Bryan Caplan and Tyler Cowen are questioning the validity of the Austrian Business Cycle Theory. Given that my macroeconomic perspective is somewhere between monetarism and the Austrian perspective, I thought that I would offer my thoughts.
Tyler Cowen challenges the notion that money enters the economy through the credit markets:
Consider an expansionary open market operation. Banks now hold fewer T-Bills and more cash. Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too), so the banks will do something liquidity-like with it. That could mean making a loan, but it also could mean spending the money to refit the ATM machines, or for that matter increasing dividends to bank shareholders.
I find Cowen’s discussion a bit lacking. If we assume that banks are profit-maximizers, then it is safe to assume that the securities on the bank’s balance sheet are deemed optimal by the bank. Thus when the Fed injects money through open market operations, the bank now has more cash on their balance sheet than is optimal. Sure, they could spend this money to refit ATM machines, but it would make more sense to earn a return on this cash and therefore make it available for a loan. This idea is not unique to the ABCT. In fact, Bernanke and Gertler (1995) argue that during a change in monetary policy, the effects on firms’ balance sheets plays an important role in their subsequent behavior. For example, during a monetary expansion the external finance premium (the gap between the cost of external funds and the opportunity cost of internal funds) narrows creating an incentive for firms to borrow. Therefore it is in the best interest of banks to loan their excess reserves.
While it is certainly true that it is possible for money to enter the economy without going through the credit market, this is only likely to occur if the marginal productivity of capital is substantially low (however, this is likely to lead to further reductions in the Fed funds rate). Thus, it is possible that the new money enters through other markets, but the overwhelming majority of the new money will enter through the loanable funds market.
Bryan Caplan’s perspective is a bit different. He believes that Austrians underestimate expectations:
What I deny is that the artificially stimulated investments have any tendency to become malinvestments. Supposedly, since the central bank’s inflation cannot continue indefinitely, it is eventually necessary to let interest rates rise back to the natural rate, which then reveals the underlying unprofitability of the artificially stimulated investments. The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account.
Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation… Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot.
I would point out that there is a significant difference between macroeconomic expectations and individual expectations. While it is true that most businessmen would have the foresight to expect artificially low interest rates to increase in the future, they may still use the opportunity created by said interest rates to make investment decisions. Similarly, it may clearly be easy to predict that rates will again rise to their natural rate (or even higher), but it is not as easy to make predictions about the timeframe in which this will happen. As Milton Friedman once pointed out:
It may be, for example, that monetary expansion induces someone within two or three months to contemplate building a factory; within four or five, to draw up plans; within six or seven, to get construction started. The actual construction may take another six months…
The primary point is that while investment decisions may take place at a particular place and time, the actual investment occurs over a longer period of time. Therefore it is not the expectation of the interest rate that is important, it is the expectation of when the interest rate will return to its natural rate (or above) that is important. This is substantially harder to predict.
Similarly, in order to understand the ABCT, one must also understand the role of expectations as seen through the eyes of Hayek (see, for example, Butos and Koppl). The only relevant expectations are those of individuals and are therefore fallible. Caplan is correct to point out that businessmen with a blind spot will be weeded out through natural selection, but fails to realize that this is in line with Hayek’s belief. As Butos and Koppl point out:
In arguing that competition breeds rationality, Hayek is claiming that the filter of profit and loss weeds out those whose habits tend to generate inappropriate responses to market signals, that is, those with inappropriate propensities to act. Losses tend to filter out inferior expectations.
Nevertheless the process of weeding out those who make mistakes is a continuous process. The individual decision-makers in the market at a given point in time are not the same as in previous times and their beliefs are a function of their knowledge and experience.
Ultimately, the length of time between monetary expansion and contraction is variable and therefore creates the opportunities for mistakes to be made by businessmen that is consistent with the heterogeneity of the expectations and knowledge of unique individuals.