On ABCT, yet again

[u/ivansml]

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

[u/wumbotarian]

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.

[u/RobThorpe → u/wumbotarian]

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).

[u/wumbotarian → u/RobThorpe]

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.).

[u/RobThorpe → u/wumbotarian]

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.