Refutation of ABCT

Economics Economics Questions
1

The core is Austrian Business Cycle Theory is that credit is extended to business without the necessary saving to fund the expansion. When the new money is paid out as wages consumers establish their old time preference meaning consumption has not been curbed enough to finance the expansion of capital goods industries.

How would we respond to someone who makes the claim that credit expansion is backed by savings - forced savings created through inflation?

We know that inflation transfers resources from the last spenders of the new money (the general population) to the new spenders (the businesses accepting the new credit). Therefore in the face of inflation consumers will have to curb their consumption thus creating the savings necessary to finance the new capital investment.

How do you refute that?

The best I can come up with is that the savings needs to take place before the investment; however, when businesses spend the new money they buy things at market prices the same as they would if there were genuine savings. Consumers later curb their consumption and buy at inflated prices.

Any help with this?

2

Newly created capital, is not necessarily savings. Capital that is built, that does not coorespond to the demands of the consumers, is no savings at all but a waste in natural resources.

There are few ways of looking at this. In the case of alleged forced savings, the claim is that resources are being forcefully redirected from present consumption, into future consumption of goods. There are two problems with this assessment.

  • First off we don’t know if the new investment is going into sectors that consumers truly have an interest in, and we don’t know if they are going to produce something that is considerd of value tomorrow. As a result your creating benign goods, goods that no one wants. The reason is because investment is not done at the hand of consumers, but at the hand of speculation with new credit.
  • Second off this is not what happens, present consumption is not forcefully being curtailed, instead the new credit actually may exacerbate present consumption. Consumers have an economic dis-incentive to save money, and instead have an incentive to spend in the now. Expansion can potentially occur laterally across all stages of production.

I’ll try to briefly explain why forced savings doesn’t happen. If interest rates have been artificially lowered, retail profits may continue to remain high(High time preference) and investment in those sectors will also remain high. So instead of areas of production closest to consumption curtailing investment, they are also continuing to expand. Meanwhile everyone else is also expanding.

So the argument assumes that forced savings creates a withdraw of investment from stages of production closest to consumption, and redirects to stages of consumption farther away. Therebye keeping a balance. This is not what happens in a business cycle, the new credit allows all stages of production to expand laterally. So investment could potentially go in all directions, driving up the cost of durable goods and capital alike.

3

There is a time lag. He is assuming that savings necessarily equals investment at all times, but this is only true in the long run. With such an assumption, all investments are backed by real savings and malinvestments cannot exist. The problem, though, is that inflation creates disequilibrium in the loanable funds market, that is, investment exceeds savings. But such a condition, namely inter-temporal disequilibrium, is only temporary. The investments can only be completed if society forgoes consumption and saves (forced savings). If they do not alter their consumption/savings pattern, than such investments cannot be completed, and there must be a liquidation and reordering process which aligns the capital structure with actual preferences, i.e., a recession/depression. The decline in investment and disinvestment will reestablish equilibrium (where savings=investment).

But they don’t, and that’s the problem. Again, investment is greater than savings when the market rate is suppressed below the natural rate–this condition is temporary.

4

That’s exactly like saying that the Mafia is good for the economy, because the criminals force their victims to save and then invest the stolen money.

5

I know I’m not grasping something here but I can’t put my finger on it. Your explanations don’t seem to explain why consumers curbing their consumption in light of inflation is not sufficient to replace the voluntary savings necessary to expand investments in capital goods.

You state…"I’ll try to briefly explain why forced savings doesn’t happen. If interest rates have been artificially lowered, retail profits may continue to remain high(High time preference) and investment in those sectors will also remain high. So instead of areas of production closest to consumption curtailing investment, they are also continuing to expand. Meanwhile everyone else is also expanding.

So the argument assumes that forced savings creates a withdraw of investment from stages of production closest to consumption, and redirects to stages of consumption farther away. Therebye keeping a balance. This is not what happens in a business cycle, the new credit allows all stages of production to expand laterally."

De Soto states in Money, Bank Credit, and Economic Cycles that the economy experiences

"a slowdown in the production of new consumer goods and services in the short- and mediumterm,

a consequence of the lengthening of production
processes and the greater demand for original means
of production in the stages furthest from final consumption.
This decline in the speed at which new
consumer goods arrive at the final stage in the production
process derives from the fact that original factors
of production are withdrawn from the stages
closest to consumption, causing a relative shortage of
these factors in those stages. This shortage affects the
immediate production and delivery of final consumer
we will see that our analysis does not
change substantially even when a large volume of unused factors of
production exists prior to credit expansion.
goods and services. Furthermore as the capital theory
outlined at the beginning of the chapter explains, the
generalized lengthening of production processes and
the incorporation into them of a greater number of
stages further from consumption invariably leads to a
short-term decrease in the rate at which new consumer
goods are produced. This slowdown lasts the
length of time necessary for newly initiated investment
processes to reach completion. It is clear that the
longer production processes are, i.e., the more stages
they contain, the more productive they tend to be.
However it is also clear that until new investment
processes conclude, they will not allow a larger
quantity of consumer goods to reach the final stage.
Hence the growth in income experienced by the owners
of the original factors of production, and thus the
increase in monetary demand for consumer goods,
combined with the short-term slowdown in the
arrival of new consumer goods to the market,
accounts for the fact that the price of consumer goods
and services eventually climbs more than proportionally;
that is, faster than the increase in monetary
income experienced by the owners of the original
means of production."

This seems to contradict what said about investment in consumer goods increasing. Either way I’m not sure I grasp how resources are not saved due to to inflation.
gradually climb, while the price of services offered by the
original factors of production starts to mount at a slower pace
(in other words, it begins to fall in relative terms). The combination
of the following three factors accounts for this phenomenon:
(a) First, growth in the monetary income of the owners of the
original factors of production. Indeed if, as we are supposing,
economic agents’ rate of time preference
remains stable, and therefore they continue to save
the same proportion of their income, the monetary
demand for consumer goods increases as a result of
the increase in monetary income received by the owners
of the original factors of production. Nonetheless
this effect would only explain a similar rise in the
price of consumer goods if it were not for the fact that
it combines with effects (b) and (c).
(b) Second, a slowdown in the production of new consumer
goods and services in the short- and mediumterm,
a consequence of the lengthening of production
processes and the greater demand for original means
of production in the stages furthest from final consumption.
This decline in the speed at which new
consumer goods arrive at the final stage in the production
process derives from the fact that original factors
of production are withdrawn from the stages
closest to consumption, causing a relative shortage of
these factors in those stages. This shortage affects the
immediate production and delivery of final consumer
364 Money, Bank Credit, and Economic Cycles
74In section 11 of chapter 6 (p. 440) we will see that our analysis does not
change substantially even when a large volume of unused factors of
production exists prior to credit expansion.
goods and services. Furthermore as the capital theory
outlined at the beginning of the chapter explains, the
generalized lengthening of production processes and
the incorporation into them of a greater number of
stages further from consumption invariably leads to a
short-term decrease in the rate at which new consumer
goods are produced. This slowdown lasts the
length of time necessary for newly initiated investment
processes to reach completion. It is clear that the
longer production processes are, i.e., the more stages
they contain, the more productive they tend to be.
However it is also clear that until new investment
processes conclude, they will not allow a larger
quantity of consumer goods to reach the final stage.
Hence the growth in income experienced by the owners
of the original factors of production, and thus the
increase in monetary demand for consumer goods,
combined with the short-term slowdown in the
arrival of new consumer goods to the market,
accounts for the fact that the price of consumer goods
and services eventually climbs more than proportionally;
that is, faster than the increase in monetary
income experienced by the owners of the original
means of production.
Sooner or later the price of consumer goods begins to
gradually climb, while the price of services offered by the
original factors of production starts to mount at a slower pace
(in other words, it begins to fall in relative terms). The combination
of the following three factors accounts for this phenomenon:
(a) First, growth in the monetary income of the owners of the
original factors of production. Indeed if, as we are supposing,
economic agents’ rate of time preference
remains stable, and therefore they continue to save
the same proportion of their income, the monetary
demand for consumer goods increases as a result of
the increase in monetary income received by the owners
of the original factors of production. Nonetheless
this effect would only explain a similar rise in the
price of consumer goods if it were not for the fact that
it combines with effects (b) and (c).
(b) Second, a slowdown in the production of new consumer
goods and services in the short- and mediumterm,
a consequence of the lengthening of production
processes and the greater demand for original means
of production in the stages furthest from final consumption.
This decline in the speed at which new
consumer goods arrive at the final stage in the production
process derives from the fact that original factors
of production are withdrawn from the stages
closest to consumption, causing a relative shortage of
these factors in those stages. This shortage affects the
immediate production and delivery of final consumer
364 Money, Bank Credit, and Economic Cycles
74In section 11 of chapter 6 (p. 440) we will see that our analysis does not
change substantially even when a large volume of unused factors of
production exists prior to credit expansion.
goods and services. Furthermore as the capital theory
outlined at the beginning of the chapter explains, the
generalized lengthening of production processes and
the incorporation into them of a greater number of
stages further from consumption invariably leads to a
short-term decrease in the rate at which new consumer
goods are produced. This slowdown lasts the
length of time necessary for newly initiated investment
processes to reach completion. It is clear that the
longer production processes are, i.e., the more stages
they contain, the more productive they tend to be.
However it is also clear that until new investment
processes conclude, they will not allow a larger
quantity of consumer goods to reach the final stage.
Hence the growth in income experienced by the owners
of the original factors of production, and thus the
increase in monetary demand for consumer goods,
combined with the short-term slowdown in the
arrival of new consumer goods to the market,
accounts for the fact that the price of consumer goods
and services eventually climbs more than proportionally;
that is, faster than the increase in monetary
income experienced by the owners of the original
means of production.

6

"Therefore in the face of inflation consumers will have to curb their consumption thus creating the savings necessary to finance the new capital investment.

But they don’t, and that’s the problem. Again, investment is greater than savings when the market rate is suppressed below the natural rate–this condition is temporary.

I completely understand the in’s and out’s. Here’s the thing, if someone claims that inflation forces people to curb consumption, that person would also say that the new low (artificially low) interest rate IS the natural rate because people have curbed (involuntarily) consumption due to inflation sapping their purchasing power and freeing up more resources to invest.

]I know something is wrong with this analysis but so for I’m not sure any of you have put your finger on it.

7

Yeah, I don’t understand your problem either. Individuals have two choices when confronted with a malformed capital structure, brought about by inflation. They can (a) curb consumption and prevent the liquidation (recession), or (b) continue to consume and face the liquidation. I see no reason to believe that inflation automatically and necessarily forces saving–individuals have a choice. If anything, inflation creates additional incentives to consume.

The only way his analysis makes sense is if he buys the Keynesian fiction that savings always equals investment, by definition. Savings=Investment only in the long run. When the market rate is suppressed below the natural rate then investment will exceed savings. The only way to reestablish equilibrium is to, again, (a) elevate savings, or (b) reduce investment.

8

“I see no reason to believe that inflation automatically and necessarily forces saving–individuals have a choice.”

Suppose a person earns $1,000, and chooses to consume $800 and invest $200.

After credit expansion his purchasing power will be diminished to the point where, say, $1,000 only buys what $900 used to.

Now if his time preference remains the same his income (in terms of old purchasing power) is essentially divided like this:

$720 consumption, $180 investment, $100 of lost purchasing power transferred to banks which is then lent out.

Total savings in society has increased from $200 to $280 due to the credit expansion.

Does this make any sense?

9

Chris Pacia, your point has been raised by Gordon Tullock in his article Why the Austrians Are Wrong about Depressions; I brought up the same point when I was critiquing ABCT a few weeks ago. Tullock stated, “First, it should be noted that if the business people are now building more factories than they were before, which is what Rothbard says, then, in fact, savings that are available for building factories must have increased. In fact, they have. What has happened is that the government by inflationary measures is transferring a certain amount of money from the general citizenry into the investment accounts and, hence, the money for building these additional factories is made available.”

10

But all this means is that in the long run, prices of the factors of production will rise, and entrepreneurs who began expansionary projects will have to re-calculate their project midway and decied if they can still afford under new market conditions. Once they realize raw materials are more expensive then they originally thought they back down, or go belly-up. Hence the recession.

11

(Please read the entire response)

This is somewhat tricky, but I believe that the highlighted part is where you’re wrong. Society does not increase savings by $100. In fact, the ratio between savings and consumption remains stable at 4:1. What’s happening is that, in period (t1), investment rises by $100 due to credit expansion by the banks, while consumption and savings remains at $800 and $200 respectively (in monetary terms). The $100 is then funneled to investors in the form of producer credits and expands the supply of money in the broader sense. Furthermore, it yields disequilibrium in the loanable funds market (where investment > savings). In other words, investment increased by $100 while savings remains stable (again, in period t1).

In period (t2), that extra $100 will get recycled back into the economic system once investors/businessmen increase their expenditures. The purchasing power of money will only fall once this newly created sum (the $100) permeates amongst the whole of society. Once this occurs, and if the ratio between consumption/savings remains stable at 4:1 in (t2), then they will rise to $880 and $220 respectively, but only in monetary terms (a total of $1100 now exists in the system where only $1000 existed before). The $1100 that now exists in the system (t2) will buy the same total product that $1000 bought in period (t1).

Again, the extra $100 represents the credit expansion (inflation) and additional investment. It will not reduce the purchasing power of money until it permeates amongst the economic system and alters relative prices. You have removed the element of time from you analysis. Again, this is a temporal process–there is a disconnect. Once the inflationary process is complete (t3), costs will rise, and investors will require either (a) additional credit expansion (but this time it must exceed $100) or (b) real savings given to them by society, that is, the ratio between consumption/saving must rise in favor of the latter. If (a) and (b) do not occur, then a liquidation process will occur, i.e., a recession.

And finally, credit expansion presupposes an arbitrary reduction in the market rate of interest, which increases the opportunity cost of saving (people save less when the interest rate is reduced, ceteris paribus). We should, therefore, expect the ratio of consumption/savings to change in favor of the former.

(He arbitrarily assumes that all investment=savings).

Key things to remember:

  1. The credit expansion occurs first.
  2. The credit expansion elevates investment if it takes the form of producer credits, yielding disequilibrium on the loanable funds market.
  3. The credit expansion does not reduce the purchasing power of money until it permeates amongst the entire system, altering relative prices
  4. The $1100 in (t2) buys the same total product that the $1000 bought in (t1), so there is no change in the aggregate. But some groups benefit at the expense of other groups (the arbitrary redistribution caused by inflation makes some groups relatively wealthier than others, but there is no change in the aggregate. It is a zero-sum game).
  5. We should expect the ratio of consumption/savings to change in the favor of the former when it should, in order to prevent the liquidation, change in favor of the latter.
12

Esuric, this is essentially what I was thinking. That credit expansion happens first, business increase investment before prices adjust and resources get distributed. The only hiccup I had was that the businesses are able to buy products are current market prices (prior to price inflation) leading me to question whether or not resources were actually being transferred to these businesses and consumption being curved later in the future to support it.

Tullock makes this point in the above paper, but he only mentions it in passing then goes on to criticize ABCT on other grounds which I don’t believe hold much weight.

Salerno has a rejoinder to Tullock, but doesn’t address the argument that inflation transfers resources to the banks.

13

Does Tullock appreciate that the ABCT is not an over-investment theory? its a mal-investment and overconsumption theory.

14

There is a transfer of resources to the banks and to investors, but this does not change anything in the aggregate. Bankers and investors save and spend, and the newly created sums will circulate and elevate prices, but total real output does not change. Total output will only change if and when capital is accumulated and/or destroyed. Consumption does not necessarily have to be curtailed in the future. The curtailment of consumption is required if (a) credit expansion stops, and if (b) consumers want to finance the malinvestments (forced saving).

Tullock’s argument shows a fundamental misunderstanding of the ABCT.

15

Let me see if I can give a Crusoe example of what I think is going on here.

Lets say Crusoe lives by picking berries and consuming them.

Suppose he gets the idea build some sort of stick to use to knock the berries of the bush in order to harvest more of them.

To do this he needs to save five days worth of berries to support him when he is building the capital equipment and cannot pick berries.

Now lets suppose they have a “berry bank”. Currently, Crusoe and Friday pick a days worth of berries, deposit them in the bank to store until the next morning. When they make the deposit they get “berry notes” and they can redeem them the next day for berries.

If Crusoe were to print up fake “berry notes” he could then redeem them for Friday’s berries and use them to support himself while he develops the capital equipment.

When Friday goes to redeem his berries from the bank, they wont be there because Crusoe withdrew them with his fake notes.

So here you have an example where Crusoe has been able to successfully complete his capital project even though there was not an increase in voluntary savings because he was able to inflate, steal the purchasing power of Friday’s “berry notes”, and force Friday to under-consume to support the new investment.

Does this not seem plausible? That inflation could force under-consumption and use the increase in purchasing power to fund additional investment?

16

Since there is a bank I’m assuming there are other Crusoe’s on this island. So what happens when they all do this action, at the same time? Are they all able to complete their projects?

17

Well then savings equals investment, and Crusoe merely stole from Friday (but in the aggregate, again, saving=investment). This situation does not, in anyway, resemble the phenomena that characterizes the trade cycle. People are confusing the arbitrary redistributive effects of inflation with the malinvestments that it, inflation, necessarily yields. These are two separate phenomena.

And flic hit the nail on the head with this comment:

No. Let’s suppose that Crusoe wants to build the stick in order to more efficiently gather berries. Let’s assume that in order to build this stick he must save “10x” amount of berries. Now let’s assume that Friday comes along and tells Crusoe that he merely needs to save 5x, and that he will bring him the the other 5x later. Crusoe believes Friday and begins his investment. But now let’s assume that Friday is a liar, and he never comes with the additional 5x. In such a condition, Crusoe must curtail his investment and begin gathering 5x berries lest he die of starvation.

But again, this is a gross oversimplification.