ABCT debate

Following Krugman's and Cowen's criticism of Austrian Business Cycle Theory several days ago, Boettke has written a post on Coordination Problem and the debate in the comments is strongly suggested for the intermediate/advanced students of ABCT.

I cut and paste my comments because I'm quite proud of them.

The first was on the strange argument by which every change in the structure of production must yield unemployment because workers are laid off, so that the boom must increase unemployment. The argument is based on the confusion between structural changes which increases the demand for labor somewhere and structural changes that reduces the demand for labor somewhere else.

If demand increases in long-term capital goods, unemployment is reduced AND the structure of production is changed; if demand decreases in long-term capital goods, unemployment is increased AND the structure of production is changed. There is no reason to expect that ANY change in the structure of production need increase unemployment: there are structural changes involving a fall in job vacancies (increased employment) and structural changes involving a fall in job positions (increased unemployment).

Then I go astray and comment on a totally unrelated topic which has been raised by someone, I hope (otherwise I'm delusional). FRED is the Federal Reserve Economic Data database. Summary: there is no compelling reason at first sight to believe that long rates are not affected by monetary policy, at least looking at the rates. The regressions I ran are quite laughable but to me appears to prove the point. A more serious analysis should consider a vector autoregression specification, several control variables, and real interest rates. I don't have any experience in applied economics, also because it is so overvalued that I'm bored by it.

I don't understand the idea of the long-run rates untouched by monetary policy. Interest rates move in parallel, just look at FRED to be sure. Correlation between fed funds and 3-year interest rates is very strong (R-squared 0.87 with a RATE3Y=a+b*FEDFUND equation). This means that to know the present monetary policy and to know the present structure of commercial paper, t-bills and constant maturity treasuries rates is almost the same thing, from 1m to 5y. One can phone Bernanke and know the whole structure of the interest rates listed above by just asking for the Fed rates. So, either Bernanke looks at the interest rates and sets the target rate, or it affects interest rates at all maturities with his only policy instrument. The latter appears to be the correct explanation to me: a 1% cut in Fed funds is a 0.6% cut in 5y rates, i.e., a 3.3% compounded gift to 5y debtors. But maybe I'm missing some VAR specification and some data modeling...

My third comment was about many themes:

As a Garrisonmania suggestion, considering that the comovement issue (does consumption fall or rise with investments?) has been discussed by many, there is a 1993 (I guess) paper, available on his site, about overconsumption and forced savings in the theories of Mises and Hayek. Although that material is also in Time and money, that article for me is the starting point to assess most of Krugman's and Cowen's (and Woolsey's, Tullock's...) criticisms of ABCT. The standard version of ABCT with reduced consumption during the boom originated with Hayek and is so at odds with reality that although I believe ABCT is right I would never say that. :-) For what concerns praxeology, I quote Boettke: praxeology is not absurd, although less powerful than most think. However, although hyperrationalist interpretations of Mises are for bloggers, they are not the layman's fault: Rothbard and Hayek sometimes made the same mistake. The problem is that Mises is read in terms of Theory and the other 50% of his epistemology, History, is downplayed. Theory is a jackknife, not a miracle machine.

Then I decided it was time for overshooting and wrote a little treatise on ABCT. This comment is long, maybe too much, and probably difficult to follow.

First point: I never said that the boom/bust is a nominal phenomenon:

My point is that *real* GDP rises more than sustainably feasible, the fact that NGDP rises is true, too, but not central. The economy is overheating in real terms during the boom, producing beyond capacity: it's Y/P > PPF.

The second point is that overproduction beyond the PPF has nothing keynesian. A theory of a real resource crunch follows (the exogenous credit crunch due to inflationary fears was too common sense for me).

Real overproduction is not keynesian, it is misesian (in Hayek there is nothing like that): malinvestment and overconsumption are a movement beyond the sustainable production possibility frontier, not a free lunch of an economy working below it's potential due to market failures. Only movements within the PPF are keynesian (or MET, or credit channel).

I would describe the boom in three chronological steps, in which the first one lasts a money circulation period (one month?) and is separated for expository purposes only:

phase 1: money injected as credit causes an investment boom.
phase 2: money originally injected as credit circulates as wages and causes a consumption boom. (underlying hypothesis: C and I go beyond the sustainable PPF, otherwise phase 2 would cause a halt to investments).
phase 3: binding production constraints halt the simultaneous booms, prices may start rising, consumption and investment will no longer be able to comove, the boom ends independently on monetary policy (the delay between phase 3 and 2 is not due to monetary circulation, is due to the time structure of production: overproduction is possible, but not forever).

The third point regarded the comovement of investment and consumption.

1. It is true that price rigidities (MET) can push the economy below its PPF.
2. Not only price rigidities can do this: also credit deflation (as in Strigl, "Capital and consumption") and financial accelerators of various kinds. MET is a special case of a more general class of accelerators which make the recession harder than neoclassically ("movements along the PPF") necessary: all kinds of financial frictions can do the same job as price rigidities.
3. Even if the bust had no decelerators (the original Austrian "below PPF" accelerators are credit destructure and panic coordination problems), real expenditures in consumption should *fall* and not rise during the recession, because the recession is the discovery of the squandering of capital, i.e., it is an inward movement of the PPF. In reality, part of the recession is not a movement of the PPF, of course. There are frictions, and rigidities are one of them.

Another point was about the relation of credit and monetary disequilibrium. I haven't finished the study of this theory (is there a study which has an end?), however. I end up criticizing Hayek.

I'm not going to say that ABCT explains the severity of all the recessions, it is not true (as recognized by Mises 1931, C. Phillips 1937 and Rothbard 1963 for the Great Depression, when they pointed out the role wage rigidities). But the recession happens when productive unsustainability is revealed, it is a concept that can do without nominal frictions (which, however, exist).

As there is no exposition of ABCT which satisfies me on this point, the best being Garrison's - as usual - which is too aggregate, I make an example.

Let's assume that I've undermaintained old fixed capital for five years. I've moved workers toward the production of new fixed capital (which will require a lot of saving which will not be available on time and which adds to the consumption stream during the overconsumption phase), and toward the production of consumption goods. I can do this because fixed capital is durable, and as long as old and new fixed capital does not physically deteriorate, the boom can go on. When however the surge in the demand for saving arrives but demand for consumption remains strong, the recession begins. During the recession I have to reduce consumption, invest in the old and new fixed capital to save part of it, and scrap the unusable (for lack of complementary capital goods, i.e., savings) submarginal part of it.

This would be a problem also without frictions. Frictions only add severity and length to the readjustment. The countercyclicality of consumption which Krugman and Cowen criticize only exists in Hayek's writings, but not in Mises's or Strigl's or Garrison's. Hayek's theory of forces saving is the standard account of ABCT, but it is theoretically indefensible. Unfortunately, more sophisticated versions to my knowledge are way too complex. What really happens to the economy during overproduction and how real resources come to bind at the onset of the depression is at least to me still a mystery.

An interesting point I never analyzed in detail was why the crisis is sudden. I don't answer the problem because I need more careful thought on it.

Hayek said that it is impossible to consume now what will be available for consumption tomorrow, although it is always possible to save and invest now what is not consumed today: it's the time of production asymmetry. Frictions (among which price rigidities, I repeat, are only a part of the problem) add to the problem. I would consider, however, speed as a positive thing: it is better to have a 3 months crisis then a 5 years one, even for similar cumulative losses. The ideal would be a one week crisis: 100% unemployment for a week and then business as usual. This is impossible, however, because the capital structure need be fixed before reverting toward the sustainable path. Fixed capital is to be reshuffled, consumption need to change, workers need to be retrained and reallocated. I would allow several months for this, and for the panic and the ensuing coordination problems, even in the best case. This is a point I never considered, thanks.

There can be, however, a slow recession, which implies no readjustment of capital: Greenspan called it a soft landing. We saw them in 1921, in 192 and 1927, and in 1990 and 2000. Problems weren't solved, just postponed, but the bill turned out to be expensive. Can there be a slow recession, i.e., a slow building up of demand for capital because of capital undermaintenance during the boom which causes a slow reduction in employment, capital utilization, output, monetary multipliers and consumption which does not impede recovery? Can time be bought for readjustment?

I believe that the secondary deflation is at least in part unavoidable. It adds to the pain, but there are no painkillers available. Friedman and Schwartz said that the expansion in the '20s made the banking system more vulnerable to shocks. There is no boom without an overextension of monetary multipliers, financial leverage, risk... and there is no recession without a painful return to normalcy. If banks need to deleverage, also some good investments will be starved, if banks are forced not to deleverage by nominal expansion, the inherent fragility of their position at the onset of the boom remains (and moral hazard adds to the problem). It is a pity that the financial structure has never played a key role in ABCT... and it is largely compatible.

Back to Krugman's argument that the shift from capital-goods to consumer-goods industries should involve no unemployment because it is a shift in relative and not in absolute demand... with applications to Japan.

The argument assumes, however, that production with capital goods (roundabout) and production with hand-to-mouth technologies are equally productive. The lack of saving stops the production process. There is no boom in consumption because there is a tug-of-war between consumption and demand for credit. No one can produce without capital, and if consumption weren't curtailed, there would be no funding available for the restructuring of production.

I will make an easier example. Krugman (Brookings, 1998) said that devaluation may have helped the Japanese economy by fostering net exports. By fostering carry trade, however, devaluation would just siphon domestic savings out of the country. With which funds were Japanese going to restructure their economy, if investing in T-bills was better than investing in Mitsubishi bonds?

Finally, submarginal capital! What is it? What does constitute it?

I agree with Barkley Rosser in that overproduction is intuitively and theoretically a more complex object than the basic (and indefensible) Hayekian story of forced saving and reduced consumption.

As far as I know, what happens to the economy when there is overproduction has never been analyzed in details. Garrison talks of triangles pulled at both ends, but it's a metaphor, not a theory. He also talks of money illusion by part of workers, which can cause overproduction. Hayek and Machlup occasionally talk about undermaintenance of capital, increased exploitation of capital goods, shifts from long-term to short-term production at the top of the boom (Ricardo effect). However, to my knowledge this is a work in progress, not a full-blown theory.

However, don’t lose time with my comments. O’Driscoll, Woolsey, Koppl and many others have given life to a wonderful thread.