Thursday, May 14, 2009


Austrian Business Cycle Theory and the "Rational Expectations" Objection

The most typical objection to the ABCT from mainstream economists is that it apparently violates "rational expectations." Loosely: Why don't businesspeople learn to be careful when the Fed lowers interest rates?

Here [pdf] is an excerpt of a paper I wrote while teaching at Hillsdale. It has all the Bayesian bells and whistles, and gives a pretty neat model (or so I thought) of the Mises-Hayek story with all the Greek letters you could want. The referees at the Austrian journals thought otherwise, but in retrospect there was some extraneous stuff I put in the critique of Carilli-Dempster (which I've removed from this excerpt).

Anyway, this is how I think central banks make market economies more boom-prone, and also why they yield more sluggish growth. Yes, entrepreneurs do try to anticipate the Fed's moves, but the presence of the Fed makes interest rates less informative of underlying scarcity. So you get more booms than you otherwise would, and you also get more missed opportunities than you otherwise would. Hence, lower average growth in the long run, plus the occasional boom-slump thrown in for good measure.

Here's a treatment of a prisoner's dilemma along the same lines:
PS - since when is the rational expectations assumption a good one anyway? Or, rather, even when you have rational expectations, doesn't mean you trust yourself or your competition enough to act on them.
Help me out with this, Bob. It's probably my own economic ignorance, but I've struggled to understand this common objection to ABCT.

Of all the entrepreneurs that I've known and worked with, I don't think any of them were especially interested (no pun intended) in short- or long-term interest rates, beyond those which were directly related to their own personal and commercial lines of credit.

They were all too busy asking seemingly-important questions like "Is there demand for this product?" From my perspective on the ground it seems like someone who's thinking of entering a business venture is not going to think much about rates qua rates.

OK that's fine, but then the Austrian story doesn't make much sense, right? The Austrian says, "The Fed lowers rates and this fools entrepreneurs into starting projects that they otherwise wouldn't."
@ Bob and Stewart

Actually Bob,

I think that Stewart has a solid point. I don't think it negates ABCT, but that ABCT needs to be explained better in terms of how entrepreneurs make decisions.

I don't think that entrepreneurs think in terms of interest rates as signals (or home buyers for that matter). A home buyer (and an entrepreneur) thinks, aha, my payments will be x, I can make this work.

As economists, we know this is a price signal, to the average home buyer or entrepreneur, it works or it doesn't in terms of payments.

Same thing. But we are talking technical, they are talking action. It would be the same thing if you asked a businessman if he prices goods at where supply crosses demand, he does, but often he thinks he is just pricing a percentage above costs.

If Stewart had said, "Bob, help me out, but the standard exposition of ABCT never made much sense to me. Businesspeople don't think in terms of interest rates," then I would have agreed with him partially. That's actually one of the things I discuss in the linked paper, after all.

But Stewart said, "I've never understood this objection to ABCT." So I thought he was saying, the way Austrians can dispose of this typical mainstream objection, is to point out that businesspeople actually aren't influence by interest rates.

So if that is what Stewart meant (and maybe I misunderstood him), then my response was that this cure would be worse than the disease, since on the surface it would negate ABCT.

Anyway maybe I'm misunderstanding everybody. I'm just saying, if we say that real-world businesspeople don't pay attention to interest rates, then that hurts ABCT, rather than helps it vis-a-vis Bryan Caplan and Paul Krugman.
I enjoyed reading that, Bob. It definitely makes much more sense describing the Fed as a source of noise. One nitpick, though: a lot of what you're doing there is information theory, and I would have wanted it described more with that terminology. That's just a personal preference on my part though.

For example, when you describe how Nature is providing a "profitable/not profitable" signal, you're describing a binary symmetric channel, and the Shannon Noisy Channel Theorem helps to explain the counterintuitive result that the information transmitted by Nature is minimized when p is 50%, not 0%, and thus why there's such a sharp jump from 70% to 65%.

But again, that's just my eccentric preference.
Bob, it's definitely my misunderstanding, not yours. If I hadn't skimmed through your paper I would have seen the paragraph on page six which reads:

In the first place, no entrepreneur ever needs to worry about the “natural” rate of interest;
he must instead make his decisions on the basis of expected actual prices.
But then I think maybe you're right to rephrase my question. I don't seem to understand ABCT, because I assumed that it was inflation of the money supply which caused the business cycle, and that the unnaturally low interest rates were merely a signal of that.

If that's correct, then maybe it shouldn't surprise anyone that so many non-Austrians attack the idea of artificial interest rates being the principle cause of entrepreneurial confusion. What confuses entrepreneurs (except maybe those directly involved in financials) isn't the low interest rates; it's all the newly-minted demand floating around.

So what am I missing here? Why is ABCT described as being about interest rates, and not about the available money supply that the interest rates are actually describing?
Bob, de Soto's argument in his treatise is that even though a bust is inevitable in the wake of artificial credit expansion, that doesn't mean that a particular project will necessary go sour. So it can still make sense to roll the dice in the confidence that you can time the market, get out before the bust, etc.
Silas: Thanks. I don't know any of that information theory stuff though, so that's why I relied on more generic terms.

Stewart: Well, I think you are misunderstanding me. I'm still blaming the interest rate distortion for the mistakes. My point in that quotation was to chastise Austrians for saying business people "think that time preferences have fallen" or that "savings have increased." One of the "actual market prices" business people care about is interest rates.

Tom: OK but then de Soto is still saying that entrepreneurs are collectively stupid. If somebody says, "Playing the lotto is an awful investment," you don't overturn that by pointing out, "Well, an individual lotto player might think he will get the winning ticket, in which case his investment is a good one."
I've actually started to work on a theory to integrate ABCT with Prospect theory (Kahneman's decision making theory) to explain how investors can get confused by price signals. It's all about risk assessment - but (I think) it works better than Tyler Cowen's model (from his book).

AFAIK, no body has thought of doing this before :D
You sent this to me upon request a couple years ago, Dr. Murphy. I thought it was a good paper, because it did address a neoclassical objection using their own preferred terms.

Building on what Dr. Woods said, however, I fail to see why the fact that there really is new money injected into the economy isn't a solid enough refutation of neoclassical objections. For example, say my business takes advantage of low interest rates and an inflationary boom, while some poor competitor -- an Austrian business -- does not do so (because the owner knows there will be a bust in a few years). Isn't it entirely possible that I will not only do better in the short-run, but also potentially in the long-run. It seems in a competitive market where there is new money being doled out, I would (in general) be a fool not to try to use it.
Are you going to submit an updated version? I think you are onto something here.
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