Why the Austrian business cycle theory needs an update

I have been thinking about this topic for a little while, even though it might be controversial in some circles. By providing me with a recent paper empirically testing the ABCT, Ben Southwood, from ASI, unconsciously forced my hand.

I really do believe that a lot more work must be done on the ABCT to convince the broader public of its validity. This does not necessarily mean proving it empirically, which is always going to be hard given the lack of appropriate disaggregated data and the difficulty of disentangling other variables.

However, what it does mean is that the theoretical foundations of the ABCT must be complemented. The ABCT is an old theory, originally devised by Mises a century ago and to which Hayek provided a major update around two decades later. The ABCT explains how an ‘unnatural’ expansion of credit (and hence the money supply) by the banking system brings about unsustainable distortions in the intertemporal structure of production by lowering the interest rate below its Wicksellian natural level. As a result, the theory is fully reliant on the mechanics of the banking sector.

The theory is fundamentally sound, but its current narrative describes what would happen in a relatively free market with a relatively free banking system. At the time of Mises and Hayek, the banking system indeed was subject to much lighter regulations than it is now and operated differently: banks’ primary credit channel was commercial loans to corporations. The Mises/Hayek narrative of the ABCT perfectly illustrates what happens to the economy in such circumstances. Following WW2, the channel changed: initiative to encourage home building and ownership resulted in banks’ lending approximately split between retail/mortgage lending and commercial lending. Over time, retail lending developed further to include an increasingly larger share of consumer and credit card loans.

Then came Basel. When Basel 1 banking regulations were passed in 1988, lending channels completely changed (see the chart below, which I have now used several times given its significance). Basel encouraged banks’ real estate lending activities and discouraged banks’ commercial lending ones. This has obvious impacts on the flow of loanable funds and on the interest rate charged to various types of customers.

US lending Basel

In the meantime, banking regulations have multiplied, affecting almost all sort of banking activities, sometimes fundamentally altering banks’ behaviour. Yet the ABCT narrative has roughly remained the same. Some economists, such as Garrison, have come up with extra details on the traditional ABCT story. Others, such as Horwitz, have mixed the ABCT with Yeager’s monetary disequilibrium theory (which is rejected by some other Austrian economists).

While those pieces of academic work, which make the ABCT a more comprehensive theory, are welcome, I argue here that this is not enough, and that, if the ABCT is to convince outside of Austrian circles, it also needs more practical, down to Earth-type descriptions. Indeed, what happens to the distortions in the structures of production when lending channels are influenced by regulations? This requires one to get their hands dirty in order to tweak the original narrative of the theory to apply it to temporary conditions. Yet this is necessary.

Take the paper mentioned at the beginning of this post. The authors find “little empirical support for the Austrian business cycle theory.” The paper is interesting but misguided and doesn’t disprove anything. Putting aside its other weaknesses (see a critique at the bottom of this post*), the paper observes changes in prices and industrial production following changes in the differential between the market rate of interest and their estimate of the natural rate. The authors find no statistically significant relationship.

Wait a minute. What did we just describe above? That lending channels had been altered by regulation and political incentives over the past decades. What data does the paper rely on? 1972 to 2011 aggregate data. As a result, the paper applies the wrong ABCT narrative to its dataset. Given that lending to corporations has been depressed since the introduction of Basel, it is evident that widening Wicksellian differentials won’t affect industrial structures of production that much. Since regulation favour a mortgage channel of credit and money creation, this is where they should have looked.

But if they did use the traditional ABCT narrative, it is because no real alternative was available. I have tried to introduce an RWA-based ABCT to account for the effects of regulatory capital regulation on the economy. My approach might be flawed or incomplete, but I think it goes in the right direction. Now that the ABCT benefits from a solid story in a mostly unhampered market, one of the current challenges for Austrian academics is to tweak it to account for temporary regulatory-incentivised banking behaviour, from capital and liquidity regulations to collateral rules. This is dirty work. But imperative.


Major update here: new research seems to confirm much of what I’ve been saying about RWAs and the changing nature of financial intermediation.


* I have already described above the issue with the traditional description of the ABCT in this paper, as well as the dataset used. But there are other mistakes (which also concern the paper they rely on, available here):

– It still uses aggregate prices and production data (albeit more granular): the ABCT talks about malinvestments, not necessarily of overinvestment. The (traditional) ABCT does not imply a general increase in demand across all sectors and products. Meaning some lines of production could see demand surge whereas other could see demand fall. Those movements can offset each other and are not necessarily reflected in the data used by this study.

– It seems to consider that aggregate price increases are a necessary feature of the ABCT. But inflation can be hidden. The ABCT relies on changes in relative prices. Moreover, as the structure of production becomes more productive, price per unit should fall, not increase.


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12 responses to “Why the Austrian business cycle theory needs an update”

  1. Nicolas Cachanosky says :

    Maybe not in the lines suggested by your post, but here are two papers that you might find interesting. The first one works in updating the ABCT from a gold standard assumption to a world of fiat currencies. The second one shows the financial foundations of ABCT.


    • Julien Noizet says :

      I always enjoy reading your research Nicolas. Very good stuff.

      But I’d say that you’re not focusing on the ‘dirty’ work (though the fiat currency paper could classify to an extent), but on the noble one!
      (Which is also good indeed, following guys like Garrison)

  2. Simon says :

    I’m not sure I follow why the theory needs updating just because it is “old”. If it is logically sound, it’s age shouldn’t matter (we’re not updating the law of gravity because airplanes can fly). The theory is based on what happens when an artificially low interest rate is set by an authority which can artificially inflate the money supply: this sends confusing signals to entrepreneurs and stimulates investment projects (a) that are only profitable while the low interest rate is maintained and (b) without providing any additional real resources to allow those projects to be completed profitably (compared with a “natural” interest rate being set when savers defer more consumption and thus both drive down the interest rate and free up resources for the investment projects). If there are more regulations now, or different channels of lending, why does that impact a theory that is based on an artificial setting of interest rates? When interest rates decline, either savers really are deferring more consumption, or they are not.

    • Julien Noizet says :

      Simon, I agree.
      But it’s the details that matter here.

      People currently misjudge the theory because they look at the wrong assumptions. Money supply growth mainly occured through corporate lending a century ago.
      Nowadays, it is mainly mortgage lending that channel this growth.
      This has consequences for the distorted structure of production narrative. This is also why we’ve mostly had recurrent real estate bubbles over the past few decades.

      The result is the same: a crisis. But the result isn’t enough to convince many non-Austrians.

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