Steven Horwitz has written about the limits of Austrian Business Cycle Theory (ABCT). He outlines three limits of ABCT as he sees it:

  1. “[ABCT] tells us nothing about exactly when the boom will break or the precise factors that will cause it.”
  2. “ABCT tells us little to nothing about how the bust will play out.”
  3. “Not every recession requires the ABCT as an explanation, nor can the ABCT explain everything about any particular recession.”

Horwitz then proposes that we take a broader approach to explaining business cycles, including monetarism, regime uncertainty, and the effects of intervention. He has brought up great points that can lead us to a discussion not just on business cycles, but the nature of economics and history.

Limit #1: Timing and particulars

A particularly prescient commenter quoted Mises regarding the limits on what economics in general can explain:

Economics can only tell us that a boom engendered by credit expansion will not last. It cannot tell us after what amount of credit expansion the slump will start or when this event will occur. All that economists and other people say about these quantitative and calendar problems partakes of neither economics nor any other science. What they say in the attempt to anticipate future events makes use of specific “understanding,” the same method which is practiced by everybody in all dealings with his fellow man.

We cannot ask more from a specific theory than the science can answer, like expecting the Pythagorean Theorem to solve for the color of a triangle instead of the length of its sides. That a^2+b^2=c^2 can’t tell us about the color of the triangle is not the fault of the theorem, but a limit to mathematics in general. Economics, like all sciences, is limited in what it can explain.

Predicting the exact timing of anything is outside the realm of economics, yet ABCT does have something to say about the factors that cause the boom to turn to bust.

One such account of these factors is in Joseph Salerno’s influential “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis”:

The anticipated demands for the products of the higher stage investment projects, even if they are technologically operational, do not materialize because of the greater scarcity and costliness of the complementary labor and capital needed to profitably transform these products into lower order capital goods. At the same time and as part of the same process, other firms lower down in the structure of production that produce raw inputs, spare parts, and equipment for the supply, maintenance and repair of plants and equipment manufacturing finished consumer goods are also incurring rising labor costs, causing them to cut back on capacity.

At some point after an artificial credit-fueled boom, the costs of production become prohibitively high and anticipated profits turn into realized losses, leading to an economy-wide reevaluation of the amount and kinds of capital available and a tethering of economic calculation back to reality. In short, the “precise factors” Horwitz is looking for are scarcity and the evaporation of illusory profits.

This may not be as precise as some would like, but it is as far as economics can go. As a general theory, however, ABCT must be able to be applied to many specific circumstances. This task is in the purview of economic history. ABCT is like a tool—a power drill perhaps—whose bits can be changed to accomplish various tasks as long as the tasks involve drilling and as long as the bits are compatible with the drill. ABCT is a tool for the historian who may need to attach various complementary ideas from outside the realm of pure economics to tell a satisfactorily complete story of a particular business cycle.

Limit #2: More particulars

The second listed deficiency was that ABCT cannot predict how the bust will play out. Horwitz expands:

The theory gives us good reason to think that further inflation and interventionist attempts to prevent the necessary reallocation of resources will make matters worse, but that’s about it. The ABCT is not a theory of the causes of the length and depth of recessions or depressions but a theory of the unsustainable boom. It is a theory of why we are in a recession in the first place, not a theory of how long or how deep a particular recession will be.

ABCT, as a specific theory in the general field of economics, deals with causes and effects not mechanical formulas. If the cause of a recession is expansionary monetary policy which led to capital malinvestments and prices that are not attuned to consumer demands or time preferences, then the recession ends when capital is liquidated and put into profitable lines of production and when prices are reconciled to people’s true preferences. These two go hand in hand: for a capital good to be reallocated to other uses, its price must change, as well as the anticipated revenues from the sale of output the capital good can help produce, which are “priced in” to the capital good.

The amount of time this takes and the size of the price changes needed depend on the particulars of the credit expansion and the presence of any hindrance to the necessary price adjustments. Rothbard said it best:

But it is clear that prolonging the boom by ever larger doses of credit expansion will have only one result: to make the inevitably ensuing depression longer and more grueling. The larger the scope of malinvestment and error in the boom, the greater and longer the task of readjustment in the depression.

And earlier in the same chapter in Man, Economy, and State:

It should be clear that any governmental interference with the depression process can only prolong it, thus making things worse from almost everyone’s point of view. Since the depression process is the recovery process, any halting or slowing down of the process impedes the advent of recovery. The depression readjustments must work themselves out before recovery can be complete. The more these readjustments are delayed, the longer the depression will have to last, and the longer complete recovery is postponed.

What’s great about ABCT is that it can incorporate the effects of intervention, regime uncertainty, and other specific theories from outside economics. If ABCT claims that prices need to adjust in the correction phase, anything that prevents this from happening will certainly prolong the correction phase. New Deal price control policies of course fit this bill and so economic theory on price controls are relevant to the historian’s task.

Mises’s own 1931 diagnosis of the global economic crisis (in The Causes of the Economic Crisis – PDF link) provides a great example of using ABCT, which he developed, along with the economics of intervention:

Both the unprofitability and the unemployment are being intensified right now by the general depression. However, in this postwar period, they have become lasting phenomena which do not disappear entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.

And later,

All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis: Forgo every attempt to prevent the impact of market prices on production. Give up the pursuit of policies which seek to establish interest rates, wage rates and commodity prices different from those the market indicates.

One cannot, however, plug the numbers of the credit expansion into a formula to get the length or depth of the recession. You cannot plug any number into any formula to get precise consequences of a process involving human action. There are no quantitative constants in human action. ABCT provides the cause-and-effect framework for understanding business cycles, and it goes as far as economic theory can go. If this is what Horwitz wants from ABCT, then he is expecting more from a particular theory than the science in general can offer, again.

Limit #3: ABCT is sufficient but not necessary

Horwitz’s next claim is interesting. Are there recessions that cannot be explained by ABCT? Is ABCT just one of many explanations of business cycles, and which theory applies to which cycle depends on the particulars?

I would argue no, but after a discussion with some colleagues, it seems this really depends on one’s definition of a business cycle. I take the “general boom and bust” definition. If “business cycle” can mean any fluctuation in the economy, then of course ABCT only applies to a subset of this vaguely defined economic phenomenon. Indeed, such a definition would apply to all action and exchange because “fluctuation” or just “change” is inseparable from time.

Rothbard makes a compelling case in America’s Great Depression that business cycles and ordinary business fluctuations are distinct phenomena. One is widespread and has a well-defined structure while the other is industry-specific and can be the result of any sort of change on the market, like preferences changing, supplies changing, expectations changing, etc. It seems to me that we do not need a “business cycle theory” as such to explain a product going in or out of fashion or the consequences of a natural disaster.

With that said, the task of any business cycle theory is to explain the cluster of entrepreneurial errors. This is a feature of all business cycles and it doesn’t seem like they are a part of the natural workings of the market process. Entrepreneurs bid up the prices of factors of production and change their production plans in effort to sell their output at a profit. After a while, however, the profits turn to losses and it seems everybody made the same kind of mistake.

If just one entrepreneur makes a mistake, we count it as the entrepreneur’s fault. His losses decrease his ability to divert more resources to his project. If he incurs enough losses, he will abandon his project altogether and the resources are freed up for other entrepreneurs to incorporate into their profitable production projects.

If many entrepreneurs make the same kind of mistakes, we must consider the possibility that they are getting bad information—that they’ve all been duped. Also, since business cycles seem to affect the economy as a whole, the cause must be something that pervades the economy as a whole.

ABCT gives a necessary and sufficient explanation for general booms and busts

Austrian economists have found the answer: something fishy must be going on in credit markets. All other explanations fall short, because only monetary expansion through credit markets can explain the widespread malinvestment and overconsumption.

Any other cause of supposed malinvestment would be confined to a few entrepreneurs at most, whose errors are quickly corrected by losses. These losses are not widespread, but focused on those who made the errors. Government interventions (besides monetary interventions), technological changes, preferences changing, and natural disasters would all fit into this category.

Any suggested cause related to the price level in general, like a disequilibrium in money supply and money demand, does not get at the root of the problem because the problem involves an intertemporal shift across the stages of production. In the correction phase of a business cycle both real and nominal changes must occur. Real capital goods must be reallocated from unprofitable longer production projects to profitable shorter projects and real capital consumption occurred in the boom phase.

But a purely monetary disequilibrium explanation can only comment on the nominal price changes or changes in the money supply (usually increases) that are said to be needed to bring money back into equilibrium. Of course an increase in the money supply through credit markets would only restart the business cycle according to the Austrian theory, so the two business cycle theories are necessarily in conflict. In this regard, Horwitz’s push to integrate the two or at least put the two on equal footing seems like a fantasy.

A closer look at Friedman and Schwartz and MDT

Horwitz seems to want us to take a special look at Friedman and Schwartz (“A full explanation from a classical liberal perspective will have to include Milton Friedman and Anna Schwartz’s work […]”), but political ideology should not be considered when gauging the truthfulness or even usability of some economic theory.

The monetarist line of thinking leads Horwitz to confuse an “excess supply of money” for a credit expansion as the cause of a business cycle. A plain increase in the supply of money that is not funneled through credit markets would not cause a general boom and bust. Joseph Salerno covers this in his recent article “A Modest Proposal for Reining in the ‘Unorthodox’ Fed”:

Even simple inflation can have devastating effects on the real economy, as episodes of inflationary war finance have shown. Military spending financed by money creation systematically promotes the production of present goods at the expense of capital goods and falsifies monetary calculation, causing the overstatement of profits. These effects result in capital consumption and a decline in living standards. Unlike the inflationary process caused by bank credit expansion, however, simple inflation will not display the characteristic “self-reversing effects” that mark the business cycle.

Horwitz also mentions the work of Ohanian on the Great Depression as a candidate for integration into our “full explanation from a classical liberal perspective”, but it must be noted that even Ohanian’s take is incongruent with the Friedman and Schwartz analysis. Ohanian points to Hoover’s labor market interventions as the culprit for the severity of the depression. These policies were put into place two years before the largest chunk of bank failures and collapse of the money supply in 1931. Friedman and Schwartz suggest that this large decrease in the money supply was the primary cause of the length and depth of the Great Depression.

Ohanian tacitly calls them out when he states that “any monetary explanation of the Depression requires a theory of very large and very protracted monetary nonneutrality.” Indeed, Monetarists and Ohanian seem to have conflicting theories whereas the Ohanian story fits in nicely with the Misesian-Rothbardian account of the Great Depression (noted here).

Therefore Horwitz has some good advice for us: we should integrate multiple theories when we do history. I would only add the caveat, “…as long as the theories are correct, relevant to the historical episode, and compatible with each other.” If ABCT is a drill, perhaps monetary disequilibrium theory is an incompatible proprietary bit that only Monetarist drills can use.


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