This video, The Austrian Theory of the Business Cycle | Roger W. Garrison, from the Von Mises University does a good job of explaining the Austrian Business Cycle Theory (ABCT). The key point is that increasing the rate of savings (capital) results in increased economic growth in the future. The theory was worked out by Von Mises and Hayek. The foundation of the theory is very similar to classical economics, which held that economic growth was the result of increases in capital. The video has a number of charts and graphs to make it look more scientific, however no empirical evidence is provided to support the theory. Other work may provide empirical evidence, but I know of counter evidence as well.
This article will first discuss ABCT of recessions and some small errors in the theory. Then I will show that ABCT is incorrect about what causes economic growth and its failure to explain economic history, particularly the Industrial Revolution.
Austrians are always focused on showing that Keynes economic theories are wrong, and they are certainly right about this. Austrians argue that there is a trade between investment and consumption, which they call the sustainable Production Possibilities Frontier. Keynesian theory would say there is no difference between consumption and investment. Certainly there is a trade between investment and consumption. The Keynesians somehow argue that by eating your seed corn you will be wealthier. However, a minor problem with ABCT is that it equates savings with investment. The two are not necessarily the same.
ABCT then states that recessions are caused by Central Banks (the Federal Reserve in the US) arbitrarily lowering interest rates below the market rate, which causes mal-investment and reduces the saving rate. Unless we narrowly define saving as putting money in a bank, savers have a number of choices which are not directly affected by interest rates. For instance, savers can put their money in stocks or corporate bonds. The return on stocks and corporate bonds is more related to the success of the underlying company than the interest rate set by the Central Bank, so the disincentive to save is not a strong as suggested by the ABCT. The second question is why does this cause mal-investment but increased saving does not. In both cases the investment intermediary is a commercial bank. Now if we were talking about direct government spending then the case is clear. In that case the government is not subject to the market. However, commercial banks are subject to the market. If interest rates are lower because of additional savings or because the Central Bank set them lower does not change their loan approval process. In addition, the ABCT completely ignores tax and regulatory policy. Are Austrians really saying that recessions can only be caused by Central Banks setting interest rates too low? Why not too high? This is why Austrians are obsessed with what Central Banks are doing and seem somewhat oblivious to other issues.
These are not my real complaints with the ABCT however. My real complaints are 1) recessions happened before there were Central Banks and 2) economic growth is not caused by increases in capital. Central Banks are a fairly new creation and fractional reserve banks did not exist in the world until around 1650s. The United States did not have a Central Bank until 1913, but there were recessions before that in the US. There were certainly recessions in the world before there were banks, including one huge one called the Dark Ages. ABCT fails to explain the source of all recessions, including the recession of 2001.
ABCT is also wrong on what causes economic growth. Robert Solow did an econometric study of the US economy to determine how much of the growth was due to increases in labor, how much was due to increases in capital, and how much was due to increasing levels of technology. According to Wikipedia
[This] technique has been applied to virtually every economy in the world and a common finding is that observed levels of economic growth cannot be explained simply by changes in the stock of capital in the economy or population and labor force growth rates. Hence, technological progress plays a key role in the economic growth of nations, or the lack of it. http://en.wikipedia.org/wiki/Growth_accounting
Robert Solow won the Nobel Prize in economics for this work. (This is not an endorsement of everything Solow says)
I would change the bolded part to state that the only way to obtain real per capita increases in wealth is through increasing levels of technology. This becomes more apparent if you look over longer timeframes. If we had the same technology as our ancestors in 1600, even with today’s total capital, would we be any wealthier than our ancestors? We would not live longer, we would not be able to produce any faster, the only difference might be that we had more savings to fall back on or disseminate existing technologies. However there was very little technological change at the time, so the increase in technological dissemination would have been small. As a result, we would be essentially no wealthier than our ancestors. Our standard of living is defined by our level of technology. I discuss this in much more detail in my upcoming book, “Source of Economic Growth.”
Note that the ABCT does not account for technological change. As a result, the theory should hold up in a technologically static world. However, this is totally inconsistent with economic history. The Industrial Revolution started in Great Britain and the United States. There is no evidence that these countries had larger savings or capital stocks than say France or China or Holland or Japan. The Industrial Revolution was really a perpetual invention machine, driven by inventions not by capital. The source of all wealth is the human mind. The application of the human mind to problems of survival is called inventing, which is how we increase our technological level.
Austrian Business Cycle Theory does not hold up under scrutiny. Austrians have misidentified the source of economic growth and have a defective model for what causes recessions. Naturally they prescribe the wrong medicine. Austrian Economics is not pro-capitalism, it is not consistent with the enlightenment, reason, and science, which I have described in other posts.
PS: I mentioned above that the Austrians misdiagnosed the recession of 2001. They love to say that Greenspan created a bubble economy, which implies that in fact there was no real economic growth in the late 1990s. The narrative that Greenspan created a credit bubble by holding interest rates too low does not fit the facts. The economic growth of the late 1990s was built on new technologies that have made our life immeasurably better. Real incomes and industrial production rose significantly in the late 1990s. In addition, the effective Fed funds rate in the late 1990s was between 5.5 and 6.5%, which looks tight by today’s standards. The Federal Reserve’s balance sheet was stable. There was an inverted yield curve in 2000, which happened as Greenspan was increasing interest rates. The commodities index was falling slightly in 1999 and rose slightly in 2000. M1 was essentially flat in the late 1990s and M2 was growing slowly. The evidence is overwhelming that the recession of 2001 was not caused by Federal Reserve “printing” too much money. In fact the evidence points to the idea that Greenspan was too restrictive and caused an inverted yield curve in his desire to cause the stock market to cool off, which caused the recession. It is true that the stock market had gotten ahead of earnings, but recent experiments in economics show this is a common with new investors and is not necessarily the result of easy credit.
Libertarians and Austrians, including such organizations as the CATO Institute, Von Mises, and the Wall Street Journal, have put forth a number of arguments against patents and intellectual property. These arguments include that ideas (an invention is not just an idea, but I will let that go) are not scarce and therefore patents are not real property rights, patents are monopolies, patents inhibit the growth of technology, patents require the use of force to enforce one’s rights, patents are not natural rights and were not recognized as so by Locke and the founders, among other arguments. I have discussed most of these arguments earlier and will put the links in below. One of their favorite fall back arguments is that patents limit what I can do with my property. For instance, a patent for an airplane (Wright brothers) keeps me from using my own wood, mechanical linkages, engine, cloth, etc. and building an airplane with ailerons (and wing warping). This according to the libertarian argument is obviously absurd. After all it is my property. Here is an article Scarcity, Monopoly, and Intellectual Property on the Von Mises website where you can see almost every variation on the arguments mention above either in the article itself or in the comments.
Can I do whatever I want to with my property, or are there restrictions? Well when I buy a book, a movie, or a song, it does not give me the right to make unlimited copies of them. I have a property right in the physical book, but not the rights (copyrights) to make copies. Of course, many Libertarians think copyrights are absurd also, so let’s look at another example. Let’s assume you own your house and land outright. Does that give you the right to do whatever you want to with you land? Most likely, your land has easements for utility lines, such as water, gas, sewer, electricity. You are not allowed to do anything that interferes with those easements. You might object that I don’t own the easement, so this is a bad example. So let’s say you own a bulldozer, does that give you the right to bulldoze my apple orchard and build a house there? It is your property after all and according to the libertarian argument you are allowed to do whatever you want to with your property. You might object, that of course the libertarians did not mean that you could take advantage of my property to build on. Of course that begs the question, what is property? If a patent and copyright are property rights, then this is exactly the same situation. Another example where you are prohibited from doing something with your property, is in the case of water drainage. In particularly wet areas of the US you are prohibited from moving the earth on your land so water drains onto your neighbors property more freely – and no this is not an EPA rule, this is common law property rights. In parts of the country where water is scarce you are prohibited from damming up water on your land. If you buy land in a residential neighborhood you are prohibited from setting up a pig farm. Just because I own a gun, doesn’t give me the right to go around shooting people. The libertarian argument that patents are not real property rights because they prevent others from doing something with their property fails even the most cursory review.
One of the common themes that runs throughout all Libertarian arguments against patents is that Libertarians’ do not seem to know what property rights are, or how they arise. Here is a post on point, Property Right, Possession, and Objects; this post not only explains the proper basis of property rights, but why the Libertarian point that property requires possession is a fallacy. Libertarians have failed to provide a clear definition of what property rights are and how they arise. In fact, most anti-patent libertarians believe property rights are a useful social convention for distributing scarce resources. This is interesting, because they can become so adamant about what is their property. But nothing in this concept of property has anything to do with RIGHTS. If another, better system comes along for distributing scarce resources, then your property is gone.
Property rights do not give the owner the right to do whatever they want with their property. The source of property rights is creation, not the idea that it is a socially useful convention. Patents recognize the metaphysical fact that the inventor is the creator of his invention and are completely consistent with other property rights in prohibiting an owner of other property from using it to build his invention.
Below is a list of other Libertarian arguments against patents and why they fail.
Inventions are not scarce:
Patents are monopolies
If patents are a monopoly, as some suggest, then it should led to certain outcomes. A close examination shows that none of the supposed monopoly effects result from granting patents.
This post explains the characteristics of a monopoly and a property right and poses three questions to show the difference. Patents fit all the characteristics of a property right and none of a monopoly. Note that professional license, such as a law license has some of the characteristics of a monopoly.
This post contains a number of quotes from philosophers explaining that patents are not monopolies.
This post compares the definition of a monopoly to the rights obtained with a patent. It shows that the rights obtained with a patent do not confer a monopoly.
This post traces the ideas of Locke and William Blackstone to show patents and copyrights are natural rights.
Patents inhibit the growth of technology:
This post shows that those countries with the strongest patent systems are the technological leaders of the world Patents: Monopoly or Property Right a Testable Hypothesis
Patents require the use of force
This is one of the more absurd arguments by libertarians. All property rights are enforced by the government’s use of force. If someone trespasses on your land or steals your car, the government threatens or uses force to get it back. The same is true for patent, which are property rights in inventions.
Many people first become interested in economics because of Ayn Rand’s works such as Atlas Shrugged. Ayn Rand did not develop a science of economics, she defined the moral codes for an economic system – specifically capitalism. In the very first sentences of Capitalism: The Unknown Idea, Rand states:
This book is not a treatise on economics. It is a collection of essays on the moral aspects of capitalism.
As a result, when students of Rand want to understand the science of economics they would often start examining the works of classical economics. Adam Smith explained that the invisible hand resulted in people pursuing their own interest efficiently allocating scarce resources. He also explained how specialization resulted in increased wealth using the example of a pin factory. Commonly, people will then read Hayek who explains the limits of bureaucrats’ knowledge and how the price system is an information system for organizing resources. Friedman who explains the problems of manipulating the money supply and Austrian economists who show that the value of a product (service) is subjective. This study usually leads to two organizing principles of economics: supply and demand and that wealth is created in a free market by competition driving down the price of goods.
This leads to certain conflicts between economic science and Ayn Rand’s Philosophy. For instance, if competition is an unqualified good then antitrust laws that encourage competition should be good. But Ayn Rand believed that antitrust laws interfered with the free market and property rights. If competition was constantly squeezing profit margins how could any person or firm become significantly wealthier than the average person unless they subverted the market. The extreme version of this was set forth in the book “A Random Walk Down Wall Street.” The stock market has already priced in all generally available information, so there is no way to beat the market. This is related to the efficient market hypothesis, which is the application of perfect competition to the stock market. The conclusion from economic science is that those people who get wealthy somehow subvert supply and demand by excluding competition and therefore are not competing fairly. In other words, people who become wealthy in a free market are acting immorally. The common solution to this dilemma is to note that human skills vary significantly from one person to the next. Those with higher skills are able to consistently stay ahead of their competition. We should not demonize them because those people who get rich do so by providing pleasure to a large number of people.
Alternatively, people who have enjoyed Any Rand’s works usually are interested in business and consider running a successful business, virtuous. When they start to study business, they find that the last thing you want to do as a business is compete on price with a commodity product or service. The whole goal of a business is to find or create a market where you can have a competitive advantage. This is in complete contradiction to what they have learned from economic science. Markets where a business is able to sustain a competitive advantage result in misallocation of resources, according to economic theory. However, these are exactly the conditions a successful business seeks. Ayn Rand says that capitalism and creating wealth in a free market are both virtuous.
By now our objectivist is completely confused. One solution is to concentrate on personally creating wealth and ignore the free market theorists. Their ideas of perfect competition are not consistent with Rand’s ideas anyway. This person will then spend more time studying business. As they start studying business they will learn that all the really tough problems involve management of people, either customers or employees. Great business ideas and inventions are a dime a dozen, right?. A successful businessperson needs to concentrate on the motivations and goals of customers and employees who may not be rational. Because people are not rational we need to concentrate on their emotions. This is beginning to sound more like Ellesworth Toohey or James Taggart than John Galt, Dagny Taggart or Howard Roark.
Finding this line of thought a little too emotive our objectivist will search for the real bastions of capitalism. This search will lead them to Wall Street and the stock market, where no one is afraid to say they are trying to make money. Here they will find fundamental and technical analysis of stocks. Fundamental analysis is based on a detailed understanding of a company’s financial statements. So real wealth is created by finance, right?. When they study technical analysis they learn that the art of divination is not dead. Nevertheless with economics focused on the money supply, government debt, tax rates, supply and demand and business focused on venture capital, stock prices, initial public offerings, and bond rates it appears that real wealth is created by finance. Funny John Galt was not an financier instead of an inventor. How could Ayn Rand have gotten things so wrong?
 Of course this does not apply to insider trading.
 There are inventors in finance and despite the bad name financial innovation has gotten recently, financial inventions have been critical to the modern economy. For instance, fractional reserve banking is key to unlocking dead assets and more recently swept banking accounts increased the value of banking deposits. Even collateralized mortgage obligations probably decrease risk and increase access to capital, when they are not manipulated by GSEs and given false bond ratings by government sanctioned ratings agencies.
- F. A. Hayek: Austrian Economics vs. Objectivism
- Carl Menger: Austrian Economics vs. Objectivism
- Economics, Evolution, and Rand’s Meta-Ethics (Intellectual Capitalism: Fundamentals Part 2)
- Latest Amazon review of my book Source of Economic Growth.
- Dale Halling and William R Thomas – Austrian Economics and Objectivism Panel: Atlas Summit 2016
- Dale Halling – Economics, Evolution, and Rand’s Meta-Ethics: Atlas Summit 2016
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- Intellectual Capitalism: Fundamentals Part 1
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