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Paul Krugman on Austrian trade cycle theory
Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
Here is the link once again. But I think the point is more effective in reverse. Why should the boom be a boom in the first place? The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages. In other words, the Austrian theory doesn't generate the very high degree of comovement found in the data. Or, in other words, there aren't that many countercyclical assets.
One MR commentator suggests this, this, and this as responses. They make various points against Krugman (who I might add is not as clear as usual in this piece) but they don't solve this central problem of generating the amount of comovement found in the data. The best shot is to relax the Austrian-favored methodological assumption of full employment; I leave it as an exercise for the reader whether that could work and what other problems for the theory it might create.
I should add that Gordon Tullock has made much the same point, as has Bob Lucas or for that matter Piero Sraffa in 1932.
Posted by Tyler Cowen on October 14, 2008 at 06:41 AM in Economics | Permalink
Comments
The short answer would be : malinvestment, not overinvestment. In ABCT, the two ways this operates are :
- inflation changes relative prices and the resulting price signals cause entrepreneurs to misinterpret consumer preferences;
- inflation introduces noise in interest rates and causes intertemporal discoordination.
Would this imply that C and I are negatively correlated?
Also, I wonder how stable the separation line is between investment and consumption goods. This makes statistics tricky to interpret.
Posted by: Gu Si Fang at Oct 14, 2008 8:12:53 AM
My name links to a demonstration of the falsity of ABCT.
Posted by: Robert at Oct 14, 2008 8:47:25 AM
I'm not sure I follow his logic that spending is necessarily equal to income. Equality goes both ways, so by this logic every dollar earned is spent; is there no option for saving?
Posted by: Brian at Oct 14, 2008 8:53:00 AM
Since when do Austrians assume full employment? Austrians are generally against assuming things that are patently false. I certainly never operated under such a silly assumption, nor AFAIK did Mises, Hayek, Rothbard, Garrison, etc etc etc.
The reason it goes to investment goods is that inflationary money enters through the banking system. This is Feature #1 of ABCT so it's pretty disappointing Krugman doesn't Get that. The increase in spending on investment goods does NOT coincide with a decrease in spending on consumption goods because the money chasing it is the first round of an inflationary expansion, meaning it's just been printed (Rothbard would say counterfeited) and prices have not yet adjusted.
Posted by: Noah Yetter at Oct 14, 2008 9:44:59 AM
It's not obvious to me why a reduction in investment necessarily would lead to an increase in consumption. What if, instead of investing their dollars, people simply stuffed dollars in mattresses?
Posted by: dan cole at Oct 14, 2008 9:56:01 AM
"..an investment slump should always be accompanied by a corresponding consumption boom? "
This is true, but the corresponding shift between investment and consumption grow in time, as the cycle ages. We start with small adjustments between investment and consumption, then the adjustments take an increasing amount of capital as the adjustments move from small wealth to large wealth.
It is the inability to make small differential adjustments continually over time. As the adjustments grow, the adjustments take place in increasingly incomplete wealthy markets. We reach a point where the auction method is the most efficient adjustment method.
Macro folks see this as an unnecessary recession, Austrians see this a simply a very large temporary auction market.
Posted by: MattYoung at Oct 14, 2008 10:11:45 AM
ABCT is a matter of increased discoordination through time. Equilibrium interest rates coordinate the intertemporal plans of households with business investment plans. Although we never have equilibrium in credit markets, in the strict sense, variations in the nominal quantity of money can increase discordination in the market for loanable funds, and result in a boom-bust cycle. With monetary expansion households and businesses aim at mutually inconsistent plans, given scarcity constraints. Inflation reveals the inconsistency of these plans over time, and the expansion ends. This is a very reasonable argument that stems from plausible assumptions regarding the informational function of prices.
Posted by: DW MacKenzie at Oct 14, 2008 10:50:16 AM
Noah's description fits my understanding.
Posted by: Gabe at Oct 14, 2008 10:51:08 AM
Many economists have put "full employment" to be an economy experiencing a 5.5% or 6.0% unemployment rate. Now imagine a production possibility frontier with consumption on the horizontal axis and future consumption or investment on the vertical axis. Next, the Fed increases the supply of money and credit that creates more economic activity, which lowers the unemployment rate to 3% or 4%. This level of full employment is a possible but unsustainable. There is a movement off the sustainable production possibility frontier in the north east direction, i.e. an increase in both consumption and investment. However, this increase in both consumption and investment is not sustainable and must eventually collapses. The credit expansion has put resources in to use that would not otherwise have been put in to use (for example, a lower interest rate cause projects that may have had a negative NPV before to now have a positive NPV) causing an increase in both investment and consumption; and wages rise across the board. The credit expansion has increased consumption and investment and also real wages for workers engaged in investment and consumption production.
Posted by: Tom at Oct 14, 2008 10:58:18 AM
I am going to write up a piece for Mises.org on all this. But to steal my own thunder, I think Krugman and Cowen are overlooking the minor detail that you need to make flour before you can make bread. (I have a PhD, which is why I know that.)
Posted by: Bob Murphy at Oct 14, 2008 10:59:52 AM
For the life of me, I could swear some GMU blogger was suggesting that Krugman was arguing for the tenets of the ABC without calling it the ABC. Not your post in April, but before that. I'm still trying to dig it up.
But I always thought the argument was similar to what Gu Si Fang is making. Namely that the change in inflation causes the interest rate to go from say 4% to 2%, thus making a project that's profitable at 3% now look worthwhile. Thus investors will invest in it, but when consumers adapt to the change in inflation the rate will change back from 2% to 4% and now this project will be generating -1% and all projects under 4% that were invested in will go bust.
Posted by: David Peterson at Oct 14, 2008 11:01:41 AM
I think that the central idea in the ABCT is the idea that money is a loose joint in the system. And this loose joint idea is backed by the austrian microeconomic theory. I think that without the micro basis with austrian flavour the austrian macro theory falls apart (rational expectations and adaptive expectations are inconsistent with the theory). If Krugman does not know the austrian micro theory, he cannot understand the ABCT.
I think that this is the central point of the theory: If you give 1 thousand dollars to everybody, everybody will think that they are richer than the though they were before, this is a boom. But when they go to spend the money, prices will go up. The perception of the target utilities is them revised down, this is a bust. The central point about this theory is that agents take time to adjust their plans, first do adjust their planned spending, then the sellers take time to discover de increase in demand and adjust prices and the agents take time do discover these changes and the pattern of change. The market process reacts to a injection of money first the discovery of the money injected and the adjustment of spending plans then with the adjustment of prices the distortions are reversed. If this process starts in the baking sector, then the process will take years to be reversed because of the distortion in the intertemporal structure of production, then we have a real business cycle.
I think that the austrian perception about the market as a process with equilibrating tendencies is essential in the ABCT, without the the underlying theory of the process of plan revision that is generated by the monetary shock the ABTC does not "work". This means that economists must know and agree that the basic theory of the market process is a valid interpretation of economic reality before they can ever discuss the more complex developments of subjetivism. Krugman and Cowen don't know/disagree on the micro foundations of the ABCT, with means that they cannot ever understand/agree with the ACBT.
Posted by: Rafael Guthmann at Oct 14, 2008 11:31:54 AM
It's been a long time since I read Mises, but why the investment/consumption either-or? I don't recall that being a part of the theory. And does investment not fuel consumption? You can't build houses everywhere without going to Home Depot. I thought the Austrians explained that it was time preference that changes, investment simply being deferred consumption.
My understanding is similar to Gu Si Fang's. Risky projects that would not normally appear profitable become "feasible" at an artifically low cost of money.
Posted by: David at Oct 14, 2008 11:52:32 AM
I'm not sure the comments so far are really addressing Tyler's issue. He says, " the Austrian theory doesn't generate the very high degree of comovement found in the data." I think Roger Garrison has taken this issue seriously and arrived at a conclusion similar to Tyler's suggestion: "The best shot is to relax the Austrian-favored methodological assumption of full employment." Here is one exposition: http://www.auburn.edu/~garriro/strigl.htm.
Roger says we go off the PPF for a while. As far as I can tell, that's the right approach. I don't recall Roger addressing the obvious question, however. How can you go off the the PPF? He redefines the PPF as "showing *sustainable* combinations of consumption (on the vertical axis) and investment (on the horizontal axis)" (my emphasis). That hints at how you could get movement off the PPF, but I don't think Roger addresses the issue fully. I don't see why it would be that hard to do so, however. One area is the difference between measured values and the theoretical constructs they point to. Empirical co-movements are going on measured values only, of course. Second, the PPF is static, but we make intertemporal choices. Thus, I think you could get something like a movement off the PPF for the sort of reasons you get a cycle in the real-business cycles literature. In the boom you buy a new car, but you postpone that vacation you'd been planning because market opportunities *seem* to have improved. During the bust, you find you can no longer afford that vacation. Your lost leisure time helps us get off the PPF, but only temporarily.
Posted by: Roger Koppl at Oct 14, 2008 11:55:26 AM
Unless I'm missing something, in a downturn C+I falls, thus Y falls, and Tyler's positing that Y must hold stable so change in C must equal change in I?
I'd say that we can posit savings, so that C and I are both deferred to the future, thus Yt can fall.
Posted by: Peter St. Onge at Oct 14, 2008 12:35:51 PM
Roger,
or household and business plans combine to aim at a point beyond the PPF. Any such point clearly implies inflation and subsequent revision of plans.
As for empirics, my recollection is that Tyler admits that ABCT fits the empirical record (in his own book on this subject), but claims only that there are logical problems with ABCT. I do not have this book handy, so I cannot check, but I am pretty sure that this is the case. This is especially puzzling because Tyler has defended some of the stranger aspects of Chicago theory by saying that "theories are just organizing concepts for analyzing data" (i.e. they do not have to be 100% realistic). At least that is what he has said to me in the past.
DWM PhD
Posted by: DW MacKenzie at Oct 14, 2008 12:36:27 PM
Krugman: So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom?
No. A flight to safety, or to cash, is a sudden shift in time preference. Selling your tulip bulbs and stashing the money is not going to increase consumption.
The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment?
Um, maybe because the boom happens over an extended period of time and the crash happens quickly, faster than labor and capital markets can adjust?
And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.
I you accept this then it is impossible to talk about a recession "led by" housing, or some other sector of the economy. If the investment/consumption dichotomy is false, then this is false. Was Schumpeter really "vague?"
Posted by: David at Oct 14, 2008 12:40:17 PM
Investments take time to become consumption. As someone said earlier, you have to make flour before you make bread. An extreme example of this is oil prices.
1) As wells gets old and produce less and less, and consumption increases, we get a very strong increase in the price of oil.
2) The price increase leads to investment, in this case new drilling.
drilling.
3) As the investment finally matures (the wells start producing oil) the supply increases. However, since the investment was very very high due to the earlier very high price, there is an overabundance of supply.
4) The price crashes.
This is an example of a market bubble. You can derive it (alternatively it can be predicted from) from three things: the efficient market theory, the law of supply and demand, and the fact that investments take time before they result in increased supply.
When the good is money instead of oil, or when tis happens overall to the whole market at once, we can use it to explain the Austrian Business Cycle.
Posted by: Jorge Jandivar at Oct 14, 2008 12:57:53 PM
David Peterson is referring to this post in which Alex points out that a number of non-Austrians cited Fed-induced credit expansion as a cause of the current bust.
Posted by: Dave at Oct 14, 2008 12:58:15 PM
Either Krugman is very dumb, very dishonest, or I'm very stupid. Whatever the case, I think he's totally incorrect here:
Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom?Total spending in the economy can exceed income when money is being created. There are still a limited amount of real resources that money is chasing. We can have an excess of investment with fixed amounts of resources because investment requires current and future spending (i.e., it requires saving). Essentially the economy's savings can be over-consumed, meaning those over-investments aren't completable and real wages can in fact rise during this boom phase. Temporarily, there are more resources (and thus real wages) available to businesses because the economy is over-consuming its own savings.
I mean, really. I know economists often assume that money is neutral, but surely they know it isn't really neutral... Right?
For a real criticism of ABCT, why not click on Robert's name? I don't think it invalidates its basic premise of temporal coordination, but it does show that its lacking in explanatory power of the whole cycle.
Posted by: Grant at Oct 14, 2008 1:03:43 PM
Here is the BCT I got from Devil Takes the Hindmost. Investors are perpetually searching for greater "yield" especially if interest rates are low. Some investment seems to provide greater yield e.g. MBSs. There is greater and greater demand for the asset. The asset increases in value. The asset itself is used as collateral to create credit which is in turn used to buy more of the asset which creates a positive feedback loop. More and more people start buying the asset and eventually its value is determined purely by speculation. The bubble bursts and the asset starts going down in value. People start selling to cover their loans, asset values decrease, credit drys up and a positive feedback loop begins in the opposite direction.
Its pretty clear from the history of speculation that in a speculative boom a large number of people know that the investments don't make any sense and that there will be a crash. They all hope they can cash out before the crash. Speculative booms basically are very similar to pyramid schemes.
Posted by: assman at Oct 14, 2008 1:14:51 PM
I feel pretty stupid, but I don't get the objection. What is the comovement in the data that Tyler is talking about? Real wages go up in the boom and down in the crash?
Posted by: Dave at Oct 14, 2008 3:26:49 PM
As is his wont, Tyler once again airily alleges a grave flaw in the ABCT without evincing acquaintance with the barest rudiments of the theory. The ABCT is a malinvestment theory, not an overinvestment theory as Tyler's post implies. Forced saving does not result in investment, but in the production of wasted capital assets. Concurrently, the creation of fiduciary media and the distortion of interest rates that feed the boom and forced saving cause the falsification of economic calculation that also misleads those involved in the production process into overestimating their incomes. Most spend part of these illusory gains on raising their standard of living in the present, setting up a general and pronounced tendency to overconsumption. Thus overconsumption, not overininvestment, is the obverse of forced saving and the essence of the boom
Mises (HA, pp. 555-56)was quite clear on this point: "The ensuing boom in the prices of producers' goods may at the beginning outrun the rise in the prices of consumers' goods. . . . But with the further progress of the expansionist movement the rise in the prices of the consumer goods will outstrip the rise in the prices of the producers' goods. The rises in wages and salaries and the additional gains of the capitalists, entrepreneurs, and farmers,although a great part of them is merely apparent, intensify the demand for consumers' goods. . . . It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment."
Thus not only does ABCT explain the requisite "comovements in the data," it demonstrates the indissoluble link between forced saving and overconsumption. Before Tyler delivers himself of anymore breezy apercus concerning ABCT, he should write 100 times, "Overconsumption not overinvestment."
Posted by: cleric at Oct 14, 2008 3:47:16 PM
Here's my explanation.
Most discussions of the ABCT, pro or con, I've seen get a little bogged down in the attempt to translate the logic out of financial abstractions and into their "real" effects. Krugman clearly falls prey to this. If you forget about "malinvestment" and just think in terms of yield curve fluctuations, the problem is much simpler.
Basically, an Austrian business cycle happens when short-term lending is maturity-transformed into the market for long-term loans, leading to a fall in long-term interest rates and a corresponding appreciation in long-term bonds. However, since maturity transformation is inherently unstable, this flow can reverse in a hurry: bank run. The result is a spike in long rates, a fall in long bonds, and a large number of projects which need to be liquidated because they are not viable at the astronomical implied interest rates of a bank run.
The last are the "malinvestments." None of this stuff is rocket science.
If you add government protection to the equation (lender of last resort), you lose the bank run and exchange it for moral hazard. If the government protection is watertight, as it is now, the government might as well just be making the loans itself. As it is now.
Basically, Secretary Paulson just shot the Chicago School in the head. It may survive indefinitely as a zombie, of course, like its Keynesian cousin. But it's now impossible to pretend that fractional-reserve banking is a market mechanism.
Posted by: Mencius at Oct 14, 2008 3:53:01 PM
Oh no Tyler, I'd say you just got PWNED by cleric. I find myself wondering why people like you and Krugman even bother to criticize ABCT given that you don't seem to have devoted enough time to understanding what it actually says.
Posted by: Vijay at Oct 14, 2008 4:21:10 PM
