Article

The Quarterly Journal of Austrian Economics

, Volume 11, Issue 2, pp 81-93

Austrian Business Cycle Theory in Light of Rational Expectations: The Role of Heterogeneity, the Monetary Footprint, and Adverse Selection in Monetary Expansion

  • Anthony J. EvansAffiliated withESCP-EAP European School of Management Email author 
  • , Toby BaxendaleAffiliated withSeafood Holdings Ltd

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Abstract

We contribute to the debate over the contemporary relevance of the Austrian Business Cycle theory (ABC) by making three theoretical developments. First, we claim that the heterogeneous nature of entrepreneurship is the best means to respond to a Rational Expectations (RE) critique. If entrepreneurs are different then the “cluster of errors” are not made by everyone, just those on the margin. And if the marginal entrepreneurs are systematically different from the population as a whole, we avoid the implication of widespread irrationality, even though credit expansion will affect real variables. Second, we argue that the size of the monetary footprint is a more telling signal than the market rate of interest, and will not necessarily be revealed by measured inflation. Therefore attention to the official interest rate or Consumer Price Index is misleading, and an inappropriate way to assess applicability. And third, the main harm from loose monetary policy is not that it encourages entrepreneurs to behave more recklessly with capital, but that it encourages precisely the people who can’t afford capital at the market rate to borrow, and makes them the marginal trader. This suggests that adverse selection is a more important issue than moral hazard. We acknowledge that empirical work is required to verify these claims, and suggest how this might be undertaken.

Keywords

Austrian business cycle theory Heterogeneity Monetary footprint Adverse selection Entrepreneur