The Austrian business cycle theory, posited by Carl Menger, Ludwig Von Mises and Friedrich Hayek, has been analyzed and refuted many times. Almost all of the mainstream Neo-Classical and Keynesian economists have rejected all components of the Austrian business cycle theory, which Paul Krugman has previously started a particularly interesting edit war on Wikipedia about. Many prominent economists from several different perspectives, like Paul Krugman and others, believe that the Austrian business cycle theory is seriously flawed in all of its various components. While there are various enormous flaws in the details that the theory postulates, I believe it is wise to ruminate about at how the current policy of low interest rates that various central banks are pursuing is effecting the bigger macro-economic picture and to predict possible future crises by utilizing the Austrian business cycle theory.
To those who are not familiar with the Austrian business cycle theory, it was formulated by three prominent economists, Carl Menger, Ludwig Von Mises and Friedrich Hayek, as a possible explanation of how business cycle works. In the theory postulated by these two well-known gentlemen, it regards business cycles as the unfounded result of improper interests rates set up by central banks, which consequently results in a boom and a bust from this malinvestment of excessive business lending by banks. The theory favors an almost completely laissez-faire approach to the resolution of financial crises caused by what they see as a malinvestment of assets. The favored resolution to the crises could momentarily cause abrupt bank failures, but the resolution that the Austrians prefer is a proper liquidation of all debt and assets. This is a cause for consternation among mainstream economists and they see the Austrian business cycle theory as nonsensical, especially its recommendation for a completely laissez-faire economy. By looking at certain components of the Austrian business cycle theory such as interest rates, empirical research and successful predictions of downturns, we could not completely discount its role in the world of economics.
(For those that are interested in more extensive explanations of the Austrian business cycle theory, here are two links: One by Professor Roger Garrison of Auburn University and another by the Better Living Through Liberty blog. Here is a a more simplistic video explanation by Tyler Cowen, Professor at George Mason University.)
The Austrian business cycle has the most peculiar way of utilizing interest rates to explain the mechanisms of business cycles. This approach combines an unique approach of analyzing interest rates in how they interfere with certain market forces, especially since it predicts that most of the booms and busts created by the fractional banking system comes from tinkering with interest rates. The ABCT believes that by tinkering with certain interest rates, the central banks create the impetus for the crises with the setting of interest rates, usually one that is too low compared to the actual interest rate. The Austrians have mentioned that the last financial crisis was caused by the central bank's insistence on keeping the interest rates lower than what is particularly possible, which might be a feasible analysis of the situation.
Despite the numerous other factors that might discount the ABCT, the theory has proven accurate at utilizing the analysis of interest rates in determining the coming financial crisis. There are obvious pitfalls to the Austrian business cycle theory due to the sheer fact that the theory does not come up with an exact interest rate that is required to not cause a catastrophic recession that happened in 2007-2008. The Austrian business cycle also mentions that interest rates should be decided entirely by the market and it could potentially mitigate long recessions such as the one we just witnessed. There are obvious pitfalls in letting the markets decide the "natural" interest rates and permitting a natural market recovery without central bank intervention. Natural interest rates could potentially cause large fluctuations within the market and could also possibly price out certain people out of the market. (such as low income families, small businesses, etc.) Permitting a natural market recovery could have massive fluctuations in employment and could put a potential strain on the workforce, which could cause acute social problems in society. Despite all of these problems that the ABCT faces, I believe it is wise to look at both the ABCT's record in looking at interest rates and also correct predictions of future economic recessions.
Empirical research conducted by prominent mainstream economists have indicated that the Austrian business cycle theory is not entirely feasible. Let's just compare the opinions of the prominent economists versus the Austrian economists in terms of the conclusions of their empirical research. Let's start with a couple of economists who are rated as libertarian by the mainstream economic community:
Milton Friedman - The late Milton Friedman is considered by everyone as one of the top economists of the last 100 years, with many considering him to be the one of the top two libertarian economists of the last 100 years, along with the Austrian economist, Friedrich von Hayek. Friedman's brand of libertarian economics was not too different than Friedrich von Hayek's theories, but they maintained a lot of the Keynesian semblances that Friedman had been influenced by in his younger economist days, especially in the expansionary benefits of money-financed debt spending.
In Studies in the Quantity Theory of Money, the late Professor Friedman promoted the approach that the monetarists at the Chicago School of Economics had developed and rejected the approach that Hayek theorized in his works denouncing Keynes. From an interview excerpt with Professor Friedman, we can conjecture that Friedman felt that the ABCT was incompatible and has done "a lot of harm to the world". From the observations in his book and from the conversations with the late Professor Friedman, we can accurately conclude that Milton Friedman does not agree with the ABCT in its basic tenets of a completely laissez faire approach and the simplicity that it offers. Despite Milton Friedman's promotion of laissez-faire capitalism, he stops short of endorsing of it as intervention could have potentially saved the banking system during the first Great Depression. I might agree with Professor Friedman's conclusions in requiring some sort of intervention in times of crises, but it's interesting that someone who is one of the mainstream proponents of laissez-faire capitalism would be so overtly critical of market corrections in terms of theory and systemic banking failures.
Tyler Cowen - A more recent and less well-known mainstream economist that has been listed as libertarian by both economists and by the media is Tyler Cowen. Tyler Cowen is the Chair of economics at George Mason University in Fairfax, Virginia. Along with Professor Alex Tabarrok of George Mason University, both of them write in a very popular blog called the Marginal Revolution, which happens to one of the quick links on the right hand side of my blog. In a blog post, he condemned the Austrian Business Cycle Theory and even gave a pretty interesting logical response to the basic tenets of the ABCT. I found the analogy particularly interesting and I have posted in his blog without the official sanction of Professor Cowen!:
"Let’s say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed. Is that government failure or market failure? The price was distorted, but I still say this is mostly market failure. No one made you put so many bananas on your roof."
I must say that this is a quite interesting observation of Mises and Hayek's business cycle theory and I must presume that I agree with most of statement, with the presumption that government is sometimes and not always the problem.
Many Austrian economists (including the original Austrian economists) have presented their particular economic theories in great detail about the great mysteries that have stumped economists from time to time about the booms and busts in the business cycles that nobody has ever managed fully figure out. We will give two separate examples where Austrian economists have published the empirical evidence that supports the final observations of those that adhere to the Austrian School of Economics.
The first example is an article entitled An Empirical Examination of Austrian Business Cycle Theory, published in the Quarterly Journal of Austrian Economics, written by Professor Robert F. Mulligan, goes through an thorough examination of the Austrian Business Cycle Theory by exploring the basic tenets of Hayek's capital theory, which has to deal with the unsustainable expansion of credit. This expansion of credit is characterized by quantitative easing (QE) and other monetary tools that are available to both policymakers in the US Federal Reserve and other similar central banks. He utilized interesting pieces of data to explore Professor Hayek's theories in how a distorted non-market price for interest rates, often lower than sustainable market-determined interest rates, will eventually create an unsustainable bubble in short-term economic outputs. There is an interesting graph in the article on the major differences between the Austrian and more mainstream (Monetarist and Keynesian approaches), which is located in the middle of the article that I will post in this blog post:
In the empirical data gathered from the Federal Reserve Bank of St. Louis, we see a potential hypothesis answered based on the author's particular biases in the model that he utilized. He concluded from his mathematical model, which was a simple statistical T-test, that the Austrian Business Cycle Theory did indeed exist. What is particular about the results is that it does not offer much hope of any policy or monetary prescriptions beyond the basic Austrian catch-phrases, which are both stated throughout the document and in its conclusion. We have arrived at an interesting
The second example of the Austrian Business Cycle Theory is an article entitled Empirical Evidence of the Austrian Business Cycle Theory, published in the Review of Austrian Economics, written by Professor James P. Keeler. In this particular article, Professor Keeler goes into similar lengths that the previous article fails to cover. I find his particular empirical evidence quite interesting and I'll point them out here:
1. This article goes into very much the basics of the Austrian Business Cycle Theory, which was also stipulated in the section on the previous article. The difference here is that Keeler provides more statistical evidence than Mulligan in how the data is presented. Keeler talked about how the theory contains such a strong adjustment of market to natural rates of interest and how this was implemented and how it offers an interesting perspective on monetary shocks.
2. Keeler strongly covers analysis of stationary measures of interest rates, with the result similar to that of the previous article. However, Keeler mentions Wicksell's notion of the "correct interest rate" that is often torn between market and the nature rates of interest. For those that are are interested in reading Knut Wicksell's "correct interest rate" theory, whom was also one of the economic giants of the late 19th and early 20th century, here is a brief introductory article on the Economist website that introduces the idea to those who are not familiar.
3. As with the previous article, Keeler shows a strong correlation between the empirical data and evidence that the Austrian Business Cycle Theory does indeed exist, which is quite interesting, because there are various ways to collate the data to suggest otherwise. What's fascinating is that the Austrian Business Cycle Theory will continue to be rejected mostly as a matter of its reliance on monetary inaction, rather than the aggressive monetary policy that people from diverse point of views such as Friedman and Stiglitz would recommend. Even though, an interesting development has surrounded Stiglitz's most recent view of the economic situation that we are facing as he has come out and very much validated what some Austrian economists have said for a long time! While curtailing the influence of supply-side economics might be beneficial if supply siders were really in mainstream these days, it's interesting to see how Dr. Stiglitz has similar views towards certain issues as his "ideological opposites".
Ludwig Von Mises in 1929 before Great Depression And the Great Recession
The last interesting part of the Austrian Business Cycle Theory is how two of the landmark Austrian economists, Ludwig Von Mises and Friedrich Hayek, predicted the coming of the economic crisis against some mainstream neoclassical economists who had simply missed predicting last two serious recessions (The Great Depression of 1929-1939 and the Great Recession of 2007-2008). Ludwig von Mises and Friedrich von Hayek had constituted the Austrian Business Cycle Theory with the influence and application of Carl Menger's ideas, which is stipulated in many of his works but most notably in his literary masterpiece, Principles of Economics. This seminal work had a huge influence on the intellectual thought of both of these gentlemen and prompted the start of the marginal revolution, which happens to be the name of a popular economics blog. Here is an article by Victor Aguilar on what the reactions of the prominent Austrian economists would have been to the Great Recession and to the Great Depression (This is because at that time, Mises and especially Hayek were extremely prominent in the economics community). In a quote from the article is that the Austrian economists had predicted the subsequent crash and the depression that followed. Despite the relative accuracy of their predictions, there is much to be desired from their responses. What good does it come when you have correctly predicted the Great Depression, but not offer any ways to counterbalance the negative effects of the boom and bust cycles. The idea of central banking is a nadir to the economic point of view of Austrian economists and Von Mises famously accused many of his classically-liberal minded colleagues at the famous classical liberal society, Mont Pelerin Society, as big government socialists. As listed by the interesting article, Aguilar talked about Austrians' disdain for the full utilization of mathematics, because they associated heavy usage of mathematics as perhaps another tantamount to socialism. While there is nothing wrong with ridiculing most tenets of socialism, it is ridiculous to consider those who don't come up with the same conclusions as Von Mises to be a heretical Keynesian or a "socialist" New Classical.
From the evidence presented here, we should take a look at the textbook definition of the Austrian Business Cycle Theory to analyze what exactly went wrong with the theory as it comes to the mainstream audience in economics. The web link to the definition posted online, but is located in the Business Cycles and Depressions encyclopedic guide that I have been browsing for my series on business cycles. (Of course this just scratches the surface on the related literature that I have been browsing concerning this particular subject and this particular blog post series on business cycles.) For those who are interested in exploring more about the Austrian Business Cycle Theory, there is a tremendous amount of literature out there that covers all kinds of perspectives, but I hope I had covered some of the introductory material in this particular article.
While there is much about the field of Austrian economics that are not particularly relevant due to the rigidity of many of its various policy prescriptions, but I believe it is worthwhile to take a look at the evidence presented by the various Austrian economists such as Hayek and Mises, especially when it pertains to the analysis that surrounds finding the correct interest rate. The presentation of the evidence that they have given to us has been great in predicting the part in interest rates where there is real change in the economy, whether conducted in a partial or a nominal way. As we look at particular ways and methods in studying the booms and busts of the business cycle, we should look at examples such as the Austrian business cycle theory, not because of the unestablished axioms of their origins, but as an addition to the base of knowledge that we have accumulated concerning the study of the nature of the business cycle. As we try to find the perfect linear model to this particular dissimilar equation of solving the mysterious nature of how the markets work, we need to return to the question of linearity within the spectrum of economic models. There are many mysteries to finding the right model in figuring out the various theoretical components of how a business cycle works and based on the record that Austrian economics have set, it should be hard to cross off this particular heterodox approach as completely wrong. As shown by Eugene Fama's much scrutinized efficient-market hypothesis to Ben Bernanke's profound confidence in the financial markets before the Great Recession has shown that various mainstream approaches could sometimes be on the wrong footing with reality as well. From the evidence that we have here and despite the obvious flaws of the theory itself that I had abundantly pointed out here, it would be wrong to completely write off the Austrian business cycle theory.
(For those that did not see the newest update on my particular blog, I will now be writing a blog post on Fischer Black's book, Business Cycles and Equilibrium. This particular book has brought a lot of attention to me based on both his views in this book, but also of his legendary status in the academic discipline of monetary economics and of business cycles. In my next two sequential posts, I will talk about the Real Business Cycle Theory, which is quite popular among those adhering to new classical macroeconomics. They are also blamed by many adherents to the other varying competing schools, for various different and contradictory reasons, for failing to have anticipated the Great Recession of 2008-2009.
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