Tag Archives: Austrian Business Cycle Theory

Empirical Support for the ABCT?

Vasso P. Ioannidou, Steven Ongena, Jose Luis Peydro write:

An excellent setting to econometrically identify the impact of short-term interest rates on bank risk-taking is Bolivia. In recent years, the boliviano was pegged to the US dollar and the financial system was highly dollarised. During this period, the proper measure of short-term interest rates in Bolivia was the US federal funds rate, which is exogenous to Bolivian economic conditions. Hence, using the Bolivian credit registry, we analyse on a loan-by-loan basis the impact of the US federal funds on risk-taking and credit risk. The registry contains detailed contract information on all loans issued by any bank operating in the country as well as several measures of bank risk-taking such as ex-post loan performance, internal credit ratings, loan rates, and borrower credit history. The analysis draws from the 1999-2003 period, when the funds rate varied between 0.98% and 6.5%, and the boliviano was pegged to the US dollar.

We find that short-term interest rates affect risk-taking and credit risk. In particular, low interest rates encourage ex-ante risk-taking. Prior to loan origination, low interest rates imply that banks soften their lending standards for new loans – banks give more loans to borrowers with lower credit score and/or with bad credit history. Not only do banks take loans with higher ex-ante risk but also grant new loans that have higher ex-post credit risk, which we measure using a loan’s hazard rate, i.e. the default rate per unit of time. In addition, banks do not seem to price these extra risks they take. This finding suggest that our results are not driven by a higher demand for loans from risky firms (vis-à-vis less risky firms) when interest rates are low. All in all, low short-term interest rates seem to increase the banks’ appetite for risk.

A couple of observations:

  • This seems to confirm one of the main assertions of the Austrian business cycle theory in that banks increase their risk taking in response to lower interest rates. The authors note (p. 20):

    “Firm fixed effects control for firm specific risk that is constant over the sample period. Consequently, when the federal funds rate is low, banks not just simply start financing risky firms that were excluded otherwise, but also engage in funding riskier projects (i.e., firms that would only have obtained loans for their safer projects when rates were high, are able to obtain financing for their riskier projects when rates are low).”

  • The previous point seems to provide weak evidence against recent claims by Evans and Baxendale (which were first advanced by Block and Barnett) that the lower interest rates attract adverse selection. Rather, it seems that the effects are supply-driven.
  • This paper also serves to answer some of the criticism leveled by recent critics of the ABCT (namely, Tyler Cowen and Bryan Caplan) who question why individuals make systematic errors in response to falling interest rates. This paper suggests that falling interest rates lead to increased access to credit for riskier firms and riskier projects.
  • Despite presenting some evidence in support of the ABCT, however, it fails to explain two things*: (1) why banks increase their risk-taking, and (2) why the duration (or time structure) of production increases. (I currently have a paper under review that, in my opinion, provides an explanation for these two points and which might be of interest.)

For those interested, here is a non-gated link to the paper.

*It should be of note that the authors are not conducting an analysis of the Austrian theory and therefore have no reason to care about these issues.

Cowen, Krugman, and the Austrian Business Cycle

Tyler Cowen highlights (and joins in on) Paul Krugman’s criticism of the Austrian business cycle theory. You can find my thoughts in the comments over at The Austrian Economists blog.

In the Mail

Prices and Production and Other Works by F.A. Hayek

For years, Monetary Theory and the Trade Cycle and Prices and Production have been scarcely available and consequently at a steep cost. However, the Mises Institute has released a hardback volume that includes both texts as well as several essays by Hayek at a very reasonable price.

Defending the ABCT

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.