to an increase in the output of consumer goods since businesses do not know how long the increase in consumer demand will last, so they take advantage of these short-term profit opportunities. While she finds several faults with Hayek’s Ricardo effect, she agrees that an increase in consumption demand will lead to a fall in investment, particularly in capital goods industries.

If businesses anticipate that the increase in demand from stimulus will only be temporary, they may not hire more workers to increase short-term production, leading to more capital output and hours worked by already-employed workers. The Austrian that was debating with this Keynesian made a good point that the resources that lay idle may not be the ones necessary to increase production efficiently as we described above. In fact, Keynes himself claimed that aggregate demand stimulus was only appropriate at certain times, favoring more “targeted techniques” as a recession progressed (1937):

But I believe that we are approaching, or have reached, the point where there is not much advantage in applying further general stimulus at the centre… . It follows that the later stages of recovery require a different technique. To remedy the condition of the distressed areas, ad hoc measures are necessary… We are in more need today of a rightly distributed demand than of a greater aggregate demand.” (My bold)

It shows, then, that even Keynes acknowledged that specific demand for specific goods are required even with considerable idleness of labor and capital, despite our Keynesian friend’s assertion that, “there needs to be a significant amount of idle resources in a recession, and a recession causes idle resources appear in every industry because of a lack of demand, which causes firms to have unused resources, capital, and money that can be put to use to stimulate the economy.” The answer to the idleness problem is more nuanced than he believes because he ignores capital/labor heterogeneity and the short-run/long-run distinction. There are also better solutions to the idle resource problem than a general increase in government stimulus that would satisfy both Keynes’ concerns and those of his young apprentice.

Our Keynesian friend makes another elementary error in his rejoinder when he claims,

According to the ABCT, low interest rates causes producers to spend more on capital goods (or invest) in their product, and this should (by their theory) coincide with a decrease in consumption of consumer goods because (a. Producers are likely spending less on consumer goods and b. When producers spend less on consumer goods less are going to be bought, even if demand stays the same). While firms might have a higher money income, this still isn’t likely to keep spending the same when the portion of capital spending increases by a large percentage. However, this isn’t the case, as explained in my original article.

Here is that point from his first article on ABCT:

If the ABCT was valid, consumption on consumer goods should decrease during booms, yet that doesn’t happen- it increases during booms and retracts with investment markets during bust periods. Consumption might fall because of a loss of consumer confidence after capital markets do, yet this requires that capital markets take the first/central hit, but often consumption takes the worst/first hit or falls in unison.

There’s two errors on his part here. First, he ignores Hayek’s triangle, i.e. the multiple stages of production. Consumption and investment can both increase during a boom due to capital consumption. This is because of overconsumption by both producers and consumers and results in the middle stages of production being deprived of the ability to maintain the capital structure due to bottlenecks and resource constraints. Second, our Keynesian friend misses the point of Cantillon effects: they take time. Accounting profits rise in the early stages of production (investment), and these additional profits allow for the increase in consumption by both entrepreneurs through increased profits, and by owners of the factors of production though wages and rents. Couple this with a temporary slowdown of consumer good production in the short-run, and higher consumer goods’ prices result. The problem with this is that businesses calculate their costs historically without factoring inflation in, especially in the short to medium-run. This means that their income is falsified and they are spending more than what they actually have due to higher costs of production, which means the amount of funds necessary for maintaining their capital is diminished as the boom progresses. The complimentary capital necessary to complete many production processes is not available. Thus, we can see that the increased spending on consumption comes not only from higher incomes of both entrepreneurs and the owners of the factors of production, but also because the amount usually spend on capital maintenance is diminished through “paper profits.”

Our Keynesian friend doesn’t seem to be aware of one of the most basic tenets of ABCT, and that is the multi-stage capital structure and it’s many heterogeneous resources. He has a very “hydraulic” understanding of the theory in which consumption and investment must be at odds because he cannot visualize the economy as anything other than a simple two-stage economy, rather than a time-oriented production structure that is equally affected by the time-discount effect and the sound version of derived demand. As Joe Salerno clarifies,

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.

Going further in his critique, he also attempts to show how Milton Friedman’s plucking model is a more accurate depiction of economic cycles than ABCT,

Evidence showing a high correlation between booms and preceding busts, while showing zero correlation between booms and succeeding busts does not align with what would happen if the ABCT was true. This doesn’t necessitate any belief that the economy is a false boom. He explains reasons how errors being discovered can lead to even more negative effects, but doesn’t address how this leads to Friedman being wrong, especially because more errors would lead to more negative effects and this should still lead to a bigger bust when there is a bigger boom (conceivably because of more misallocation).

It seems neither our Keynesian friend nor this lone-wolf Austrian he was debating are on the right track. There is considerable empirical evidence that ABCT is sound. More importantly, Friedman’s plucking model and ABCT need not compete, and may even be complimentary to one another. Roger Garrison sums up how Hayek’s “secondary depression” relates the two (pg. 227-228),

The self-reversing process highlighted in Austrian theorizing refers to

something going on within the output aggregate. It is represented in

Friedman’s Plucking Model not by the preceding up-sag but rather by some

portion of a segment of string that Friedman, operating at a higher level

of aggregation, identifies as trend-line growth. The bust, even in Austrian

theorizing, can affect both the composition and magnitude of the economy’s output…. In sum, a boom–bust theory in the sense of policy-induced malinvestment followed by an inevitable capital restructuring and complicated by a secondary contraction leaves, at a higher level of aggregation, a data trail that suggests bust–boom cycles. Friedman’s Plucking Model provides no evidence against the Austrians. Ironically, it does provide evidence against the boom–bust theory based on short-run/long-run Phillips curve since that theory adopts the same high level of macroeconomic aggregation depicted by the Plucking Model.

Even when looking at our Keynesian friend’s link that shows evidence for the validity of Friedman’s plucking model, the paper concludes that,

The results presented here suggest that exogenous transitory shocks may be

important for most recessions, but that U.S. real GDP experiences more permanent movements than what might be expected based on conventional business cycle models. These results indicate that there may be different types of recessions with different underlying causes. These different causes may have important policy implications. One possible research agenda to follow would be to consider the suggestion of Hamilton (2005) that the volatility of interest rates may play an important role in causing asymmetric shocks. He finds that many, but not all, economic downturns are accompanied by a change in the dynamic behavior of short-term interest rates. Another reasonable direction to follow is to try to determine if the asymmetric shocks are monetary, as suggested by Friedman (1993). (My bold)

Even the study he linked shows the possibility (and probability) that 1) there are numerous causes of recessions which several notable Austrians agree with and 2) that changes in short-term interest rates have a direct effect on the business cycle, which dovetails nicely with ABCT. (More on interest rates and time preference below)

Part Two: Straffa and ABCT

The more recent article on ABCT begins with a comment on Hayek’s proposal to maintain a steady nominal income. Hayek is criticized for the following,

He ignores that money is not only a medium of exchange, but a store of value and the standard by which debts and other legal obligations or habits– meaning that when the price of one or more commodities change, these relationships change in terms of such commodities. Things like money-contracts, wage-agreements, sticky wages, and debts are also ignored

Hayek was very aware of the issues of the secondary deflation as early as 1931, five years before The General Theory was written. In fact, here’s Hayek’s exact words,

I agree with Milton Friedman that once the Crash [of 1929] had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression

Hayek acknowledged the problem of deflation with wage rigidity as he states the existence of it in another quote. Our Keynesian friend has overlooked the fact that Hayek knew a fall in demand (a decrease in either M or V) would exacerbate a recession due to the lack of price and wage flexibility. The next two sections “The Essential Contradiction” and “The Concept of Forced Savings” also focus on Hayek’s version of ABCT, and are largely fluff and non-threatening to the theory especially within the monetary equilibrium framework, not to mention poorly written (De soto clarifies the unimportance of consumer loans in terms of ABCT on pages 316-317 here). But one thing I want to show is his point about the Austrian definition of “inflation (in terms of an increase in the money supply, as Austrians use this definition and reject the notion of a general price level).” This is true of some Austrians, but not Mises and Rothbard, among others. In a few editions of The Theory of Money and Credit , Mises defined inflation as an increase in the supply of money beyond the demand to hold it, calling this the money relation. Rothbard uses the same definition in chapter 11 of Man, Economy, and State, despite using other definitions elsewhere. In fact, in certain places when translated from his non-English work, Mises used the price level when defining inflation. The truth is, many Austrians have used different definitions of inflation as I point out here.

Next our Keynesian friend discusses Wicksell’s “natural” rate of interest relative to market rates of interest, and is seemingly correct to point out that there are numerous natural rates of interest. However, he errs in several ways. First, he assumes a fixed definition of the natural rate(s). In fact, there are different connotations of the term that even economists differ on to a certain degree, so a precise definition here is not strictly important. What is important is his faulty view, once again, of the Austrian position when he states, “the Austrian economic school of thought expresses the claim that a society that makes additions in their savings will keep the money interest rates at equilibrium…”

The Austrians believe no such thing. Money rates of interest are never in equilibrium, and the same goes for any price. No Austrian worth their salt believes equilibrium is an obtainable goal, only that there is a tendency towards it. Furthermore, he misunderstands that, like an equilibrium price, the natural rate(s) can never be observed by individuals, because even if we do look at a given price or money interest rate in the market and it happens to indeed reflect an equilibrium price or rate at a given moment, we do not have the Hayekian knowledge to know if it is the true equilibrium price/interest rate or not. In other words, we wouldn’t know what an equilibrium price is even if we were staring right at it. In this way, the natural rate of interest is an equilibrium price despite his claim to the contrary because, to the Austrians, it is the basis for the exchange ratio between present goods and future goods in a barter economy (which makes the single natural rate criticism valid). The problem is that when money is introduced, there are other variables that do not occur in barter which leads money rates of interest to diverge from the natural rate(s) which we will cover below.

Before we do that, it should be noted that our Keynesian friend states “in times of expansions of production, there is no such thing as an equilibrium or natural rate, so the money-rate could never be equal to it or lower than it.” While he considers himself a post-Keynesian, his new Keynesian cousins (of which Krugman is one of his favorites) actually agree with the Wicksellian natural concept here and here. Normally I wouldn’t use an argument from authority, but here is an important thing to consider. If we agree that there are numerous natural rates in existence, then it’s proven that while the natural rate(s) concept isn’t conceptually wrong, it is more important to ask “is it useful?” The overwhelming majority of economists, both orthodox and heterodox, would agree that it is useful. It’s true, even, that Keynes used it in his Treatise on Money, then rejected it when adopting the liquidity preference theory of money (which we’ll cover) in The General Theory. The question is if it can be measured to any reasonable degree. Through discussions with an Austrian scholar I’ve had, there is work being currently done on this very topic within Austrian circles. Suffice to say that the economics profession has a deep-seeded interest in using the natural rate concept and I can see no reason why we should completely abandon it, especially in ABCT. Professor Scott Burns makes a good case for this,

. Piero Sraffa (1932) famously critiqued this notion of a single “natural” rate of interest by arguing that in the context of a barter economy with multiple goods there must be multiple natural rates. A number of Austrians have attempted to either defend or update the Austrian theory to account for Sraffa’s criticisms (See: Lachmann 1986; Murphy, 2010). Mises (1949 [1996]) and Rothbard (1962) defended their position by maintaining that the natural rate is, in fact, a money rate of interest. This is because money is the actual good in which time preferences are demonstrated, not a “veil” that is added to a barter economy. It is therefore possible to have a single natural rate of interest because the different rates are quoted in terms of a

single commodity (money) that can be equilibrated (Boettke & Newman, 2015, p. 9-10).

That being said, our Keynesian friend continues,

This also shows that non-monetary economies still retain the essential feature of money, the singleness of the standard, and nothing is proven when it is shown a monetary policy is “neutral” in that it is equivalent to a non-monetary economy (from which it doesn’t differ). Even in economies that are truly non-monetary, where different transactions are formed in different standards, no monetary policy can reproduce these results. The essential consequence of a divergence between supply and demand is the same under monetary and non-monetary economies, too. Basically, with or without money, if savings and investment aren’t planned to match, an increase in savings is to a large extent abortive. (My bold)

It’s somewhat difficult to see what he’s trying to say here because his writing is quite roundabout and never quite says to the reader “here is the point,” but I will try to interpret him. His misunderstanding of money seems apparent when compared to a non-monetary economy (barter). In a money economy, money acts as a common denominator in which we “measure” different prices or exchange ratios. In barter, there is no “numeraire” as there is in the money economy. Everything is relative in barter because goods exchange directly for goods. But with money, it is subject to supply and demand just as much as any other good, and is one half of virtually every transaction. When the price or value of money changes, there is a change in the price level. But there is no price level in barter because goods can only be exchanged for other goods. Everything is a relative price, whereas in a money economy, there are relative price changes within a changing price level.

This means there is no inflation or deflation in barter. It cannot be measured by any single good. Inflation is commonly defined as an increase in the price level. If the value of money changes, it changes the exchange ratio of each and every good compared to money, on the margin. There can be changes in “saving” and “income” in barter, but these are nominal changes. Money allows for the measurement of “real” changes, or purchasing power.

This strengthens the argument above on the validity of the natural rate because, as our Keynesian friend argued, numerous natural rates exist in barter between individual commodities. But with the introduction of money, there can be changes in real income due to inflation or deflation on the money side. These changes induce a wedge between money rates of interest and there inherent natural rate(s) between specific goods which people typically look at (and Keynes seemingly admits below).

A conception underlying the ABCT is that when savings take place in a non-monetary economy, a stream of finished goods that might not be consumed is diverted from consumption to investment, and the problem is to find a monetary policy that does not interfere with the stream. However, this stream is a delusion. When it flows into investment, it doesn’t flow out of savers’ hands in the form of consumers’ goods, as production must have been planned ahead to not produce unwanted goods. When saved goods flow out of consumer hands, they do not reach investment unimpaired. Savings may possibly be the inducement for investment, but it is not the source. This view lines up with the Endogenous Money Theory that I have previously talked about in my Post-Keynesian article.

This quote is one big non-sequitur and too ambiguous to be taken seriously. What does “unimpaired” mean exactly? And what is the difference between savings as an inducement and savings being a source of investment? He doesn’t explain. The point is when saving occurs, derived demand is at play. Resources dedicated to producing consumer goods, and the consumer goods themselves, fall in price relatively, not absolutely, because while their supply dwindles, the demand falls even more. This fall in price for both the consumer goods and the factors of production that was previously producing them enables entrepreneurs to better afford them so that costs remain below their selling prices and capital asset values. If this saving does not occur, then their prices will be relatively higher since they will have alternative uses competing for them, and thus will make costs rise for the early stages (investment) of production if they wish to expand production. Put simply, all stages of production are competing for these factors, and increased saving releases them with less alternatives for employment (as well as the consumer goods) making them less expensive, thus creating new opportunities for the early stages with the now low natural and market rates to borrow these savings with.

As far as the endogenous money theory is concerned, it’s no longer new and edgy and has been covered ad nauseum. The mainstream embraces much of it here and here, with some noteworthy quibbles. The fact is it doesn’t harm Hayek’s version of ABCT so I am not sure what importance it has here. Perhaps we’ll find out below.

Time Preference

In the previous two articles, our Keynesian friend has briefly mentioned the Austrian pure time-preference theory of interest. In a preceding article to those, he has shown criticism for it as Keynes did, insisting that liquidity preference is a better explanation of interest. Instead of going over his arguments, we will get right to the point. First, not all Austrians subscribe strictly to time preference as the sole explanation of interest rates. So a critique of it is not specifically a critique of ABCT. Second, and more importantly, both time preference and liquidity preference explain the phenomenon of interest, but at different times and to differing degrees depending on the situation.

Here is Nick Rowe on the matter,

In the short run, when prices are sticky, production and income will increase. The increase in income will increase desired saving, shifting the saving curve to the right, as shown in the left diagram. The increase in income will also increase the demand for money, shifting the money demand curve to the right, as shown in the right diagram. Until the two different theories end up giving the same answer. That answer is the green interest rate shown in the diagram.

In the long run, when prices are perfectly flexible, production and income won’t increase, but the price level will increase. The increase in the price level will increase the demand for money, shifting the money demand curve to the right. The price level will increase, and the money demand curve will shift right, until the Liquidity Preference theory ends up giving the same answer as the original Loanable Funds theory.

In the short run, both theories are partly right. The truth lies somewhere in between the two theories. (Where exactly the truth lies depends on the elasticities.)

In the long run, the Loanable Funds theory is right. The price level adjusts, and the demand for money adjusts, until the Liquidity Preference Theory adjusts its answer to equal what the Loanable Funds theory was originally saying. So, in the long run, we can ignore the Liquidity Preference theory, and just use the Loanable Funds theory.

So we can see that, once again, Keynes’ perspective is not part of a general theory, but a nuanced, though important, case at a specific time. It’s not that our Keynesian friend is completely wrong about liquidity preference, it’s that he’s wrong that time preference takes a back seat in the discussion. The Austrians here have the upper hand because they have explicitly acknowledged Nick Rowe’s point since the time of Mises. In fact Mises admitted “the costs incurred by holding cash are equal to the amount of interest which the sum concerned would have borne when invested.” He is essentially restating the liquidity preference theory of interest (he does so again in another quote from that link about his money relation). Yet, Mises was known for his defense of time preference as an explanation for interest, indicating he didn’t reject either theory. In fact, we’ve seen other Austrians make the long-run/short-run distinction when speaking of this issue. Hayek did (pg 359). And Hazlitt echoes Rowe on how liquidity preference doesn’t apply at all times (pg 448),

If Keynes’ theory were right, short term interest rates would be highest precisely at the bottom of a depression, to overcome the individual’s reluctance to part with cash then. But it is in a depression that short-term interest rates tend to be the lowest. If the “liquidity preference” theory were right, short-term interest rates would be lowest at the peak of a boom, because confidence would be highest then, and everybody would be wishing to invest in projects and “things” rather than in money. But it is at the peak of a boom that short-term interest rates tend to be highest. It is not easy to “prove” this relationship statistically, partly because so many influences govern interest rates,and partly because there is no “pure” index of “depression” and “prosperity.”

Going even further, Keynes himself inserted the time element into his liquidity preference concept, “the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.” In the previous link, Keynes is also quoted as saying that one needs to account for changes in the purchasing power of money as an approximation when investigating interest rates, which reflects our earlier points about inflation, the price level, and the natural rate. It seems now that the Austrians have the correct perspective on interest rates, distinguishing between the long-run and the short-run.

Conclusion

To be clear, the Austrians have a lot of work to do to clear up the many misconceptions about their business cycle theory, and thus far some of the blame is on them for 1) not explaining the nuances of the theory clearly enough to critics and 2) not providing enough peer-reviewed and/or high-quality work showing definitive evidence that ABCT is a coherent story of the trade cycle. At the same time, it’s even clearer that critics like our Keynesian friend have not done the requisite research on the relevant material in order to make such grandiose statements like Austrian business cycle theory “shouldn’t be taken seriously in modern day.” Indeed, like a teenager who didn’t do his homework, he should stop while he’s ahead and hit the books.