No, I am not describing the greater fool theory. I am describing the distortion to the structure of production that is introduced by the central bank. This also creates the “cluster of entrepreneurial errors”, and a widespread boom and bust across all industries, all geographic locations, the entire world even, at the same time.
It has nothing to do with selling to the “greater fool”. My description was imprecise as I was trying to use a simple example.
The entrepreneurs during the artificial credit expansion are not stupid. They are not foolish. The folks they are selling to are not foolish. Nobody is foolish. Whether or not someone is foolish is not the crux of the theory.
ABCT is in direct contrast to normal “fluctuations” that occur due to specific entrepreneurial error, or specific industries, or regions affected by bumper crops or draught, for example. The market automatically adjusts to those types of fluctuations if it is left alone. Fluctuations like this are part of the market “process”.
When I read critiques of ABCT, I almost always sense that the critic does not understand (or ignores / refutes) capital theory and the structure of production.
I think the criticism is that even if Austrian business cycle was mainstream, or widely accepted as true, the fact that entrepreneurs still fall prey to artificial interest rates makes them “stupid” or “irrational”. This criticism, however, does not hold water when you consider the following arguments,
What the “natural” rate of interest is unknown, as society’s time preference cannot be calculated and expressed as a number. As such, even if entrepreneurs considered that the rate of interest is artificially lower then it should be they have no idea by how much.
Entrepreneurs invest no matter the uncertainty. Less entrepreneurs will invest as uncertainty increases, but entrepreneurship is innate amongst men. All human market agents aim towards certain ends, and this forms the basis of entrepreneurship, with or without a Federal Reserve.
There are papers which suggest that entrepreneurs do attempt to calculate the risk of interest rates when deciding on whether or not to make an investment. But, during periods of boom the economy seems healthy and vibrant, and as such it doesn’t follow that an entrepreneur needs to be as cautious. All it takes is for the entrepreneur to genuinely believe that his investment will become profitable. The risk of malinvestment is not immediately apparent.
To me, the criticism of Austrian theory that entrepreneurs should begin to “see it coming” is the most elementary. If that is what economists are grasping onto, then it means they have no real criticism to offer.
No one has answered why bad investments would necessarily be made. Why, according to the Austrians, does “speculative” irrationality increase? Why don’t entrepreneurs have the same chance of profit-or-loss?
How is the entrepreneur to distinguish how much savings is based on prior production and how much from monetary inflation when the central banks perpetually corrupt the interest rates via OMO etc.? It’s like someone shifting the magnetic poles of the earth around all the time, then blaming a captain for being a poor navigator because their compass isn’t taking them where they want to go… in spite of their navigational skills, when it’s not their fault at all. I’m honestly curious why Caplan and Cowen are too obtuse to understand this. It boggles the mind how neoclassicals will understand price-control theory generally but not the ABCT.
I remember reading Mises saying that, yes it is theoretically possible that eventually people will wise up.
Let’s assume that is so. What measure will entrepreneurs use to gauge the level of productive savings in the economy barring the interest rate? If the answer is “none” (and it probably is), the issue (that others have described before me) is that their competitors still will avail themselves of artificial (?) credit putting them at a competitive disadvantage (if FRB were not propped up by a central bank it’d be too unstable to allow for this.) Entrepreneurs can hardly divine the interest rate because they’ve -no- idea where it should be due to repeated governmental interventions in the economy not allowing corrections to take place. The weather may be more complicated than the Fed’s actions, and more unpredictable, but actually knowing where the interest rate would be absent CB interventions is far more difficult.
Yes, they do! Quoting Bryan Caplan, But why couldn’t they just use the credit market’s long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates?
To quote an article by Peter Robinson, As Fed chairman, [Greenspan] had only lowered short-term interest rates, he argued in the Wall Street Journal, not the long-term rates on which mortgage prices are based. “No one, to my knowledge,” Greenspan huffed, “employs overnight interest rates–such as the Fed Funds rate–to determine the capitalization rate of real estate.”
Commenting on that idea, Bryan Caplan states, The government cut interest rates, and then… banks started offering loans to people who wouldn’t be able to pay them back - and borrowers accepted. . . . Unfortunately, for [the ABCT] story to work, we also have to admit that business and consumers are so clueless that they’re habitually on the edge of disaster.
There’s no hiding the fact that LvMI scholars repeatedly, in books and online, blame human irrationality during “speculative booms.” Giving them more credit should not lead to “malinvestments,” just more investments that can either lead to profit or loss. This isn’t a price control per se–if there were a floor, there would be excess supply; if there were a ceiling, there would be a shortage.
Essentially, Austrians claim that investors are too stupid to use credit wisely.
According to the ABCT, they are! Why would so many investors make decisions that lead to economic disaster and liquidation?
I agree! That’s one reason I hate the Austrian Business Cycle Theory! I believe it states that booms are caused by human irrationality (“speculative” booms) which, clearly, criticizes the ability of investors to manage their own funds wisely.
Why would credit immediately lead to malinvestments? Why not simply more investments, with a typical proportion of profit and loss?
Also, why does bubble form in a particular sector (e.g., housing)?
Smiling Dave, strong rebuttal on my “weather” example.
You people are crazy! If you want to abolish Social Security because you predict that people will privately save for their retirement, then you believe in rational expectations!
Not at all. Its not that a bunch of “stupid” loans were made to “stupid” people. It may have been rational for people to accept such low interest rate loans. The problem with an artificially low interest rate is that it causes capital structures to depart from real consumer time preferences, so that if you lower the interest rate without an increase in consumer savings, new projects get started that can never be seen to completion because consumers haven’t actually saved up to purchase all of these future goods.
Now should investors be able to predic this? Yes. But even if they did, they can still hold out the hopes that their investments won’t fail because cheap credit allows them to bid away resources from other ventures. Moreover, the greenspan put and other unspoken authoritarian gaurantees make it rational to overinvest in certain markets.
Rush Limbaugh blames people for being stupid and taking out loans. Austrians claim everyone basically played the game rationally, its just a lousy game.
Yes, they do! Quoting Bryan Caplan, But why couldn’t they just use the credit market’s long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates?
By determining short-term interest rates, a central bank exerts a strong influence on longer-term interest rates (such as, for instance, 10-year bond yields). The expectation theory of the term structure of interest rates explains why this is the case.[1]
In its simplest version it says that a long-term interest rate such as, for instance, the 10-year bond yield, is a weighted average of short-termed interest rates expected over the maturity of the credit contract.
Then to this:
I agree! That’s one reason I hate the Austrian Business Cycle Theory! I believe it states that booms are caused by human irrationality (“speculative” booms) which, clearly, criticizes the ability of investors to manage their own funds wisely.
Spend less time hating it and more trying to understand it. It has nothing to do with “irrationality” but more to do with tampering with a price signal, i.e. interest rates. That said, Austrianism does use a much weaker form of rationality than mainstream economists. That is a strength of it because it shows it requires much less on part of market participants for its theories to prove correct than the much stronger form of rationality neoclassicals posit.
When speaking in terms of Austrian lingo, there is a difference between “rational” and “perfect”. In the Austrian framework, all actions are “rational” but that doesn’t mean perfect foresight.
Like I said, there’s no hiding this. I’m not sure why several of you are doing so. Let me quote some contemporary, orthodox, respected Austrian economists.
Robert P. Murphy, [M]arkets are capable of periods of mass delusion as it were, in which asset prices get pushed far above any “rational” level justified by the underlying fundamentals.
Jesus Huerta de Soto, Widespread discoordination in the economic system results: the financial bubble (“irrational exuberance”) exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of the entire real productive structure, which inflation has distorted.
Doug French, People seem to do the craziest things when it comes to money. Whether it’s chasing stock-market bubbles or paying good money after bad on a home that’s hopelessly underwater, the idea of individuals acting as homo economicus seems far-fetched. Only in the ivory-tower world of rational-expectations theory does one find perfectly rational humans making judgments using all available information to satisfy their subjective ends.
Could you tell me which of these quotes actually blames the business cycle on irrationality?
“Mass delusion” = result of thwarted price signals.
“Irrational exuberance” = a borrowed phrase, in scare quotes no less.
“Seem” = self-explanatory. The last does repudiate the neoclassical view of rational expectations but Austrians do not take this as necessary to posit rational action.
In essence, if we presume humans are maximizing their utility–attempting to increase their satisfaction as Mises might put it–then why, ever, would they invest in a “speculative boom” that would lead to loss and liquidation?
It’s very hard to imagine someone purposefully walking off a cliff. Not impossible, of course, but the assumption holds enough to be used for predictions.
None of them are saying that people are too stupid to use credit wisely. As has been said, it’s not that the people are stupid, it’s that the game has been rigged. People tend to make the best informed decisions they can, given what they know. If the interst rate is 2%, then they will act on that fact. They don’t know what the interest rate “shold be” and they don’t know when it will get there. It would be like saying “I know what the price of X should be on the market.” People can’t just know this, so they can’t act on this.
Rational expectations predicts that market participants will wise up at some point; why don’t you? For instance, if inflation is rising, you don’t believe workers will include such knowledge into their contract negotiations?
This is a quoted phrase, borrowed for a purpose. It was used unironically and uncritically.
He posits that humans employ irrational means to achieve the ends they seek. If this is correct, faith in the free market collapses!
Once again, our commitment to the self-correction of the market also applies here; we adjust to government interventions to short-term interest rates!
you overlook the time it takes for errors to be revealed, i.e. you do not even mentino the speed at whcih error correction can occur.
you overlook the fact that the government intervenes dynamically, in large part directly with the intention of ‘re-erroring’ entrepeneurs when they begin to correct for errors in ways that the government doesn’t like.
Rational expectations predicts that market participants will wise up at some point; why don’t you? For instance, if inflation is rising, you don’t believe workers will include such knowledge into their contract negotiations?
And I asked how? What will they use instead of the interest rate, the price of credit? They could stop borrowing altogether, but how would they then compete with competitors willing to
This is a quoted phrase, borrowed for a purpose. It was used unironically and uncritically.
It seemed more like an Austrian explanation of the posited phenomenon.
He posits that humans employ irrational means to achieve the ends they seek. If this is correct, faith in the free market collapses!
If he does, then he does not do so as an Austrian economist… but he doesn’t. He used “seems”.
Once again, our commitment to the self-correction of the market also applies here; we adjust to government interventions to short-term interest rates!
How, when the government constantly distorts the interest rate? You seem to think that entrepreneurs are miracle-workers who can circumvent the government’s mucking about.
Its irrational on a macro level… each individual is playing the game rationally. You seem more intent on cherry picking quotes out of context than actually tackling ABCT, particularly as the members of this forum would lay it out. Bob Murphy is not some god figure we worship.
If a legislated low price of money (credit) could not be accompanied with a central authority’s ability to create it out of thin air, that would produce shortages just like in your MB vehicle example. You are aware that MB vehicles can not (yet) be created by a mere mouse-click, right?
This is a pretty key point, underated I think. This objection belies a larger problem in that Caplan is begging the question when he assumes such things can be known absent a free market functioning to deliver such knowledge. There is no Platonic ‘thing’ out there we can point to as The Interest Rate. Even the market generated interest could not be said to be such a thing. The market as a system generates the very information to which its participants respond.
Just a quick (preemptive) note to myself and others, regardless of how any of our opponents decide to behave, we should strive to debate fairly in order to give our ideas their best shot. Ridicule and ganging up are really discouraging tactics. I’ll only continue to pitch in if something important hasn’t been said.