Our series into Capitalism continues. In this, our purpose is in no small degree to wean you Libertarians of an Austrian bent away from Austrian economics and toward Alexander Hamilton’s superior vision of economics, Robber Baron Capitalism.
We now take aim at that pillar of Austrian economics, the Austrian theory of the business cycle, knock it down to size, and replace it with an explanatory model that builds on what you have learned in Part I.
We also expand on why, in Part I, we emphasized policy makers should view their nation’s economy from the prism of sectors.
The Austrian take on the business cycle is an interesting, but ultimately unsatisfactory, explanation of boom and bust. At most, their theory explains why fractional reserve banking can in some cases reinforce poor economic decision making.
But, as you will see, its explanatory power falls short in important areas not the least of which is its explanation of boom-bust cycles and their remedy for it which might be labeled an ideal Austrian monetary system (AMS).
It is especially weak compared to the Hamiltonian theory of the business cycle we now introduce to you.
First we outline the respective assumptions behind the Hamiltonian and Austrian positions and the propositions that flow from those assumptions –
- If producers align their operations to satisfy any boom in customer demand for any kind of good or service a cluster of economic errors will necessarily occur that will lead to a bust because producers can never under any circumstances consistently, mathematically, project exactly how much demand there currently is or will be at a future point.
- Booms in demand are usually concentrated in a specific economic sector or group of sectors that have particular resources and operations more capable of satisfying this demand than other sectors (e.g., the resources of the housing sector are better positioned to satisfy housing demand than the health sector, etc. etc.)
- More sector resources will be devoted to satisfying a boom sector(s) the more customer demand booms.
- Eventually booming demand will cool off as customer utility is reached.
- When customer demand falls, producers scale back resources dedicated to
- Loose monetary policy is insufficient cause to increase production if the business believes the action does not bring enough business value.
- Capital goods are especially hard hit when demand falls because reallocating capital resources is more time consuming than reallocating other resources is (e.g., firing workers in the marketing sector during a bust can be done faster than a manufacturer can shutdown a manufacturing plant).
Hamiltonian Arguments Against the Austrian Business Cycle
In a very basic way both Hamiltonian and Austrian business cycle theories agree economic declines are the result of market signals encouraging producers to indulge speculative bubbles by overinvesting (malinvesting/misallocating) their resources during a boom.
The point where Austrian theory falls short lies in its simplistically assigning the cause of this overinvestment to “faulty” signals created by monetary stimulus under fractional reserve banking. This has given rise to a number of flimsy assumptions and questionable logic that deserve to be challenged.
First, Austrians exaggerate how much more accurate projections of customer demand would be absent excessive FRB monetary stimulus. And let there be no doubt how important accurate demand projections are to preventing distortions in the structure of production that lead to busts. To eliminate these distortions customer demand must be projected beforehand with perfect accuracy by the producer so the producer’s resources are exactly aligned at all the right times with demand. If demand and production are not exactly aligned at the right time a general cluster of malinvestment develops because producers either produce too little or too much relative to what perfect demand estimates would justify.
While Austrians are right to point out excessive quantitative easing distorts market signals it does not follow that an Austrian monetary system would eliminate faulty signals to a point where perfect demand projections are feasible. This is because perfect demand projections are inherently impossible to make regardless of what monetary system – or any type of economic system whatsoever – exists. Too many other random variables aside from monetary conditions impact demand for a producer to ever make consistently perfect projections (Note we are talking about consistent projections. On very rare occasions models of customer demand do estimate demand precisely ahead of time. But these instances are one-time statistical coincidences which the models are unable to repeat with the same accuracy).
Second, Austrians cannot explain why general clusters of errors accumulate in particular areas of the economy without making reference to demand.
The Austrian explanation of how human behavior reacts to easy credit is, roughly –
1 – Loose credit encourages producers and consumers to misread market signals.
2 – Producers and consumers use excess credit to speculate.
3 – A general cluster of errors in the structure of production arises from this excess credit.
But credit availability is not a sufficient explanation – on purely praxeological grounds – for what human actions led to this cluster of production errors.
In cases where FRB monetary policy is excessively loose, this excess of credit is available to fund speculation in any business action. But not all business actions attract the same level of speculative mania which lead to production distortions. In fact, only a small number of possible business actions that could employ credit are taken at all.
For example, Austrians claim easy credit encourages excessive speculation in new technological innovations. But Austrian theory fails to explain why speculators and producers chose a specific innovation or group of innovations to speculate on – there are always many innovative technologies businesses do not act on. Why is it that certain kinds of innovations attract hot money, thus concentrating a cluster of economic errors in a specific sector or group of sectors, while other innovations did not attract speculation despite FRB generated credit being available for any activity?
For speculative and production actions to be made there must be a perception that a particular economic activity is in or will be in demand and that satisfying demand provides business value to the producer.
Easy credit by itself can sometimes make the difference in whether a producer engages in a marginally profitable activity. But unprofitable activities will largely remain unattractive to speculation while profitable activities will still invite speculative bubbles for reasons unrelated to credit conditions. Even under tighter conditions preferred by Austrians, producers will still often feel the business value of satisfying growing demand will justify taking loans at higher interest rates.
Thus the correct and more complete Hamiltonian explanation of how credit influences the business cycle is –
1 – Loose credit can encourage producers and consumers to misread market signals and overproduce, but credit in isolation is insufficient grounds to explain why producers overproduce.
2 – Producers and consumers speculate on a boom in customer demand regardless of whether credit is loose or tight.
3 – A general cluster of errors in the structure of production arises from the attempt to satisfy once booming demand when this demand cools off.
4 – Because demand cannot be projected perfectly in advance due to random factors, boom and bust cannot be eliminated through changes to the credit environment or any kind of change whatsoever in the economic environment.
Only customer demand for a specific type or types of goods or services explains why a cluster of errors occurred in the location they did. Without acknowledging particular surges in demand, the explanatory power of the Austrian outline fails.
Acknowledging demand heavily influences the business cycle undermines the strength of Austrian theory because demand adds numerous other variables to their one-variable explanation: Basically, anything that is an obstacle to projecting demand perfectly will contribute to malinvestment. Since the reasons projections cannot be made perfectly are essentially infinite, the explanatory power of a credit driven business cycle sinks to irrelevance.
Third, Austrians never take into account that credit conditions might be too tight under an Austrian monetary system. If Austrians point out an excess of FRB generated credit often contributes to over-speculation in an innovative technology, why do they assume under the restrictive conditions Austrians prefer that credit cannot be too low for certain producers to take benefit society by investing resources into innovative technology?
In reality interest rates are, like economic value, subjective because different economic actors will react subjectively to the same credit conditions in very different ways: Under the tighter lending conditions of an Austrian monetary system, any cash rich business would still be able afford to speculate with credit more than small businesses, or startup businesses that usually run at losses for a number of years. Therefore there cannot be numerically “correct” credit conditions to set for an ideal Austrian monetary system, or any other type of monetary system. There are only a set of tradeoffs between different types of credit conditions that will still lead to malinvestment.
Moreover their belief in an objectively “correct” credit environment (e.g., interest rates, supply of money, etc. etc…) exists contradicts Austrian skepticism of quantitative economic empiricism itself: If it is true there are “correct”, numeric, values that should be represented in the credit environment, those “correct” metrics must be subject to quantitative and empirically based methodologies.
To suggest there are objectively “correct” credit conditions cannot be reconciled with the parts of Austrian logic which assumes the subjectivity of economic value.
Austrians believe simultaneously –
1 – In modern FRB monetary systems, quantitative metrics of the credit environment are often objectively, numerically, quantitatively, wrong because credit is too easy.
2 – Economic actors base their actions on their own subjective interpretation of what they consider is economically valuable; and that what one actor subjectively considers valuable is usually valued differently in the preference rankings of a different actor.
3 – If FRB monetary systems are replaced with a restrictive Austrian monetary system, actors that make subjective decisions will stop making the “objectively wrong” decisions they made under FRB and instead make enough “objectively correct” decisions to eliminate the business cycle.
This “objective truth” in #1 that Austrians cling to leads to complete incoherence throughout the rest of their business cycle analysis.
It results in them making objective, quantitative value judgements about economic activity that are inherently subjective in nature.
For example Austrians often blame FRB managed credit systems for causing “too much” investment with cheap credit into technological innovation which then leads to malinvestment and bust. But by saying there is “too much” investment in technology makes the mistake of objectively and quantitatively passing judgment on the value of an activity that is subjective.
On what basis can Austrians claim technological investments are objectively excessive? For some businesses investing in technology with borrowed money gave them a long term competitive advantage that was more valuable (to them) than whatever losses they suffered during the crash. Others that did not take advantage of easy credit to upgrade their technology led to their going out of business.
Also the assumption that tightening credit will prevent malinvestment in technology is wrong because not investing in technology may well lead to a crash. A small nation whose monetary system is Austrian and which is dependent for economic growth on agriculture will crash if it cannot borrow enough to upgrade its agricultural technology relative to a competing agricultural economy that uses FRB and is able to outcompete the former in agricultural productivity.
Hamiltonians accept that interest rates are inherently “subjective”, therefore there is no “correct” monetary system. There are only tradeoffs between monetary systems and an Austrian monetary system simply creates new problems that do not stop boom-bust, nor prove that FRB is inherently worse than alternatives.
Just as Austrians clumsily try to have it both ways with objectivity and subjectivity, they also make a hash of their simultaneous rejection of empiricism generally but selective use of empiricism elsewhere.
For example, Austrians may say that instead of the Federal Reserve setting rates at 1.5%, an Austrian monetary system would “correctly” set rates at 15%; or the money supply should be 30% of what it is.
Even claiming Fed rates are “too low”, while not suggesting what they “should be”, is a quantitative judgment.
But since Austrians insist the ability of economists to derive objective truths from quantitative and empirical methods is very limited, how can Austrians rightfully claim to know what are “correct” or “wrong” credit conditions without making quantitative arguments for what they should be?
Obviously, Austrians cannot claim what “correct” values should be given they reject quantitative methodology. Without empiricism, Austrians can never justify their rationale for such metrics are numerically too high or too low to prevent malinvestment.
And if they were to do an about face on empiricism, they would be inviting quantitative testing into their theory of how credit conditions relate to the business cycle.
The Austrian’s ideal monetary system would substantially depend on a precious metal standard (we’ll assume gold, but the argument will be as strong if a different precious commodity is used). Unfortunately for them there is no necessary causal relationship between the price of gold (or any other precious metal or rare commodity) and what it should cost a business to borrow.
The price of gold is, like all other prices of all other goods and services, an aggregated reflection of how different customers of gold subjectively value gold according to each customer’s different hierarchy of preferences. Among the uses of gold that are factored into its market price are its industrial applications. If Austrians had their way how heavy industry uses gold in certain mechanical processes would, by helping limit the supply of gold, partly influence what rate a food processor, raw material supplier, or pharmaceutical company can borrow at to fund their operations.
But why should gold’s industrial uses impact borrowing and how does it lead to better business decision making? It does not because there is no logical connection between its industrial applications and borrowing.
Finally, Austrians claim their credit theories explain capital goods best. I don’t know why they insist on this because Austrian theory isn’t needed at all. Capital goods suffer during booms simply because reallocating investments in physical assets (if they can be reallocated at all) is inherently more time consuming than reallocating other forms of resources such staffing reductions or selling investment assets. Hamiltonian theory of allocation and reallocation trends more than adequately explains the impact of busts on capital goods.
A Note on Empiricism, Regression Analysis and Praxeology
Praxeology does not, as Austrians would like to believe, make the Austrian Business Cycle immune to empirical criticisms based on regression analysis (or other non-Gaussian methodologies used to determine causal relationships between variables). One Austrian criticism of regression is that causation cannot be proven by regression.
This is false.
In the judgment of the entire field of mathematics the Gauss-Markov theorem has established that causal relationships (not mere correlations) between an outcome variable (dependent variable) and a causal variable (independent variable) can be mathematically represented.
Other Austrian criticisms of statistical empiricism include arguments that economic activity makes statistics minimally useful in economic analysis. Only correlations can be made that do not properly reflect the subjective nature of human economic action.
This ignores the fact the many economic actions which are quantifiable can also be translated into true praxeological statements – it is true that statistics has found a powerful relationship between how the supply of oil and the demand for oil affects the price of oil (oil’s supply, demand, price are all clearly quantifiable variables) and that this relationship can be expressed in praxeological grounds.
Datasets for Federal Reserve actions and economic performance are basically as quantitative as oil industry statistics, yet Austrians have no problem applying regression to the oil industry but do object to using statistical empiricism.
Perhaps more importantly, Austrians misunderstand how regression analysis relates to their business cycle theory – regression is a powerful analytic tool for confirming or disproving a strong causal relationship between variables, and more questionable at making a conclusion for a weak relationship.
If there were a strong relationship between FRB actions and boom-bust cycles regression would be able to easily validate Austrian claims because, if it existed, FRB activity would overwhelm the effect of other variables.
Question – if the causal relationship between interest rates and boom-bust cycles is as strong as Austrians suggest, and if there are quantitive datasets available for both interest rate policy and economic growth, why do Austrians have qualms to studying this relationship in a regression model?
The Austrians use praxeology as a shield to dismiss trying to quantify their theory, but it is
Austrian analysis of FRB does not explain why speculative bubbles occur.
Austrian Business Cycle Theory Compared to Hamiltonian Business Cycle Theory
There is no quantitative method to find an objectively “correct” interest rate because different economic actors will act differently to the same interest rate – whether set by an ideal Austrian monetary system or FRB-
Alexander Hamilton’s Theory of the Business Cycle – Instead of the credit driven cycle suggested by Austrians, Hamiltonians argue the business cycle is demand driven. In Hamiltonian theory economic boom and bust cycles are a function of changes in consumer demand for a type, or types, of goods and/or services. These cycles are usually concentrated in a specific economic sector or sectors during both the upswing and downswing phases.
In the triangle of value signals, the consumer, producer, and economic environment, the consumer signals the demand they desire producers meet.
Hamilton’s Second Law of Economics – How Efficient Processes are is a Function of a Triangle of Value Signals from the Customer, Producer, and Business Environment
Production processes are efficient if they allocate a minimal amount of resources (relative to alternative processes) to produce the most valuable (in the opinion of the customer) goods or services.
The producer interprets these customer value signals.
If the producer believes satisfying customer demand is valuable enough to the producer considering the producer’s business environment, the producer adjusts their operations and allocates resources towards meeting demand.
As mentioned in Part I, the act of satisfying particular types of demand in one sector requires the producer to establish processes and allocate resources that differ in type and kind from resources used in other sectors. Therefore meeting types of demand creates different types of sectors:
Types of customer demand leads to the creation of different sectors because different types of consumer demand frequently require producers to design different types of processes in order satisfy different demands: The medical industry exists to satisfy medical needs; the financial sector exists to satisfy financial needs, the housing sector exists to satisfy housing needs. Each of these sectors have developed substantially different types of medical, financial, and housing processes to satisfy the demand in their respective sectors.
Because satisfying different types of desires requires different types of business processes, different sectors ultimately allocate different types of resources in their business operations that are often not needed in other sectors: Medical processes are allocated medical resources, financial processes are allocated financial resources, housing processes are allocated housing resources.
Because what consumers, producers, and the economic environment indicate is valuable is constantly changing, producers must continuously reallocate resources and fine tune business operations to align with signaled changes in demand and environment.
This reallocation of resources and process fine tuning by the producer never ceases.
Because time is required for producers to adjust to new value signals, there is always a time lag between the moment when value is signaled by the customer and the environment and when the producer can act on this new information.
Just as trains moving at top speed cannot stop on a dime, businesses cannot reallocate on a dime during a boom or downturn because it takes time to alter the course of their planned business operations.
In mathematical terms, how quickly and efficiently reallocation is performed is a function of how liquid a producer’s assets are and how quickly a producer can redirect other resources (land, labor, material…) dedicated to old business activities to new activities. Sometimes resources in an old business action can be reallocated to new purposes. But usually at least some resources cannot be reallocated because they are not recoverable from the old business action.
Economic booms are usually concentrated within a particular sector that experiences a large upswing in consumer demand relative to demand in other sectors.
When a sector booms because of increasing demand, producers in that sector reallocate more and more resources to activities that satisfy this increasingly valuable demand.
Sector momentum naturally cascades through the rest of the economic system during rapid expansion. This cascade becomes self-reinforcing for downstream businesses that indirectly or directly support the boom sector: Sectors – such as raw material suppliers, financial services, marketing, staffing agencies, etc… – that are downstream or complementary to the producers in boom sectors also devote more of their resources and operations towards supporting the boom sector.
The more demand there is and the more resources are allocated to the boom sector, the greater the influence this sector has over national economic performance.
Sector momentum also naturally cascades throughout the economy when previously booming sectors turn to bust.
Downturns occur whenever demand for a good or service, for whatever reason, reaches diminishing utility to the consumer. As utility is reached, demand falls below what producers projected demand would be. When demand misses expectations, producers must decide how to reallocate resources, if resources should be sold off, or if the producer can remain in business.
To Hamiltonians, economic downturns are inherently unavoidable. Over time, demand projections must consistently overshoot or undershoot because there are too many random and non-quantifiable factors for the producer to know in advance when and exactly to what degree a booming sector will see demand taper off.
Indeed, economic value itself is inherently non-quantifiable.
Because projections almost always miss their targets (and when projections are forecasted exactly it is due to a fortunate statistical accident that is not repeated in future projections) some misallocation (malinvestment) of resources is inevitable. Especially when a bust starts.
After a boom a often a significant proportion of invested resources are lost/not recoverable because the demand they were meant to satisfy disappears. Some operations at this point were near completion and had assumed robust demand. In mathematical terms, reallocation is easiest to perform when the old business action is at its earliest stage, hardest when the old action was closer to completion before cancellation.
For cancelled activities, a business actor may be able to rollback some resources invested in the cancelled activity to other activities, but some capital is usually not recoverable.
Economic recovery happens, and the boom cycle reestablishes itself, when a new demand emerges that is valuable for producer’s to serve.
Growth in Capitalistic economies is ultimately superior to Socialist economies because producers in Capitalism are ultimately reflecting the true desires signaled by the customer. Because customer desires are best reflected in Capitalism, Capitalistic systems ultimately enjoy lasting benefits in processes after economic boom and bust cycles have ended. The internet bubble and the industrial expansion of the 1920s all had positive impacts that long survived their respective crashes.
We note here that our theory holding that demand is the true driver controlling boom & bust is similar to Schumpeter’s theory that technological innovation drives market cycles. We generalize Schumpeter’s point to argue that demand of any kind – whether driven by demand for technology, cultural preferences, or any other customer motivation – is the key explanatory factor.
The traditional Austrian counter to Schumpeter is to argue fractional reserve banking causes boom and bust because central banks hold interest rates at artificially low levels. These low interest rates then encourage malinvestment in technological innovation, such as malinvestment in the green energy sector.
The Austrian argument against Schumpeter is weak because low interest rates are not by themselves sufficient to determine what specific technology investors decide to malinvest in. The number of possible investments in technology are essentially infinite, but not all of these possibilities attract malinvestment when interest rates are excessively low.
In the case of green energy malinvestment, Austrian theory does not explain why the green energy sector was favored over traditional energy sectors. The easy credit directed towards green energy would have been just as easily directed towards more profitable oil and gas companies.
Hamiltonian theory explains why. In Hamiltonian Capitalism investor actions are primarily explained by demand.
From a Hamiltonian viewpoint (as well as Schumpeter’s), malinvestment in green energy is the result of Liberal governments distorting normal consumer demand for energy towards politically favored green energy. Under normal market signalling conditions, “green” energy would not have enjoyed so much investment because that sector has not technologically matured to the point where it can substitute for classic energy industries.
Progressives substituting their perception of value for the customer’s normal preferences is the real culprit, not fractional reserve banking.
The Limits of Austrian Market Cycle Theory
As for the remedy to boom and bust so often proposed by Austrian economists, the gold standard, this too must be rejected as a cure.
It is at best just another economic tradeoff with disadvantages that do not obviously outweigh the flaws in fractional reserve banking.
The first error in Austrian affection for the gold standard is that the price of gold itself carries no inherent information about what interest rates should be.
Value, and associated prices, are inherently subjective for all goods and services. Gold is no different. The price of gold at any given moment reflects the preferences of its many customers. Those preferences include customers who value it in industrial applications and those who value it for aesthetic reasons. Neither gold’s industrial uses nor its aesthetic appeal hold advice about what a “correct” interest rate is.
Second, interest rates are also not quantifiable as “correct” or “wrong” because what qualifies as correct varies from the preferences of each individual economic actor. A very cash rich business such as Apple can tolerate much higher interest rates than a cash poor startup.
If interest rates are subjective, and the price of gold is like all other prices subjective, gold cannot indicate a “correct” interest rate of any kind. If there is no correct interest rate, a gold standard is not inherently better than fractional reserve banking.
No matter how interest rates are set, a given rate at a given point of time will always be too high and too low in the opinion of many economic actors.
What Austrians have misidentified as a flaw in fractional reserve banking is actually a side effect of Progressive economic policy.
Interest rates have been kept artificially low because economic growth across the West has been artificially suppressed by Progressive economics. Progressive policy, and any kind of Socialist economics, depresses economic growth because the network of value signalling between the consumer, producer, and economic environment is distorted by Leftist interference in the economy – usually by Liberals substituting their own subjective value preferences for the natural preferences of the consumer.
To compensate for lower growth, Progressive central bankers set interest rates low to make borrowing cheaper for business operations. This strategy reaches diminishing returns because low interest rates cannot compensate for the distortion of consumer demand signals.
Under Capitalism, interest rates would be less politicized (and therefore higher) because economic growth would be consistently higher. Hence, there would be no need for a gold standard to hold interest rates at traditionally healthier levels.
The Policy Implications of Hamiltonian Theory of the Business Cycle
For Capitalists, Hamiltonian analysis brings important implications for policy.
If the government cannot eliminate bust cycles for the reasons already discussed, then government policy should be to nurture the business environment in preparation for new demand to emerge and lead the next upswing in the economy.
This environmental nurturing should include creating a favorable environment for as many economic sectors to prosper so that dependence on one booming sector – a sector that must eventually experience a decline – is minimized. If one growth sector fails, others will be able to make up at least partially for this missing growth. This diversification in economic portfolios will alleviate risk from becoming too dependent on one sector of expansion.
The government should treat its overall economy like a basket of investments that, because of compound growth, increases over time despite periodic downturns. Occasional downturns should not alter long term economic strategy.