oh well, since Esuric broached the topic already, I had in mind not even qouting Mises directly but rather plucking an entry direct from the Mises made easier Glossary to Human Action.
Equation of exchange. An equation, first made popular by Irving Fisher (1867-1947) in hisPurchasing Power of Money (1911), which states: The average amount of money outstanding (M) multiplied by velocity (V), i.e., total expenditures divided by the average amount of money outstanding, equals the sum of the average price paid for each good and service (p) multiplied by the quantity of each sold (q), or MV =(pq + p’q’ . . . + p(n) q(n)), or more often MV = PT, in which P represents average prices and T the total physical volume of trade.
In short, the equation merely equates the sums spent to the total of prices paid, assuming an equality between the values of the prices paid and the goods bought. This is contrary to the subjective or marginal theory of value, wherein all voluntary exchanges are exchanges of unequal values. In using totals and averages, the equation of exchange also implies the fallacies inherent in the concepts of“price level”and the“neutrality of money”(q.v.).
Although designed as an explanation of the purchasing power of money, the equation of exchange is an holistic concept which fails to explain either how the purchasing power of money arises or how changes in it occur. The purchasing power of money is actually determined by the reactions of individuals to their ever changing individual situations and not by any mathematical formula.
Really? Have you ever taken more than an intro to economics course? This is getting ridiculous. I used the standard definition and I’ve used it consistently. An excess demand is the same as a shortage of supply. It’s pretty intuitive.
Again, the equation of exchange is not a theory. It can be used to demonstrate any theory. Maybe you disagree with the level of aggregation involved. Fine, but make that your argument. Bashing the equation itself literally makes no sense.
MISES IS SAYING HE DISAGREES WITH THE QUANTITY THEORY OF MONEY. THE EQUATION OF EXCHANGE IS NOT THE QUANTITY THEORY OF MONEY. I don’t know how I could make this any more clear. Mises doesn’t like the term velocity. Fine, replace it with 1/money demand.
At most, my comments are mainstream ideas with an attempted incorporation of certain aspects of the ABCT. Just because you can’t handle that doesn’t make it incomprehensible.
You can avoid the substance of my arguments all day. They won’t be offended.
Mises is taking issue with a certain aspect of the quantity theory of money. He is using the equation of exchange as a proxy for that theory.
He falsely claims this as an assumption of the equation. The equation is not about the equality of utilities of consumers and producers, as Mises seems to imply. It is about the equality of money spent and money gained.
Actually, his entire comment seems to be a straw-man. I don’t see how the quantity theory equates prices with subjective value. The theory is really just a hypothesis which says that in the long run only prices are affected by nominal changes in the money supply.
You woud have entered the next period with a lower money supply and hence a fall in either P or Y on the other side of the equation.
This converstaion is ridiculous and is not contributing anything to the main point. It is usually evidence that someone has lost an argument when they are backed so far into a corner that they begin questioning universally accepted identities.
Jake, I’m probably more receptive to your views than most here, but I think that the ABCT is probably the strongest part of Austrianism,
Whilst we can certainly talk about misallocation of resources without reference to the time structure, I don’t see how it makes much sense in this regard. Presumably you’d agree with me that misallocation of resources occurs as a result of incorrect pricing (whether that be because the market is inefficient or because the government has inteferred with the market process). But all the Austrian theory really says is that the government has caused the rate of interest on the market to deviate from the natural rate and has thus caused a misallocation of resources across time. In this regard I don’t see how one can avoid talking about the time structure of production since the market price that is incorrect is that of time. Now, Roger Koppl has said that the ABCT is not compatible with the rest of Austrianism on the grounds that it is insufficiently subjectivist. Perhaps this is what you’re getting at, or perhaps you just don’t think that the notion of a time structure of production is particularly coherent/ useful. If the former is the case I disagree because I think that it is merely necessary to note that the time structure of production refers to the foward looking plans of entrepreneurs aimed at satiating the wants of consumers. If the latter is the case, I’m merely going to have to disagree and point out that the notion of time structure of production is one of the biggest contributions of Carl Menger.
Whilst I certainly agree that there is an overinvestment side to the theory (and it is the overinvestment that makes malinvestment possible) I don’t think that’s all. I’d argue that when you make claims such as these “The unsustainable aspect of the story is that the fall in rates is only a short-run phenomenon while the induced investment is expected to last for the long-run.” you’re attemtping to sneak the notion of intertemporal malinvestment in through the back door. Perhaps I’m wrong in that you think that if the Fed doesn’t raise interest rates the bust won’t follow, but I’d disagree here. In any case, there’s certainly some aspect of the aforementioned statement of yours that relates to the misallocation of resources, over time.
As for the Cambridge Capital controversy, I don’t think this presents a problem for Austrians. As Huerta de Soto has pointed out, the controversy actually strengthens the Austrian view that capital can’t be measured as you pointed out. There is no measure of roundaboutness. The structure of capital is foward looking, and not backwards. All that matters from the Austrian perspective is that when time preferences fall, the length of planning of an individual overtime, increase. IOW, when TP people transfer the use of scarce resources from the present to the future.
If I’m not understanding anything, point it out. I’ve not found any of the critiques of ABCT that I’ve read to refute is successfully (Caplan makes some good point, but I think these have already been answered and Tullock was, I believe, successfully countered by Salerno).
I am not disagreeing with the ABCT per se. I just think that specific parts of the story are outdated and not really that useful. I don’t view it as a general theory of business cycles and would actually prefer to call it something else, like the Mises Effect.
I think our disagreement is over the role of interest rates. I think that interest rates are relatively unimportant and that it is the excess supply of credit which is at the heart of the issue. Interest rates may fall, but this by itself is not the cause of the malinvestment. In my view, there is a real increase in the supply of credit caused by inflation, but only in the short run. This excess credit can be used for any purpose- maybe producing the wrong type of consumer good, for example. If we remove the interest rate from the picture, there is no need for malinvestment to be directed specifically towards higher stage production process. I may be wrong, but I think Hayek agreed with me on this. I remember reading that he only saw what is now the standard version of ABCT as a specific interpretation.
I don’t disagree that there is a malinvestment of resources over time. I just disagree with the specific way that is interpreted. Malinvestment could be directed towards increasing retail inventories, which would eventually cause some retailers to go out of business. I view this as an intertemporal misallocation, just in the opposite direction as the standard story.
I may have misinterpreted Salerno’s response, but from what I can tell he didn’t really say that Tullock’s main point was invalid; only that there would still unemployment. Basically, they disagreed on magnitudes. My view is somewhere in the middle: there will be a small increase in unemployment which may trigger something like a Keynesian demand-side depression. Selgin, White and Horwitz take this view as well.
Which parts in particular? If you’re saying, as I think you are that Austrians need a more thorough explanation of what causes business cycles then I agree. I don’t think that all business cycles can be said to be caused by the tradition Austrian theory. This is why I really like the work of Garrison and Horwitz on a more thorough elaboration of Austrian macroeconomics. Garrison has done some really great work in Time and Money elaborating what may cause a business cycle besides overexpansion of credit such as transfer of wealth, deficits, risk and taxes. Horwitz has also done absolutely superb work in combining the tradition Austrian view with the monetarist notion of monetary disequilibrium (by authors such as Yeager and Clower). But I feel that you’re saying something bigger, so perhaps you could be more specific in regards to which part of the story you find outdated and useless.
Jake, as far as I can tell what you’re saying is that the overinvestment part of the story is the more important. And perhaps that the malinvestment occurs as a result of overinvestment as opposed to any specific distortions of the interest rate. I suppose my question is why would it be that distortions in the the price of time don’t cause specific misallocations of resources whereas incorrect prices in other areas of the economy would. I mean, it’s quite clear that if you push the price of labour above the equilibrium price there will be shortages of labour and that more people will begin supplying labour. However, you don’t seem to see anything analogous with regards to the rate of interest. If you conceive of the interest rate as the price of time (which I believe you do) then clearly a price of time that is below equilibrium would cause a drop in the supply of time (people become more present orientated) and an increase in the demand for time (entrepreneurs begin longer planning periods).
So whilst I entirely agree with you that perhaps it is possible that people will use the extra funds to provide more consumer goods, the general trend would be to invest more in consumer goods. I think that whilst the Austrian analysis might not capture malinvestments such as these, it’s simply because abstracting them makes the issue far clearly. From a more mechanical point of view, would you not agree that when the interest rate decreases, long term investments become more profitable because they’re discounted by a smaller amount. To give a somewhat extreme example if there was a potential investment that would generate $10,000 in 20 years it’s present value would be $115 and $9052 with market interest rates of 25% and 1%respectively. Given this would it not be a bit hasty to dismiss the market rate of interest from the picture? Clearly such a huge reduction would have huge implications for the sorts of investment that occurs.
I’ll have to reread the exchange, I read it a while ago didn’t give it much thought (it was during my more dogmatic days) so I can’t really remember all of it. I’ve read Caplan’s critique and I think he makes some good points, not that they seriously damage the substance of the ABCT, just it’s application the real world. As for Horwitz and Selgin, I entirely agree. Horwitz use of monetary disequilbrium and the insights of W.H. Hutt deserve a lot of attention, although, perhaps it’s a bit misleading to call it a Keynesian “demand-side” depression since it’s not really demand that is the cause but withheld supply due to incorrect pricing.
Mostly issues on expectations, which is what Caplan focuses on, and things like the interest rate, which we are talking about now. Also, a lot of the terminology Austrians use could be translated into mainstream jargon. For example, in his response to Tullock, Salerno writes pages about relative price shifts in complementary capital goods due to malinvestment and… A mainstream economist would have referred to this as “technological frictions due to an unexpected structural shift.” Most economists understand what malinvestment is without the Austrian’s capital theory, which I think is unnecessarily complex. Real business cycle theory is based on something like malinvestment, after all.
Correct me if I’m wrong, but you look at the fall in interest rates as a disequilibrium phenomenon even in the short run, like if the Fed literally said “the interest rate is going to be 1% now.” This is the way Jerry O’Driscoll discusses it, I think. The interest rate is set below the intersection of supply and demand for loanable funds. In my view, the fall in the interest rate is actually a short run equilibrium adjustment. The problem is that the increase in the supply of credit itself only occurs in the short run. In the long run there is no increase in credit. It is that discord between the short run and long run supplies of credit that causes the malinvestment. If this is the case, the interest rate is only responding to changes in the supply of credit and it is in equilibrium.
Think of it this way: The Fed increases bank reserves above what banks want to hold at the current price level. However, the banks can’t get rid of those reserve at the current interest rate because demand at that rate has already been met. In order to get rid of these reserves, the banks must lower the interest rate. The fall in rates is necessary to induce any new investment at all. As time passes, investors who had received funds at the original interest rate may take advantage of the lower rates by extending their projects. I would agree that this is what might happen happen if the increase in credit would last for the long-term, say due to a permanent increase in consumer savings. But the interest rate usually only take 1-2 years to adjust fully and so I don’t know if it could happen on a large enough scale, especially if inflation expectations begin to kick in.
I’ll respond to your comment on the other thread here.
This seems to be a description of a normal structural shift. Tullock just takes issue with the severity of the problem. He doesn’t think any structural shift could lead to a recession the magnitude of the great depression or the current downturn. He doesn’t think that the capital goods created by the malinvestments are “squandered.” They will still be used but their price will not cover their cost of construction, only their operation cost. Businesses will go bankrupt because of this but any losses to the economy as a whole will only be due to the “technological frictions due to an unexpected structural shift” I mentioned in the beginning. Salerno seemed to agree with this but he thought that the losses would be much larger than Tullock thought. Of course, this debate becomes irrelevant if we just take the structural shift to be a catalyst for something else.
I don’t think so. Horwitz likes to say that the Austrians, Keynesians and Monetarists are all telling a different part of the story. An Austrian boom/bust leads to a monetary disequilibrium (where demand for money exceeds the supply) which, if not addressed immediately will lead to the story Keynes described.
If I recall correctly (which I might not do) Caplan says that first of all if the credit expansion is correctly anticipated by entrepreneurs they will bid up the rate of interest and the Austrian theory of the business cycle won’t follow. He then states that given the Austrian perspective of the market and coordinating role entrepreneurs play it flies in the face of Austrian theory to claim that they entrepreneurs won’t anticipate the credit expansion. Therefore the ABCT merely elucidates a special case of an unanticipated credit expansion.
Now, this seems somewhat correct to me, I would certainly agree that if entrepreneurs understand that the Fed has reduced interest rates through credit expansion then the Austrian theory wouldn’t follow. However, I’m not sure (literally) whether or not this is incongruent with the rest of Austrian theory. I think that due to the nature of the price in question any falsifications of the price would not be revealed until a certain amount of time has passed. And after a certain passage of time entrepreneurs will understand that they have invested resources in a way that is not in line with the most urgent wants of consumers.
As for the terminology, this is perhaps a different issue from the validity of the in and of itself. I also doubt, although can’t say for certain, that there would be certain losses involved in the usage of different phrases.
I think this comes from a different understanding of the natural rate of interest. I’d argue that the natural interest rate is the spread between the different, temporal, stages of production. In a free market the interest rate will correspond to the natural rate, and ex ante saving will correspond with ex ante investment. However, when the Fed pushes interest rates below the rate at which ex ante saving and investment are in equilibrium the business cycle will follow. Now, as far as I can see you mean that when the Fed creates extra credit the new interest is actually the equilibrium rate. But does this not imply that the credit expanded by the monetary authority should be considered as genuine savings?
I suppose this is the crux of the differences between us. Whereas you see the business cycle as stemming from a discord between the short run and long run interest rates (the short run interest rate being in equilbrium). I see the business cycle as sort of being a “medium run” phenomena in that the expansion of credit pushes the interest rate below that natural rate and causes ex ante discrepencies between saving and investment which leads to all the problems of which you’re aware.
Ah, well, I think I’d actually have to agree with you here. I’m not sure how big the losses could be, althought I’d point out that the macroeconomics as elucidated by Horwitz, Yeager, Hutt, Garrison, Selgin and others could account for this and make Austrian theory more robust. However, this is really a different question. Perhaps I’m misunderstanding but all this would challenge the application of Austrian theory to various historical episodes, not the validity of Austrian theory. I think Salerno is on the better ground when it comes to the validity of the theory, I don’t think that Tullock is correct when he says the business cycle would increase consumer well being because I don’t think that the new capital goods created could be used profitably.
I know what you’re saying, and I agree. My disagreement comes in over the terminology used. Like Hutt, I wouldn’t call this a demand problem. Rather, the problem comes from the supply side which translates into insufficient demand.
I just went back and read the Caplan critique. He says that long-term rates will be bid up even if short term rates will not. This will indicate to other investors that the short term rate is only temporarily low. This knowledge will prevent them from making malinvestments even if they take funds at the lower rate. But as you say, unanticipated expansion could still set off the cycle.
Terminology is a side issue, of course, but I think moving away from the term Austrian is a good idea as it would remove some of the percieved eccentricity of the theory. I think that most maintream economists implicitly accept parts of the theory anyway and so a common terminology might make it easier for austrians and neoclassicals to talk to each other.
I agree with this. The point I was making was more directed at the idea that malinvestment will necessarily be in higher stages. In the short-run I think that depends on who the marginal investors are, though it is probably true in the long-run. I agree that an increase in desired savings will eventually lead to more investment in higher stages.
This is mostly true. For example, I would say that it is not clear that the Great Depression was the result of ABCT although maybe the 1920-1921 downturn was, due to the newness of the Fed.
What Tullock is saying is that the producers of the capital goods will take a loss but subsequent owners will be able to operate them profitably. I think the effect this has on consumer welfare is ambiguous. The discovery of malinvestment will reduce wages but prices will fall as well. I would say overall there is a loss but it won’t be any greater than that from a standard sructural adjustment.
Okay. I guess I’m just comfortable with the other terminology.
But if you actually check historic data, you’ll notice how long term rates were pushed down. It’s arbitraged, takes some time to work but profit is just so big that given liquidity is there it’s guaranteed to happen. For example, 15 yr FRM was pushed down as low as 4.75% in 2003, from over 6% before year 2000.
you plan on building an awesome hotel as you feel there are big profits to make in an as yet untapped location, you think if you build a big 5 star, and market the culture, then people will flock in and you will clean up.
you place orders for purchasing diggers, concrete, metal, you hire away a few hundred work men, to construct the building.
you complete the building and set a date for the grand opening
unfortunately a freak storm comes and your wonderful construction is destroyed. you lose your shirt. (in a boom bust, the storm is a reveal, both of false prosperity and false signalling of consumers time preference)
now of course, things arent as bad for the economy as a whole as they might have been, since you can sell off your construction equipment at firesale price to others who were luckier than you , also you can sell rights to reclaim scrap material from the wreckage, metal ec. but theres a whole lot of sunk costs. if you had the foresight not to invest in the project that had been doomed to fail, you wouldnt have ‘broken the window’.
unusally large cluster errors, brought about by credit-expansions effects on investment and consumption, that are commonly understood to be ‘busts’, big oh!noe!-reveals of large scale error, and the sudden dissappearance both of false prosperity and the illusion that the productive potential of the economy has long been focused in the correct direction (wrong!), should not be consider ‘trivial’ or ‘ambigious in their effect’.
to put it crudely; impact on consumer welfare ambiguous? ‘ambiguous my ass’.
Right, and as such the ABCT would be a special case as opposed to a general theory. I suppose I’d agree with Caplan on theoretical grounds here (providing there are no other criticisms that I missed), but I think many (most) business cycles that have occured are in line with the Austrian explanation for what causes a cycle. Now, of course the insights of Horwitz, Yeager, Hutt et al can be used to provide a greater understanding of other phenomena at work (deflationary monetary disequilibrium).
Well, to begin with, I think Austrians should begin emphasizing that they are a neoclassical school. Austrians and mainstream neoclassicals don’t differ on their ends, they both wish to analyze price formation in terms of marginal units. Where they differ is the means used to acheive this end, mainstream economists use math Austrians use verbal logic. That said, I’m not too sure I can agree, I’m not sure if there’d be any huge gains from adopting neoclassical terminology, the ideas are still pretty unorthodox. I mean, if Tullock had trouble getting his work on rent seeking published, I’m not sure how easy it would be for Austrians to make any ground.
Ah, OK, I see what you’re getting at. Although, I’d still disagree. I think the point is that due to the importance of time and the fact that it affects every market, any changes in its price will have a huge effect on the distribution on the economy’s resources. So I think it’s not so much an issue of who the marginal borrows are, because, upon seeing a lower interest rate these borrowers (and existing borrowers) may dramatically alter their entrepreneurial plans. I mean, all of this could be avoided if time could be traded in market of its own, but it can’t due to it’s very nature.
I agree with this as far as it goes. And I also agree that if this were the whole story the losses in a depression would be relatively mild. The fact is that there are other losses involved with refitting the capital goods and retraining labour. Nevertheless, unless the credit expansion was huge and went on for an exceedingly long period of time I can’t see the losses being too big (and history seems to agree with me). This is where I’d emphasize the roles played by price rigidites in mitigating against coordination after the bust.