Austrian Economists Need to Get their Business Cycle Theory Straight…

…or else their theory may appear inconsistent and impossible to validate. Don’t get me wrong, the Austrian Business Cycle Theory (ABCT) is great and applies sound economics every step of the way. But its application suffers from a deficiency: It is only part of a larger theory. I will explain what I mean by that and the inconsistencies it leads to.

When Austrian Economists talk about the business cycle they are actually referring to what I called the production business cycle. It is that business cycle which causes entrepreneurs to withdraw resources from the production of consumer goods and directs them toward the production of capital goods.

They never consider the idea of a consumption business cycle, at least I was unable to find it anywhere. But I can’t find a reason to dismiss the notion of such a cycle.

What does this lead to? It leads to problems when it comes to explaining historical events. If, say, the recession of 2008 was caused by excessive production of capital goods and a shortage of consumer goods then how can they explain the massive expansion of the production of consumer goods throughout the recent boom:

Click on images to enlarge.

In case you are wondering what the ratio would look like if we assumed that the entire trade deficit was due to consumer goods:
us-consumption-as-percentage-of-gdp-q3-2010-minus-tradedeficit

In fact, a much more realistic assumption is that the ratio of consumer vs capital goods is the same for imported/exported goods as it is for all of production, in which case the real ratio would be closer to the blue line or at least somewhere in between blue and green.

In fact the entire problem of an excessive production of consumer goods, of surplus strip malls, of Starbucks locations on every block, or of a glut in homes makes little sense when one tries to apply the concept of over production of capital goods. What makes even less sense when applying this theory is the fact that the production of capital goods throughout this entire period was utterly neglected, factories “shipped off to China”, etc.

The solution to this is simple. What Austrians currently refer to when they say business cycle has to be viewed as the production business cycle. Together with the consumption business cycle it forms a general theory of the business cycles which simply establishes that resources are misdirected as a result of government intervention. From where to where, however, highly depends on the types of loans made and/or subsidized.

This is what I established and outlined in detail in The Business Cycle Revisited, and I am open to feedback and constructive criticism from the Austrian community. :)


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11 thoughts on “Austrian Economists Need to Get their Business Cycle Theory Straight…”

  1. Hi,

    I wrote a quick response to this entry. Hopefully my response is still relevant (it doesn’t seem as if anybody else has stepped up). It’s not a refutation of your theory, as much as its a refutation of the accuracy of your understanding of the Austrian Business Cycle. In any case, the explanation can be found here: http://www.economicthought.net/2009/08/correction-on-the-austrian-business-cycle-theory/

    Thanks,

    Jon Finegold Catalán

  2. Before I delve into a detailed rebuttal, let me ask you a few simple questions regarding some of your statements:

    “The assumption is that the Austrian theory suggests that during the boom years there is an increase in the production of capital-goods and a decrease in the production of consumer-goods. This is incorrect. The Austrian theory takes into consideration an increase in both, which is what causes unsustainable economic growth.”

    My question: Provide me an example of how this would work. Robert Murphy has tried this in http://mises.org/story/3155 and in the very process confirmed my position.

    “The difference is that the Austrian theory forecasts that the capital-goods sector will be hit harder than the consumer-good sector, and so far that has proven to be true.”

    My question: Which industry, would you say, was hit hardest in this recent slump?

    “There is an increase in frictional unemployment, as workers which once labored in the capital-goods industry must find employment elsewhere”

    My question: Which industries, as far as your data tells you, are currently shedding most of the jobs?

  3. My only qualm is that you use “capital goods” and “consumer goods” instead of stages of production.
    You said, “In fact the entire problem of an excessive production of consumer goods, of surplus strip malls, of Starbucks locations on every block, or of a glut in homes makes little sense when one tries to apply the concept of over production of capital goods.” However, strip malls, Starbucks locations, and homes, in this particular case, are higher on the stages of production than are the the electronics sold in the strip malls and the coffee drinks sold at Starbucks, and houses were bought as “investments”, not as places in which to live.

  4. However, strip malls, Starbucks locations, and homes, in this particular case, are higher on the stages of production than are the the electronics sold in the strip malls and the coffee drinks sold at Starbucks, and houses were bought as “investments”, not as places in which to live.

    I already commented on your assertion that houses were bought as investments and explained that that still doesn’t make them a higher order good, or a capital good, or a good at a higher stage of production, or whatever else you want to call it.

    Regarding the other things you point out: Whether I use capital goods or stages of production is rather immaterial. Yes a Starbucks location is a factor of production, a capital good. But it is one that immediately turns out cups of coffee, consumer goods. It is thus much closer to the consumption stage, than, say, a store that sells industrial robots, or a factory that produces metal parts, or an oil rig that drills for crude oil.

    When I talk about a shift from producing capital goods to consumer goods, I mean that, as a tendency, and within a certain period, the entire structure of production moves closer toward turning out immediate consumption goods rather than goods that are half finished or that aide in the production process. I do NOT mean that suddenly all capital goods disappear and all we have is consumer goods. This is simply not possible since the consumer goods also need to be produced by utilizing capital goods.

  5. “The difference is that the Austrian theory forecasts that the capital-goods sector will be hit harder than the consumer-good sector, and so far that has proven to be true.”
    My question: Which industry, would you say, was hit hardest in this recent slump?

    Hi Nima – when you take into consideration the fact that China and the rest of the world were indirectly or directly loaning US consumers a lot of money, the answer to this question becomes a little more complete.

    By doing so, they transferred consumer purchasing power to US citizens at the expense of their own (and through the increase of the money supply, for example in China this transfer took place directly as a result of printing RMB and buying dollars from exporters), but their own production structures were affected exactly as ABCT would describe.

    And when you take into account all of those lending us dollars and ask this question again, it becomes clear that the higher stages of production were hit by far the hardest in China and other countries that lent a lot of money to US consumers.

    You have to look at the whole system as an economic whole, even if that means stepping outside of (arguably artificially constructed for these purposes) national boundaries.

  6. @Jeremy

    Actually, my thesis integrates very well with the entire system. China, Japan, and Europe produced a lot of the goods that US consumers used up. Thus their industries, too, were aligned toward the production of more consumer goods vs. capital goods.

    This is, in part, the reason why they are not immune to the current downturn, and all those businesses there that either manufactured these consumer goods or catered toward US consumption, need to go through a correctional period and the structure of production needs to get aligned more toward capital goods than consumer goods.

  7. I have the book, and it’s on my list, but I haven’t gotten to it yet.

    But what you posted there pretty much hits the nail on the head. It’s almost exactly what I am saying.

    The only minor flaw he makes is to say that the production of “durable consumer goods” necessarily lengthens the structure of production.

    I don’t see him backing this assertion up anywhere. If fewer factors of production are produced, and more “durable consumer goods”, then this still shortens the existing structure, for a “durable consumer good” is still closer to the consumption stage than, say, an industrial robot.

    It would only be true if people were to sacrifice consumption of non-durable consumer goods for the purchase of durable consumer goods. It is clear that this did not happen during the recent housing bubble, as people were taking out home equity loans in order to go on vacation, buy plasma TVs, go shopping, etc …

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