Tuesday, October 16, 2012

Questions for Bob Murphy and other Austrians on the inevitability of the bust

David Glasner had some recent posts (here and here) on Ludwig von Mises and Austrian Business Cycle Theory (ABCT). Bob Murphy pushed back here with a good rebuttal. But David's general point still stands: what necessarily forces a central bank that has adopted the practice of lending at a rate below the natural rate to ever cease this practice? Why does there have to be an inevitable bust?

I consider myself an Austrian in that one of my favorite economists is Carl Menger. I've also written a thing or two for the Mises Institute, my most recent being on Menger and Leon Walras and how the two would have differed on the phenomenon of high frequency trading. On the other hand, when it comes to macroeconomics, I remain a business cycle agnostic. I'm willing to be converted though. All you've got to do is answer a few questions of mine.

Say a central bank decides to reduce the rate at which it lends below the natural rate. Businesses can come to it for cheap loans -- and they do. Mises points out that as long as this differential exists it'll eventually lead to a "crack-up boom". The currency enters hyperinflation stage and, at its peak, people either turn to barter or dollarization occurs. Alarmed at this prospect, the central bank will probably increase rates in order to stave off the crack up.

But say the central bank and the currency users exists on a small island far from everywhere so dollarization can't happen. Say also that the police force is vigilant about preventing people from bartering. As a result, the currency issued by the central bank continues to be used, even during hyperinflation. The inevitable flight from money — the crack-up boom — can't occur. The currency perpetually falls.

So having assumed the crack-up boom away, why should the setting of market rates below the natural rate inevitably end in a bust? Sure, in the interim there might be a redirection of capital towards projects that are only profitable at low rates. In this context, a sudden increase in rates by the central bank back up to the natural rate might show some of these projects to be unprofitable. You've got a bust of sorts. But our central bank, released from the disciplining threat of a crack-up boom, steadfastly refuses to raise rates.

So if rates can be kept perpetually too low, and a crack-up boom can be averted, what causes the bust?

To start off, one explanation for a bust occurring is that when rates are kept too low, excess resources are allocated to interest-sensitive distant projects and not enough to less interest-sensitive near-term projects. At some point there's a realization that not enough capital has been allocated to present needs and all those future projects suddenly collapse in value. Thus a bust. What causes this sudden epiphany? As David Glasner asks, are workers dying of starvation?  It can't be higher interest rates that render these projects unprofitable since, as I've already pointed out, the central bank keeps rates permanently low.

Even if capital begins to flow into projects that are only profitable at low rates, wouldn't the prices of materials required by those projects be bid up relative to other prices, thereby putting a quick end to the profitability of these distant projects? Wouldn't the relative prices of material required for near term projects fall, thereby increasing the profitability of near term projects? How can any significant capital misallocation proceed given these rapid relative price adjustments?

If you can answer all my questions, then you'll have successfully converted me.


  1. Show me a human who can continuously calculate monetary profits and losses without end, in a world with continuously accelerating inflation without end, and you'll convert me to inflationism.

  2. Profits and losses continue to exist in hyperinflationary periods. Though they would be harder to calculate, why would a hyperinflation prevent calculation altogether? Wouldn't the people on the island get somewhat skilled at factoring inflation into their calculations? What are you saying causes the bust?

  3. Hi JP,
    I personally also find that ABCT (as it is expressed in academic papers and books)as too simplistic and somewhat unrealistic in offering convincing explanations of the boom/bust phase in all economies. While I do not completely disagree with its implications, I have found it's application has to take into consideration a whole host of variables within an economy and its changing dynamics i.e. price stickiness, controls, ease of capital mobility in and out that particular economy, its size, the balance of payments among other economic and social arrangements within a particular economy. For example, the Kenyan central bank engaging in quantitative easing would not be able to prevent mounting inflation to cause it to change its stance to prevent complete collapse of the currency and its social implications on business. This actually took place in Kenya following last year after a sustained credit boom following the 2008 crisis. The response mechanism was pretty fast given the size of the economy and the lack of sophistication (derivatives) in the economy. This sort of scenario would hardly unfold in the US given the dollar's reserve currency status among other reasons that allow prices to remain less volatile and numb in the face of continued QEs.

    I found these particular articles rather helpful in addressing some of the questions that you’ve posed.

    Peter Warburton - Inflation but not as we know it

    Sean Corrigan - The ABC(T) of the crisis

    Sean Corrigan - Attempting an Austrian‐based macro‐economic approach to the business cycle

  4. Hi Husein.

    I read the Corrigan pdf. He says "So, withdraw the dope and a severe spell of cold turkey will be the inescapable result" but never touches on why the dope must be removed, which is one of my questions.

    In any case, I agree with your point some of the applications of Austrian thinking. It's probably helpful to think of capital as non-homogenous. Reallocation of capital takes time and effort. On ABCT I'm still agnostic.

  5. Here is my humble attempt to reconcile Sean Corrigan's point on why "the dope must be removed" and the unsustainability of low rates and central bank easing indefinitely.
    The improbability of the financial crack-up boom in the face of easing and low rates (as a result of an inability to barter (i.e. preventing a complete collapse of currency demand) and dollarization) does not necessarily mean that a crisis is not inevitable. The only question is whether it is sudden or a slow subtle unfolding of economic pain in different pockets of the economy as not all price increases can be passed on to the each successive consumer down the supply chain (whether it be the regular end-consumer or the business at the intermediate stages of an industry) given the varying price elasticities of demand of people. At some point, this inability to pass on price increases amid mounting costs (as wage earners also pressure employers for salary hikes to reflect increasing costs of living) renders the production of certain things unprofitable. Does this process all happen at once? No, I think that would be too simplistic an explanation. I find that these processes unfold rather subtly given the rather complicated interdependent relationships among businesses and industries all the way down to the consumers. What makes this process complex is our inability to understand exactly how the multitude of prices in the economy will react to the various allocations of the multitude of individual “demands” in the economy. What prices will be bid up and by how much cannot be forecasted with a degree of certainty, and this is what makes the whole of process of easing by the central banks not completely without consequence. Which is why, I would assume that the central banks would be not be completely cavalier about an infinite easing process (low interest rates). They can control supply of currency and credit, but they definitely do not have control over demand or whether exactly where and how the money will flow. Unless, of course, certain measures highlighted by Peter Warburton are in place that prevent prices from sky-rocketing in relation to the unconstrained increases in money and credit.
    In so far as trade and production is undisturbed and businesses are still able to remain as going concerns amid increasing costs of raw materials (as other businesses previously non-existent are also vying and bidding up various raw materials and resources i.e. labour, etc given the plentiful supply of credit), then one can assume that the competition in and of itself would keep prices somewhat lower than expected. So I find that there are lots of factors that have to come together (ease of capital mobility, competition, soft price controls (regulation of rents), increasing supply of labour or increasing wages, the size of the economy, the proliferation of derivatives as repositories of the increase in credit) to prevent a crack-up boom from taking place. In these scenarios among others highlighted by Warburton, prices in the real economy would be somewhat suppressed relative to an economy lacking a sophisticated financial sector devoid of the myriad of derivatives and complexity currently present in the more advanced economies.
    I have also found that the assumption in ABCT that the low interest rate attract funds only to long term capital intensive projects at the expense of the more near-term stages, as too weak and mechanistic. The ABCT assumes that these financial intermediaries are too selective on the ground of a business’s position of the Hayekian triangle spectrum. I do not agree with this part of the theory as I find that credit can flow to all sectors of the economy irrespective of the business sector involved i.e. as indicated by the period between 2002 -2007, whereby all the sectors of the economy leveraged up, in varying degrees of course and with differing implications and outcomes.

  6. In a nutshell, I much like yourself, do express a skeptical outlook with regards to ABCT’s rendering of the probability of a crack-up boom and the inability of the central bank to sustain low interest rates. But I find Glasner’s perspective also indirectly assumes uniform movement of prices that would numb the effects of the central bank easing and all sectors of the economy viable. The mere fact that prices can never move in unison owing to the subjective nature of demand is sufficient to render question of low interest rates forever in doubt. That demand will vary across the different sectors of the economy with respect to their ability to pass on increasing costs over to their consumers, is evidence of the fact that not all businesses will remain viable despite “unlimited credit.” As unemployment will eventually result in certain pockets of the economy, then social strife is bound to occur as the interdependencies across sectors of society suffer as a result of falling demand of the affected sectors of the economy. Unless of course we are also assuming that the unemployed will merely continue to receive financial aid from the state in place of their salaries to sustain the demand in the rest of the economy. This is plausible, but for how long? The unsustainability of the low rates is in my humble opinion not in doubt, what I cannot equivocally point to is when the end point is. As long as businesses and trade and production continue unabated, then we can assume away a crack-up boom. But as long as demand is subjective , and not all businesses can pass on their increasing costs over to consumers with price increases (unless we are also assuming an unlimited leverage for every end-consumer), eventually results in failing businesses and unemployment, which with time can does affect other businesses and on and on. Once this starts happening, the social implications of this increasing disparities alone might suggest reasons for why, as Sean Corrigan puts it, “the dope must be removed.” The central banks can only control money supply, how individual demands in the economy react is to a large extent beyond them. In other words, the answer to the question in my opinion, lies on the subjectivity of the demand side in deciding what has value and what does not at those particular prices, and assuming also incomes do matter (as not all consumers can access unlimited credit at all times).

    I am not sure if this rather long explanation helps or still doesn't answer some of your questions. Apologies for the length. Looking forward to your insights. Thank you.

    1. Husein,

      It sounds to me like you are telling a sticky wage story, not the traditional ABCT story which is what I'm really interested in. I'm not sure what you mean by demand is subjective... I don't think anyone would say that demand is objective. Perhaps you are talking about uncertainty?

      If there are businesses that suffer because they can't pass off price increases due to price stickiness, that means there are just as many that are prospering because they can more than pass of prices increases. It may take some time for employment and capital to switch over to the prosperous ones. But this is the typical sort of pull and tug between businesses that always characterizes economies. It applies to low inflation economies -- I don't understand why anything changes in high inflation environments.

      If you're right that price stickiness is capable of causing recessions, then we don't need rates set below the natural rate to cause it. A real shock would do it. But ABCT is specifically a monetary theory that blames a bust on the a missetting of rates and subsequent inflation.

  7. JP,
    Thank you for the response. I think you might have misunderstood me, as I chose to focus on the quantitative easing's effect on the various prices (prices of goods, labour, capital and raw materials) within the economy. I don't mean to belabour the point, just want to make sure i'm understanding you correctly and not making any faulty assumptions.
    "...why should the setting of market rates below the natural rate inevitably end in a bust? Sure, in the interim there might be a redirection of capital towards projects that are only profitable at low rates. In this context, a sudden increase in rates by the central bank back up to the natural rate might show some of these projects to be unprofitable. You've got a bust of sorts. But our central bank, released from the disciplining threat of a crack-up boom, steadfastly refuses to raise rates.So if rates can be kept perpetually too low, and a crack-up boom can be averted, what causes the bust?"
    First of all, does this scenario also assume that the end-consumers also have access to the credit indefinitely and are not restricted to their incomes alone at some point. Unless all the businesses could succeed, which is impossible given the fact its customers do not have unlimited income to guarantee them a sale amid their rising costs, isn't the inevitability of bankruptcy and defaults itself a bust of sorts. Don't all these debts that are building up whether on the consumer side or business still need to be serviced via income. I would assume that we wouldn't necessarily need a resetting of interest rates to effect a bust of sorts. But that doesn’t exempt the artificial pricing of the interest rates below the natural rate (as implied in ABCT) from spawning the distortions and misallocation that eventually end up in a bankruptcies and defaults (i.e. a bust) as a result of an inability to earn enough income to sustain mounting costs (some of these costs will be addressed at the bottom).

  8. In other words, let us assume central banks allow interest rates to remain at the natural rate (in line with the savings in the system), would that prevent businesses from accessing debt and misallocating it and failing in the process? No, they would definitely fail all the same. However, my understanding leads me to believe that what is different under a scenario with an artificial underpricing of interest rates (low interest rates) is rather the magnitude of distortions and misallocations and the overcapacities that eventually build up that make the bust that much more severe. And the only reason that these businesses would fail is limitations on the growth of income to keep up with the debt levels. Now of course, we can make all manner of assumptions with regard to consumer credit. But I’m assuming we are not saying all these debt and credit is unlimited and without restraint. What businesses will fail is ultimately decided by many factors… it could be insufficient income to sustain the cost increases (whether it is raw material prices that have been bid up, whether it is wages, the mounting interest expenses, etc). In other words, the low interest rates exacerbate the price distortions that would eventually arise. Even if the central banks do not reset interest rates back up, it does not necessarily mean a bust is not necessarily unlikely. Given that new issuances of debt in a falling interest rate environment will not translate into rising interest rate costs (expenses), the business still has to worry about depressing margins given the increasing costs of its other inputs (whether labour, raw materials, etc), assuming it cannot keep passing on these costs. And for all those business that cannot pass on those costs to consumers, assuming that consumer credit is not unlimited, and even assuming that there is a limit to how much it can attempt to cut its costs (fire workers as much as is feasible, mechanize operations, etc), default becomes an inevitable prospect. What becomes of those businesses that fail in these environment, what becomes of those banks exposed to these loans, given its magnitude in this particular scenario of artificially low interest rates as opposed to the fewer defaults that would occur in a natural interest rate environment. Failure is not special to low interest rates, but rather the magnitude is what causes the bust to be particularly painful.
    The bust might not necessary involve a concentration of defaults in businesses in one particular sector, but a myriad of others as well in so far as their revenues (incomes) were not able to sustain their debt levels even at those low interest rates. Unless we are assuming these debts do not have to paid back which i doubt is the case, surely the overcapacities that would build up in various industries would require as you say adjustments of capital and employment, but wouldn't these realignments effect a recession, and unemployment. Given the debts that have built up whether on the consumer level as well as the business level, wouldn't the defaults or even the deleveraging process cause a bust of sort among the more exposed financial intermediaries. We acknowledge that it "may take some time for employment and capital to switch over." Wouldn't these massive adjustments be considered a bust of sorts.

  9. Apologies once again, JP for length. I realize that my explanation does bear some assumptions but I hope I’ve clarified some of my views. Can I please bother you to offer an example of perhaps, how is it that these low rates will continue the sustain the myriad of businesses that crop up as a result of the build up of debt and bid up resources? What is the position of the end-consumer in your particular scenario of low interest rates? I’m just curious as to how that process (low interest rates without a possibility of resetting back to the natural rate ) can continue indefinitely given the implication on the various prices in the economy and physical limitations of raw materials. Excuse my naivete, still a student and curious about this topic as well. Apologies once again for the length. Promise not to bother you again.

  10. Selgin and Glasner eventually seem to agree:

    Glasner: "George, No need to repeat what I just said to Roger. I think that the specific point that we are now arguing about is largely semantic. What you call an unsustainable boom is an allocation of resources induced by an unanticipated monetary expansion which will have to be reversed or altered once the monetary expansion is correctly anticipated. We agree on the analysis. What we disagree about — and it is likely a small disagreement – is whether the real adjustment qualifies as the upper-turning point of a business cycle. But there is also the further question prompted by the quotation I found in The Theory of Money and Credit at pp. 361-62 in which Mises conceded that a monetary expansion could actually cause a permanent reduction in the natural rate of interest and therefore would entail no subsequent real reallocation."


  11. Isn't the scenario constraints you drew up equivalent to what occurred during the Weimar hyperinflation?

    Dollarisation, while possible there was still very limited because few people had any access, due to the country being isolated in contact with the rest of Europe. In other words it was too limited to have had any material influence of the outcome.

    In that scenario as well as in the case of Zimbabwe more recently the central bank stopped because of the will of the people.

    Put differently, after the hyperinflationary period had destroyed pillars of society (which it did in both cases) eventually the CB had to conceed to failure or see the CB direction taken out and shot on the street.

    Why do you, as an economist, want to portray that an outcome would be different when all the empirical evidence of hyperinflationary events all had more or less the same expression of human suffering?

    Is it economics as a fantasy hobby or is it economics in the sense that we need to provide a foundation to allow growth and prosperity to flourish, so as to avoid unnecessary human suffering and conflict?

    1. I think you're missing the point of my post. We all agree that hyperinflation is disasterous. ABCT also has a few things to say about problems created by relative capital movements. By taking the hyperinflationary crack up out of the picture, and thereby removing the necessity that the central bank raise interest rates, I am asking 1. what actually causes an ABCT bust? 2. why must there be a bust at all?.

    2. JP, i think the reason that some of us are missing your point, because of a lack of clarity on certain issues. Are you saying that the ABCT as a theory is flawed in assuming that a bust can only be brought about by a raising of rates by the central banks? In other words, a bust would happen inspite of the central banks' keeping rates low forever.
      Or are you saying that if the central banks keep rates low forever (and assuming your scenario of no bartering and no hyperinflationary crack-up) it totally prevents a bust from taking place whatsoever, as put forth by the ABCT. If your position is the latter, can you please explain how that scenario unfolds despite its unsustainability given your acknowledgment of the "problems created by relative capital movements." I'm just wondering if it was this easy (never raising rates up along with all your scenarios of no barter) to prevent a bust, it would have already been done. I can't quite imagine such a scenario unfolding unless in a completely socialized economy, where the resources are allocated arbitrarily and prices do not mean anything anymore.

    3. Hussien, I'm not saying the theory is flawed, I'm just asking questions.

      "Are you saying that the ABCT as a theory is flawed in assuming that a bust can only be brought about by a raising of rates by the central banks? In other words, a bust would happen in spite of the central banks' keeping rates low forever."

      What I'm asking is, if the central bank never has to raise rates - which is the classic Austrian explanation for the boom ending (see Murphy here) - then why should a bust ever happen? What kickstarts it? As long as the central bank keeps rates low forever, why can't it prevent a bust from taking place?

      "can you please explain how that scenario unfolds despite its unsustainability given your acknowledgment of the "problems created by relative capital movements.""

      Why should these relative capital movements be sustained, given that input prices change quickly? I asked this in my post. And if even if they were sustained, how can this ever be "uncovered" if interest rates don't have to change?

      I don't mean to be rude, but in the blogosphere fashion, please keep your answers short. Also, an Austrian response should not be your special version of ABCT. It should make reference to what either Hayek, Mises, Rothbard, Murphy, Selgin, or Salerno say - these are the gatekeepers.

    4. JP, No offence taken, I do apologize for the length of the previous comments. Should have kept them short. But having now followed all of the comments on Bob Murphy’s blog and a re-reading of Human Action (chapter 20 –Interest, credit …, section 6 (the Gross market rate… pages 555 -565), I do your question a bit better given your assuming away of the crack-up boom and no bartering. While I acknowledge the unsustainability of the low rates indefinitely, I honestly cannot exactly tell what internal or external causes would trigger the bust? Though, I did find Major_Freedom’s comments in Bob Murphy’s blog convincing for me personally.

      Thank you either way for the discussion and apologies once again for the length of the previous comments.

    5. Major Freedom was kind enough to give me an answer, but he still fell back on hyperinflation being unsustainable, in this case due to problems involved in calculation. But if we assume that people are able to properly calculate even at high inflation rates, then why can't the process go on forever? If the real aspects of the boom are so unsustainable, why does it continue to infinity? Anyways, I'll have more posts on this in the future. Hopefully Bob Murphy will be able to set me straight.

  12. Hi, JP, I just recently discovered your fantastic blog, and I find it really excellent, one can learn a lot here. Thank you for writing, and keep up great job! :)

    On this topic, I just thought it might be helpful to quote Steven Horwitz from his book:

    "If bouts of inflation can send the economy into a boom (albeit
    artificial) and it is only when the additions to the money supply stop that the
    snapback will take place, critics of the theory asked why continuing the
    inflation could not forestall the snapback and the bust indefinitely. By providing
    borrowers with a continuous source of new funds for investment, what would
    prevent the boom process from never stopping? Hayek’s response to that
    line of argument was decidedly microeconomic. He points out that the
    microeconomic insight we now call ‘derived demand’ is perfectly valid for individual final goods and their inputs, but cannot be true of all final goods
    and inputs collectively. That is, it is surely true that the demand for the
    capital and labor necessary to make bread derives from the demand for that
    bread, and if the demand for bread rises, the demand for the inputs will rise
    and those inputs will be bid away from other uses. However, it is impossible
    to raise the demand for all capital goods simultaneously by increasing the
    aggregate level of expenditure on final goods. In the sort of continuous
    inflation envisioned in this example, the prices for final goods would be
    continually rising, apparently leading the critics to think that this increase in
    demand would lead to an increase in the capital and labor available to
    produce those final goods.

    The problem, however, is that in the sound version of ‘derived demand’
    the inputs are bid away from other uses. In the inflation story, all the lines of
    production are bidding after inputs, causing their prices to rise significantly
    and making the inflation-induced investments eventually unprofitable even
    if the additions to the money supply continue. Inflation-generated spending
    must eventually bump into the constraint created by the scarcity of capital
    goods. The critics of the Austrian theory seemed to suppose that capital
    could be created out of thin air (or at least was currently abundant enough)
    so that any increase in demand for final goods would somehow bring forth
    the capital necessary to produce it. Capital, however, is not abundant, and
    the bidding war that inflation would precipitate would drive input prices to
    heights that would make the production of the final goods involved
    unprofitable.24 Moreover, given the imperfect substitutability of specific capital
    goods, the whole cost of bidding away capital includes not just the rental or
    selling price, but also the cost involved in any refitting that would have to
    take place to render the capital good complementary to the firm’s existing
    capital goods."