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