Abstract
Informational cascades can be used to augment the existing Austrian business cycle theory. As first-order users of knowledge know the direct causes of a price change, they transmit this knowledge to second-order users through the price system. Banks with direct knowledge of the sources of the fresh liquidity during a credit-induced boom have knowledge of the boom’s artificial and unsustainable nature. Higher order users lack this direct knowledge and hence continue investing largely ignorant of underlying developments. When first-order users of knowledge sense the boom has run its course, they exit the market, sending a strong signal to higher order knowledge users that the boom has ended—a fragile situation built upon an informational cascade begins collapsing. Simultaneously, the boom is characterized by an influx of capital and knowledge into the financial sector owing to increased profits relative to the real economy stemming from Cantillon effects surrounding the credit injection. As knowledge pertaining to real production has also exited, the bust commences with a misallocated productive structure requiring equilibration to become consistent with consumers’ wants. Actions which inhibit this knowledge from returning to the productive structure will unnecessarily lengthen the time to recovery.
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Notes
Tullock (1987), Cowen (1997), Yeager (1997), and Wagner (1999) provide negative assessments of the relevance and fundamental validity of ABCT. Salerno (1989), Block (2001), and Barnett and Block (2005, 2006) provide responses stressing the applicability of a properly understood ABCT, used within its logical limitations.
See also Carilli and Dempster (2001) for a similar application and conclusion. Mises (1928: 135–136) also comes to a similar conclusion, if in less formal terms. These works are significant as they explain why it is that banks seemingly fail to learn from last experience concerning the consequences of an inflationary monetary policy. For even if they did learn, the knowledge would be useless if they still were forced into acting in the manner described by Huerta de Soto (1998/2006).
This distinction may, however, be better attributed to Pigou (1927) as he wrote of individuals routinely abdicating responsibility in situations where high amounts of social agreement exist. Particularly important is the emphasis on the financial realm whereby attitudes and beliefs toward business conditions are spread and diffused through the market with little regard to fundamental reason. Errors in optimism among some segments of the market will be transmitted to others with little heed to the underlying causes of such expectations.
Indeed, Lachmann (1943: 72) had already alluded to the problem of separate knowledge sets and their effect on action, stating: “Two farmers confronted with the same observable event, a rise in apple prices, will yet take different views of the situation and react differently if one interprets it as a symptom of inflation and the other as indicating a shift in demand under the influence of vegetarianism.”
One interesting early application of informational cascades has been presented by Brillouin (1956). As information is either held as free (i.e., non-communicated) or bound (i.e., physically transmitted in some manner), the two are linked by the possibility of loss of resultant information (i.e., negentropy). In fact, as Brillouin (1956: 155) demonstrates, with any transmission of information, the best case scenario is that no loss of relevance results. Hence, with the probability of the loss of transmitted knowledge always greater than, or equal to, zero, there is always the strong possibility that knowledge will eventually lose relevance through continual transmission. As Brillouin (1964) later shows, each additional transmission of information results in a general increase of entropy. We thank an anonymous referee for referring us to this work.
Some may argue that central bank transparency allows individuals to become aware as to the true origin of the fresh credit. This is, however, complicated by two factors. First, money’s fungibility makes those higher order users of knowledge unaware of what portion of the new liquidity is savings and that which is credit. Second, as any initial increase in bank credit under a fractional reserve system will be compounded as it is transferred among latter recipient fractional reserve banks, the degree to which the newly available liquidity is caused directly from an increase of credit by the central bank, and that which is caused indirectly by the fractional reserve system, will be difficult to discern.
Keep in mind that both Hayek (1968/2002) and Mises (1949/1998, 1951/1980) viewed all prices as disequilibrium prices and, by definition, false prices (to use Mises’ (1949: 338) words). It is Hayek’s competitive discovery process that seeks the necessary knowledge to replace these false prices with somewhat less false prices. Indeed, much like Kirzner (1992: 117) stresses, it is the existence of these disequilibrium prices that spurs on the entrepreneurial discovery process.
Coordination can occur through ways other than the pricing system. Kirzner (1973: 216) shows that this can be achieved through the decision to interact with another or not, a signaling process which need not rely on any price. Likewise, Thomsen (1992: 90) reminds us that not all action coordinations need result from information coordinations.
Huerta de Soto (1998/2006) reckons that in the monetary sphere, entrepreneurs are susceptible to being unable to discern between one such price—the natural rate of interest. As money is a fungible good, entrepreneurs are unable to identify that which has resulted from true savings (i.e., an offsetting reduction in consumption) and that caused by an inflationary monetary expansion. Carilli and Dempster (2008) explore some of the difficulties inherent in identifying the real interest rate (i.e., that caused by time preference), as they attempt to proxy this from historical savings rates.
Garrison (1982: 133) recognizes the implications of Hayek (1945) regarding the duality of knowledge with which agents will be acting upon. Hence, one set of Hayek’s tin users know directly the knowledge of the new demand conditions, and another group becomes aware of this through the actions of this first group—they lack the information as to the original source of the demand shift.
For earlier attempts at classifying investors into groups endowed with heterogeneous information, see Grossman and Stiglitz (1976, 1980), Townsend (1983), and Stein (1987). Most of these approaches treat knowledge as a costly commodity, thus affecting the degree with which it will be sought and ignore the entrepreneurial discovery process of unearthing and directing this new knowledge. Hence, one group of entrepreneurs becomes automatons as they simply follow the actions of the other group. See Kirzner (1984b: 205), Thomsen (1992: 33–36), Boettke (1997: 31), Huerta de Soto (1992, 2004), and Sautet (2000: 9) for critiques of this dualism of entrepreneurs based upon an objectively defined knowledge.
Lachmann (1943: 79) claims that interest rate expectations are inelastic and that expectations may only remain inelastic if the underlying fundamentals comprising the current monetary situation are known. As second-order knowledge users are largely unaware of this underlying situation, their interest expectations can be highly elastic—resulting in an acceptance for the increased quantity of credit at a lower than natural interest rate. von Mises (1943): 251–252) responds to Lachmann from a different angle, stating that the interest rate need not be visibly depressed compared to other periods but only lower than it would be if the inflationary monetary conditions were appropriately factored for.
See, in particular, Koppl and Mramor (2003: 256) as they state: “[S]uccess now becomes more closely tied to anticipating the behavior of the big player [i.e., the central bank], resulting in a reallocation of entrepreneurial alertness toward this task and away from fundamentals.”
A true demand for goods would correspond to the renunciation of consumption in the present—real savings.
We may think of the recent shifts from production to finance that occurred in America’s economy over the last boom—profits from production at GM diminished as its financing arm, GMAC, enjoyed increased growth and profitability. Similar cases can be found in many previously large American production companies (i.e., Ford, GE, etc.). Bagus and Howden (2009a) analyze Iceland’s recent financial crisis, particularly noting the preceding shift that allocated capital from the real sector (characterized mainly by the fishing industry) into the financial sector (characterized by banking and financial speculation).
See Bagus (2008: 291): “[T]he shift in the structure of knowledge or human capital during the asset price boom parallels the shift in non-human capital that has long been at the center of ABCT.”
Much “rational bubble” literature focuses on this disconnect between real and financial asset prices. Froot and Obstfeld (1991) note that “intrinsic bubbles” develop as fundamental values are departed from for extended periods of time due to the fact that they come to be viewed as either under or overvalued. Hence, initial “mispricings” may also reinforce future ones, creating a bubble. Tirole (1982) demonstrates that price bubbles cannot occur in assets having a finite life and, hence, determinable equilibrium value. Tirole (1985) furthers this to account for individual time horizons that continually update and reset to achieve bubbles in assets of finite life, in a dynamic setting. Koppl and Mramor (2003: 256), in distinction, reckon bubbles become irrational manifestations of herding behavior. The fact remains that rationality has not changed concerning the end goal sought by entrepreneurs (i.e., profits); rather, the only change is the means used to attain the profit oriented goal.
Bagus identifies three sources of the herding phenomenon: (1) illusory gains increase optimism, (2) credit expansion creates the belief that production is possible without consumption restraint (i.e., Huerta de Soto 1998/2006), and (3) increased financial profits attract new entrepreneurs to exploit profit opportunities (i.e., Mueller 2001: 14). Devenow and Welch (1996), and Bikhchandani and Sunil (2000) provide some alternative sources of herding behavior and review the relevant literature. See also Koppl and Yeager (1996), Ahmed et al. (1997), Gilanshah and Koppl (2001), Koppl and Mramor (2003), and Koppl and Sarjanovic (2003) for empirical looks at herding behavior caused by “big players” (i.e., those who are influential, insensitive to profit and loss, and have discretion over the exercise of their power) in the financial markets.
Remembering the implications of Dornbusch (1976), the real sector (defined by sticky prices) will experience little direct impact in the form of downward pressure on prices resulting from this monetary capital shift.
Paradoxically, one ancillary effect is that the previous pasture remains quite green. With fewer entrepreneurs exploiting profit opportunities in the real sector, there will be upward pressure placed on profit margins. Although these may increase in absolute terms compared to the scenario before the entrepreneurial shift, they will remain lower than exist in the financial sector, a condition necessary to ensure that the shift continues.
The homogeneity of the end sought (profit) answers the problem raised against herding behavior theory by Bikhchandani and Sunil (2000: 13): “[T]o examine herd behavior, one needs to find a group of participants that trade actively and act similarly.”
Of course, only in equilibrium could a situation exist where entrepreneurs are coordinating the needs between consumers and producers optimally and sustainably (see Kirzner 1984a: 415, 1984b: 204). However, as has been shown, a situation exists which complicates the problem in a much more fundamental way through an inflation-induced informational cascade which not only disrupts the convergence between consumption and production needs but between the productive economy and the financial economy as well.
Some posit that the bust is caused by a loss of confidence in the financial markets (i.e., Bagus 2008: 292). However, this is a proximal effect, not a cause of the bust. The cause of the loss of confidence is that loss of knowledge concerning the real economy. As the solution is now known to lie in creating a more cohesive productive structure, entrepreneurs are in a position where the necessary knowledge to do so is lost or temporarily forgotten. With no immediate knowledge of how to rectify the malinvestments in the economy, entrepreneurs may then lose confidence in their own ability to navigate the ensuing storm.
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Acknowledgment
The author wishes to thank the Ludwig von Mises Institute for generous support while writing this paper. Philipp Bagus, Roger Garrison, Matt McCaffrey, Matt Machaj, Joe Salerno, Leland Yeager and two anonymous referees provided helpful comments which greatly bolstered the arguments herein. All remaining errors are solely my own.
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Howden, D. Knowledge shifts and the business cycle: When boom turns to bust. Rev Austrian Econ 23, 165–182 (2010). https://doi.org/10.1007/s11138-009-0095-3
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DOI: https://doi.org/10.1007/s11138-009-0095-3