Re-switching, the average period of production and the Austrian business-cycle theory: A comment on Fratini

Abstract

In a recent contribution to this journal Saverio Fratini (Review of Austrian Economics, 2019) offers a critique of our work on Austrian Capital Theory on the grounds that our conception of capital and “roundaboutness” does not appear to provide adequate support for the Austrian business-cycle theory. In this comment we explain why we think this criticism is wrong.

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Notes

  1. 1.

    In fact, Fratini appears to agree with us that capital is not a factor of production and interest is not the price of capital, though he does not elaborate on these leaving us to wonder whether he agrees with our conception of what capital and interest are and how, in particular, the interest rate is determined.

  2. 2.

    There are other problems with the APP that need not detain us here (see Lewin and Cachanosky 2019, section 3.2).

  3. 3.

    We make the usual assumption that the rate of discount applied in each period dt is the same for all periods.

  4. 4.

    A derivative construct known as modified duration measures the semi-elasticity of NPV with respect to the interest rate.

  5. 5.

    The change in the ranking of investments is not really a paradox. NPV can be shown to be a polynomial whose degree depends on the number of periods involved and for which there are multiple roots, representing the rates of return (discount rates). The pattern of net revenues may be such as to display a large number of changes in response to changes in the discount rate. The rankings of any number of investment in terms of Duration may move back and forward in various ways. (See for example Osborne 2014, chapter 7; also Lewin and Cachanosky 2019, appendix).

  6. 6.

    A referee has pointed out to us that in his model Fratini assumes that both, labor employment and the wage rate are fixed (see his last passage before the conclusions).

    We are not sure what to make of this. It appears to confirm our impression that we and Fratini are talking at cross purposes. If Fratini builds a model in which both “the wage rate and the employment of labor are fixed” we wonder how such a model can illuminate anything about a business-cycle. Of what variations is the business-cycle composed? In our world, a cycle downturn implies a reduction in employment, and often a reduction in the wage rate and earnings. And our discussion of the AP using a financial concept of capital provides an explanation of this – the very issue that Fratini purports to discuss. Since our model does not make the assumptions Fratini does, we wonder how his comments are relevant to our model and its connection to ABCT. Evidently his cycle consists solely in variations in the labor-output ratio which, because of reswitching, does not behave the way he thinks it should for a proper cycle. However, this is not our cycle or, as we have explained, our concept of capital. We leave aside why Fratini would think it appropriate to assume that the wage rate and the quantity of labor employed should be assumed fixed.

References

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Lewin, P., Cachanosky, N. Re-switching, the average period of production and the Austrian business-cycle theory: A comment on Fratini. Rev Austrian Econ 32, 375–382 (2019). https://doi.org/10.1007/s11138-019-00460-1

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Keywords

  • Average period of production
  • Degree of roundaboutness
  • Capital
  • Re-switching
  • Austrian business-cycle theory

JEL classification

  • B25
  • B53
  • D24
  • D33
  • E32