The blogosphere wants to know: during the artificial boom, how can both investment and consumption grow at the same time?
There are multiple answers. But one aspect of the answer has not gotten the attention it deserves.
Douglass North has some wonderful books showing how social stability and secure property rights fuel the growth of wealth via the expansion of the division of labor and the ever increasing incorporation of once marginal non-economic goods into the division of production. North not only documents how productive inputs like land have gone into and out of production, and also explains the how and why of it — and the consequences for social wealth — using not much more than freshman-style marginalist analysis applied to labor and production.
Largely un-noted, Friedrich Hayek has an equally powerful discussion on the same topic, explaining the economics of the existence of non-demanded (hence non-scarce and non-economic) but latently valuable resources, currently unused but potentially exploitable — potentially productive goods exploitable once the time-depth and complexity of the capital structure is extended beyond it current dimension. Imagine some currently unused rare earth material exploitable in the production tools dedicated to the production of nuclear electric plants. (See Hayek’s discussion, The Pure Theory of Capital, pp. 59-63, [Collected Works Ed., pp. 80-83] )
In simple words, during the artificial boom, the depth of the time and complexity dimensions of the capital structure are extended beyond the point where they can be sustained, temporarily adding to output — and temporarily giving value to — previously latent inputs which will lose their value when the time and complexity dimensions of the economy retract. Things which were temporarily counted as economic goods suddenly lose their economic status — they are no longer in the chain of production, they are no longer demanded, and they are no longer counted as scarce for the purposes of economization. They are simply no longer economic goods, and are no longer counted in GDP. And they are no longer contributing to output.
These same considerations should apply to highly specialized labor skills — non-economic but latently valuable prior to the artificial boom, valuable and contributing to output during the artificial boom, and once again non-economic and not contributing to output after the boom.
{ 32 comments }
Professor Garrison’s wonderful presentation to Mises U that was posted here a couple of days ago explains it so well even a Nobel laureate Princeton Professor could (but would refuse to!!) understand
It would seem, and I wish I was better read in Austrian scholarship (I am in process of becoming though as my loaded up kindle gets a workout) which would have probably provided a far better explanation, that investment and consumption goods are not competitive. In other words, via artificial credit expansion, I can just as easily buy a new car as an entrepreneur invest in longer stages of production, and we can do so simultaneously. In Professor Garrison’s Austrian model there is a PPF tradeoff between I and C goods via savings, whereas he points out, with much audience laughter, Keynes argued the impossibility of such.
The artificial money and credit causes both, increases in I and C goods, which in time causes the bust. In one sense, it seems an almost too obvious and logical scenario, shortening consumer time preference while lengthening investors. But what are we to make of the logic of those who think war and burying bottles of cash are good policy?
Are you using a Kindle to read PDF’s? Does it work well?
Thanks.
Excellent point. I was thinking of exactly this point earlier today. It also comes out nicely in a paper GR Steele did on Hayek’s Pure Theory of Capital a few years ago. Another way to put it, I suppose, is that the existing capital stock is not “fixed”, even at a point in time.
I assume as well that people may choose to consume less leisure during the boom due to increased demand for labour. Of course, the consumption of leisure is not valued and included in GNP so the numerical effects of the decision to consume less leisure and more of something else just looks like the “more of something else.”
I really don’t understand this objection, nor do I understand why so many Austrian’s have a hard time dealing with it.
Investment and consumption simultaneously rise during the boom, it is true, but the malinvestments cannot be completed on time, at all, or will be completed only at the expense of other, more warranted productions, precisely because of scarcity (the economy operates off of the PPF only in the short run). The restructuring and liquidation process (the bust) occurs, again, because of scarcity, because there aren’t enough real resources in the economy to sustain the simultaneous elevation of consumption and investment. Inter-temporal disequilibrium, brought about by an arbitrary credit-expansion (i.e., a reduced market rate of interest below the natural rate), makes it so that investment is not a function of savings in the short-run.
For example, assume that M1 (malinvestment one) begins in period t1 and is completed in period t5. M1 requires a steady flow of real capital (intermediary goods) during periods t1, t2, t3, t4, and t5. But because not enough resources exist, and because society consumes the required resources in order to complete M1, the process will end before period t5. In other words, before the final period (t5), the investment project will be revealed as a malinvestment and must therefore be scrapped (we see that investment and consumption simultaneously rise, but only in the short run. Investment will collapse in the “long run” as malinvestments are exposed).
This is also why forced savings is required in order to complete some of the malinvestments and ease the restructuring/liquidation process (the recession). So I fail to see how comovement is a “problem” for the Austrian theory of cycles (the ABCT explains why the comovement exists, but why it must inevitably come to an end), and the concept of malinvestment only makes sense precisely because of scarcity.
Nice point, John.
Folks like Cowen need to explain why they see this as such a decisive objection.
Often it seems folks are simply looking for any excuse ready at hand to dismiss the causal mechanism — it doesn’t matter much what they come up with, or how plausible or relevant their excuse might be.
HI John.
I think the essence of the “criicism” is: if we are on the production possibilities frontier, how can we simultaneously get more consumption and investment, even in the short run? Where do the extra real resources to achieve this come from? That’s why some of the explanations, such as Garrison’s or Greg’s as set out above, focus on moving beyond the existing production possibilities frontier. Another way to characterize the latter explanations might be as explaining why the production possibilities frontier shifts out temporarily.
What I don’t understand is why opponents of ABCT see co-movement of consumption and investment during the boom as uniquely a criticism of ABCT.
Keep in mind the short and long run. How does the PPF ever move out? It can’t in the short run, by definition, as you note. It can’t in the Austrian model or in the mainstream model. But the PPF is slowly, constantly moving out in a growing economy, as Richard Ebeling points out. It does so via investment in greater production capacity, that is, investment. Increased investment leads to greater consumption.
Also, keep in mind that the PPF is potential, and doesn’t match what is actually happening. During a depression we will be producing inside the PPF, considerably below potential for quite a long time. The economic expansion is the process of using up idle resources and capacity and moving back to the PPF. That process can take years. Cowen’s empirical data showing consumption and investment increasing together mostly tracks that period in which the economy is trying to get back to the PPF. When we hit the PPF, we have used up the idle resources.
But not all investment is malinvestment in the move back to the PPF, so we move the PPF outward each cylce. The economy grows and creates a new, improved PPF. But credit expansion causes the unsustainable growth beyond the new PPF. That’s possible for a very short time by consuming capital and by the fact that some goods which were formally not considered economic goods now being considered such and put to work.
I would argue that the economy can’t go for long beyond the PPF because the competition between capital good producers and consumer goods producers for scarce resources causes price increases in consumer goods, and that kicks off the Ricardo Effect.
I wonder whether there really is only one PPF. Any single PPF is conditional upon, it seems to me: a) an assumed dividing line between capital and other resources that may become capital in the future (or might become capital if the interest rate was pushed below its natural level) but which are currently non-economic; and b) an assumed trade-off between labour and leisure. Is that wrong?
@pussum27
The point is that resources are reallocated towards ultimately untenable investments which begin, but which cannot come to fruition. The ABCT does not assert that real savings and consumption simultaneously rise in the short run, only that investment and consumption simultaneously rise, but credit-expansion makes it so that investment is not a function of savings (in the short run). So for example:
Assume that there are 8 available resources in the economy (total output and income = eight) in period t0, and that savings also equals 8 so that all is saved and nothing is consumed. Let’s also assume that total investment equals zero in period t0 (all savings are trapped in the banking system, for whatever reason, during period t0).
Now let’s assume that the total supply of money rises by one in period t1 and that this expansion in the supply of money takes the form of producer credits. Thus, there appears to be 9 available resources (available for investment) in the loanable funds market. Let’s assume that the economy begins malinvestment 1, which begins in period t1 and is completed in period t3, but which requires 9 total resources for its completion.
M1 requires a steady flow of real capital throughout its production process (3 resources per period, t1, t2, t3). And finally, let’s assume that society consumes one in period t1, and one in period t2. Thus consumption and investment simultaneously rise, but there are only 6 actual resources left in the economy. This means that M1 (malinvestment one) will be revealed as a malinvestment after period t2 (the 3 resources required for period t3 don’t exist), and will have to be liquidated (the bust).
M1 cannot be completed precisely because scarcity exists, because inflation only makes it appear as if there are actually more resources available in the economy. I realize that this is a very crude explanation but hopefully it’s somewhat helpful.
I agree with most of what you said but I think perhaps you are overlooking one point and that is an increase in consumption and investment “consumes” real resources. The question is therefore where do the necessary resources come from if we were previously operating on the PPF? It is the scarcity of real savings that ultimately undoes the boom.
There’s one thing I don’t understand: how it is possible for the economy to operate off of the PPF (even if only in the short run?) Isn’t the PPF _defined_ as that boundary which it is not physically possible to surpass because of scarcity? Could you or someone else explain how in the short run it is possible to do the apparently impossible? Thanks
I understood it as the PPF is the limit of what an economy could do *sustainably*, but it is possible to extend past the PPF temporarily and unsubstainably. I conceive of this in the following analogy. When you’re hiking a very long distance, you need to spend some of your energy walking (consumption of energy) and some of your energy on eating (investment in maintaining and growing energy reserves). One one day of the hike, you can choose to use more energy to eat, and also more energy to walk, but inevitably this is an overextension, and the shortfall will need to be made up at a later date.
This is just the way I thought of it, if I’m wrong please don’t hesitate to let me know.
Don’t expect Cowen or Caplan to learn anything from this discussion. I would expect Cowen to continue to repeat the same “critique” on a regular basis and just ignore the explanations of Mises, Hayek, Garrison and others.
However, I could be wrong. Has anyone seen a response from Cowen to these defenses of the ABCT?
Maybe we shouldn’t say that credit expansion causes the economy to produce beyond the PPF. Conceptually that’s difficult, aspussum27 points out. Capital consumption and using previously ignored resources can work for only a very short period of time. Maybe what we should say is that when we hit the new PPF after years of using up idle resources, the PPF if the brick wall that the economy runs into. Hitting the new PPF is what causes the malinvestment made during the expansion (the trip from a point inside the old PPF to the new PPF) to be revealed. That malinvestment is revealed, becomes worthless and sends the economy spinning backwards to a point inside the new PPF. What do you think?
at Greg and fundamentalist:
Even though I believe there are good reasons to believe that the Hayek-Bawerk story of the credit boom is accurate in describing cycles, one should not ridicule other economist like T.Cowen, B. Caplan or even P. Krugman for not buying the story. T. Cowen and B. Caplan are not ignorant of it. They understand it better than most people, have a degree from Harvard and just think it is wrong. T. Cowen has therefore provided an alternative theory which is quite interesting.
I believe the Hayekian theory has to be put in a formal dynamic macro model to be checked for its explanatory accuracy. Indeed the logic makes it a nice tool to describe bubbles or overinvestment in some sectors, which many models ignore. The process is described in a nice way.
But this does not mean the changes in the production structure really bring about the turn-around. Maybe they are not important at all. If you want to argue they are, you will have to bring the proof. It is not easy to show. A bubble in some sector might as well just be a side-effect. But my feeling tells me, that it is not.
Props to Cowen for actually understanding ABCT, unlike most critics
Moreso considering he not only predicted the crash but also lost an investment opportunity in an article entitled “If I believed in Austrian Business Cycle Theory”
For those who don’t understand Daniel’s comment, read Cowen’s post here it’s beautiful and the date is completely genuine…
http://www.marginalrevolution.com/marginalrevolution/2005/01/if_i_believed_i.html
I have read the critiques of Austrian econ by both Cowen and Caplan. All I can say is that either they don’t understand Austrian economics or I don’t. Knowing what I know, I can’t see how either makes the criticisms they make. In my opinion, Austrian economists haven’t said what Cowen and Caplan claim they said, or sometimes Cowen and Caplan distort what the Austrians have said and combat a straw man.
The only excuse I can make for Cowen and Caplan is that they read Austrian econ when they were much younger and didn’t get it quite as well as they think and have forgotten some of it. I have noticed that a lot of PhD’s don’t actually read the books they claim to have read; they skim them for the chief ideas. I don’t think anyone really familiar with Hayek, Rothbard, and Mises would agree that Cowen and Caplan understand Austrian economics.
Hey,
I do not know whether they know every part of Hayek or Mises. I do not care. You can spend your whole life reading books from the 30s and 40s. Then you are a historian of thought, which is fine , but not for everybody.
To learn something about today’s economy you also need new ideas and cannot just recite what Mises wrote in the 40s. The world changes over the passage of time. Is not this a huge part of our criticism on long-run forecasts? We live now. And Caplan and Cowen have good ideas that – as I would argue – are in the tradition of the Austrian school. They describe processes and institutions. Also other schools did that. Does it make them bad when they are not basing their stuff on Hayek?
In my opinion both understand the Mises-Hayek cycle theory very well. I think they just disagree with it, which is fine. Maybe they do not think the production structure is key in producing the cycle. It is not a God given fact that the theory is correct just because Hayek won a Nobel for it.
Mises and Hayek were not religious leaders, but part of a subjectivist school of thought. The explicit fight between schools is over. Most economists do not consider themselves part of a school. Let us just progress with makings sense of the world and compete about ideas.
To me it does not matter whether Mises or Hayek wrote this or that. If I think it makes sense, fine I will make use of it. If I think it does not, I will ignore it. There are many people that I would argue stand in the tradition of the Austrian school. The Austrian tradition also lives on in new research, e.g. by Andrew Schotter, Bill Easterly or in information economics and the likes.
The isolation of some so-called Austrians from everybody that may not agree with some things in Mises (such as methodology) is ridiculous and does nothing good to the ideas of Hayek and Mises. To me it seems there is a significant amount of people that think economics cannot move beyond the 60s. But it does and that is good!
Therefore it is great that e.g. Pete Boettke, who clearly stands in the Austrian tradition (even method), encourages people to publish in top-journals and thereby not ignore the rest of economics.
Last I checked Mises.org has published several new books and while they reference Mises/Hayek/etc. they certainly do not always agree with them. A pointer to this is the fact that neither Mises nor Hayek were anarchists, yet many of the bloggers here are. And while Rothbard believed in copyright most of the bloggers here do not believe in it.
Rothbard accepted a common-law view of copyright, which pertains to unpublished manuscripts, but not modern copyright. And as for Andreas, thank you for your lofty insights into whatever but your general approach strikes me as strangely Whiggish and anti-intellectual.
I did not mean to offend people that publish with the Mises institute. I like what they do and write.
I just think that we have to be more open to explanations that come about from different approaches. Of course this does not only apply to us, but also applies to others such as game theorist that have long ignored findings from experimental economics. They misunderstood themselves.
Further I do believe that good and innovative ideas will be published in good journals.
When it comes to you finding this approach anti-intellectual, I do not see how you get there from what I wrote. Maybe I or you misunderstood things.
Fund: Well, we won’t agree on Cowen and Caplan. That is fine!I think we are not as far apart as it seems. Otherwise we would both not look at this site. I guess my post sounded too much like a general critique of current AE’s research program. I wanted to defend Cowen who does what I think good stuff. And I do not understand how people would hate on him for just not agreeing on a few things that have never been tested. I also think ABCT is a useful to describe cycles. But it has to be tested.Besides, I like Garrison’s book and other work. I also like e.g. J. Salerno’s, L. White’s and M. Rizzo’s stuff.Just sayin’
Pointing out that someone is wrong is not hating them. I like a great deal of what Cowen does. Caplan doesn’t do much economics so I don’t read him as much. But when he is wrong he is wrong and he is wrong about this particular criticism of Austrian econ.
And the ABCT has been tested many times. The empirical evidence is clear. The first people to grasp aspects of it were the Scholars of Salamanca, Spain back in the 16th century. Their theories were based on observation of how people act in the marketplace. Next cam Richard Cantillon in 1720, followed by many others. The ABCT isn’t like string theory, pure imagination. The ABCT has been built up over centuries by observation, logic and testing against historical data. Mises, Hayek, and all other Austrians always include historical example of the ABCT at work.
Fund,Okay, fair enough. Hate was too strong of a word. I just have the feeling that when these two say something, a lot of people that like Mises-Hayek jump in and argue they have no clue! Besides, I also like Cowen’s updated cycle theory.Maybe they are wrong in saying abct is wrong!But – as widely agreed – we have to show that abct decribes reality better than the monetarist theory that lacks a capital structure. Every serious modeler tries to explain reality or aspects of it. I know a lot of them and they are too interested in what happens and causalities.Because of the former Austrian phobia against math-modeling, we have not yet been able to show that the wrong building up of the production structure during the boom leads to an inevitable turn-around. But if this is not the case, abct can be thrown out of the window as an explanation. To test this, we need some structural equations, we can take to the data. I think one day some macro guy will put the structure in a model and find the effect. He will definitely get into a top journal with it. Or maybe he finds, that it does not matter.So far we only argue that it does or did, and show that the structure changed and there was a bust. But every theory agrees that more is invested in capital goods in the boom. Causality for the bust is the issue. And this has yet to be done!Besides, if this failed to be significant (which I do not think), it would have tremendous effects on stabilization policies. We could then actually stabilize the system as the structure is not a problem. This would be fabulous as it would solve many problems. But it is unlikely. And this would also be fabulous, as then politicians would be warned about action in the crisis.
But maybe my view is too optimistic in the sense of accepting the theory. I just see a lot of people that are interested and they ask me why we have not modeled it to show the relevance (- even if we think this is not necessary).
The simple fact is that much of what Cowen and Caplan claim that the ABCT says it does not say. They are wrong in their characterization of the ABCT in many ways, and not just that of Mises and Hayek, but of the modern Austrians as well. If they know the theory so well, why do they get it so wrong? The issue in this article is a good one. There is no reason whatsoever that any Austrian, even those writing today, would be embarrassed by the fact that consumption and investment both rise during the boom. Every Austrian since Mengler has predicted that just such a thing would happen. So how did Cowen get the theory so wrong if he knows it so well?
No one says that Caplan and Cowen don’t have good ideas, occasionally, though I haven’t read one that was original. They’re obviously very intelligent guys. But they are wrong to claim they understand the ABCT because their writings prove they do not.
Andreas: “If I think it makes sense, fine I will make use of it.”
So how do you know if it makes sense? You have to have sound theory in order to test an idea. Austrian econ has stood the test of time. That’s why it’s making such a strong comeback. Many people will quibble with the details, but the framework is the only sound economics and everything that disagrees with it is simply wrong.
Clearly, you haven’t read many modern Austrians. Austrian economists on the whole understand the other schools of economics very well. Check out Roger Garrison’s “Time and Money” for a comparison of the main schools. I have an MA in mainstream econ from a good state school and I know that many other Austrians have earned degrees in mainstream econ before turning to Austrian econ.
No one is stuck in the past, but at the same time, don’t think that just because an idea is old it must be wrong. Much of fundamental economics was discovered in the 16th century, the quantity theory of money for example. That doesn’t make it outdated. We can always improve on our knowledge of old ideas, but age doesn’t invalidate something in econ as it does in say medicine. That’s because econ is based on human nature, which hasn’t changed in several thousand years. For proof, just check out a book on the history of money. 5,000 BC people were charging interest on loans and guess what the rate was? Around 6%/yr.
PS, no one is ignoring the rest of economics. Austrians would love to be published in other journals. The mainstream ignores Austrians, and as Cowen and Caplan, it deliberately mischaracterizes it.
Andreas,
Some of the best biological thinking of the last 40 years has been directly inspired by folks thinking hard abou Darwin’s original ideas. And it would be an embarassment for any biologist to get their Darwin all wrong — or to clail ideas in Darwin as there own.
I don’t believe that it is non trivia l that Cowen repeatdly mischaracterizes the economics of other economists, and I don’t much care when they wrote.
I’m happy with Cowen’s updating and his original efforts.
I’m not happy that he doesn’t acknowledge that changes in risk perception and risk aversion are part Hayek’s explicit articulation of the boom and bust cycle.
Again, I’m all for excellence and helpful use of new conceptions and updating and new ideas and all the rest.
And I’m against ignorance and the corruption of economic conversation with false explication.
It’s a problem when Darwinian biologists are ignorant of the hardest conceptual problems in there science — and the basic evolution of those problems through time in the conceptions of their best scientists.
This problem is much more serious in economics, where the science and the field research, and the causal understanding is far worse, and the significance of the data is essentially contested.
Hi Greg,
I agree with everything you say. But I think T. C. has given a good critique on the ABCT in his book. And maybe he just does not buy the growth, non-economic goods, or middle stage goods explanation. I think from Hayek’s original contribution, this was not clear enough. Otherwise we would not have a discussion on it.
Note well. T.C. give a critique of only one version of the ABCT — and part of his “critique” is to hold up as an alternative a version Hayek gives _as_ the ABCT.
And far as I’m aware, Cowen isn’t aware of the economics of non-economics goods, not that this makes him any different than any other economist. I’ve never gotten the sense that Cowen has read Hayek’s _TPTofC_ or that he is a very well read student of Hayek generally. His critical eye — as with many one time teen age libertarians — is focused on principally on Rothbard, secondarily Mises, and to a slight degree on the third instance on the 1970s generation of Austrians.
Adreas writes,
“T. C. has given a good critique on the ABCT in his book.”
and
“maybe he just does not buy the growth, non-economic goods, or middle stage goods explanation.”
Greg,
this is a problem with the cycle theory of the Austrian school. When somebody asks me which book to read to understand ABCT, I tell them to go and read Hayek’s P&P or MTaTC.
But as you see, when we discuss the theory, some quote Human Action, others P&P and the next one will make use of thoughts in the PToC, or e.g. Lachmann’s stuff that incorporated expectations explicitly.
Thoughts and ideas are elaborated and spread through many different books. This is natural and no surprise. But they are made under changing assumptions. Therefore one has to be quite careful in combining the ideas in a coherent description of the cycle that has it all. From different assumptions, it is hard to judge what would happen if another variable enters the system. From modeling you know, that you cannot just take a variable with an effect in model A and put it in model B (which has different assumptions) and expect the same effect. This is quite problematic.
Garrison has done a great job in combining the frameworks. But there are other possible interpretations that emphasize different parts as we see in the discussions.
Comments on this entry are closed.