Accounting for the Business
Cycle: Nominal Rigidities,
Factor Heterogeneity, and
Austrian Capital Theory*
Robert F.
Mulligan
Western Carolina University
and
the State University of New
York at Binghamton
Abstract. An Austrian
interpretation of the New Keynesian small menu cost model of the business cycle
is proposed. Austrian and New Keynesian
business cycle theories share the feature that the cycle is generated by
rigidities which prevent the economy from adapting instantaneously to changing
conditions. Austrian business cycle
theory is capital-based, focusing on credit expansion which artificially lowers
interest rates and causes an investment boom and unsustainable business
expansion. In contrast, the New
Keynesian small menu cost model of the business cycle is based on nominal
rigidities which prevent markets from clearing.
Small menu costs introduce dichotomous behavior, where firms find it
locally optimal to avoid instantaneous output price adjustments in the face of
the cost, but this local optimum results in economy-wide output and employment fluctuations
which are much greater in relative magnitude.
The small menu cost model of the business cycle is extended and
reinterpreted in light of Austrian business cycle theory with heterogeneous,
multispecific capital, thus providing a rigorous formalization of the Austrian
business cycle. The Austrian
interpretation of this New Keynesian model fortuitously addresses several of
its shortcomings.
Key words: Austrian
business cycle theory, New Keynesian small menu cost model, Hayekian triangle
JEL classification: B53, E12, E23, E32
Solomon: ... You take this table ...
You can't move it. A man sits down to
such a table he knows not only he's married, he's got to stay married -- there
is no more possibilities.
Arthur Miller (1968) The Price Act 1
1. Introduction
Every economic decision has
an opportunity cost, and decisions to invest in long-lived capital equipment
have long-lived and especially onerous opportunity costs. As Arthur Miller's appraiser might conclude
about capital equipment, "it's furniture and you're married to
it." Once entrepreneurs commit to a
definite production plan, they surrender many possible future states in return
for the opportunity to pursue one;
future possibilities are limited by the act of choosing. In effect, "there is no more
possibilities." However, until entrepreneurs commit to a
production plan, they are no more than potential entrepreneurs[1]. Austrian business cycle theory is unique in
recognizing the role of time preference in coordinating a production structure managed
by many independent entrepreneurs with subjective knowledge, information,
preferences, and unique abilities.
The Hayekian triangle (figure
1; Hayek 1931:39; subsequently developed by Hayek 1933, 1939, 1941) illustrates
the production structure. In the most
stylized case, the interest rate is proportional to the slope of the
hypotenuse. The steeper hypotenuse
reflects the higher interest rate and consumers' increased time preference – in
this higher-interest environment, consumers are less willing to wait for
immediate consumption goods. Conversely,
when interest rates fall, the structure of production becomes more roundabout,
redistributing marginal resources toward productive activities with lower rates
of return. These more roundabout
production processes produce more final output but require more production
time.
Although the
Hayekian triangle is a general model of intertemporal resource allocation, it
is generally interpreted as a model of how interest rates determine allocation
of investment versus consumption spending, and how the production structure is
manifested in the capital stock.
Figure
11
The
Hayekian Triangle
Mining Refining Manufacturing Distribution Wholesaling Retailing
Production Time
1 Source: Garrison
2001, p. 47.
Because this paper discusses
a formal model of a kind which is uncommon among the Austrian school, it
attempts to answer Spadaro's (1978) call for selective adoption of rigorous
formalism. New Keynesian models of the
business cycle emphasize the result that insignificantly suboptimal behavior
causes aggregate demand shocks with significant real effects (Akerloff and
Yellen 1985). Resistance to changing
prices or wages plays the same role in the New Keynesian models as resistance
to adjusting the capital structure plays in Austrian business cycle theory:
both rigidities or intertial properties keep the macroeconomy from full general
equilibrium, and introduce large fluctuations in aggregate output and
employment.
The paper is organized as
follows: section 2. The Austrian Theory of the Business Cycle, summarizes the
theory; section 3. Qualitative Applications and Earlier Empirics, reviews
applications of the theory to historical data; section 4. The New Keynesian
Small Menu Cost Theory of the Business Cycle summarizes that theory; section 5.
An Austrian Critique of the Small Menu Cost Model, develops some Austrian
objections to the small menu cost model; section 6. An Austrian Model of
Inertia in the Production Structure, reinterprets the small menu cost model in
light of Austrian business cycle theory; and finally section 7. Conclusion,
provides concluding comments.
2. The Austrian
Theory of the Business Cycle
This section briefly
summarizes the Austrian capital theory on which the reinterpretation of the
small menu cost model is based. Hayek
(1935:136-139), Mises (1949: 550-566), and Garrison (1986:440; 1988;
2001:71-73) draw a fundamental distinction between ordinary changes in time
preference and policy-induced changes in interest rates. Only a decrease in interest rates caused by
credit expansion can drive the business cycle.
According to Austrian business cycle theory, there should be no cycle if
the decrease in interest rates is due to a general lowering of time preference. Because production takes place over time,
time preference assures outputs from each stage have greater expected value
than the sum of inputs (Mises 1949:483-488; Rothbard 1962:323-332; Garrison
1985:169; 2001:46).
The interest rate is the rate of time discount
implicit in the pattern of prices of productive resources, including capital
goods. Garrison cautions (1985:169-170;
2001:50) this is not necessarily the same as the loan rate determined in the
loanable funds market, though he also acknowledges the market process eventually
adjusts the loan rate to the broader market rate of interest. In the Austrian view, determinants of the
broader market interest rate are not exhausted by the determinants of the loan
rate in the loanable funds market (Rothbard 1970:321-323), although the slope
of the hypotenuse of the Hayekian triangle reflects the interest rate
determined in the loanable funds market (Garrison 2001:50). The value of inputs is a derived demand
determined by the price an entrepreneur expects to command for output at the
end of a production stage[2]. This expected price is discounted over the
duration of the production stage (Garrison 1985:170; 2001:46).
Productive
resources have differing degrees of substitutability and complementarity
(Garrison 1985:168; 2001:49). Austrian
business cycle theory emphasizes the inflexibility imposed by the high cost of reallocating
installed physical capital. It is
important to realize that similar kinds of inflexibility and high adjustment
costs can come from other resources, particularly labor. Workers often resist seeking employment
outside preferred venues. Because this
source of high unemployment results from high adjustment costs which frustrate
resource allocation and adjustment of the production structure, rather than from
real or nominal wage or price stickyness, this potential cause of recession,
though labor-based, should be recognized as Austrian rather than
Keynesian. Mulligan (2002) presents
evidence that labor employment is reallocated over the business cycle in a
manner similar to that predicted by Austrian business cycle theory for the physical
capital it complements.
When
changing conditions call for entrepreneurial managers to revise their
production plans, they face the constraint imposed by the pre-existing capital
structure[3]. Future entrepreneurial plans are always
potentially constrained by the desirability of making some use of the existing
capital and goods in process, though in extreme cases it may be abandoned
completely. This is more likely to be the
case the closer capital equipment is to the end of its usable life, but then
the adjustment cost is the whole value of the discarded equipment. Much production which occurs during business
expansions is simply wasted, because given people's time preference, this
output was never desired anyway.
In
the Austrian theory of the business cycle, policy-induced monetary or credit
expansion discoordinates the Hayekian production structure in an unsustainable
manner, creating the boom before the bust.
Expansion is manifested in an artificial oversupply of investable
resources (often called loanable funds, see Garrison 2001:36), signaled by a
below-market interest rate. As a
practical matter, it is much easier to conclude either that (a) money or credit
supplies have increased, or that (b) commercial and industrial lending or
private domestic investment spending have increased, than to assert that a
particular prevailing interest rate is lower than what the market would dictate
in the absence of the overexpansion. Austrian capital theory does not rely on
Fisher's (1896) distinction between real and nominal interest rates or the
distinction between anticipated and unanticipated changes in the general price
level, instead emphasizing a distinction between preference-based changes in
interest rates and policy-induced changes.
The unsustainable expansion
is most often considered in terms of an overabundance of physical capital which
is installed in increasingly earlier stages of production. As the expansionary intervention supplies
more investable resources, and does so at a depressed interest rate,
entrepreneurial managers fund lower and lower yielding investment projects in
earlier production stages more remote in time from final users, simultaneously
taking advantage of the lower loan interest rate and the newly more abundant
supply of investable resources.
However, the business cycle
can also be described in terms of how expansionary policy forces an
overcommitment on the part of entrepreneurial planners to activities which are
both more capital-intensive and time-intensive, and thus, lower-yielding. Such production plans cannot be expanded or
sustained indefinitely, even if the interest rate continues to fall, because
the nominal interest rate cannot fall below zero. Planners surrender flexibility whenever they
commit liquid financial capital to a particular production plan. If business conditions change, production
plans can not be completed as originally anticipated. The removal of
flexibility on the part of the entrepreneurs can be though of as the proximate
cause of the business cycle.
The production structure
simultaneously extends average production time, and attempts to increase the
amount of output supplied to consumers, who save less in response to the lower
interest rate. Hayek (1935:137)
describes this concave "triangle" as curvilinear. In earlier stages of production, more
productive activity occurs, but with a lower rate of return to compete with the
low interest rate. In the latest stages
of production, high rates of return are necessary in spite of the low interest
rate, because the low interest rate influences consumers to demand more final
output. Resources are allocated out of middle
stages of production into earlier and later stages, forming the
"curvilinear" triangle. But
middle stages of production serve the essential function of connecting the
early and late stages. Because the early
and late stages overexpand while middle stages atropy, there is no way to move
the full volume of early stage goods-in-process through the middle stage
bottleneck, to the late stages where consumers are clamoring for more
output. Expansionary policy locks
entrepreneurs into production plans which are specific courses of action the
same policy renders unfeasible. Hülsmann
(2001) particularly emphasizes that this overinvestment-overconsumption boom,
which everyone applauds as an era of blessed prosperity, is better understood
as a period of waste. Scarce resources
are committed to a production structure which cannot supply as much output over
the long run as the sustainable preinflation, preexpansion production
structure.
Lower interest rates reward
entrepreneurs and firms which exploit most fully the most roundabout,
capital-intensive production activities.
These plans can not prove profitable in the long run, unless the low
interest rate persists indefinitely, that is, unless the lower interest rate is
due to a permanent lowering of the general rate of time preference.
The Austrian business cycle
focuses on intertemporal production plans because heterogeneous, multispecific
factors must be coordinated in an intricate and deterministic way to yield
consumable output. All factors of
production should be regarded as inherently heterogeneous. Even two otherwise identical piles of coal of
the same type and grade, take on a heterogeneous character if one is located in
North Carolina and the other in Korea.
Transportation costs must be expended to render the two resources more
truly homogeneous. Even if the two piles
were located contiguously, their consumption or use in production must
necessarily be separated temporally, if not spatially. Coal located in the interior of a pile can
not be used as soon as coal located on top.
a. Say's Law and the Austrian Business Cycle
Conventionally rendered as
"supply creates its own demand," Say's Law asserts that satisfying
the wants of others enables us to earn the income we need to satisfy our own
wants. Prior to Keynes (1936), Say's Law
was interpreted as asserting the impossibility of a general
overproduction. If producers supplied
more than what consumers desired, or if they produced the wrong items, produced
output would go unbought, signaling to the producers to produce less. Keynes (1936:26) argued that Say's Law
systematically broke down during the Great Depression. More had been produced than people were
willing to buy. Aggregate demand had
collapsed, lowering prices, and making it impossible for private industry to
employ enough of the work force at reasonable pre-depression wages. With so many people out of work, there was a
significant decrease in demand for output, preventing business firms from
employing enough people in a vicious cycle.
In Keynes's view, private
industry had supplied too much, and it could no longer create enough demand for
this much output. It is significant that
Keynes was unable to explain why the economy should ever overproduce, beyond
claiming it was just an inevitable shortcoming of capitalist organization. His argument was that this was a natural
instability of private economies, and he felt government intervention was
warranted to counter it. As Keynes saw
it, the only alternative to intervention was outright socialism.
From the perspective of Austrian business cycle theory,
it is easy to see that overproduction did occur in the late twenties, and also
easy to see why. Government and Federal
Reserve System policy was to expand the money supply, getting commercial banks
to loan out more than they held in deposits.
This expanded the supply of goods and services, increasing the demand
for labor and other resources, and lowering the unemployment rate. The expansion was unsustainable because it
was unsupported by real savings. When
the Federal Reserve System finally tightened the money supply in the late
1920s, the economy collapsed as banks called in business loans. Businesses were forced to cancel planned
expansion activities. Throughout the
depression, supply of and demand for output were both lower than their pre-depression
levels (Rothbard 1962).
Austrian business cycle theory can be understood as an
explication of Say's Law. This is most
obvious in a barter economy where the demand for any commodity is identical to
the supply of all other commodities. In
a monetary economy, when consumers demand a good, they are supplying money,
which they receive from other demanders in exchange for the supply of other
goods or resources (Hutt 1974, Johnson 2001, Salerno 2001). Entrepreneurs compete to best satisfy
consumer wants and gain cost advantage by making the best use of available
resources. Recessions occur when
entrepreneurs are given too cheap access to too plentiful credit
facilities. Entrepreneurs respond by
expanding production and employing more capital in more roundabout and
time-consuming, and thus lower-yielding, productive activities. Entrepreneurs demand more producers' goods in
early stages of production, even as they attempt to supply more consumers'
goods in later stages. Consumer demand
rises because saving falls with the lower interest rate. The derived demand for labor is discounted
based on how remote the labor is from final output (Van den Hauwe 2001). Unless the production possibilities set
expands, the economy cannot simultaneously produce more producers' goods and
more consumers' goods. Correction
becomes inevitable.
b. Installed v. Financial Capital in
Entrepreneurial Plans:
Bischoff’s
Putty-clay Model
Bischoff (1970) presents a
valuable distinction between uninvested financial capital and installed
physical capital: the "putty-clay" model. In his formulation, "putty" capital
is uninvested saving which helps clear the loanable funds market. "Clay" capital has already been
installed, and is expected to yield a definite return in currently-operating
entrepreneurial plans[4]. This expected return must be at least as high
as the return on financial assets, such as government bonds, available to
entrepreneurs when they formed their production plans. The actual return on installed capital may be
lower, as expectations may be disappointed.
When interest rates change,
this impacts entrepreneurial decisions about whether and where to invest
"putty" capital.
"Clay" capital, which is already installed, may be abandoned
completely, or may be used exactly as called for in the original production
plan. Most commonly, however,
"clay" capital is used in modified production plans, which attempt to
extract as high a return as possible (Garrison 2001:74). The available "clay" capital was
intended for a different production plan, predicated on a different interest
rate, for a given maturity corresponding to the useful life of the installed
capital.
In Keynesian terms, there is
a liquidity constraint on "clay" capital, in contrast to uninvested
"putty" capital. Investors would
take funds directly out of installed capital and invest these funds in
higher-yielding government bonds or other financial assets if they could, but
these funds are tied up in illiquid physical assets, or in term leases on
physical assets. These physical assets
may be sold but cannot command as high a price once their productive yield
becomes less competitive. Lachmann
(1956) recognized that installed "clay" capital is inherently
multispecific and heterogeneous.
It is less obvious that
multispecificity and heterogeneity are also shared to some extent by
uninstalled financial or "putty" capital. This insight is the basis for the segmented
markets (Culbertson 1957) and preferred habitat (Modigliani and Sutch 1966)
theories of term structure, the relationship between average annual return and
the time to maturity at any point in time (Thomas 1997:138-154; Van Horne
1998:83-100). In the more basic pure
expectations theory (Fisher 1896; Lutz 1940) and liquidity premium theory
(Hicks 1946:146-147) different maturities are perfect substitutes, thus supply
of and demand for different maturities of investable assets-loanable funds have
infinite elasticity of substitution.
Under the pure expectations
theory, arbitrage ensures that only expectations about future interest rates
enables financial assets of different maturities to have different yields. Under the liquidity premium theory, in
addition to expectations, it is recognized that individual's desire for
liquidity means lenders will demand, and borrowers be willing to pay, a
liquidity premium for longer maturities, partly to offset higher default risk
(Fisher 1959). The segmented markets
theory treats different maturities as having zero elasticities of substitution,
and the more realistic preferred habitat theory assumes substitution
elasticities across maturities are low, but that if one maturity offers a
higher yield than others, arbitrage across maturities would drive away savings
and attract investment demand, until the yield inequality was minimized. The market process consists of
entrepreneurial planners effecting adjustment toward a dynamic equilibrium they
continuously redefine. The prevailing
term structure of interest rates determines resource allocation among early,
middle, or late stages of production, in accordance with consumers' time
preference and available investment alternatives.
c.
Entrepreneurial Behavior in Business Firms
Market order evolves
spontaneously (Hayek 1973:39) and because firms are intelligently-designed
entities, it is difficult to place the firm within the market order (Khalil
1995, 1997a, 1997b). Coase (1937, 1988)
advanced the thesis that production is generally organized in firms to minimize
transactions costs which would otherwise prevent many exchanges and productive
activities. This assertion cannot be
attacked on its face, but this is not all firms accomplish. An extensive management literature has
emerged on entrepreneurial planning within firms (Pondy 1970; Pfeffer and
Salancik 1978; Hannan and Freeman 1984; Levinthal 1994; Lombardo and Mulligan
2003). It seems clear that the Austrian
school also offers additional insight into why production is organized in firms. Firms provide an institutional context for
entrepreneurial discovery (Kirzner 1973, 1979, 1985), facilitating the use of
relevant knowledge and information (Potts 2001) and the coordination of the
production process (Yu 1999).
Because Austrian business
cycle theory is built on the concept of production or capital structure, the
role entrepreneurial managers play in adjusting and maintaining the production
structure connects Austrian macroeconomics with Austrian microeconomics. Production structure is central to the
Austrian theory of the firm (Dulbecco and Garrouste 1999), thus grounding
Austrian business cycle theory firmly on microeconomic foundations. Baetjer (2000) notes that the need to
coordinate production through the capital structure is ongoing and omnipresent
due to the frequent arrival of new knowledge, which generally requires the
production structure be changed.
Baetjer emphasizes that
capital equipment is useless if workers do not know how to use it, and if
complementary capital is not available, e.g., a locomotive cannot be operated
by a lay person, and cannot run without tracks.
Cochran (2001:22) makes a similar point.
Maintaining the production structure is a dynamic, disequilibrium
process, as described by Lewin and Phelan (2000:68). Augier and Augier (2003) develop a set of
formal models to explore the implications of regarding stages of the production
the production process as endogenous, that is, determined by entrepreneurs
responding to incentives within the economy.
3. Qualitiative Applications and Earlier
Empirics
Austrian business cycle
theory is unmatched in offering persuasive qualitative explanations of historic
business cycles. This fact by itself
makes a powerful case for the Austrian school, which should be accepted as the
dominant macroeconomic policy paradigm. Curiously, the Austrian business cycle
was once the leading theory (Haberler 1937).
More recently the Austrian theory is often dismissed (e.g., Friedman
1969:261-284, 1993; Hummel 1979; Yeager 1986:378; Tullock 1987, 1989; Cowen
1997; Wagner 2000) or simply ignored. In
response, an Austrian literature of defense, apology, and counterattack has
developed (Salerno 1989; Garrison 1996, 2001; Cwik 1998; Block 2001). Although their analysis of investment as a
driver of recession owes little to the Austrian school, Chari, Kehoe, and McGrattan
(2002) conclude the Great Depression was caused by labor market rigidities, and
that investment frictions played a minor role. Holcombe (2001) discusses some
reasons why Austrian macroeconomics is undervalued by the neoclassical and
Keynesian mainstream.
Rothbard's (1963) monumental
study of the inflationary roots of the Great Depression persuasively argues
that credit expansion created an unsustainable boom in the 1920s, and that
government policy frustrated the efforts of economic agents to liquidate
inefficient capital, resulting in a protracted secondary contraction, thus
transforming what would have been a routine recession into the Great Depression
by preventing prompt liquidation of overinvestment. Valuable resources which could have been used
for more productive purposes, and for output more urgently desired by
consumers, instead were tied up in fruitless and counterproductive attempts to
maintain labor employment in the same industries which had already overexpanded
through the malinvestment boom. Focusing
on unorthodox and rarely examined monetary aggregates, Rothbard shows that
inflation and credit expansion continued sporadically well into the 1930s,
effectively preventing any general liquidation of malinvested capital. Rather than facilitate liquidating
malinvestment, easy credit policies generated further opportunities for
malinvestment. The misallocation of
productive resources was further exacerbated by governmental efforts to restore
and maintain artificially high prices through cartelization and price controls.
|
Table 1 Competing Views of the Great Depression |
||
|
Keynesian |
Monetarist |
Austrian |
|
Liquidity trap created once
nominal interest rates became low enough; bank demand for excess reserves
became perfectly elastic. Monetary
base doubled between 1929-38: monetary policy was expansionary, but excess
reserves accumulated in banks. Demand
for loans depressed due to unfavorable business outlook. Banks did not buy any but the shortest-term
securities because nominal yields were so low. |
Real interest rates
extremely high due to price deflation: e.g., CPI fell 10% in 1931 and
1932, indicating contractionary
policy. Growth in monetary base mostly
attributable to currency held by public, unavailable for lending, rather than
bank reserves. "Flight to
quality" greatly increased demand for short-term Treasury securities,
depressing their yield. Fed tightened
discount lending policy in 1931, and doubled the reserve requirement between
1936-37, triggering a secondary recession. |
Expansionary monetary
policy depressed interest rates and created an unsustainable investment boom
throughout the late 1920s. Monetary
policy was intermittently expansionary and contractionary throughout the
1930s. Government intervention
initiated under the Hoover administration between 1930-32 delayed liquidation
of malinvested capital. Price fixing,
fiscal stimulus, and monetary activism (intermittently expansionary and
contractionary), continued and extended under the Roosevelt administration,
prevented liquidation of malinvested capital, delaying liquidation of
malivested capital, prolonging the Depression. |
|
Keynes 1936, Hicks 1939,
Modigliani 1944 |
Friedman and Schwartz 1963:
411-419 |
Rothbard 1962, Garrison
2001 |
This view contrasts markedly
with Friedman and Schwartz's (1963) conclusion that the secondary contraction
was caused by the Federal Reserve System's failure to provide enough
liquidity (Table 1). Using the standard
monetary aggregate that ultimately emerged as M1, Friedman and Schwartz find
that the main problem during the depression was that the money supply shrank,
even though the monetary base grew.
Table 1 summarizes some of the evidence cited by Keynesian, monetarist,
and Austrian authors. It is difficult to
avoid the conclusion that the Austrian explanation is the most encompassing,
even though Austrian business cycle theory focuses on the unsustainable
expansion which precedes a recession[5]. The monetarists are simultaneously to be
applauded for introducing the first evidence of contractionary policy over
three decades after the start of the recession, as well as to be scolded for
selectively ignoring very real evidence of expansionary policy, which remains
irrefutable.
The Austrian perspective can
be interpreted as intermediate between the Keynesian, emphasizing a liquidity
trap which made expansionary monetary policy ineffective, and the monetarist,
which criticizes the Fed for unwittingly implementing a contractionary
policy. The Austrian school blames the
expansionary policy of the 1920s for the onset of the Depression, and active
government and central bank policy for transforming what would have been a
routine recession into a decade-long ordeal.
The Austrian school goes beyond the monetarist school in emphasizing the
real discoordination and resource misallocation forced by government and
central bank activism, resulting in persistent and abnormally high
unemployment.
Because he was not an
academic, Harwood (1932) focused only on the unsustainable aspects of
inflation, not on how it created an overextended production structure. Economic historian William Graham Sumner
(1891) also recognized that inflation precipitated economic downturns. Harwood's theory of the business cycle was
that the root cause was any excess of investment spending over saving. Such an imbalance can only be introduced
through systematic expansion of the money supply, which allows banks to lend
funds for business investment in excess of the savings they hold on deposit. He argued that the amount might be small initially,
but would necessarily grow over time, as producers' goods face increased
demand, bidding up their price.
Harwood agreed with Mises and
Hayek that unsustainable expansion comes about primarily because the interest
rate is kept artificially low due to the oversupply of cheap credit, and
businesses take advantage of the attractive low borrowing rate to finance
expansion of production facilities. He largely disregarded the impact of
localized distortions, recognizing that they occur, but arguing that their
impact distorting the allocation of productive resources must be
negligible. This is a major difference
between Harwood and Mises and Hayek.
In Harwood's view, as soon as
investment spending exceeds saving, businesses that sell producer's goods start
expanding to satisfy increased demand for productive assets. The increased spending results in increased
income to households and workers, meaning that the increased demand is for
consumption goods as well as investment goods.
Harwood's point is that this leads to a general increase in business
activity to satisfy what businesspeople perceive as increased demand for goods
and services. Though he accepted the
Mises's and Hayek's views that investment and employment expand fastest and
farthest in the industries most directly affected by the additional investment
spending, he felt this was generally less important than the fact the increase
in spending is quickly diffused throughout the consumption-goods-producing
sector.
O'Driscoll and Shenoy (1976)
present an account of the stagflation of the 1970s. They note that credit expansion increases
nominal demand at the point the newly-created money is injected, distorting the
price vector and the allocation of resources, especially of capital which cannot
be easily reallocated. Credit expansion
always increases consumption expenditures because any new money results in
increased nominal income to some households.
Firms engaging in production most remote from consumption find resource
prices bid up, and resources bid away, by firms selling directly to
consumers. Unemployment starts in these
firms remote from final consumption even as prices continue to be bid up by
continued injections of cheap credit.
Garrison (2001:145-164), in the most important contribution to Austrian
macroeconomics since 1949, also provides convincing accounts of both the Great
Depression and the stagflation of the 1970s using the Austrian model.
Cwik (1998) uses the Austrian
theory to analyze the Gulf crisis recession of 1990. Carilli and Dempster (2001) argue that
Austrian business cycle theory places undue reliance on economic agents
misperceiving credit expansion as a real increase in loanable funds. They suggest that even if rational agents
correctly anticipate inflation, agents maximize profits under uncertainty by
taking advantage of the market interest rate whenever it falls below the
underlying rate of time preference.
Keeler (2001) used standardized quarterly data for eight U.S. business
cycles, finding monetary shocks did cause cycles which were propagated through
relative price changes, including nominal interest rates.
Powell's (2002) account of
the Japanese recession of the 1990s is especially noteworthy because he focuses
on exactly how expansionary monetary and fiscal policy recommended to spur
recovery, actually lengthened and deepened Japan's recession. His conclusion is that monetarist policy
prescriptions proved only marginally less ineffective than Keynesian ones. As with the Great Depression, poor policy
prescriptions transformed what should have been a routine recession into a
decade-long ordeal. Mulligan (2002) used
sectoral labor data as indicators of resource allocation among industrial
sectors. Resources are reallocated among
early, middle, and late stages of production in response to changes in nominal
interest rates, as Austrian business cycle theory predicts. Callahan and Garrison (2003) explain the 1990
technology boom and subsequent recession of 2001-2002 in terms of Austrian
business cycle theory. They are able to
point to specific Cantillon effects created when excess liquidity was injected
into localized markets, showing how markets temporarily inflated prices for
computer programmers and web developers, real estate in certain cities, and technology
stocks. Cochrane, Call, and Glahe (2003) argue that the location and timing of
credit injection are especially critical in determining where and how far the
production structure will overexpand, and what will be the nature and timing of
the inevitable collapse.
In marked contrast to
orthodox neoclassical and Keynesian accounts of the business cycle, Austrian
business cycle theory presents a consistent and coherent explanation of the
causes and propagation mechanisms of the business cycle. Though more typically qualitative than
quantitative, the explanatory successes of Austrian business cycle theory have
proved robust over an impressive time period and range of specific
applications. This remarkable success
makes it even more puzzling that Austrian business cycle theory has not been
enthusiastically embraced by non-Austrians, and that it has yet to emerge as
the dominant macroeconomic policy paradigm.
4. The New Keynesian Small Menu Cost
Theory of the Business Cycle
The New Keynesian small menu cost
model of the business cycle is an attempt to explain the business cycle in
terms of resistance to small changes in prices.
Price stickyness results in large changes in real output, employment,
and consumer welfare. When all factors
are considered heterogeneous, the critical contribution of the entrepreneurial
planner can be appreciated. Entrepreneurs
are not resistant to changing small menu prices merely because of the
accounting cost of doing so, but because of the cost of marshalling information
against the uncertainty of future market conditions and the cost incurred when
their decision goes wrong.
The small menu cost model
attributes the inability of entrepreneurs to reallocate resources to the false
signals given by market prices which are temporarily slightly out of
equilibrium due to price-setters' desire to avoid costs associated with
changing prices. Thus the allocation
realized by the market is necessarily suboptimal, resulting in large swings in
real output and employment.
It seems much more
satisfactory to view the underlying inflexibility in resource allocation to a
more general resistance on the part of entrepreneurs to altering their production
plans, an activity which occasionally becomes imperative, but often can be
avoided as particularly risky, costly, and undesirable. It seems more promising to incorporate
behavioral inertia into models of entrepreneurial action, an element of
resistance to revising production plans.
Entrepreneurs hope for an environment where their plans can be left in
place as long as possible.
Thus a reformulated Austrian business
cycle theory emphasizes costs associated with changing production plans, rather
than merely with costs associated with changing prices or capital allocation alone. The production plan formulated by an
entrepreneur specifies the quantity and types of resources to be combined, in a
definite manner, given expected resource and output prices, to yield a certain
amount of a definite output of a certain expected value. Many characteristics of such a plan would
frustrate attempts at too-frequent revision, not only resource prices. Each characteristic of such a plan imposes
certain difficulties and costs, and thus contributes to large fluctuations in
output and employment, along with small menu costs. The small menu cost model serves as one
example of how these fluctuations can arise, but it seems clear that it is only
one cause among many and that Austrian capital theory offers a more general,
and consequently more satisfactory, explanation of the business cycle.
The small menu cost model (Rotemberg
1987; but see also Rotemberg 1982; Akerloff and Yellen 1985; Mankiw 1985; Ball
and Romer 1987, 1990; Ball, Mankiw, and Romer 1988; McCafferty 1990: 453-463) is
based on the Taylor series expansion[6] of
the profit function for a representative firm in a monopolistically competitive
market. Firm i should refrain from changing output prices as long as the (economy-wide
with J identical firms) difference in
profits gained through changing prices is smaller than the cost of changing
prices, the menu cost c,
D ≡ Jpi1 - Jpi0 < c,
where pi1 is firm i's
profit if it charges the new price and all other firms continue to charge the
old output price P0, and pi0 is firm i's
profit if it refrains from changing price, along with all its competitors who
continue to charge P0. The result
|
D |
@ |
q1/(1 - β) |
1 - (1 -
q)2 |
(P0
- P*)2, |
|
P* |
2(1 - q) |
(P*)2 |
an expression for the
difference in profits divided by the flexible-price equilibrium price level P*, contains no first-order expressions
in (P0 - P*), the change
in prices. It is observed that if D < c, then not changing output prices will be optimal for
all firms, and since D is proportional to (P0 - P*)2, very low menu costs may still be
compatible with the condition D < c.
It is also demonstrated that
output levels Yi = Ci
always lie on the demand curves
JCi = (Pi/P)1/(1
- β)(M/P)
in this monopolistically
competitive market[7]. Since Pi
= P* for all i, and P* solves M = P*q1/(1 -
β), the
fixed-price equilibrium output level is
Y0 = q1/(1 - β)(P*/P0),
and the difference between
the fixed-price and flexible-price equilibrium output levels is given by
|
Y0
- Y* |
= |
q1/(1
- β) |
(P* - P0). |
|
P0 |
This expression demonstrates
that changes in output levels due to nominal price rigidity, and therefore in
employment levels, can be first order in
(P* - P0) while the
underlying menu costs may only be second
order (proportional to (P* - P0)2).
Rotemberg's conclusion was that his argument demonstrated the
possibility that small menu costs, which plausibly delay producers from
adjusting prices toward equilibrium and prevent markets from clearing, result
in much larger swings in real output and employment.
Evidence for small menu costs
has not been overwhelming. The key
result is that nominal rigidities may be small and still cause business cycles;
it may well be that the rigidities are too small to perceive. Cecchetti (1986) found evidence of rigid
newsstand prices for magazines.
Rotemberg (1982) suggests firms that change prices too frequently may be
viewed by their customers as erratic and face reduced sales. Rotemberg's small menu cost model is closely
related to Akerloff and Yellen's (1985) model demonstrating second-order
departures from optimal equilibria at the individual level can result in
first-order fluctuations in macroeconomic aggregates. A closely related class of New Keynesian
business cycle models, the efficiency wage models, base their results on wage
rigidities rather than output price rigidities, exemplified by Yellen (1984).
5. An Austrian Critique of the Small Menu Cost Model
Rotemberg's implicit
assumption is that menu costs are the only
barrier, or at least the most important barrier, to perfect and instantaneous
market clearing. The Austrian view is
that all prices, or nearly all prices, are nearly always disequilibrium
prices. Prices are either held steady in
between experimental entrepreneurial adjustments, or are in the process of
being adjusted experimentally. Production
plan adjustments aim at increasing profits but are not necessarily always
successful. In between experiments,
entrepreneurs are resistant to changing prices because they are deterred by the
cost of getting the decision wrong, although they also understand that the
current price is also wrong in some sense, and higher profits could nearly
always be earned by changing to the currently unknown, currently correct
price. This Austrian understanding
accords very well with the New Keynesian concept of small menu costs. The justification for nominal rigidities is less
important than the conclusion they are justified.
However, the Austrian view of
the entrepreneur's price setting decision is that it is only one element the
entrepreneur carries out in managing a production plan. The Hayekian production plan, which is
subject to constant revision, includes current and expected future output and
input prices, selection of technology, input and output quantities, and
resource bills. Because production takes
place over time, inevitable changes in market data change the most desirable
outcome of the production process, even as output is being produced. Whenever the interest rate changes, optimal
allocations of capital in each stage of production change, but production plans
are more inflexible. Each stage of
production is filled with half-baked cakes (Kirzner 1996:37-41). If there were no adjustment costs to be
borne, the production structure could instantaneously adapt to changed market
conditions, but usually it is too wasteful to completely abandon unfinished
goods-in-process and already-installed capital equipment. However, as the New Keynesian small menu cost
model emphasizes, resistance to making small price changes results in
larger-order fluctuations in employment and output.
Because capital equipment is
long-lived and its cost must be amortized, the relevant choice an entrepreneur
faces when new market information is revealed is best understood not so much in
terms of what is the best production structure newly installed from scratch,
but what is the best use of already-installed capital. Thus, the use of capital equipment, and other
difficult to reallocate resources, such as human capital, imposes an additional
set of inflexibilities on the market beyond nominal rigidities. Although nominal rigidities clearly impose
inflexibility on entrepreneurial attempts to respond to changing conditions, nominal
rigidities are nested within a given production structure. Thus Austrian business cycle theory can be
considered as subsuming the New Keynesian small menu cost theory of the
business cycle, although there should be a substantial debate between Austrians
and New Keynesians over which plays a more important role in driving the
business cycle, nominal rigidities or rigidities in intertemporal resource
allocation, that is, in the capital structure.
The greatest shortcoming of
the small menu cost model seems to be the lack of compelling justification for
connecting nominal rigidities in clusters of errors, which must occur randomly
fairly frequently, with the non-periodic business cycle. Individual entrepreneurial errors are common,
occurring both frequently and randomly (Rothbard 1997:73; Mueller 2001:13),
although in the small menu cost model, nominal rigidities are not errors in the
local sense, only in the global sense. Since
postwar recessions have occurred approximately every ten years on average, it
seems fair to ask, that if recessions are due to nominal rigidities, why
recessions are not more frequent. If the
economy experiences a recession simply because it is optimal for firms to keep
using old menus since it costs a non-negligible sum to replace them, it seems
reasonable to ask why recessions occur less frequently than once every two
weeks to six months.
Apart from the issue of how
frequently the models predict recessions, is the issue of what coordinates the
discoordination throughout the economy.
Schumpeter's (1911, 1939) technology-based business cycle model faces
the same difficulty. In the small menu
cost model, firms face nominal rigidities, and periodically overcome them,
seemingly at random. It may be that the
business cycles are in fact due to nominal rigidities, but do not occur more
frequently, because it calls for a fairly extraordinary confluence of random
events to ensure a sizable number of firms are simultaneously failing to adjust
prices, and perhaps this only happens randomly about once every ten years. Hülsmann (2001:36-39), in recognizing the
importance error clusters, criticizes Garrison's (2001) modeling of them. Hülsmann emphasizes that the boom, which
appears to be a period of growth and prosperity, is actually a period of
wasting scarce resources. People's
belief in the reality of their prosperity was as erroneous in 1999 as it was
1929.
In the New Keynesian view,
recessions are inevitable and occur at random. Sechrest (2001:73-75) argues that monetarism
provides a more plausible explanation of the timing of recessions than the
small menu cost theory, but it also fails to explain why it takes so long for
the economy to recover. In Austrian
business cycle theory it is clear that the interest rate coordinates the
economy's production structure, and credit expansion causes a general
overexpansion of production and economic activity. Recessions are not inevitable, but result
from poor monetary policy. Recessions
last six months to two years because that is how long it takes for
entrepreneurs to reallocate resources in a sustainable production structure, in
the absence of continued central bank intervention delaying or preventing
liquidation of capital misallocated during the wasteful expansion.
6. An Austrian Model
of Inertia in the Production Structure
An Austrian reinterpretation
of the Rotemberg (1987) model is developed below. Entrepreneurs seek to maximize the profit
function incorporating a heterogeneous-capital-using technology (Lachmann 1956),
which might be represented in Cobb-Douglas form[8] as
|
Yt |
= |
ALa |
n |
Kiβi. |
|
Ő |
||||
|
i = 1 |
Each entrepreneur seeks to
maximize the subjective profit function
|
pjt, |
= |
pjtYjt |
- |
n |
pjitkjit |
- |
n |
pjitljit
, |
|
ĺ |
ĺ |
|||||||
|
i,j = 1 |
i,j = 1 |
subject to the technology
selected by the entrepreneur and the expected vector of prices, potentially
revised even during the production process.
In each period t,
entrepreneurs purchase basic and intermediate inputs to transform into
lower-order intermediate inputs and final output in period t+1.
Rotemberg's
profit-differential function now takes on a new and broader
interpretation. Firm i should refrain from changing its
production plan as long as the difference in profits gained through changing
the plan is smaller than the adjustment cost a, analogous to, and including, the menu cost c,
D ≡ pi1 - pi0 < c < a.
Clearly this adjustment cost a, since it includes the menu cost c, must always be at least as great as c, and often will be much greater. Thus the Austrian interpretation of the small
menu cost model automatically imposes a higher threshold which must be exceeded
before entrepreneurs react, suggesting a less flexible, less adaptive economy,
an important advantage to the Austrian interpretation. The Js
drop out because each entrepreneur's profit function is unique and while there
might be a typical entrepreneur, there are no identical representative agents. The
production plan at any time t is predicated
on an information set[9] F, which incorporates the production plan itself. In a zero-adjustment-cost environment, it
would always be optimal and costless to adjust the production structure
whenever new information becomes available.
In the real world, however, entrepreneurs face information costs
whenever they confront, develop, evaluate, and respond to new information.
In addition, entrepreneurs
face the cost of discarding old installed physical capital, human capital, and
goods-in-process embodied in the old production structure, as well as
discarding outdated menus. Because the
production structure cannot be constantly readjusted without incurring
significant cost, once entrepreneurs have implemented a production plan, they
may resist revising it, and may even resist alertness to new information which
calls for revising a production plan once it has been implemented (Kirzner
1973:35, 64-68, 1992:26-28; Hannan and Freeman 1984). It seems to be in the nature of production
planning that entrepreneurs are always engaged in adjusting them and
reallocating resources, but adjustment costs and the desire to make use of
already-installed physical capital and already-produced goods-in-process,
ensure the production plan is never fully adjusted to the optimal,
zero-adjustment-cost production structure.
It is attractive to think of the
individual profit states and the difference in expected future profits which
can be realized by adjusting the production structure as being a function of
the generic information setF which includes the production technology relating
inputs to outputs in each stage of production, and input and output prices,
both present and those expected to prevail in the future. One essential component of the information
set is the current interest rate, and expected future interest rates. This will be a key element in coordinating
the behavior of disparate firms which are otherwise unlikely to act in concert.
In each decision period,
entrepreneurs assess whether to revise the production structure. To obtain Rotemberg's result, expand a
generalized expression for D aroundF0 = F*,
whereF0 represents the original information set which was the
basis for the prevailing production structure, andF* represents
a new information set implying a new and different zero-adjustment-cost
profit-maximizing production structure. The second-order Taylor series
expansion of D aroundF0 = F*
is given by
|
D(F0) |
@ |
D(F*) |
+ |
dD |
F0 = F* |
(F0 - F*) |
+ |
1 |
d2D |
F0 = F* |
(F0 - F*)2. |
|
dF0 |
2 |
d(F0)2 |
The first derivative of D with
respect toF0can be written as
|
dD |
= |
dpi1 |
- |
dpi0 |
|
dF0 |
dF0 |
dF0 |
or equivalently in terms of
partial derivatives as
|
dD |
= |
∂pi1 |
dFi |
+ |
∂pi1 |
- |
∂pi0 |
|
dF0 |
∂Fi |
dF0 |
∂F0 |
∂F0 |
in which it can be seen that
the first right-hand-side term is identically equal to zero. This is because under the general assumption
of expanding the Taylor series aroundF0 = F*,
the partial derivative of each firm's (or each entrepreneur's) information set Fi is identical to the original starting information set
F0 = F*,
thus the first derivative dFi/dF0, is identically equal to zero, essentially by assumption.
The analogous expression for
the second-order Taylor-series expansion, here for changes in the basic
information set, can now be expressed as
|
D |
@ |
q1/(1 - β) |
1 - (1 -
q)2 |
(F0 - F*)2. |
|
2(1 - q) |
F* |
This expression for the
minimum change in the production structure, or for production plan revision,
contains no first-order expressions in (F0 - F*), the information set revision.
It is observed that if D < a, then not changing production plans will be optimal
for all entrepreneurs, and since D is proportional to (F0 - F*)2, very low adjustment costs may still be compatible
with the condition D < a.
Since output price is one
component of the information setF, Rotemberg's original conclusion still holds.
Entrepreneurial hesitancy against instantaneous and error-free adjustment in
response to new information can prevent markets from clearing, and can result
in much larger swings in real output and employment.
Including economy-wide
interest rates in the information set F enables
Rotemberg's model to plausibly face an economy-wide shock, general
policy-induced credit expansion including a lowered real interest rate,
resulting in an economy-wide unsustainable expansion, and consequent
correction. Embodying past information
sets in a production structure characterized by inertia, an essential feature
contributed by Austrian business cycle theory, enables the Rotemberg model to plausibly
explain why recessions occur approximately once every ten years rather than
once every two weeks.
Comparing the two theories in
this way demonstrates the Austrian theory at least as good as small menu cost
theory, if not better, perhaps more importantly, that it is encompasses the New
Keynesian theory, and that it more plausibly explains why recessions occur when
they do. The biggest difference between
the two theories is that in the small menu cost model, recessions are inevitable
and occur at random. In the Austrian
model, recessions are avoidable and are caused by expansionary monetary or
fiscal policy.
7. Conclusion
Interest rates facilitate
intertemporal coordination of productive resources by clearing the loanable
funds market (Garrison 1986:440; 2001:39).
In this regard disequilibrium interest rates play the same role as
prices in signaling opportunities for entrepreneurial discovery (Kirzner
1984a:146; 1984b:160-161; 1997), and individual entrepreneurs respond by
maintaining the production structure, that is, they adjust it by reallocating
resources.
An Austrian critique and
interpretation of the New Keynesian small menu cost model of the business cycle
has been presented and discussed. The
Austrian generalization of the small menu cost model reveals that Austrian capital
theory's multispecific-capital-using economy reduces to a nominal rigidities
model when capital is removed. Austrian
business cycle theory is proposed as an encompassing model of the business
cycle, in which cycles arise due to resistances to instantaneous change, which
can arise from many sources. The
Austrian interpretation of the small menu cost model addresses several
problems, including how rigidities are coordinated across heterogeneous agents.
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