Arnold Kling Takes on Rothbard and the ABCT.

Economics Economics Questions
1

http://econlog.econlib.org/archives/2010/09/rothbard_on_the.html

His two main points (which I think he stole from me) are:

  1. If one always preaches that the sky is about to fall, then when recessions do actually happen, one can boast that one’s model is obviously correct, even though other forecasts have been “embarrassingly bad.”
  2. One cannot assume entrepreneurs are abnormally stupid about low interest rates.

The best response, so far, comes from andy:

"My main problem with the Austrian theory is that it presumes that businesses are highly myopic. An entrepreneur should be able to tell when the central bank is keeping interest rates too low. In that case, he should not say, “Oh, boy. Let me commit to long-term production based on these low interest rates.” Instead, he should say, “I’d better be careful. These interest rates are artificially low.” "

There are 2 problems with this objection:

  • Market price is both ‘result’ of market forces and ‘incentive’ to do some things. If government starts influencing the rate, you may know that this signal is wrong. But you do not have a better signal. It’s like driving an airplane with totally non-sensical speedometer. The fact that you know that some information is wrong doesn’t mean you know the correct information.

  • The lower interest rate means that money is more available. The whole notion is based on the fact that prices do not change instantly. More money available means that more people have incentive to invest. However, if we assume good investors decide not to invest, the bad investors get the money.

One of the reasons market works is that it directs money from bad investors to the good investors. If the good investors know about the problem, they will refrain from investing - and the money can go to bad investors. If it still doesn’t work, the Central bank WILL lower the interest rate further to make them invest.

It’s a kind of prisoner dilemma.

2

At the interest rate available on the market, there are three types of projects: those that cannot be done at the current rate, those that can be done at the current rate and could be done if money were in a free market, and those that can be done at the current interest rate but cannot have been done if there were free market money. Everyone thinks their particular project is a good idea, that’s why they pursue it. Those in the first group have a means to learn the truth. How is the world’s smartest businessman supposed to differentiate between the last two? He doesn’t know what the market rate would be, so he doesn’t know if it would be high enough to knock out his project or not. Clearly, he thinks it’s a good idea, and that people want the product.

3

But one may assume that abnormally stupid entrepreneurs appear to do exceptionally well for a short time. Moreover, since discerning the natural rate of interest with anything othern than a well-functioning price system is nigh impossible, the longer the distortion persists and the greater profits “stupid” entrepreneurs make, the more people come to believe in the sustainability of their investments. The “smart” entrepreneurs appear to be stupid, as investors hastily turn to others who are offering higher returns. Even in the long run, it is unclear whether the “stupid” entreprenuers actually lose – isn’t the very smartest entrepreneur one who helps drive the boom but exists just before the crash?

4

"My main problem with the Austrian theory is that it presumes that businesses are highly myopic. An entrepreneur should be able to tell when the central bank is keeping interest rates too low. In that case, he should not say, “Oh, boy. Let me commit to long-term production based on these low interest rates.” Instead, he should say, “I’d better be careful. These interest rates are artificially low.” "

There are 2 problems with this objection:
* Market price is both ‘result’ of market forces and ‘incentive’ to do some things. If government starts influencing the rate, you may know that this signal is wrong. But you do not have a better signal. It’s like driving an airplane with totally non-sensical speedometer. The fact that you know that some information is wrong doesn’t mean you know the correct information.

Along the lines of Andy’s response, when there are price ceilings on milk for instance, you get a shortage of milk. The criticism that Austrian economics assumes entrepreneurs must be stupid seems akin to saying that consumers must be stupid for buying more milk when the price is artificially lowered when they know there’s going to be a shortage if they continue to buy as much as they are (assuming they all know basic econ). Like Andy is saying it’s a prisoner’s dilemma. I might know that in order for there not to be a shortage, we can all only get half a gallon a week, but since the price is artificially low, I have the incentive to buy as much milk as I can because if I don’t, someone else will.

5

I’ve seen Austrians make this point before, and I still believe the analogy is faulty; this isn’t just a simple price control.

Kling’s point is made more clear when, in the voice of an irrational entrepreneur, he states, “Oh, boy. Let me commit to long-term production based on these low interest rates.”

You purchasing artificially low-priced milk does create a shortage; however, artificially low interest rates, according to Austrians, creates a surplus of long-term production. Kling is asking a more pointed question: why would entrepreneurs invest in long-term production specifically if such investments were predictably doomed?

6

Because it’s not guaranteed that all investments made during the period of a credit boom will be malinvestments? How many times do we have to revisit this topic?

7

I think the better way to put it is that not all investments will prove unprofitable to everyone, certainly in the short term, but also for some in the long term.

Considering the opportunity costs involved in redirecting the structure of production onto a path that is not aligned with consumer preferences, I would avoid stating that since some investments do prove profitable (in the short term or long term), that not all are malivestments.

One important point that strangLoop is still not grasping is the non-neutrality of money in the long run. This prevents him from seeing that not all that has been done as a result of the boom will just have to go away into liquidation. The structure has been altered forever.

8

You’re right. It should have been phrased: not all investment will result in a loss.

9

The “entrepreneurs aren’t stupid” argument is, well, stupid. Businesses can’t afford to wait around for rates to change before they can make an investment. Opportunities do not wait for Ben Bernanke to raise rates, sometimes you have to embark an a project NOW and that means acquiring financing at current levels. If you aren’t growing, you aren’t making money. Especially in an inflationary environment.

At any rate the whole argument is settled by the fact that if rates do rise the whole inverted pyramid of debt unwinds bigtime. We can even deduce a priori that interest rates would be higher than they are now if decided by market forces.

Moreover, the (up until recently) correlation between the stock market and the AUD/JPY carry trade is the purest example of ABCT I have seen in my short career as a market observer. Short JPY, buy AUD, buy stock. Pure interest-rate arbitrage, the trade doesn’t even work unless the Yen is depreciating ie: the interest rates are low.

10

Conceivably, then, couldn’t lower interest rates produce zero malinvestments? That is, would it be logically possible that all investments selected did not eventually result in a loss? Is that simply unlikely or strictly impossible?

11

“Kling is asking a more pointed question: why would entrepreneurs invest in long-term production specifically if such investments were predictably doomed?”

<= Because there is no such thing as a clear and cut sign that points and says ‘this is a long-term production process that won’t be profitable as soon as the interest rate goes up again’. Nor is there any way of making such a sign. That’s why.

The idea is very simple: even given ‘correct’ prices, new and long term production processes are more risky than short term and not new production processes. If you give wrong inputs, it’s only logical you’ll expect more mistakes; not necessarily because of the ‘long term’, but maybe because of the higher risks.

12

“Conceivably, then, couldn’t lower interest rates produce zero malinvestments? That is, would it be logically possible that all investments selected did not eventually result in a loss? Is that simply unlikely or strictly impossible”

That’s like saying: 'what if we gave a class of students the wrong ‘x = a random number’. It’s logically conceivable they still have the right solution - because all made mistakes given the information they had. Just not very likely.

13

“Conceivably, then, couldn’t lower interest rates produce zero malinvestments? That is, would it be logically possible that all investments selected did not eventually result in a loss? Is that simply unlikely or strictly impossible”

That’s like saying: 'what if we gave a class of students the wrong ‘x = a random number’. It’s logically conceivable they still have the right solution - because all made mistakes given the information they had. Just not very likely.

14

Yup. I just realized that ABCT, even if true, doesn’t necessarily lead to malinvestments, so I thought that was neat. (Unless both you and I are mistaken.)

15

What an embarassing post from Kling. It is sad that I as a layman can spot gaping holes in his argument in under 45 seconds.

Or maybe I am more awesome than I give myself credit for!

EDIT: Ha! Peter Klein crushes it out of the park in the comments.

16

Conceivably, then, couldn’t lower interest rates produce zero malinvestments? That is, would it be logically possible that all investments selected did not eventually result in a loss? Is that simply unlikely or strictly impossible?

I think, at this point, a brief and incomplete overview of Austrian business cycle theory would be useful. The concept, at least broadly speaking, is that by increasing the supply of loanable funds (usually in the form of credit) there is an “artificial” fall in the “rate of interest”. This reduction in the rate of interest acts as a price ceiling for capital goods, especially those of higher order. Just like other price fixing schemes, this manipulation of the rate of interest creates economic chaos—in this case, intertemporal chaos in the structure of production. The aggregate supply of saved capital goods is decided by society’s time preference, and this time preference is indirectly reflected on the market (assuming a fixed supply of money, or a fixed moment in time) by the rate of interest; a falling rate of interest reflects a decreasing marginal utility for accumulated economic goods, or an increasing supply of accumulated economic goods.

This fall in the rate of interest causes entrepreneurs to borrow and invest, lengthening and widening the structure of production. How one approaches the topic of an ever-lengthening and ever-widening structure of production is paramount to understanding the full implications of Austrian capital theory, I think. Changes in the structure of production should be seen as the product of entrepreneurs knowingly embarking upon more “roundabout” processes of production. In other words, entrepreneurs do not take advantage of low rates of interest to explicitely and purposefully engage in more roundabout process of production, rather they invest in lines of production they believe are profitable. The structure of production, therefore, should be seen as the product of a dynamic process of capital allocation, based upon the actions committed to by the entrepreneurs in question. In other words, the structure of production—illustratively divided into a number of phases, each of different lengths (representing time) and widths (representing the scope of necessary capital-goods required just for the production of economic goods produced in that one phase, each of which may necessitate its own structure of production of varying lengths and widths)—should be seen as immediately disjointed but effectively interdependent (either directly or indirectly) processes of production embarked upon by entrepreneurs with various different objectives in mind.

Seeing the capital structure in this way, I think, makes it much easier to become aware of how entrepreneurial decisions are made during eras of credit booms. Knowing that the structure of production is but a matrix of different processes of production, each dependent on entrepreneurs’s rational action, we can therefore become aware of the fact that the profitability of each process of production is directly independent (they are indirectly independent in that the collapse of the structure of production due to the re-equilibration of intertemporal prices will reveal malinvestment, and the collapse of certain parts of the structure of production will lead to the collapse of others because of this interdependency). Let us take the housing market and provide a simplified example. Knowing that there is demand for housing, an entrepreneur decides to borrow artificially cheap credit in order to fund a project which will provide one hundred houses to the market. This project, of course, requires a widening of this new phase of production—the entrepreneur needs to access nails, lumber, tools, et cetera. The profitability of the nails is not immediately dependent on the profitability of the house. In other words, the entrepreneur will pay the nail producer out of accumulated capital (or savings), and therefore the nail producer will strike a profit even if ultimately the housing-project owner finds that his investment was unprofitable. Just the same, the housing-project owner may be able to sell the houses before this intertemporal misallocation of capital is revealed.

This is where DD5’s correction of my original point gains value. It is not that the lengthening of the structure of production does not lead to a rise in malinvestment—because, it will and it does—but not all individual investments made during this time will prove to be unprofitable. Therefore, there must be a distinction between the malinvestment which is represented by a general quantity of investments made along a general and partially-aggregated line of production, and then the de-aggregated and individual investments which makes up that cluster of phases of production which make up a particular sector.

17

Excellent explanation, Jonathan.

P.S. I didn’t mean to reignite a debate on ABCT. I mainly wanted to simply present a new critique of ABCT from a popular economics blog.

18

It wasn’t a new critique though. Kling doesn’t appear to understand the ABCT or Austrianism.

19

It was a new critique, but without any new criticisms.

Rather than say “Kling doesn’t appear to understand the ABCT,” it’d be more substantive to expose his ignorance through demonstration. Anyone that disbelieves in the ABCT could easily be dismissed by an Austrian as someone that “doesn’t appear to understand the ABCT”; but, of course, that doesn’t provide evidence of it being the case.

20

Respectfully, I think the point you are quoting here might stand. The lengthening of the production cycle reduces to taking on more capital-building projects. Suppose (God’s eye view, unknown to the actual actors) the market would have a rate of 5%, and the Fed lowers it to 4% through FOMC actions. It is possible, although incredibly unlikely, that there are simply are no projects that anyone has thought of that are profitable at 4% but not at 5%. Isn’t it?