On The Incoherence Of Austrian Business Cycle Theory

I thought I would try to summarize again some objections to the Austrian school.

Austrian Business Cycle Theory (ABCT) focuses on the consequences of the monetary authority setting the monetary interest rate below the natural rate of interest. Following Knut Wicksell somewhat, the theory argues that capitalist entrepreneurs will lengthen production processes. Since these decisions do not synchronize with household consumption and savings decisions, the artificial boom is unsustainable. A bust is the result.

This theory is built on mistaken capital theory. When Sraffa spanked Hayek, he deliberately put capital theory aside.

What would it mean for a production technique to be more capital-intensive? To examine the (il)logic of this approach, I make various simplifying assumptions.

Accordingly, consider vertically-integrated firms. They produce a given commodity or, rather, a basket of commodities, in fixed proportions. The only input is homogenous labor. All means of production, tools, intermediate goods are produced and used internally.

Under these assumptions, one can talk about (net) output per person-year. Productivity is well-defined. I start by postulating that with a more capital-intensive technique, workers are more productive.

It turns out that a lower interest rate does not induce managers of firms to adopt more capital-intensive techniques. Numerical examples illustrating this point have been available in the literature since the 1960s. And they are accepted by all sides. "The interesting point, however, is the perversity, not the duplicity." -- Robinson and Naqvi (1967).

I have now demonstrated that marginalist capital theory, including the Austrian variant, is invalid. Given typical assumptions, the traditional stories about 'capital' markets do not follow. But what about all that stuff Austrian school economists say about the structure of production?

They are wrong there, too. First, I consider aggregate measures of the period of production. Bohm-Bawerk's measure assumes simple interest, not compound interest. The counterexamples mentioned above demonstrate it is invalid to conclude cost-minimizing entrepreneurs will lengthen the period of production when they anticipate lower interest rates.

Nicolas Cachanosky and Peter Lewin have recently proposed a financial measure of Duration. By this measure, the technique chosen at a lower interest rate, around a switch point, has a larger Duration. But a larger Duration is associated with lower productivity in the counter-examples.

You could also consider how long capitalists will choose to run given machinery. Machines last for more than one production cycle, and capitalists must choose to set their economic life. Surely, a lower interest rate will provide incentives to capitalists to increase their economic life. Well, no. A longer economic life of a machine can be associated with a less capital-intensive technique in the sense that the productivity of labor is decreased. I happen to know that the recurrence of the period of truncation is possible without the reswitching of techniques.

And then there are Hayekian triangles. They do not work either. Hayekian triangles, as Roger Garrison notes, are heuristic pictures, useful for pedagogic purposes. Hayek unsuccessfully tried to put them on rigorous foundations in Prices and Production. But it all fell apart. He even discovered capital-reversing, in some sense. You can find more recent statements with these triangles, but nothing that addresses the difficulties that Hayek found, much less anything that surmounts them.