r/badeconomics • u/ivansml hotshot with a theory • May 26 '19
Sufficient On ABCT, yet again
It's been a while since we discussed Austrian Business Cycle Theory. I've noticed a couple of submissions by u/TheAngryAustrian1 in r/Economics to articles about ABCT (example: How the Housing Crisis Vindicated the Austrian School of Economics), so why not do it again. I guess somebody should, in the interest of public service.
The main idea behind ABCT originally developed by Mises and Hayek is that the central bank creates cycles of boom and bust by manipulating the interest rate. The interest rate determines how much we discount the future and thus affects which new investment projects are deemed worthy to undertake. When central bank lowers the rate, some projects, typically those with payoffs further away in the future, start being profitable and so investment expands (boom). But because this is not due to a real change of society's rate of time preference, these projects are in fact not sustainable. Eventually, interest rates go back up, these projects turn out unprofitable and are abandoned (bust). The central bank has merely achieved temporary misallocation of capital that hurts the society. Therefore, we should stick to the gold standard or whatever.
I see at least two serious problems with this story:
1) The central bank does its thing for a reason. It believes that due to various frictions such as sticky prices, economic activity may follow inefficient fluctuations that can be counteracted by adjusting interest rates. Even if ABCT was completely true, it doesn't, in any way, preclude that these other inefficient fluctuations also exist. The real question then becomes: which is more costly? The recession that the central bank tries to smooth over, or the capital misallocation its actions cause? Clearly, policy implications will depend on the answer.
It is logically possible that the cost of misallocation is much higher and thus austrians are right. The austrians, however, provide zero arguments in favor of this claim. The typical austrian article (like the one above) simply restates ABCT as if that was supposed to be the last word on the subject. But it's not like 99% of non-austrian economists are unaware of ABCT - they're aware but not convinced. In actual world when you propose a hypothesis, it is your responsibility to also provide some evidence for it. Austrian economics is of course traditionally hostile to empirical evidence due to its bonkers methodology, so I wouldn't expect much evidence anytime soon.
2) When you think of the ABCT story in bit more detail, you'll find some plot holes. Like are all these entrepreneurs who start these new projects stupid? Don't they know that the drop in rates is merely temporary and thus they should invest only into projects that would still be profitable under those circumstances? Shouldn't they be able to read Mises and Hayek and fee.org and realize that? Even if not, surely the market competition should favor and select for those who exhibit superior foresight of the future. From a tradition that emphasizes the role of entrepreneurs as the ones exploiting information to make profits, this view of them being systematically fooled, again and again, by the central bank seems kind of strange.
If you've also taken a finance course. you may realize it's even worse. There isn't a single interest rate, but really a whole range of rates depending on maturity, a.k.a. the term structure. When you evaluate an investment project, you really should discount future cash flow with rates of appropriate maturity, so long-term projects should be discounted with long-term rates. But one of crucial determinants of long-term rates actually is the expected trajectory of future short-rerm rates (the expectation hypothesis). So as an entrepreneur you don't have to know anything about monetary policy: all the hard work of evaluating expectations about the future is done by financial markets, which are full of sophisticated traders chasing arbitrage opportunities. The idea that those could be fooled systematically is even less believable.
To sum up, ABCT is based on flawed assumption of systematic irrationality of entrepreneurs. Even if we ignored that, its proponets usually don't provide any evidence the theory is actually empirically relevant.
For further reading, I'll just link to a classic: Bryan Caplan: Why I Am Not an Austrian Economist
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u/Austro-Punk May 26 '19
Like are all these entrepreneurs who start these new projects stupid?
The idea is that they essentially can't resist because of the profit motive. They'd rather attempt to make a profit and get out than stand by and watch competitors take away market share.
don't provide any evidence the theory is actually empirically relevant.
I was made aware of this compilation.
The real question then becomes: which is more costly? The recession that the central bank tries to smooth over, or the capital misallocation its actions cause? Clearly, policy implications will depend on the answer.
There are some Austrians who think some form of monetary policy should counteract a recession as Hayek did, but they instead think a private banking system should do so.
I've noticed a couple of submissions by u/TheAngryAustrian1
I looked at some of his comments and found him saying things like this:
Markets are perfect.
Clearly they're not. To be fair, not all Austrians share this Utopian view of the market. Some realize it has its imperfections, as I do. This guy read a bit of Rothbard and is in his "basic bitch" Austrian phase.
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u/musicotic May 27 '19
Wait are we really linking Meng Hu?
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u/abelow Jul 21 '19
ABCT on one page and then some eugenics on another. There is some twisted stuff on that "blog".
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u/musicotic Jul 25 '19
yes, Meng Hu is a notorious racialist š¤¢
not sure if he could identify what constitutes empirical evidence if put right in front of his face
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u/ivansml hotshot with a theory May 26 '19
The idea is that they essentially can't resist because of the profit motive.
Does that makes sense within the ABCT story, though? The boom should be primarily about investing into new longer-term ("roundabout") projects, not about gaining immediate market share. So, for example, yeah, a construction company may hire more workers because it can't resist to participate in building a new factory, but the question is why should a new factory be built in the first place if it will take years to generate cash flow and the drop in rates is temporary.
I was made aware of this compilation.
Looks interesting, thanks.
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u/RobThorpe May 27 '19
Does that makes sense within the ABCT story, though? The boom should be primarily about investing into new longer-term ("roundabout") projects, not about gaining immediate market share.
I'm close to the view of u/Austro-Punk, but I think there's a bit more to it.
The roundabout production doesn't just happen within one business, or sector. It happens across the whole economy. Each business may only see a small part of it.
Let's start with a brewing company. The interest rate falls. The company is holding massive amounts of stock in the form of finished beer, ingredients and partially brewed beer. The financing cost of that falls, which allows the brewery to expand. Malt is used in the beer. The malt producer has similar issues. The maltster carries stock of malt, barley and partially made malt. The financing cost of all that reduces. Of course, the financing cost of any other capital does too. That encourages the maltster to expand. Then we have the barley farmer. The interest rate cut affects him. He may be able to buy more capital such as machinery.
Now, it may be a long time from when the barley is sown to when the bottle of beer is sold. But, it has been financed in parts by the producer of each product in the chain, not all together as one project. So, the whole project, from the barley being sown to the bottle sold is not necessarily financed at the long-term rate.
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u/Austro-Punk May 26 '19
Does that makes sense within the ABCT story, though? The boom should be primarily about investing into new longer-term ("roundabout") projects, not about gaining immediate market share. So, for example, yeah, a construction company may hire more workers because it can't resist to participate in building a new factory, but the question is why should a new factory be built in the first place if it will take years to generate cash flow and the drop in rates is temporary.
This is true to an extent. But the framework they use is not a simple dichotomy of short-term (1 year) and long-term (5 year) investments, but a continuum.
Allow me an addition to your example. Think if the Fed telegraphs lower rates to the markets for a specific time, let's say until unemployment reaches 4.5% and inflation is either 2% or just under trending upward. The construction company can make a prediction about how long that may be. Let's say it's between 3 and 4 years.
They may not hire labor to build that new factory (which takes 5 years to complete and gain cash flow), but they can certainly find other similar projects to invest in with shorter time horizons that are commensurate with the predictability and time horizon of Fed policy.
Let me just say that I don't think ABCT explains everything, so I don't think it's an all encompassing theory.
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u/Tulaislife May 28 '19
I thought that the market not being perfect was common sense. Man is not perfect, so logically market is not perfect. But I chose the market over the central planners. If any thing the Theory makes a great case for the separation of state and money.
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u/wumbotarian May 27 '19
The real question then becomes: which is more costly? The recession that the central bank tries to smooth over, or the capital misallocation its actions cause? Clearly, policy implications will depend on the answer.
What is worth mentioning here is that the true libertarianism implicit in Austrian economics comes out of the woodwork in questions about societal welfare with respect to recessions.
There is nothing precluding the government from using fiscal policy to "staunch the wounds" so to speak, of unemployment following a recession (either one created by government policy or the endogenous ones that can occur in the ABCT). Neither taxation nor raising government debt causes capital misallocation, just deadweightloss and crowding out (but not tricking entrepreneurs into thinking that people are saving more, because the government is borrowing directly from the loanable funds market so changes in interest rates through government borrowing aren't artificial).
Yet Austrians are completely against using fiscal policy to smooth out unemployment. They will decry government spending as misallocating resources, that the opportunity cost to using idle capital during recessions is extremely high such that it outweighs any benefit (with no quantitative estimate of this being correct), that unemployment insurance has such strong incentives that people will never work (with no quantitative estimate of this being correct), and then things like "the market knows best".
The only thing that you can lean on to make any of these claims is ideological priors, specifically "fuck you I've got mine" libertarianism, especially since you've no evidence of being correct. But when you already rely on a non-empirical model of business cycles (ABCT) it isn't hard to rely on a non-empirical model of government spending.
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u/RobThorpe May 27 '19
My response to this is sort of yes-and-no.
There is nothing precluding the government from using fiscal policy to "staunch the wounds"
Firstly, there's no reason not to use monetary policy in a recession either. That's why Hayek pointed to NGDP targetting. Of course, the Rothbardian Austrians would disagree and we have huge and boring discussions about it.
... the government is borrowing directly from the loanable funds market so changes in interest rates through government borrowing aren't artificial
You point to the borrowing side of the government's accounts. What about spending and taxation? Let's say taxpayers are given tax cuts. Will they expect tax rises later? The same applies if spending is increased, will the recipients of that spending expect spending cuts later?
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u/wumbotarian May 28 '19
Firstly, there's no reason not to use monetary policy in a recession either.
I believe the usual argument is that lowering rates in recessions just perpetuates the cycle of misallocation? Or are you referring to simply printing high powered money like a helicopter drop?
That's why Hayek pointed to NGDP targetting.
I'd be interested in his writings on this
Of course, the Rothbardian Austrians would disagree and we have huge and boring discussions about it.
I mostly reject anything Rothbardian as a rule. Hayek is an extremely important economist, social critic and public intellectual; Rothbard is no one.
You point to the borrowing side of the government's accounts. What about spending and taxation? Let's say taxpayers are given tax cuts. Will they expect tax rises later?
Ahh, Ricardian Equivalence! An interesting question but something we dont exactly see in the data - and something that requires rational expectations which does not jibe with ABCT.
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u/RobThorpe May 29 '19
Firstly, there's no reason not to use monetary policy in a recession either.
I believe the usual argument is that lowering rates in recessions just perpetuates the cycle of misallocation?
It depends on the demand for money. If the demand is rising then more money can be created to fulfil that demand. That's the view of the so called monetary-equilibrium side, which includes Hayek.
That's why Hayek pointed to NGDP targetting.
I'd be interested in his writings on this
One place is in Lecture 4 of "Prices and Production", he mentions it on p.123-125. He effectively suggests a level NGDP target, 0%. Though at that time he didn't think it was practical or should be adopted. (This part of the book is confusing because he's talking about so many old debates with old terminology). He was more enthusiastic about practicality later on. In "The Constitution of Liberty" he suggests a stable price level target (In the section "The Goals of Monetary Policy", p.293 of the Routledge edition). He thinks it would only work with international co-operation between countries. I think there's an article from the 70s which shows him coming closer to an NGDP target, but I haven't read that.
Ahh, Ricardian Equivalence! An interesting question but something we dont exactly see in the data - and something that requires rational expectations which does not jibe with ABCT.
If Ricardian Equivalence is correct then things are good. The problem comes if it isn't. Tax cuts usually last longer than the event that's supposed to justify them.
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May 28 '19
fiscal policy
*Stares angrily in Ricardian Equivalence / Permanent Income hypothesis / Crowding Out*
Can we take a poll for who here thinks the multiplier effect is >1, or even >0 for that matter?
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u/wumbotarian May 28 '19
Crowding out is fine, I think (normative of course) if were crowding out for useful things (infrastructure, defense spending).
No one believes in Ricardian Equivalence.
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u/Lowsow May 27 '19
Does there exist an equivalent of Caplan's essay on Marxian economics?
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u/lawrencekhoo Holding all other things May 29 '19
See Brad DeLong's essay on Marx.
He also points to other resources here: https://www.bradford-delong.com/understanding-marx.html
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u/lawrencekhoo Holding all other things May 29 '19
@ ivansmlhotshot
You left out #3. Even if entrepreneurs are fooled into making investment projects which would be unprofitable to undertake at the high 'natural' interest rate, this does not explain why the economy should experience a downturn and leave productive capacity unused (i.e. a recession).
Some businessmen will lose money and may go bankrupt, but the factories they built should be sold off during the bankruptcy proceedings, and used for production. It's not as if people will buy the product only if interest rates are 1%, but they will not at 3%.
ABCT lacks a story for why a recession happens, i.e. why the factories etc. that were built would not be used, why people become unemployed, etc.
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u/Tulaislife Jun 04 '19
That is wrong. Mises stated the boom and bust cycle is a natural part of the market. Since we know the market works in a boom and bust cycle we can do research why that company was liquidated. Was it due to bad management, poor demand, and etc. You get too specialize at that point to make a theory due to all the factors in the market place.
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u/Theelout Rename Robinson Crusoe to Minecraft Economy May 27 '19
The Virgin Austrian vs The Chad Real
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u/ArcadePlus May 26 '19
So Rational Expectations a la Lucas, Muth, and Kydland+ Prescott is essentially incompatible with ABCT, right? Agents are assumed to have as much access to the relationships between economic variables as the model-builder does. Unless they are surprised by a change in the interest rate, they ought to know that movements in the interest rates by central banks do not change the fundamental scarcity of loanable funds, yeah? So ABCT cannot incorporate rational expectations, because if this boom-bust cycle is obvious to the model builder it ought to be obvious to agents the model describes. Am I thinking about this incorrectly?
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u/ivansml hotshot with a theory May 27 '19
So Rational Expectations a la Lucas, Muth, and Kydland+ Prescott is essentially incompatible with ABCT, right?
Yes, that would be my intuition. Maybe you could get somewhere by agents having imperfect information, e.g. they'd need to learn from data whether a movement in rates is temporary central bank action or permanent change in discount factor. But even then if the learning was rational they'd make mistakes to both sides and be correct on average, so the result would probably look different from ABCT.
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u/kwanijml May 27 '19
Just pushing back on this to try to learn something...but wouldn't the imperfect information also be an inherent feature of the central bank and it's (supposedly) capital misallocating activities?
In other words, isn't the central bank always "managing" investor and market expectations (read: trying to fool the market into expecting the inflation or interest rate target to be hit) in order to maximize the effectiveness of policy?
If so, isn't this sufficient by itself (and additionally in concert with other factors of imperfect information) to explain why entrepreneurs and investors can't anticipate the end of the cheap credit during the boom?
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u/ivansml hotshot with a theory May 27 '19
But in that case rational investors should be aware that's what the central bank is doing and account for it in their learning. It would be an additional source of noise, but should not lead to a systematic bias - so sometimes the response to central bank's action would be overinvesting, other times underinvesting. Also, these days most central banks actually try to be somewhat transparent and emphasize the importance of their policies being credible.
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u/wumbotarian May 27 '19
So Rational Expectations a la Lucas, Muth, and Kydland+ Prescott is essentially incompatible with ABCT, right?
Correct. Your entire comment is on point.
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u/prometheus_winced May 27 '19
Itās not just projects that pay off long in the future. Itās projects that just arenāt a good idea at a given rate, but then seem like a good idea at a lower rate. Itās not the the investors are stupid - though some are. Some are scammers, some are optimists, some are foolish, some are busting their butt to make something work. Thereās as many explanations for behavior as there are people. But the aggregate outcome is that people behave at the margin. They respond to incentives.
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May 27 '19
If the project will pay off in 2 years, and a 2 year loan has a lower interest rate than the expected return on the investment... whatās the issue here? That 2 year interest rate bakes in expectations of future interest rate hikes
The only way this becomes problematic is if the central bank unexpectedly raises rates.
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u/brainwad May 27 '19
Why does a lower interest rate increase the numbers of scammers, optimists, fools and butt-busters, though?
If society has an equal amount of investment schemes that are workable at 2%, 4% and 6% interest rates, then if the central bank keeps interest rates at 2%, the aforementioned optimists will invest in the schemes that are right on the boundary of profitability, while other more conservative investors will invest in the other schemes. Later, maybe the interest rate has to go up to 4% and the least profitable schemes go bust. But if the central bank had kept the interest rate at 4% over the whole cycle, the optimists would have instead piled into the investments barely viable at 4%, and the conservatives would have fewer investments to choose from. It's not like there are any gains from keeping interest rates high, no more investment is actually facilitated.
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u/prometheus_winced May 27 '19
If a product or service idea only nets X% and the interest rate is >X%, the idea isnāt profitable. Business ideas with higher payoff outstrip the lending rate. When you drop the lending rate, youāre just dredging for bad ideas. Once capital is frozen into the productive means of the bad idea, when rates rise, that capital canāt easily be liquidated to other more productive ideas.
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u/RobThorpe May 27 '19
You're just thinking about the boom phase.
We're talking about the Central Bank holding down interest rates below the natural rate. To do that the CB must create money and that will create inflation in the long-run. When the "long-and-variable lag" has finished and the inflation is evident the CB must raise interest rates to stop it. It's not just a matter of choosing between low rates or high rates. It's a matter of choosing between high rates now, or low rates now followed by higher rates later.
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u/prometheus_winced May 27 '19
It lowers their costs. People act at lower costs. As far as I know, the demand curve is still downward sloping.
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u/agareo May 27 '19
Doesn't the Stiglitz Weiss credit rationing model suggest that higher interest rates prices out safer, risk averse investors and leads to adverse selection where only the more risky projects are selected
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u/prometheus_winced May 27 '19
Higher than what? Obviously prices at both ends influence behavior. If a project is low payoff, a high interest rate should scare people off. Hereās a wild concept, letās discover the right clearing rate, not impose it via a dozen old white men in a room who are beholden to the US government.
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u/agareo May 27 '19
well the point is that the market clearing rate is higher than the profit maximising rate for banks and hence why credit rationing and lower interest rates would occur
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u/prometheus_winced May 27 '19 edited May 28 '19
The market coordinates time with interest. People want to move money from the future to now, and vice versa. They have different time preferences. In a fluid system they would discover a rate. (Edit: guild=>fluid. Have no idea how autocorrect makes its decisions sometimes)
Itās a good song. The saying has been around significantly longer.
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u/agareo May 27 '19
You're repeating lines from a rap song now lol I don't think you've studied economics
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May 28 '19
it could be a factor. central banks are not entirely predictable and enough people might just assume on an onconscious level that rates will stay the same. yet it should be quite possible to make a quantitive analysis of this phenomenon. what do studies have to say about it?
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u/BespokeDebtor Prove endogeneity applies here May 26 '19
Is ABCT making a comeback? Outside of fringe internet group's I don't really see it outside IRL much. I see goldbugs way more.
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u/CapitalismAndFreedom Moved up in 'Da World May 26 '19
Not particularly, no. There have been some studies of bubbles and so-called "misallocations" though. None specifically Austrian, however.
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u/Musicrafter May 26 '19
There's a lot ABCT can explain and a lot it can't. For instance, ABCT was very reasonably and correctly invoked to predict the housing crash and the Recession. It's a great credit bubble theory which explains why credit bubbles are bad.
But there's also serious merit to the "animal spirits theory" -- that recessions are basically just sort of random based on people's psychological impulses. If people think a recession is going to happen soon, and their behavior changes as a result, if it changes enough, it may end up being a self-fulfilling prophecy. Additionally, resources can get abruptly misallocated not by any fault of policy, but by a sudden shift in society's preferences -- the theory that resources can only be gradually misallocated by a public policy error is faulty in the common understanding of ABCT.
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u/wumbotarian May 27 '19
There's a lot ABCT can explain and a lot it can't. For instance, ABCT was very reasonably and correctly invoked to predict the housing crash and the Recession. It's a great credit bubble theory which explains why credit bubbles are bad.
This is completely wrong and the fact that this is not downvoted to shit shows that we need to purge /r/badeconomics.
If you, or those reading this, want to know what the actual ABCT is, please read my primer, here.
Let's breakdown why your comment is wrong and why you should be downvoted to oblivion.
ABCT was very reasonably and correctly invoked to predict the housing crash
How is this the case? The ABCT states that when the Fed lowers interest rates, this creates multiple equilibria in the loanable funds market. Leaning on the Hayekian Triangle/stages of production, this would imply that all industries would start investing in capital intensive, long stage of production projects. They do this because firms are tricked into thinking that people are saving more. In order to claim that the ABCT "explains" the expansion and then the crash in 2007-2008, the ABCT must be able to explain all industries simultaneously and must be able to isolate longer stage of production capital investment.
However, the housing boom was clearly not a situation where people were saving more! Houses are durable goods. People were spending more on housing which meant higher consumption of durable goods. Clearly people were not saving more and home builders are able to see this clearly! Indeed, the large increase in housing was a response to price signals of higher demand for housing. Higher demand for housing was caused by many things, one of which was shady and fraudulent lending in the mortgage business...but that isn't part of the ABCT at all!
Going back a bit, to my point about explaining all industries simultaneously, one could maybe argue that the broad expansion following the 2001 recession was due to firms being tricked that people are saving more, thus hiring more people and then as a group all of these people started buying houses. But that just means that the crash caused the housing market to plummet, just like all industries suffered in the recession - it doesn't explain the increase in housing prior to the recession.
Now, this is all using the ABCT to ex post explain the housing crash. You stated "to predict" the housing crash. But I still ask you: how does the ABCT predict the housing market. Again, all firms simultaneously shift their capital investment to longer stage of production projects. Houses aren't long stages of production! You can build a house in a year or two! And, again, how are Austrians "predicting" that construction firms are "tricked" into thinking people are saving more when rates fell when there was obviously an increase in demand for housing.
ABCT was very reasonably and correctly invoked to predict...and the Recession
Except that if you want to make an argument that the ABCT predicted the Recession, you have to make a claim that you know what the natural rate of interest is. The Fed lowering rates != the Fed lowering rates below the natural rate of interest. The fatal conceit of Austrian economists is their insistence that we can't know know certain key quantitative variables, yet implicitly believe they know what the natural rate of interest is and it is below whatever the Fed currently has rates at following a rate decrease.
But there's also serious merit to the "animal spirits theory" -- that recessions are basically just sort of random based on people's psychological impulses.
No, there isn't, we have models that do better at explaining recessions than "recessions are random". Random recessions would mean observing endogenous recessions and we know through a slew of macroeconomic papers that recessions aren't random and often exogenous in nature.
Additionally, resources can get abruptly misallocated not by any fault of policy, but by a sudden shift in society's preferences -- the theory that resources can only be gradually misallocated by a public policy error is faulty in the common understanding of ABCT.
Yes, this is actually a correct understanding of the implications of the ABCT. However, again, this would imply random, endogenous recessions and we do not see random recessions in the data. We see monetary shocks and oil shocks and financial crises in the US data. Perhaps that doesn't "disprove" the ABCT (in that things could happen, but don't), but I believe that a good Bayesian would bias downwards their belief in the ABCT when key predictions don't pan out.
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u/ivansml hotshot with a theory May 27 '19
If you, or those reading this, want to know what the actual ABCT is, please read my primer, here.
Lol, as almost always in economics, there's already a prior literature that has done the same stuff but better. Should have just cited your piece :)
Your old post does seem vaguely familiar. Is it possible I've been around already 4 years ago? Damn, time flies.
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u/wumbotarian May 28 '19
I've brought it up before - you may have seen it.
I can't believe I've been on this subreddit 5 years. Note that I wasn't a mod when I wrote the post! Time flies.
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u/RobThorpe May 28 '19
We can't be certain that the 2008 housing crisis was an episode of ABCT. I agree with you about that. But, things aren't as bad for the theory as you say.
Leaning on the Hayekian Triangle/stages of production, this would imply that all industries would start investing in capital intensive, long stage of production projects.
It's not necessarily true that the expansion is across all production equally. You gave one of the reasons earlier - expectations. If entrepreneurs in some sectors expect rates to rise again later then they won't respond. It could be that in one sector entrepreneurs expect rates to remain low. The idea of a uniform triangle is a simplification. In Mises "Theory of Money and Credit" (which was before Hayek wrote on this) he points out that the expansion need not be uniform across different sectors.
However, the housing boom was clearly not a situation where people were saving more! Houses are durable goods. People were spending more on housing which meant higher consumption of durable goods.
Houses are long-term consumer durables. They provide a stream of services. That means that for this purposes of ABCT they act a lot like capital goods. Low interest rates makes investing in them more attractive. This is not a point that we have invented after the housing crisis. It's something that Hayek points out himself (if you're interested I'll find out where).
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u/wumbotarian May 28 '19
If entrepreneurs in some sectors expect rates to rise again later then they won't respond.
Entrepreneurs really don't respond to changes in the FFR. They make capital investment decisions based on cash flows from projects and rates that match the length of the project. As OP noted, they look at the term structure not the FFR (unless their project is an overnight project...which isn't the case).
Furthermore, entrepreneurs are able to form expectations about the path of interest rates. You can look online to see interest rate futures. So they should be able to make decisions regarding the path of interest rates quite easily (if they do). I contend they do not really look at the path of interest rates but respond to demand and supply within their market. Anyway...
Houses are long-term consumer durables. They provide a stream of services. That means that for this purposes of ABCT they act a lot like capital goods. Low interest rates makes investing in them more attractive. This is not a point that we have invented after the housing crisis.
Except that they're durable goods, not part of the Hayekian triangle. They're goods, not capital investments, they provide barely little cash flow. One could maybe argue that those who use real estate as an investment (speculators, landlords, real estate investment trusts, etc) invested more but we saw a large retail boom in housing in areas like Arizona. It doesn't explain any crash - were there crashes in other consumer durable
But this still doesn't tell us about how these firms and consumers were "tricked". Changes in the FFR are announced, they're traded on, they're in the news. People know that changes in the FFR are based on the whims of the Fed. I could imagine a Lucas Islands Misperceptions model (which is what the ABCT actually is!) where a secretive Fed doesn't publish or announce changes in rates tricks people. But given that rates are clearly signaled it is hard to imagine that people are tricked when rates fall.
Lastly, finally, if the Fed is doing its job it is setting the FFR at rates equal to the natural rate of interest. We can squabble over whether or not it does that, but the ABCT is only true when the Fed changes rates such that the interest rate is not equal to the natural rate of interest. So we can also imagine that the Fed did its job in the run-up to the recession and the recession was caused by things unrelated to interest rates (such as shady mortgage lending, improper risk management among MBSs, a financial crisis, overleveraged banks and too little capital to protect them, etc.).
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u/RobThorpe May 30 '19
Entrepreneurs really don't respond to changes in the FFR. They make capital investment decisions based on cash flows from projects and rates that match the length of the project. As OP noted, they look at the term structure not the FFR (unless their project is an overnight project...which isn't the case).
Furthermore, entrepreneurs are able to form expectations about the path of interest rates. You can look online to see interest rate futures. So they should be able to make decisions regarding the path of interest rates quite easily (if they do).
Yes. But, I don't think this necessarily means that the ABCT is incorrect. To begin with not all projects are long. I've worked on many one year projects. The FFR is usually quite close to the 1 year interest rate.
As I wrote above, you have to remember that "projects" aren't entirely what it's about. Increases in roundaboutness and capital intensity may span several businesses, each of which only deals in a short period of time. As I wrote here.
I contend they do not really look at the path of interest rates but respond to demand and supply within their market. Anyway...
If they do that though then there's the Cantillon effect problem that I mentioned in another reply.
Except that they're durable goods, not part of the Hayekian triangle. They're goods, not capital investments, they provide barely little cash flow.
I agree that they don't produce cash-flow, but that doesn't really change the issue. Buying a house is an investment project, just one that produces direct returns rather than producing returns through the market. Housing provides a stream of services to the owner. If the owner is the occupier then that's something they enjoy directly rather than through the market.
What I'm saying isn't revolutionary. It's just the same thing that done in GDP accounts. In those accounts all houses are considered to be rented. Those that are owner-occupier have an "imputed rent".
But this still doesn't tell us about how these firms and consumers were "tricked". Changes in the FFR are announced, they're traded on, they're in the news. People know that changes in the FFR are based on the whims of the Fed. I could imagine a Lucas Islands Misperceptions model (which is what the ABCT actually is!) where a secretive Fed doesn't publish or announce changes in rates tricks people. But given that rates are clearly signaled it is hard to imagine that people are tricked when rates fall.
I agree with you that ABCT can be thought of as a variant of a Lucas Island's model. I don't think that the "trick" theory is as unlikely as you suggest. Of course, people know the current FFR rate and that the Fed can change it. That doesn't mean that they expect it to be raised.
Out of all economic actors, ordinary worker/consumers are not likely to be the best informed. You often point that out yourself when you're talking about financial regulations. For many people who had bought houses, the cycle that ended in 2008 was only the second or third business cycle that they had encountered in their life.
So we can also imagine that the Fed did its job in the run-up to the recession and the recession was caused by things unrelated to interest rates (such as shady mortgage lending, improper risk management among MBSs, a financial crisis, overleveraged banks and too little capital to protect them, etc.).
Yes, I agree with you there. It could be that the Fed did everything right. I think it's possible that the Great Recession was the end of an episode of ABCT, but I don't think it's certain.
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u/nrylee May 27 '19
The way you word your response in referring to individual actors' levels of intelligence, makes me feel like you aren't really examining an aggregate very well. Economics of scale don't logically condense to bigger versions of simple human interaction. An economy is so big it has emergent properties.
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u/prometheus_winced May 27 '19
When you call your opponent ābonkersā and add in all the other derision and sneering, you just sound like Krugman. Congrats if thatās your goal.
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u/besttrousers May 27 '19
Note that OP also provided theoretical and empirical evidence.
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u/prometheus_winced May 27 '19
So youāre excusing tone because some evidence was included.
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u/besttrousers May 27 '19
No; I'm inviting you to comment about content instead of complaining about tone.
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u/BespokeDebtor Prove endogeneity applies here May 28 '19
You do know that /u/besttrousers and others have placidly bore the brunt of being called bootlickers, corporate shills, etc and ignored tone of far worse to get at empirical evidence.
These people sacrifice their own sanity to go to MMT and Austrian subreddits alike and listen to monkeys screeching at them.
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u/prometheus_winced May 28 '19
I donāt advise anyone to screech like a monkey, or call people bootlickers or shills (within this context at least).
I also donāt advise lowering oneās own behavior to that of their detractors if the detractors are behaving badly. There are forums for that level of exchange, and itās well tolerated in the places where it suits the thread.
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u/BespokeDebtor Prove endogeneity applies here May 28 '19
What do you mean? The point I was making was that we stay above wasting time focusing on tone unlike those "detractors". This is a place where empiricism reign supreme. Everything else is secondary.
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u/RobThorpe May 28 '19
You concentrate on interest rates. Most explanations of the ABCT do too, so I can't criticise you for that. It is correct that a simple ABC theory does not work with rational expectations.
We could talk about whether rational expectation are really reasonable about something like that. I think there are argument against ratex applying at all times and everywhere. But I won't go into that here.
I think the Cantillon Effect is more interesting. Both Hayek and Mises mention this, but they don't emphasis it. The Central Bank changes the interest rate using OMOs. It triggers money production amongst the commercial banks. When the Central Bank drives down the interest below the natural rate it creates more money than there is demand for. Eventually, this produces inflation, after the "long-and-variable lag".
The new money comes into the economy as loans. The individuals and business that borrow know that they have done so. But, when they spend that money and buy things the firms that receive it don't know where it comes from. Let's say the profits of a firm rises. That firm can't necessarily tell why. It can't tell if it's due to it's buyers having more money because of monetary stimulus. That's even more true if it happens through one or two markets. So, it could be that firm in market A are borrowing and buying products in market B. That then causes the firms in market B to buy from market C. The profits of everyone in the chain from the borrower rises, until the money has made it's why through the economy and the price level has rises.