Monday, 27 March 2017


Austrian business cycle theory and optimal resource reallocation

March 30, 2016

Last time, I argued that the two chief components of Austrian business cycle theory (ABCT)—inconsistent consumption and investment plans engendered by faulty interest rate signals, and reallocation of resources during the bust—could be understood even within a tight framework of rational expectations and ‘equilibrium always’ modeling conventions. I will now tackle the second of these claims.

First, start with the important insight that the point at which resources are destroyed is during the boom. It is during the bust that the errors of malinvestment are realized, but from the moment they are misallocated (i.e. are put to inferior uses due to faulty price signals) society becomes poorer. Once it becomes known that resources have been misallocated, the errors in production plans must be fixed. This process is costly, partially due to the fact that some investment is irreversible. Not all of the value of invested resources can be recouped. In the limit, labor and capital services used in production plans cannot be reallocated; they are simply gone.

What this means is that during the boom, unsustainable current consumption and investment come at the expense of future consumption and investment. As Will Luther and I argue in our paper, “The boom itself shifts down the real output time series by the present discounted value of the lost future wealth, which becomes realized during the recession. Society is forever poorer.” This highlights the fundamental supply-side factors associated with recalculation. Those resources, lost at the point of malinvestment, are taken from the future stock of wealth which has yet to be differentiated into consumption or investment. It is only at the expense of this future wealth that both current consumption and current investment can rise above their sustainable levels.

Thus there is nothing in the Austrian story that cannot be told according to the conventions of New Classical economics. The question still remains, “Is this the best way to tell the Austrian story?” This depends on what kinds of explanations one finds convincing. Some economists are comfortable with eschewing equilibrium analysis, to better focus on the implications of radical subjectivism and constant flux in the market process. Some are only satisfied with stories that explicitly incorporate strong conceptions of rationality and equilibrium. Telling an ABCT story in this manner is not intended to be the final word, the ‘one true theory’ in the Wicksell-Mises-Hayek line. Instead, it is intended to show that, even in a sub-paradigm of economic analysis, seemingly unhospitable to ABCT, a consistent ABCT story can be told.

One Comment

  1. Brian J Gladish April 27, 2016 4:56 PM

    Comments are off on your previous post, so I'll make a comment on it here. Isn't there a herding phenomenon that overcomes the "rational expectations" of entrepreneurs. Some "irrational" entrepreneurs will not be hesitant to jump on the new demand, and will start rolling up profits from the credit expansion. Once the "rational" entrepreneurs see this phenomenon they will feel pressure to follow suit, either from their own psychology (I'm missing out!) or from investors (Hey, we're losing out!). At some point only the most steadfast entrepreneur will refrain from attempting to profit from the expansion. Long time spans between collapses will, of course, weakenhe effect of past lessons and weaken or eliminate resolve.