Sticky aggregate consumption is a demonstrable phenomenon in economies throughout the world, but to our knowledge it has not yet been incorporated into capital structure macroeconomics. Doing so suggests an explanation for business cycles. On the heels of a technological advance, sticky consumption facilitates increased savings and lower real interest rates. These lower rates lead to accelerating elongations in the capital structure. Even though such elongations facilitate more rapid economic growth, if duplicative overinvestment in research and development occurs, economic contraction will follow the exposure of such error.
This is a preview of subscription content, access via your institution.
Buy single article
Instant access to the full article PDF.
Price includes VAT (USA)
Tax calculation will be finalised during checkout.
The Life Cycle Hypothesis (LCH) and Permanent Income Hypothesis (PIH), according to Modigliani (1986, p. 299) were both inspired by a “highly imaginative” analysis of Margaret Reid (unpublished) which pointed to a totally different explanation for the association between the saving ratio and relative income—namely that consumption was controlled by normal or “permanent,” rather than current income. Under the emerging consensus interpretation of the PIH (see Footnote 2), it is reasonable to lump the LCH and PIH together as in Hall (1978).
“There are many possible definitions of permanent income, and if we are to be precise, one must be selected. I work with a definition whereby permanent income is the annuity value of current financial and human wealth, and in which consumption is set equal to permanent income. Although there are passages in the book where Friedman explicitly dissociates himself from this interpretation, in later work, Friedman (1963), he is much more sympathetic, although he suggests that consumers may discount the future at rates that are a good deal higher than normal market rates.” Deaton (1992, p. 81)
According to the life cycle and permanent income hypotheses, past changes in consumption should not explain current changes in consumption because those past changes in consumption, by those theories (where the PIH is interpreted to mirror the life-cycle hypothesis (see Footnote 2), would have built in any changes in permanent income. Changes in current consumption should, on these theories, be driven solely by current changes in permanent income. But, again, after removing the influence of changes income and/or asset holding, Carroll, Slacalek, and Sommer find a statistically robust ‘persistence’ in changes in consumption growth of 0.7. Were consumption growth changes characterized by a random walk, as Hall and Carroll, Slacalek, and Sommer explain is implied by the PIH, the estimated persistence coefficient would have been 0.0, instead of 0.7.
Throughout this literature, beginning with Hall (1978), the focus has been on non-durables for two reasons. First, non-durable consumption is the vast majority of consumption. And secondly, as Hall (1978, p. 979) explains “dropping out durables altogether avoids the suspicion that the findings are an artifact of the procedure for imputing a service flow to the stock of durables”. In keeping with the practice of this literature, we show growth in non-durables in Fig. 1.
Business Cycle Dating Committee of the National Bureau of Economic Research.
Garrison’s (p. 59) Figure 4.1 and our Fig. 2 differ in only by our adding the letters “L” and “M” on the production possibility diagram; these were added to facilitate cross comparisons with our later diagrams.
The interest rate designation is “i” in Fig. 2 because changes in nominal interest rates are the focus of Garrison’s analysis of the excessive money supplies that drive ABCT. Because monetary distortions are not our focus, we assume an absence of any monetary distortions and couch our discussion in terms of real rather than nominal interest rates. Hence in Fig. 4, the interest rate designation in the loanable funds diagram is “r” for real interest rate rather than the “i” for nominal rate found in Garrison’s text and as shown in Fig. 2 of this paper.
In Fig. 2, one sees that the Hayekian triangle’s horizontal leg is labeled, as Garrison had it, “Stages of Production.” In Fig. 4 (and beyond) one sees that this leg has been relabeled “Structure of Capital.” This change is crucial to this paper and its importance will be explained in great detail in Section 4.
See Hayek (1931); Figures 2, 3, 4, 5, and 6 on pages 44, 52, 56, 59, and 61. Also note that Hayek’s (1931, p. 39) Figure 1 shows a linear version of his “Means of Production” diagram that is more recognizably similar to the Hayekian triangles shown by Garrison; an obvious difference, that all familiar with Hayek and Garrison know well, in order to fit the triangle into his multi-quadrant macro graphs, Garrison’s depicts the Hayekian triangle with consumption on the vertical leg and stages of production on a horizontal leg that has the time remoteness from consumption of stages of production increasing from right to left.
“…[T]he term ‘trade secret’ means all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if—(A) the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information…” 18 U.S. Code § 1839—Definitions accessed online at: https://www.law.cornell.edu/uscode/text/18/1839.
One of us has extensive experience as a CEO of firms doing R&D. From his experience we learn of another way to protect trade secrets. The knowledge of a particular innovation can, in some cases, be compartmentalized so that no individual has full knowledge of it. Compartmentalization of knowledge, in such cases, is another technique that can keep new product R&D securely sequestered.
Research and Development expenditures in the US are estimated to exceed 400 billion dollars in labor costs alone.—http://www.oecd.org/innovation/inno/researchanddevelopmentstatisticsrds.htm.
Hayek’s (1933) famous general critique of “disproportionality” (p. 54) business cycle theories (in his discussion of them, too many capital goods are created relative to consumption goods) is correct if narrowly framed within the context of the stages of production (where products are produced, bought and sold and where market prices are constantly moving resources toward a restoration of equilibrium). Within this context, Hayek raised questions that were unanswerable by economists considering disproportionality theories: “Why do the forces tending to restore equilibrium become temporarily ineffective and why do they only come into action again when it is too late?” Once the context is expanded from stages of production to include all elements of the capital structure (that is, including sequestered, new-product R&D), Hayek’s questions can be straightforwardly answered: The activities in new-product R&D are by design secretive and errors are revealed only as prototypes enter the stages of production where prices and other signals are emitted; systematic errors are exposed when new products emerge in swarms as Joseph Schumpeter (1912, 1934) observed.
“Prior to late 1912, there were no laws or regulations restricting amateur radio transmitters in the United States. The industrialized northeast quickly became congested with a mixture of competing amateur and commercial stations…” http://earlyradiohistory.us/sec012.htm
“Sheer survival was always a paramount concern of the early automobile firm. Motor Magazine found 300 commercial firms had entered by 1910 and 270 had retired.” Robert Paul Thomas (1969, p. 147)
Imitation in the wake of a particular innovation is not only something that would have been palpable in Schumpeter’s day (Footnotes 14 &15), but continue to be so. Recall, for example, the dotcom bubble. It began in early 1999 following the hugely successful IPO of Netscape and other early Internet companies. This motivated venture capital firms to find and fund myriad startup ventures. According to the National Venture Capital Association, NVCA Venture Report (2016), the quarterly number of investments into early stage R&D projects soared from about 400 in May of 1999 to over 1000 in June of 2000 and then plummeted to only about 200 by September of 2002. The emergence of large numbers of R&D firms beginning in 2000 whose unprofitable business models (and therefore with no exit strategies) where expose shortly thereafter led to a collapse of capital investments and an industry-wide contraction.
Not all innovations will bias new-product R&D in this way. Absent this bias, as one referee pointed out, some widely successful innovations would emerge from the expanded new-product R&D and some would be losers. Without the duplicative bias we are highlighting, variance would just have been increased by sticky consumption; that is, no systematic negative (unprofitable) bias appears to be implied by sticky consumption.
The implication of the changes in the capital structure shown in Figs. 4 and 6, in light of our discussion of Fig. 8, is straightforward: During periods of economic expansion, sticky consumption will move increasing proportions of economy-wide investment into sequestered, new-product R&D. So although sticky consumption can foster economic expansion, it can also tip the scales over time toward contraction by pushing an increasing proportion of invested resources into new-product R&D.
The extent of contraction depends on the circumstances, institutions, and innovations involved in the particular unsustainable boom being considered. For example, the dotcom boom & bust (circa 1999 to 2002) was largely limited to the “tech” sector, whereas in the case of the housing bubble (circa 2006 to 2009), because it was funded by the overextension of credit by the commercial & investment banking system incentivized by the Federal Government, the bust played out in a much broader fashion, impacting many sectors of the economy.
The reason that point H lies inside the PPF labeled t1 is that, sensibly, in Garrison’s framework and in Austrian economics more generally, overinvestment/malinvestment precipitates busts that land the economy with curtailed production possibilities relative to those that would have been attainable and sustainable had there been no overinvestment.
Observations about the stickiness of consumption during contractions led Duesenberry (1959, p. 24) to illustrate his habit formation/relative income theory with this example: “Suppose a man suffers a 50 % reduction in his income and expects this reduction to be permanent. Immediately after the change he will tend to act in the same way as before. When the situations which led him to make expenditures before recur, he will continue to respond by making the same expenditures. But if he does this for a time he will find that his assets are being reduced; or if he had none he will find that late in the income period he has to forgo purchases which seem more important than those made earlier. In retrospect he will regret some of his expenditures. In the ensuing periods the same stimuli as before will arise, but eventually he will learn to reject some expenditures and respond by buying cheap substitutes for the goods formerly purchased. Eventually he will reach a new consumption pattern such that he will not, in retrospect, regret any of his expenditures. This pattern is likely to become habitual in the same way as the original pattern.”
Bean, C. R. (1986). The estimation of “surprise” models and the “surprise” consumption function. Review of Economic Studies, 53, 497–516.
Campbell, J., & Deaton, A. (1989). Why is consumption so smooth? Review of Economic Studies, 56(3), 357–373.
Campbell, J. Y., & Mankiw, N. G. (1987). Permanent income, current income, and consumption. NBER Working Paper No. 2436.
Carroll, C., Slacalek, J., & Sommer, M. (2011). International evidence on sticky consumption growth. Review of Economics and Statistics, 93(4), 1135–1145.
Constantinides, G. (1988), Habit formation: A resolution of the equity premium puzzle. University of Chicago. Unpublished paper.
Deaton, A. (1992). Understanding consumption. Oxford University Press.
Deaton, A. S. (1987). Life-cycle models of consumption: Is the evidence consistent with the theory? In T. F. Bewley (Ed.), Advances in econometrics, vol II (pp. 121–148). Amsterdam: North-Holland.
Duesenberry, J. (1959). Income, saving and the theory of consumer behavior. Cambridge: Harvard University Press.
Erkens, D. H. (2011). Do firms use time-vested stock-based pay to keep research and development investments secret? Journal of Accounting Research, 49(4):861–894.
Friedman, M. (1963). Windfalls, the ‘Horizon’ and related concepts in the permemant income hypothesis. In C. Christ et al. (Eds.), Measurement in Economics (1–28). Stanford University Press.
Garrison, R. (2001). Time and money: The macroeconomics of capital structure. London: Routledge.
Hall, R. (1978). Stochastic implications of the life cycle-permanent income hypothesis: theory and evidence. Journal of Political Economy, 86(6), 971–987.
Hall, R. E. (1988). Intertemporal substitution in consumption. Journal of Political Economy, 96, 339–357.
Hayek, F. A. (1931). Prices and production. New York: Augustus M. Kelley Publishers.
Hayek, F. A. (1933). Monetary theory and the trade cycle. In J. Salerno (Ed.), Prices & Production and other works. Ludwig Von Mises Institute.
Horwitz, S. (2012). What the Austrian business cycle theory can and cannot explain. http://www.coordinationproblem.org/2012/02/what-the-austrian-business-cycle-theory-can-and-cannot-explain.html; February 11, 2012; Accessed 2 June 2016.
Kuhn, T. (1962). The structure of scientific revolutions. Chicago: University of Chicago Press.
Mises, L. (1998). Human action. Auburn: Mises Institute.
Modigliani, F. (1986). Life cycle, individual thrift, and the wealth of nations. American Economic Review, 76(3), 297–313.
Schumpeter, J. A. (1912, 1934). The theory of economic development: An inquiry into profits, capital, credit, interest, and the business cycle. Cambridge: Harvard University Press.
Thomas, R. P. (1969). The automobile industry and its tycoon. Explorations in Entrepreneurial History, 6(2), 139–157.
For providing valuable critiques and suggestions on earlier versions of this paper we are indebted to: Philip Coelho, Chris Coyne, Randall Holcomb, Steve Horwitz, Roger Garrison, Paul Mueller, Ben Powell, and Lee Spector.
About this article
Cite this article
McClure, J.E., Thomas, D.C. Can sticky consumption cause business cycles?. Rev Austrian Econ 31, 51–72 (2018). https://doi.org/10.1007/s11138-016-0371-y
- Sticky consumption
- Business cycle
- Capital structure
- Economic growth
- Sequestered capital