In my last article, I shortly summarized a Keynesian criticism of the Austrian Business Cycle Theory (ABCT) views on the misallocation of resources. However, the numerous problems of the ABCT have, in short, been largely ignored by the libertarian community.
The following article is a summarization of the criticisms of the ABCT made by the Keynesian Papers.
The Keynesian Papers explain the central idea of the theory as “The central bank lowers interest rates in hopes of encouraging investment, below the ‘natural rate,’ or the rate that would be charged if money was truly neutral or if commodities were loaned out and repaid for with themselves,” and this therefore leads to companies shifting funds from consumer goods to capital goods. This leads to an overexpansion in capital goods and an inflation in the industry and the resources required for it, and the misallocation is realized and the crash happens. Wages then lower to the equilibrium wage, and resources get properly allocated. Spending in capital and consumer markets return to normal. Using this definition, and not the oversimplified ones, you realize this isn’t about consumers buying cars they couldn’t even afford, or taking an unaffordable mortgage getting packed into synthetic CDOs.
The Natural Rate of Interest
Austrians say that the crash is caused by the central bank lowering interest rates below the “natural rate,” but what if I told you there was no there was no ACTUAL “natural rate” of interest, or an infinite amount of them? This natural rate is the rate that would happen if there were no monetary effects to distort this market. However, this isn’t true for multiple reasons.
“There are as many natural rates as there are goods in a market. Demand for one good and the interest that would be asked for it would vary for every single commodity. As long as money exists, there will always be some effect on the interest rates, no matter how that money is backed. Gold doesn’t solve it, because it’s still only a symbol of the goods being purchased with it, which still have their own unique rate of interest.”The Keynesian Papers
To summarize, there is an infinite amount of “natural rates” because they vary for every, single commodity. There’s also always some sort of distortion because of the nature of loans not being made in goods themselves, but rather money, either on a gold standard or fiat. The Keynesian Papers use the Investment Savings – Liquidity Money (ISLM) Model.
As long as we have a monetary system of exchange, interest rates aren’t only determined by the “supply and demand of funds,” which is only the IS curve. An increase in the supply of funds leads to more people saving, and because of the multiplier effect, that leads to less income (and a decrease in investment demand will decrease GDP with the same results). The Liquidity Money curve shows supply/demand for money for loans. When income increases, so does demand for money on the market for loans, which increases interest rates. Therefore, a change in interest rates because of Federal Reserve policies don’t cause anything to leave equilibrium, but rather create a new equilibrium point. So when someone says the Federal Reserve sets rates artificially low, just know that there isn’t anything “artificial” about it.
When you demand is expanded in the capital goods industry, the ABCT claims that inflationary pressures come as a result. Resources get used up by expanding companies, creating upward pressure on prices. However, this doesn’t take into account the significant amount of idle resources (which is especially significant during recessions). There is rarely 100% crowding out, and rarely is our economy at 100% capacity. Think about it– there are empty factories, workers to spare, unused resources, etc. Using up these idle resources, this unused production capacity and output, won’t usually cause inflation, as they aren’t currently demanded by other in other industries. Without inflation, malinvestment cannot occur. Only if we are at full capacity and employment will it present itself, but Keynesian policy would be to increase rates. After all, a small amount of overexpansion is preferable to a long, deflationary, unemployment-filled spiral.
Critics of the idle resources critique usually reference Say’s Law, the postulate that supply creates its own demand. The consequence of this is that an economy cannot overproduce, even though a certain industry might. He believed that only negative shocks could decrease aggregate demand, so any overproduction was just because of misallocated resources that caused another product to be underproduced. However, there is flaws to this because it does not address things like loss in consumer confidence (“animal spirits”) and decreasing aggregate demand.
Say’s model is also unable to account for an increase in the demand of money in another way. In a situation where an economic agent reacts to a negative shock by holding on to money, they have produced but not consumed, and have no greater incentive to consume than to save. This is essentially an increase in the demand for money, which is not a produced commodity in the way that food items or computers are. This rise in demand for money necessarily results in a fall in demand for commodities in general, or as it is known today, a fall in aggregate demand. Since producers have already produced the commodities currently on the market, they are powerless to adjust to this sudden fall in aggregate demand. This creates a surplus “across the board” for commodities, also known as the general glut that Say claimed could never exist.The Keynesian Papers
Consumption in Booms
Another issue in the ABCT is how it deals with consumer markets. The ABCT claims that during booms, spending is going to capital goods, as the low interest rates encourage this (as explained before, and because total income is total spending). If the ABCT was valid, consumption on consumer goods should decrease during booms, yet that doesn’t happen- it increases during booms and retracts with investment markets during bust periods. Consumption might fall because of a loss of consumer confidence after capital markets do, yet this requires that capital markets take the first/central hit, but often consumption takes the worst/first hit or falls in unison.
Friedman is known for being the face of the monetarist movement, a movement that is in some ways in the “middle” of Keynesian and Austrian theory. His viewpoints are characterized by a laissez-faire fiscal policy with a regulatory monetary policy, and he had an interesting perspective on the ABCT. In Friedman’s 1993 paper on the theory, he explains that there is a “bust-boom” cycle rather than a “boom-bust” cycle. Basically, recessions are cause booms that are in the same intensity, but booms don’t cause recessions of equal intensity, which is required by the ABCT. The misallocation during the boom and the reallocation during the bust should cause booms and recessions of the same magnitude (in that order) according to Austrian theory, yet that is empirically not the case.
2008 Financial Crisis
Nobody denies misallocation of resources can happen, but it’s usually not what the actual problem is, merely a rare exacerbation of a current problem. A good example of this is during the 2008 financial crisis. While low interest rates contributed to the crisis, it by no means caused it.
“If deregulation never happened, and if the NRSROs weren’t corrupt and didn’t make ratings to keep business with investment banks, the crisis would’ve never been taken to the heights that it went too [sic]. On top, easy credit conditions would’ve remained in the US even if the Fed didn’t lower rates in 2001. Between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the US to borrow large amounts from abroad, much of it from countries running trade surpluses. These were mainly the quickly growing economies in Asia and oil-exporting nations in the Middle East. The balance of payments identity requires that a country (the U.S.) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the U.S. to finance its imports. All of this created demand for various types of financial assets, raising the prices of those assets while lowering interest rates.”The Keynesian Papers
Cheap credit can also only account for 1/5 of the inflation in house prices from the boom from 1996 to 2006. Falling real rates during the 2006-2008 price bust can’t account for the 10% decline in the FHSA indexes (a result of low interest rates) those years.
The ABCT has many flaws, dealing with natural interest rates, idle resources, Say’s Law, the “bust-boom” cycle, and consumption in booms. Austrianism has further flaws in praxeology, their capital theory, and more, but I guess my final point is this: according to the ABCT, once the central bank causes interest rates to decline, why do the “perfectly” rational and sound businessmen decide to act like extremely irrational people? Why do they act without restraint, taking out loans for things that won’t be profitable without the low rates and when the economy turns to normal? Why should we then give these businessmen almost complete control of our economy? These are questions we should ask ourselves when looking at the ABCT, and the economy in general.