Monday, December 24, 2012

A Very Discount Christmas: Mises and Hayek are Dead part deaux

So what is wrong with the Austrian theory of the business cycle?

For one thing, the entire theory is predicated on the assumption that economic agents not only don't possess perfect information and foresight about the future, but cannot and do not react to events occuring around them in real time. To believe that real interest rates will be suppressed by inflation for a prolonged period of time comprising the "boom" you have to believe lenders don't notice rising prices around them and readjust nominal interest rates upward to keep the real rate constant.

For another, in the theory the mechanism by which the "boom" ends and the "bust" begins is a rise in real interest rates as they return to their equilibrium, making low-returning investment projects suddenly unprofitable on margin. This represents a misunderstanding of how finace works and what forms of liabilities are used to do what. Short-term debt like commercial paper is used to meet payroll and fund daily operations and basically allows for firms to consumption-smooth, because operating revenue flucuates more than operating costs. But no self-respecting firm would dream of building a factory or any large, long term project and financing it with short-term money. The market for long-term bonds exists to prevent exactly the thing Austrians say causes the business cycle.

Inflation drives nominal interest rates because bond markets
are forward looking;the monetary authority has
little to no ability to peg a real magnitude
A world that operated on the lines of the Austrian theory would be chaos. It is a great irony that the school of economic thought that claims to place the most faith in the market is predicated on the assumption that market paricipants are myopic to a fatal extent. A form of capitalism where lenders don't respond to expected inflation, firms make long-term investments with short-term variable rate debt, and the governmnet can fool everyone time and time again would be a hellish nightmare; indeed state-run communism would be preferable! Thankfully, its the not world we live in. Long-term bonds do exists, as does the Fisher effect. Lenders and businessmen are more savy and less easily outsmarted by government bureaucrats than Hayek of Mises gave them credit for.

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