Hi all- first off, I must say I am glad to be part of the community. There is a lot of great stuff going on here.
Like some others, I have been reading up on the ABCT, its assertions, and its implications for policy. I am still trying to work out a complete understanding of the theory, and in doing so I have run into a question. What happens to the prices of capital goods during the “boom” period?
In his reply to Gordon Tullock’s critique of the ABCT, Martin Stefunko states that even with knowledge of the theory, entreprenuers will still get involved with the boom because “they would try to earn as much money as possible by buying certain higher-order producers’ goods, because their prices will rise most, and then selling them before the end of the boom” (pg. 5, bold and italics mine).
Seemingly on the contrary, Jesus Huerta de Soto, in Money, Bank Credit, and Economic Cycles, writing about the difference in accounting profit between industries closer to and further away from the final consumption stage: “In contrast, in the stages furthest from consumption the price of the intermediate goods produced at each stage does not show a major change, while the cost of the original factors of production employed at each stage climbs continuously…” (pg. 367, 397 in online version).
I must admit my confusion here. Is there something I have missed? What really happens to the prices of capital goods during the boom? This is important in that it seems to me that only if capital goods prices rise during the boom does a “rationally-expecting” entrepreneur have the incentive to invest during the boom period. I will appreciate all help on this issue.
If he were “investing” by speculating on the prices of capital goods then that might be the case. On the other hand, if you took starting companies and building factories etc. to mean investment then the rational entrepreneur might simply decide to invest during the boom because of a miscalculation as to their real costs (owing to the artificially low interest rates that are available as a result of the credit/monetary expansion)… and the rational entrepreneur would be unable to know what a reasonable rate of interest would be in the absence of monetary inflation either. They could try to adjust their calculations for inflation to get “real rates of return” but such calculations will almost invariably be based on historic rates of inflation. If price increases haven’t yet caught up with the monetary expansion then a rational investor may very (and probably will) underestimate future inflation and thus miscalculate real returns.
As to whether capital prices will increase during the boom or not, that depends entirely on what the new money gets spent on. In the first instance the new money will enter the system in the form of additional reserves (injected by the central bank through Open Market Operations). The immediate effect may be to lower the yeilds/returns on whatever the primary dealers effecting those OMOs are buying (typically treasuries in the United States) and to lower the interbank lending rate (which was the whole point).
The knock on effect will be (at least this is the intention of the central bank) to make credit cheaper for the commercial and private entities that borrow from the commercial banks. Next in line will be the goods that those borrowers spend their money on. If they’re borrowing to finance housing loans then you’d expect the price of houses to go up (as well as all the goods and services required to supply houses). If the borrowed money was used to finance margin trades on commodities then you’d expect the price of certain commodities to go up. So maybe capital goods (like houses) will go up in price and maybe, on the other hand, commodity prices will go up. It’s really hard to tell in advance.
What is certain though is that investments will be made in projects that quite simply are not profitable. They appear to be profitable in nominal terms due to an incorrect accounting of the total costs involved (most notably the cost of savings - as reflected by interest rates) but this is just a temporary fiction that the market engages in. Duped by the central bank, they pretend for a while that savings are less scarce (and thus cheaper) than they really are and they put those savings to use building new companies, houses, factories etc. However there are not really enough savings in existence to sustain the completion of all of these projects and, in particular, those that are financed by the inflationary boom.
I’ve read descriptions of the ABCT that distinguish between capital goods and consumer goods prices and, althoug they might accurately describe some booms I don’t really see the kind of goods that get subsidized by the inflationary boom as being central to the ABCT. More important is the fact that there are lines of business that spring up and are only able to spring up as a result of the monetary expansion. Regardless of what kinds of investments these are, they are unprofitable and they are bidding resources away from the genuinely profitable lines of business that either were or would have existed in the absence of the monetary expansion… and so whether it be overinvestment in capital goods or commodities, the monetary expansion still leads to a distortion in the structure of capital and the end result will inevitably be the same.
Perhaps one reason for the focus on capital goods is the long term nature of these investments (and this is precisely what makes these investments so sensitive to interest rates)… which also relates to the function of interest rates in reflecting people’s time preferences and stabilizing the supply of goods over not just the immediate but the medium and long term as well. However if what is required for the particular capital goods that borrowers are investing in (e.g. factories) is stuff like steel and wood and land then it seems more likely to me that you’ll see the price of those basic commodities going up rather than the prices of factories… so it’s pretty difficult to make broad generalizations about what will go up or down in price during the boom. Maybe Huerta De Soto or Tullock comment on this in more detail (I’ve still got De Soto’s book sitting on my desk waiting to be read actually - did you enjoy it?)
I don’t recall reading Tullock, so I can’t comment on whether there is a contradiction, but the de Sota statement is correct. It is the distortion caused by the prices of some goods not rising fast enough, while the prices of others are rising too fast, that causes the bust. The distorted prices cause not enough of the underpriced goods to be produced, while too many of the overpriced goods are produced. This is why the ABCT is a mal-investment theory, instead of an overinvestment theory.
I like Rothbard’s example of building a house where all of the building materials are covered with tarps. The builder uncovers the first day’s building materials and builds the foundation for a three-story house. Over the next two days, he builds the first and second stories. On the fourth day, he lifts the tarp for the third floor and roof and finds that there’s nothing under it. If he had known from the beginning that there was nothing under the fourth tarp he might have exchanged the materials under the third tarp for roofing materials and settled for a one-story house. As it is, he has a one-story house without a roof. The fourth day materials are equivalent to the intermediate goods that never get produced in the boom phase.
It is nonetheless true that a rational entrepreneur is forced to invest during the boom phase. It simply isn’t financially feasible to sit out the up side of the business cycle, particularly since it will only be followed by another cycle. He will either invest in the elements of the production process that he expects to increase in price most rapidly and try to sell them before the bust hits or buy the underpriced goods and wait for their prices to rise. If he gets caught in the bust, he’ll still be better off, on net, than if he just sat out the whole process.
Thank both of you who offered answers. Jimmy, you have reminded me that it’s important to take stock of how future inflation distorts business calculations; I was originally thinking more strictly in terms of interest rate alone.
As I indicated in the first post, my understanding of the ABCT is still developing, but it seems as though the central bank’s monetary expansion has the effect of intensifying entrepreneurial risk through its obscuring of the “true” market signals (which themselves have of course been obscured by decades of intervention). However, it seems to me that the rational expectations argument cannot eliminate the presence of the profit motive. Only if everyone knew when the bust would begin would the incentive to get involved in the boom be nixed; I think Mises wrote on this point somewhere in Human Action. Without that knowledge, the profit motive inspires entrepreneurs to take the risk of getting involved in the boom in the hopes of liquidating their products before the bust. The action of the central bank depends on our lack of future knowledge. I am still reading on this subject; hopefully I am at least on the right track.
Finally, I have yet to complete the complete De Soto book; I read Ch. 5 and part of Ch.6 because these chapters dealt most specifically with the ABCT. I certainly need to finish the book.
Surely not houses? They’re durable consumers’ goods. I think any good sensitive to interest rate fluctuations is likely to experience a boom, whether capital or durable consumer good, though the Austrian theory tends to frame it in terms of capital vs consumer goods, as opposed to interest-sensitive vs non-interest-sensitive goods (because capital goods normally fall sharply within the former category.)
In today’s screwed up world, with the amount of money support and general malinvestment, houses are like the uber investment, fusing durable consumer goods and capital goods. They satify our immediate consumption and investment. People buy houses mainly for the belief that they are an investment.