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.
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Notes
It may appear to be an oxymoron to say “a broad view of Austrian uniqueness,” but this uniqueness stems from combining non-neutrality of money; dynamic process; methodological individualism; and heterogeneity of capital. A narrow view of Austrian uniqueness would be to ignore “fellow-travellers” that don’t satisfy all conditions. A broad view would utilize any points of tangency.
Note that Cowen denies that his critique of ABC is built on rational expectations (Cowen 1997, p. 8).
Obviously this implies massive profit opportunities for those of us who are familiar with Austrian theory! We are sympathetic to this point but also view financial markets as being efficient. In a neoclassical framework this creates Wagner’s Paradox: “The world is efficient today and it will be efficient tomorrow. Yet tomorrow’s world will be different from today’s. But it is inefficient to change what is efficient. So tomorrow can never happen” (Wagner 1994, p. 136). We reconcile these views by making a distinction between our roles as scholars (observers of the financial system) and entrepreneurs (participants within it). By acting as if financial markets are inefficient, we make them become efficient, but this is a process view of human action.
Wagner (1999) makes this very point, “This requires a framework that allows for divergent expectations, in contrast to homogeneous expectations that characterize a postulated order framework.... What is surely noticeable about people and their expectations... is their heterogeneity and not their homogeneity” (p. 71).
We credit Nick Schandler with first making the point that follows; it came from a personal discussion.
We credit Isaac DiIanni, from personal discussion, for this point.
For example, Forbes compiles several lists ranking individual’s wealth.
Tullock said, “For our analysis, we shall assume that the interest rate which should have been 5 percent had been forced down to 3 percent although that seems a rather large cut granted the generally quite feeble instruments that government have for lowering the interest rate” (1987, p. 75).
Wagner stated, “Between Böhm-Bawerk and Wicksell, the path to the Mises-Hayek theory of the business cycle was a short one” (1999, p. 67).
As a referee points out, nonprice mechanisms are not unique to the loan market.
Furthermore, if we accept that Austrian assumption of uncertainty the entrepreneurial component is impossible to quantify.
This concept has been referred to in print more often than formally defined, but see Shostak (1999).
Also see Rothbard (1978) and Salerno (1987). In practice we follow Shostak’s Austrian School of economics money supply definition (AMS) as being the most accurate measure of the monetary footprint. Also see the new measurement “money with zero maturity” (MZM) which focuses on money that is immediately redeemable. Thornton views this as being close to an Austrian definition (Thornton 2008), while Shostak does not (Shostak 2003). The Ludwig von Mises Institute also tracks the true money supply (TMS) which is comprised of the following: currency component of M1, total checkable deposits, savings deposits, U.S. government demand deposits and note balances, demand deposits due to foreign commercial banks, and demand deposits due to foreign official institutions.
Austrians would stress the relative price changes, or “Cantillon effects” along the way. Cantillon is generally credited with the idea that inflation creates relative price changes as well as a rise in the absolute level. Since these relative changes occur during different time periods, inflation creates redistributive effects depending on how it is injected into the system.
Our thanks to Roger Garrison for pointing out this quotation.
Also, in a footnote we hear that: “Although the Fed must bear the ultimate blame for the real estate boom, there is enough blame to spread around to other parties that aided and abetted them... probably most important were the folks at Fannie Mae and Freddie Mac... they expanded their balance sheets immensely... because they... understand their debt to be guaranteed by the U.S. Treasury... a major case of moral hazard.” (Barnett and Block 2006, p. 32, n. 11)
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Evans, A.J., Baxendale, T. Austrian Business Cycle Theory in Light of Rational Expectations: The Role of Heterogeneity, the Monetary Footprint, and Adverse Selection in Monetary Expansion. Quart J Austrian Econ 11, 81–93 (2008). https://doi.org/10.1007/s12113-008-9034-6
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DOI: https://doi.org/10.1007/s12113-008-9034-6