Tuesday, September 21, 2010

Here We Go Again...

Long-time SWEET members probably remember that I have something of a love-hate relationship with the Austrian Business Cycle Theory. The Austrians had a lot of good ideas, but I'm not convinced the ABCT was one of them.

On one hand, the Austrian's have an intuitively satisfying theory about how the business cycle fluctuates. State manipulation of the interest rate distorts the capital structure, creates malinvestments and causes recessions, and more State intervention will only exacerbate the problem. It's easy to grasp and provides an appealing explanation about how we got into our current mess. On the other hand the ABCT suffers from some odd theoretical assumptions about the behavior of entrepreneurs and investors, and largely lacks the empirical validation necessary to stand as a respectable alternative to neoclassical business cycle theories.

Any economist would agree that expansionary monetary policy decreases the short term rate of interest, stimulating investment in more roundabout projects. The question ABCT doesn't explain very well is why these investments tend to become malinvestments. Bryan Caplan made this observation over a decade ago. Obviously the lower rate of interest will cause people to reevaluate the profitability of current investment projects, and some projects that wouldn't otherwise be undertaken now will be. However when the Fed announces that they're targeting lower interest rates you can't seriously expect those artificially low rates to deviate from the natural rate forever. What any sensible entrepreneur will do is invest in projects that they expect to be profitable within the expected time frame between the credit expansion and the subsequent readjustment. To assume otherwise is to assume that entrepreneurs consider only current interest rates in their investment calculations and ignore other variables like long term interest rate trends, expectations of future tax rates, expectations of government policies, etc.

H.L. Mencken once said that "For every problem, there is a solution that is simple, elegant and wrong". So too for theories of the business cycle I guess.

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