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.

A Very Discount Christmas Special: Mises and Hayek are Dead

Austrian economics dominates online amateur economics blogging and commentary. Their views go largely unchallenged because most people who read their stuff agree with it or have better things to do than worry about it. Yes, I have nothing better to do on Christmas Eve than try to start a war with libertarians.

This is actually a rather charming picture and makes the
headline seem morbid and untactful.

The Austrian business cycle theory posits that the business cylce is caused by the monetary authority. So far, so good. As I understand it, the theory is based around the analysis of the so called "boom and bust cycle," with booms preceding and causing the inevitable bust. The monetary authority increases the money supply which in short-order causes an increase in prices (inflation) and a fall in real interest rates. These artificially low interest rates are below the equilibrium real interest rate that would prevail in an "unmanipulated" market, and remain so for an extended period. Firms borrow funds at these interest rates and use the loans to invest in capital projects, which because they are financed at low interest rates are low-quality projects. Later, at some unspecified point in time, real interest rates are revised upward to their equilibrium value and the investment projects, which were undertaken to the point where their rates of return equalled the previous, low, interest rate, are now unprofitable. A recession ensues as firms cancel their "malinvestments," banks write off bad loans made with the initial increased money stock, and workers and capital are reallocated away from investment, which was made excessive, and toward consumption or other sectors. 

To Review:

1. Money Supply Increases 2. Interest Rates Fall 3. Firms Borrow and Make "Malinvestments" 4. Rates Rise Again 4. Malinvestments are liquidated 5. A Reallocative Recession Ensues 6. Rinse Repeat

This all sounds reasonable enough; but as we'll see in part 2, there are fatal flaws that need to be addressed.

The Fed Takes Another Step in the Right Direction

How I love printing money.

But seriously, the Fed just announced a new set of actual RULES it intends to use as guidelines to set monetary policy for the next several years. Basically, its a committment to keep the Fed funds rate at zero and continue the $40 billion a month in asset purchases until unemployment falls below 6.5% or inflation rises above 2.5%. Its not targeting the TIPs spread, or NGDP, but its something- and a sign of good things to come. Check it.

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments."

From here: http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm

I've Performed and Invaluable Public Service

Behold, a time series illustrating one of the more elusive economic indicators, the real interest rate. The blue line is the real rate on corporate AAA bonds, the red on 10 year Treasuries. Useful stuff. FRED data transformations are the miracle of the age.