Cachanosky, Salter - 2017 - The View From Vienna An Analysis of The Renewed Interest in The Mises-Hayek Theory of The Business Cycle

Rev Austrian Econ (2017) 30:169–192
DOI 10.1007/s11138-016-0340-5
The view from Vienna: An analysis of the renewed

interest in the Mises-Hayek theory of the business cycle
Nicolás Cachanosky 1 & Alexander W. Salter 2
Published online: 22 February 2016

# Springer Science+Business Media New York 2016
Abstract We review the post-crisis literature that engages Austrian business cycle
theory and we discuss what is being said that is correct, what is being said that is
incorrect, and what is not being said that ought to be said. This last category is
important due to the fact that the post-crisis literature engaging Austrian business cycle
theory has not addressed advances in the theory made since the days of Mises and
Hayek. We also highlight three key areas of contemporary economics where Austrian
business cycle theory has the potential to do significant work.
Keywords 2008 crisis . Subprime crisis . Austrian business cycle theory
Jel Codes . B53 . E32 . E52
1 Introduction
The 2008 financial crisis, largely unanticipated by the economics profession, has
resulted in a serious re-examination of business cycle theories in an attempt to discover
what went wrong. One aspect of this re-examination is renewed scholarly interest in the
Mises-Hayek, or BAustrian,^ theory of the business cycle (ABCT). Several studies
have located in Mises’s and Hayek’s writings on monetary theory and business cycles a
potentially useful framework for understanding the financial crisis (Borio and Disyatat
* Nicolás Cachanosky
ncachano@msudenver.edu
Alexander W. Salter
alexander.w.salter@ttu.edu
1
Department of Economics, Metropolitan State University of Denver, Campus Box 77, P.O. Box
173362, Denver, CO 80217, USA
2
Free Market Institute, Texas Tech University, 308 Texas Tech Plaza, Box 45059, Lubbock,
TX 79409, USA
170 N. Cachanosky, A.W. Salter
2011; Caballero 2010; Calvo 2013; Diamond and Rajan 2009a; Hume and Sentance
2009; Leijonhufvud 2009) 1 Other studies, frequently not citing Mises nor Hayek,
nonetheless contain themes that are easily reconcilable with those in ABCT narratives
(Diamond and Rajan 2009b; McKinnon 2010; Meltzer 2009; Schwartz 2009; Taylor
2009).
In this paper we analyze the discussion of the Mises-Hayek business cycle and its
constituent parts. While other works have explored specific links between Austrian
theory or theorists and mainstream work (e.g., L. H. White forthcoming explores
Hayek’s influence on contemporary economics), we consider a number of broader
points. What themes and mechanisms are being discussed? What themes and mecha-
nisms are not being discussed? How do these studies deal with updates to the theory
that has occurred since the 1930’s? And given the renewed interest in ABCT, how can
that theory be put to work in answering pressing economic questions going forward? It
is sometimes argued, informally, that whatever the Austrian literature has to contribute
to the economics profession has already been incorporated into modern economics.
However, if this is the case, why do prominent scholars turn to the old Mises-Hayek
theory in search of answers where modern macroeconomic falls short? We think there
are compelling reasons to review the recent references to ABCT and to point out some
examples where gains from trade can be reaped between BAustrians^ and Bnon-
Austrians.^
The next section of this paper contains a review of how current economic re-
searchers are engaging Austrian business cycle theory. Section 3 is an assessment of
this literature, in terms of what themes originally discussed by Mises and Hayek have
been captured accurately, what has been captured inaccurately, and what has been
overlooked. Section 4 discusses why the ABCT should be considered as theory with
explanatory power. Section 5 summarizes the current literature on ABCT and the
potential for ABCT as a progressive research project going forward and how it can
contribute to the mainstream literature. Section 6 concludes.
2 Literature review
The literature re-examining ABCT can be separated into two general categories: those
that tell an ABCT-type story and acknowledge the reference, and those that tell an
ABCT-type story but do not acknowledge the reference. To be clear, we are not
evaluating how much each author is actually influenced by the ABCT, but whether or
not they recognize the mechanisms within this theory in their research. An in-between
case is Caballero’s (2010, p. 85) drawing of attention to macroeconomics having
Bbecome so mesmerized with its own internal logic that it has begun to confuse the
precision it has achieved about its own world with the precision it has about the real
one.^ Caballero identifies this misplaced faith in the Bcore^ of macroeconomics,
namely the dynamic stochastic general equilibrium (DSGE) framework, with the
Bpretense of knowledge^ problem identified by F.A. Hayek in works throughout his
scholarly career and Nobel acceptance speech.2 After citing Hayek and building off
1
Other papers that refer to the ABCT are Lal (2010); Oppers (2002) and W. R. White (2009).
2
For a closer evaluation of DSGE and Hayek’s theories, see L. H. White (forthcoming).
The view from Vienna 171
Hayekian themes, Caballero (2010, p. 87) argues B[t]he idea is to place at the center of
the analysis the fact that the complexity of macroeconomic interactions limits the
knowledge we can ever attain. In thinking about analytical tools and macroeconomic
policies, we should seek those that are robust to the enormous uncertainty to which we
are confined, and we should consider what this complexity does to the actions and
reactions of the economic agents whose behavior we are supposed to be capturing.^
Although Caballero never discusses ABCT in his survey of business cycle theory in the
context of the financial crisis, he is working within a Hayekian framework and
engaging ideas of robustness and uncertainty. His call for further exploration in the
Bperiphery^ of macroeconomics shows that some of the answers for which scholars are
looking since the crisis can be found in the Austrian literature.
2.1 ABCT-type explanations with reference to the ABCT
The papers that explicitly tell an ABCT-type story focus on the interplay between
capital flows, credit, and interest rates in the context of the crisis. For example, Borio
and Disyatat (2011) explore the hypothesis that the financial crisis was proximately
caused by the flow of capital from many developing nations’ current account surpluses,
the so-called Bsavings glut^ hypothesis. Borio and Disyatat (2011, p. 13) find that
Bcurrent accounts and the corresponding net capital flows say very little about financing
activity and intermediation patterns^ and, as such, cannot be the major mechanism at
work. Instead Borio and Disyatat (2011, p. 20) point to divergences between the market
and the natural (i.e. Wicksellian) rates of interest, a mechanism that shoulders the major
part of the explanation in ABCT: BWe argue that the saving-investment framework is
best regarded as explaining developments in the natural, rather than in the market,
interest rate, which is primarily determined by monetary and financial factors. Here
again, the distinction between saving and financing is critical. Deviations between the
two can persist for long periods, need not show up in rising inflation and may in fact be
one reason behind the financial crisis.^ The authors argue this divergence is a charac-
teristic of a monetary economy, in which credit creation drives a significant part of the
dynamics. Borio and Disyatat (2011, pp. 27–28) conclude, BThe financial system can
endogenously generate financing means, regardless of the underlying real resources
backing them. In other words, the system is highly elastic. And this elasticity can also
result in the volume of financing expanding in ways that are disconnected from the
underlying productive capacity of the economy. In macroeconomic models, the role of
money and credit should be essential, not ancillary. This calls for a revival of an old and
highly respected tradition in macroeconomics – one which, sadly, has been largely
neglected in the current prevailing paradigm.^ In making their argument, the authors
cite both Mises’s (1912) Theory of Money and Credit and Hayek’s (1933) Monetary
Theory and the Trade Cycle, showing their arguments are not merely coincidentally
couched in ABCT-type terms and mechanisms.3
Hume and Sentance (2009) also do not find much explanatory power in the global
savings glut hypothesis. They analyze the credit boom preceding the crisis and in doing
so critically engage ABCT, arguably more so than the other studies in this section.
3
It is probably no accident that Borio and Disyatat use the word Bparadigm^ to refer to BAustrian^ and Bnon-
Austrian^ economics. On this topic see Caldwell (2013); Kohn (2004) and Zanotti and Cachanosky (2015).
Hume and Sentance (2009, p. 1438) find that, Bsomewhat paradoxically, it appears
output and inflation were generally stable in the advanced economies where the credit
expansion was concentrated but increased in the emerging economies where it was
not.^ The authors go on to assert that the Borthodox model,^ i.e. DSGE, cannot provide
a mechanism for credit being the driver of business cycle fluctuations (Hume and
Sentance 2009, p. 1439). In considering alternative approaches, the authors turn to
the Austrian School, which was among the first to put credit at the heart of a
business cycle theory. The capital theory originated by Menger (1871) and the
theory of money and credit developed by Mises (1912) were the micro-
foundations upon which Hayek’s (1929) BAustrian^ business cycle model was
built. It is the injection of credit by the central bank, resulting in the market rate of
interest falling beneath that of the natural rate of interest, which initiates the
boom. Desired investment rises and desired saving falls with the difference
between the two being met by the increase in credit. This puts in motion an
inter-temporally unstable process because the investment is not being financed by
genuine savings reflecting a willingness to postpone consumption (2009: 1443).
The citations here are to Menger’s (1871) Principles of Economics, Mises’s (1912)
Theory of Money and Credit, and Hayek’s (1933) Monetary Theory and the Trade
Cycle. The authors also note that ABCT has the attractive feature of being able to
explain why the boom was not accompanied by increased inflation: The forces of
increased demand may be offset by the forces of increased supply due to higher levels
of investment. The authors even mention (but do not cite) Garrison’s (2001) arguments
that credit booms during the 1990’s would ultimately be unsustainable. However, the
authors assert ABCT cannot explain the Bunusual length^ of the recent boom, nor Bthe
absence of stronger output growth.^ As such, Hume and Sentance (2009, p. 1443)
conclude ABCT is Bright for largely the wrong reasons.^ 4 Nonetheless, Hume and
Sentance (2009, p. 1453) credit ABCT with being Bremarkably prescient^ and even
suggest its failure to become incorporated into economic orthodoxy Bbecause its policy
recommendation of letting the cycle run its course was unacceptable,^ rather than any
major theoretical deficiencies.
A recent working paper by Calvo (2013) stresses similar themes. Calvo (2013,
pp. 1–3) is unsatisfied with the tertiary role played by money in most general
equilibrium models and argues that issues of liquidity and credit crunches are
better understood with a more integrated monetary theory. Media of exchange and
inside money are the foundations of liquidity, defined as saleable assets, which
facilitates credit flows to their highest-valued uses. However, this also entails the
possibility of a BSudden Stop,^ i.e. a drying up of liquidity and a credit crunch
(Calvo 2013, pp. 5–6). Unfortunately in Calvo’s view, mainstream macro largely
ignored developments in financial markets as a matter of theory, since the
Hicksian IS-LM synthesis and subsequent developments in Bsaltwater^
4
Other Austrian-friendly themes stressed by the authors include the dangers associated with attempts to stem
off the inevitable bust-recalculation period by further easing money creation (Hume and Sentance 2009, p.
1449) and the importance of institutions in defining incentives that shape agent behavior, and hence
macroeconomic outcomes (p. 1452).
macroeconomics placed the interesting dynamics elsewhere (Calvo 2013, pp. 10–
13). Insisting that financial markets matter and cannot safely be ignored, Calvo
turns to exploring why a growing empirical literature suggests financial crises are
preceded by credit booms. At this point Calvo turns to Mises’s and Hayek’s
theories. It is worth quoting Calvo (2013, pp. 54–55) at length:
[…] the Austrian School offered valuable insights – disregarded by mainstream

macro theory – that help to rationalize […] [the observation that credit booms
precede financial crises] […] without resorting to irrationality. Over-extension of
credit was at center stage of the Austrian School theory of the trade (or business)
cycle, but authors differed as to the factors responsible for excessive credit
expansion. Mises (1952), for instance, attributed excessive expansion to central
banks’ propensity to keeping interest rates low in order to ensure full employment
at all times. As inflation flared up, interest rates were raised, causing recession.
Thus, in his view the cycle is triggered by procyclical monetary policy with a full-
employment bias which was not consistent with inflation stability. Hayek (2008),
on the other hand, dismissed the explanation of Mises, not because it was not a
good depiction of historical events, but because he thought that instability was
something inherent to the capital market and, in particular, it is related to what
might be called the banking money multiplier mirage. His discussion conjures up
contemporary issues, such as securitized banking, for example. At the risk of
oversimplifying Hayek’s views, a phenomenon that seems central to his trade
cycle theory is that credit expansion by bank A induces deposit expansion in bank
B who, in turn, has incentives to further expand credit flows, and so on. If bank A
makes a mistake, the money-multiplier mechanism amplifies it. This is reminis-
cent of the misperception phenomena stressed in Lucas (1972). Hayek’s discus-
sion does not exhibit the same degree of mathematical sophistication but focuses
on a richer set of highly relevant issues. For example, credit expansion is not
likely to be evenly spread across the economy, partly because of imperfect
information or principal-agent problems. This implies that credit expansion is
likely to have effects on relative prices which are not justified by fundamentals.
Here Calvo cites later editions of Mises’s (1912) Theory of Money and Credit
and Hayek’s (1931) Prices and Production. Calvo goes on to assert that a mix of
Mises’s and Hayek’s stories are needed to explain the financial crisis, but Calvo
(2013, p. 16) leans towards Mises in this particular context. Calvo’s narrative
continues to assert that financial markets matter, that liquidity matters for financial
markets, and that Mises and Hayek are important theorists to engage when
discussing issues of liquidity, especially in the context of unsustainable credit
expansions.
Diamond and Rajan (2009a) examine a similar problem, more focused on the
microeconomic relationship between household lending to banks and banks’
financing long-term asset portfolios. These long-term assets are typically not very
liquid, so if households become subject to negative current-period wealth shocks
that incentivize them to withdraw their holdings to bolster current consumption,
banks can quickly run into liquidity shortages. Diamond and Rajan (2009a, p. 2)
immediately link this story to the Mises-Hayek theory of the business cycle, which
they discuss more in-depth later in the paper.5 Diamond and Rajan discuss policy
implications from intervening in credit markets to affect interest rates, even
pointing to such intervention as a possibly destabilizing force if lenders are
sufficiently forward-looking. The main substance of this paper is a model showing
that a central bank that cuts interest rates during times of financial stress, or favors
low rates in a general pro-capitalist policy, incentivizes higher-return but less-
liquid bank investments. This in turn can precipitate a liquidity crisis. In a passage
with Austrian flavor, they assert (p. 5):
Indeed, the current financial turmoil in the United States could be thought of as
being partially caused by lenders, anticipating a continued environment of low
interest rates following the implosion of the Btech bubble^ in early 2000 and the
subsequent collapse of corporate investment, choosing to take on more illiquid
financial assets financed with short term debt. Anticipation of low interest rates
may have been strengthened by the so-called Greenspan Put, whereby the
financial sector believed that if it ever came under strain because of excessive
expansion, the Federal Reserve would cut interest rates. Put differently, if policy
drives short-term interest rates to a low level, and solvency and financial stability
constraints on future policy rule out future high short-term rates, then financing
illiquid assets with short-term debt will be profitable and safe, at least for a while.6
In a more explicit mention to Mises, Diamond and Rajan admit (pp. 16–17) they
are certainly not the first to place the emphasis for contraction and crises on the
mismatch between the long duration before investment produces consumption
goods, and the temporal pattern of consumption in an expansion. This dates back
at least to Von Mises (1949) and the Austrian School. Von Mises placed the
emphasis, though, on an artificially low initial rate of interest, induced by bank
credit expansion, which makes the process of creating new goods excessively
long compared with the tolerance of consumers to postpone consumption. While
it is difficult to map his theory precisely to a rational expectations general
equilibrium model, it would appear that Von Mises (1949) places the blame for
crises squarely on the heads of overly optimistic, excessively aggressive, bankers
(and on central bankers who encourage aggressive credit expansion).
The work cited by the authors is Mises’s (1949) Human Action, and in their
conclusion, the authors also cite Rothbard’s (1963) America’s Great Depression.
Ultimately Diamond and Rajan (2009a, p. 33) see themselves as providing an expla-
nation of crises featuring Brational optimizing banks,^ since in their view the Austrian
explanation Bseems to rely on banks that are excessively optimistic.^
5
Interestingly, Diamond and Rajan (2009a, pp. 1–2) also discuss the possibility of a positive shock to future
wealth, which also incentives additional current consumption due to the equation of marginal utility from
consumption across the life cycle. This bears some resemblance to modifications made to ABCT by Garrison
(2001), but Diamond and Rajan do not discuss this particular link.
6
Callahan and Garrison (2003) ask if the ABCT can contribute to explain the dot-com bubble. These
references goes unmentioned in Diamond and Rajan’s paper.
Leijonhufvud’s (2009) critique of pre-crisis macroeconomic theory seems a strange

piece to find engagement with the ideas of Mises or Hayek, given that the title suggests
the importance of Keynes. But the author is clear that his allusion to Keynes is in the
spirit of focusing on the nature of the problem to be solved, more than the particular
method or theory used to solve it. Excoriating orthodox and New Keynesianian,
monetary theory along with the general equilibrium framework, Leijonhufvud insists
the way forward will be in a dynamic conception of monetary theory, one that focuses
on issues of process and systemic stability. Leijonhufvud (2009, p. 742) provides the
following tie-in to ABCT: BOperating an interest targeting regime keying on the
consumer price index (CPI), the Fed was lured into keeping interest rates far too low
for far too long. The result was inflation of asset prices combined with a general
deterioration of credit quality (Leijonhufvud 2009). This, of course, does not make a
Keynesian story. Rather, it is a variation on the Austrian overinvestment (or
malinvestment) theme.^ To be fair, immediately following this Leijonhufvud claims
ABCT will not be of much help in analyzing the finance industry-specifics of a
malinvestment boom, instead favoring the theories of Hyman Minsky. But the narrative
of unsustainable investments precipitated by artificially low interest rates, itself being
the avenue by which financial sector problems are introduced, is a thoroughly Austrian
story, and Leijonhufvud recognizes it as such.
Lastly, we consider the work of W. R. White (2012), who explores the unintended
consequences of ultra-easy monetary policy following the crisis. The head quotes W.
White chooses to motivate his paper are illustrative: one is from John Maynard
Keynes—the familiar Bin the long run we are all dead^ quip—and the other from
Mises, on the importance of appreciating the long-term and less obvious consequences
of economic policy. W. R. White (2012, p. 3) is obviously sympathetic to Austrian
ideas in this context, and while he never cites Mises nor Hayek, he does mention them
by name, discussing their worry that credit expansions will result in malinvestments
that eventually must be liquidated.
W. R. White’s work is an extensive summary and integration of various literatures
that shed light on possible deleterious consequences of excessively easy money that
may not be currently appreciated by policymakers. He explicitly discusses the rele-
vance of Wicksell’s natural rate theory (p. 15) to ABCT, refers to empirical work that,
in his view, shows Austrian concerns over malinvestment due to credit expansion to be
Bessentially correct,^ and spends some time describing the malinvestments that pre-
ceded the recent crisis. To be clear, W. White does not wholeheartedly endorse ABCT
and its underlying framework to the exclusion of other theories; he clearly has concerns
over the demand-side of the economy which are more nearly Keynesian.7 But just as
clearly, he does believe ultra-easy monetary policy can have negative unintended
consequences. Such policies Bcreate malinvestments in the real economy, threaten the
health of financial institutions and the functioning of financial markets, constrain the
‘independent’ pursuit of price stability by central banks, encourage governments to
refrain from confronting sovereign debt problems in a timely way, and redistribute
income and wealth in a highly regressive fashion^ (p. 38). For the purposes of our
argument, the first of these is most relevant, and it is obvious that W. White believes
this consequence is best understood with reference to ABCT.
7
See also W. R. White (2013).
2.2 ABCT-type explanations without reference
The papers in this sub-section use an ABCT-type narrative when discussing the crisis,
but do not provide textual citations to Mises, Hayek, or latter-day contributors to the
ABCT literature. This literature can be a sample of the fact that ABCT insights are
more common than usually acknowledged. For example, Diamond and Rajan (2009b),
unlike in their other study cited above, tell a more conventional story with the global
savings glut, Boriginate-to-securitize^ strategies by banks, and excessively illiquid
portfolio construction by investment houses doing a larger share of the work than
previously. However, even here Diamond and Rajan (2009b, p. 608) discuss the natural
rate—market rate wedge in a way that is compatible with the ABCT narrative: B…with
the Federal Reserve emphasizing its willingness to pump in liquidity and cut interest
rates dramatically in case of a sharp downturn (the so-called BGreenspan Put^), it is not
surprising that banks were willing to take illiquidity risk.^ The discussion of investment
misallocation and poorly-adapted capital structure in prominent financial houses also
echoes Austrian themes (Diamond and Rajan 2009b, pp. 606–608).
McKinnon (2010) is more explicit in emphasizing the natural rate—market rate
wedge in his discussion of the international dollar standard. Discussing the run-up to
the crisis, McKinnon (2010, p. 11) writes, B[f]earing deflation after the collapse of the
high-tech bubble in 2001–02, the US Federal Reserve Bank lowered the Fed funds
interest rate to just one per cent in 2003–04. At the time, this interest rate was far too
low for balancing actual inflation in the ‘headline’ CPI with the economy’s excess
capacity. The well-known Taylor Rule suggested that the Fed funds rate should have
been closer to 4 % in 2003–04.^ McKinnon goes on to suggest this excessively easy
monetary policy fueled a global carry trade that helped contributed to the Binternational
bubble economy.^ It did so by signaling to foreign exchange dealers that further dollar
depreciations would be forthcoming, incentivizing them to engage in Bshort-term
borrowing in New York at low interest rates to buy appreciating foreign-currency
assets and primary commodities […] Thus did carry traders collectively accentuate
the price movements from which individual traders hoped to profit^ (McKinnon 2010,
p. 12).
Meltzer’s (2009) reflections on the financial crisis exhibit a similar theme. While
chiding the moral hazard created by Fannie Mae and Freddie Mac and rebuking both
politicians and members of the press for their lack of economic sophistication, Meltzer
(2009, p. 28) also indicts the Fed: B[W]e must note the role of the Federal Reserve in
the financial crisis. Alan Greenspan did make a mistake. He kept interest rates too low,
too long. He was afraid of deflation. That was a mistake.^ Schwartz (2009, pp. 19–20)
writing in the same issue as Meltzer, also supports the Btoo low for too long^ thesis:
The basic groundwork to the disruption of credit flows can be traced to the asset
price bubble of the housing price boom. It has become a cliché to refer to an asset
boom as a mania. The cliché, however, obscures why ordinary folk become avid
buyers of whatever object has become the target of desire. An asset boom is
propagated by an expansive monetary policy that lowers interest rates and
induces borrowing beyond prudent bounds to acquire the asset…The Fed was
accommodative too long from 2001 on and was slow to tighten monetary policy,
delaying tightening until June 2004 and then ending the monthly 25 basis point
increase in August 2006. The rate cuts that began on August 10, 2007, and
escalated in an unprecedented 75 basis point reduction on January 22, 2008, was
announced at an unscheduled video conference meeting a week before a sched-
uled FOMC meeting. The rate increases in 2007 were too little and ended too
soon. This was the monetary policy setting for the housing price boom.
Thus Schwartz goes into more detail than Meltzer, alluding to artificially-low
interest rates resulting in resource misallocations in her Bbeyond prudent bounds^
comment.
Finally, John Taylor’s explanation of what caused the financial crisis also rests
on the Btoo low for too long^ thesis. Taylor (2009, p. 1) wastes no time in
indicting loose money for setting the stage for the housing boom and subsequent
bust-crisis-recession: BThe classic explanation of financial crises, going back
hundreds of years, is that they are caused by excesses—frequently monetary
excesses—that lead to a boom and inevitable bust…monetary excesses were the
main cause of that boom [the housing market boom] and the resulting bust.^ 8
Taylor shows the divergence between the actual federal funds rate and the
prescribed the Taylor rule (Taylor 2009, p. 3). Taylor makes it clear that other
developments in financial markets, such as excessive risk-taking by financial
institutions due to moral hazard, also are needed to explain the crisis, but he
makes sure to link these behaviors to the presence of easy money (Taylor 2009,
pp. 13–14).
The last paper that tells an implicit ABCT story is Gjerstad and Smith (2009;
see also 2014, which extends the analysis to other post-WWII cycles). Smith, the
co-recipient of the 2002 Nobel Prize in economics, is deeply influenced by the
ideas of Hayek, as can be seen in Smith’s work on ‘ecological rationality’ (e.g.,
Smith 2009). Thus, while Gjerstad and Smith do not cite Mises, and cite Hayek
only in the context of his work on the coordinating aspects of the price system
(2014, p. 30), and social rules more generally (2009, p. 295), the Austrian
influence can be legitimately ‘read between the lines,’ especially when they
discuss mechanisms underlying financial crises.
Gjerstad and Smith’s narrative of the housing crisis begins in the late ‘90’s,
when rising income and public policy, specifically the elimination of up to half a
million dollars of capital gains taxes on residences, made housing much more
attractive. Immediately after this background fact, Gjerstad and Smith (2009, p.
279) indict the Federal Reserve, in a very ABCT-sounding manner:
The recession in 2001 might have brought the housing bubble to an early end, but
the Federal Reserve—with its eye focused not on any one sector, but on the
overall economy—decided to pursue an exceptionally expansionary monetary
policy in order to counteract the recession…Naturally, when the Fed opened its
liquidity valve, the money flowed to the fastest expanding sector of the economy.
8
Taylor’s implicit endorsement of artificially-low interest rates as contributing to unsustainable investment
cycles as Bclassic^ seems to be an overstatement. This seems to imply that such an explanation is, if not
accepted orthodoxy, a part of the mainstream economic narrative. However, the influence in Friedman (1964,
1993) in dismissing the artificial boom-inevitable bust story might be too strong to refer as Bclassic^ the excess
of credit explanation. If this were a Bclassic^ explanation, why the sudden renewed interest in the ABCT?
Gjerstad and Smith combine this with a recognition that public policy, under
the Clinton and Bush administrations, channeled this excess liquidity into housing
markets. This fits with a crucial, but often overlooked, aspect of ABCT. ABCT is
a theory of the unsustainable boom, but in order to ascertain where malinvestment
will occur, we need additional empirical detail, such as how public policy affects
incentives to direct easy credit into particular lines of production. Gjerstad and
Smith deepen the analysis by—unsurprisingly, given the authors’ research inter-
ests, and in particular the work for which Smith was awarded the Nobel Prize—
reviewing the experimental literature on asset bubbles, which relies on a differen-
tiation between consumption markets and asset markets. They combine this with
historical data on housing bubbles in the post-WWII era, with special emphasis on
the recent crisis. While their explanation relies on a distinction between traders
who make exchanges based on underlying value (fundamental value), vs. traders
who make exchanges based on expected future prices (momentum traders), it is
clear what drives this result is not a conception of ‘individual irrationality,’ but a
rationality that is conditioned by the institutional environment in which asset
trades take place. Thus, we are justified in reading the following (2009, p. 278)
in a Hayekian light:
With nominal interest rates around 6 % and actual inflation around 6 %, the real
interest rate approached zero. With continuing expectations of rising prices,
people borrowed in response to this strong incentive. As measured by the
Case-Shiller 10-city index, the accumulated surge in homeownership prices
between January 1999 and the peak, in June 2006, was 151 % —but the CPI
measured an accumulated increase of a mere 25 %. 3 As the Federal Reserve
monitored the economy for signs of inflation during the early part of this decade,
home price increases were no longer so visible in the CPI. Consequently, the Fed
saw no reason to curtail its lax monetary policy.
Even after the Fed began to raise the federal-funds rate in May 2004, the
housing bubble grew for two more years, due, we would argue, to self-
reinforcing expectations of rising resale prices and to overgenerous mortgage
financing in the form of low down payments, interest-only loans, negative-
equity loans, and adjustable-rate mortgages (ARMs), enabled by the Fed’s
loose-money policy. 4 Surely such financing unintentionally encouraged
momentum buying. But the liquidity that sustained subprime and ARM
lending was about to evaporate.
There is much more that will interest scholars of financial crises in these
works—the role of balance sheet shocks, the importance of derivatives in the
collapse in financial markets, and the difficulty of post-crisis economic recalcula-
tion, for example—which, due to space constraints, we cannot consider here.
What is clear, from the context of their research projects and the mechanisms
they find important, is that Gjerstad and Smith’s Hayekian approach to markets
also influences their narrative of the crisis. Excessively easy credit was not the
only cause of the crisis, but Smith and Gjerstad do believe the crisis cannot be
fully understood without this detail.
3 Assessment of the literature
3.1 Mistreatment of money and the ABCT in a nutshell
The literature reexamining ABCT correctly captures a number of the theory’s mecha-
nisms. First, and most importantly, all of the above papers recognize the importance of
money in generating the boom-bust cycle. Several of the above authors, and especially
Calvo (2013) and Hume and Sentance (2009), turn to ABCT due at least in part to
dissatisfaction with the way mainstream models handle money. Second, these authors
recognize that, since business cycles result in turbulence in all of an economy’s
markets, then that which is common to all markets ought to be examined as a potential
transmission mechanism. Money, as one half of all exchanges, is the missing link.
Monetary distortions result in distortions in the price system itself, setting the stage for
the boom-bust dynamics to follow.
The second mechanism is closely related to the first. Continuing the Bmoney
matters^ theme, the above authors in some way make use of the interest rate theories
of Wicksell (1898, 1934), which form the backbone of ABCT as developed and argued
by Hayek (1931, 1933); Mises (1949, Chapters 19, 20) and Rothbard (1963, Chapter
1). Wicksell recognizes that, like all other markets, the market for savings tends towards
equilibrium, where the price of savings—the interest rate—equated the quantity
demanded and supplied of savings. The interest rate that cleared the savings market
Wicksell called the Bnatural rate^ of interest. But importantly, the natural rate of interest
can, and frequently does, diverge from the current market rate. As developed in the
ABCT, credit expansion by the central bank in loan markets forces a wedge between
the natural and market interest rates and delays the return to equilibrium. The additional
liquidity injected into the loan market makes it appear Bas if^ real savings are more
abundant, although the effect is purely monetary. 9 This results in the price system
sending faulty signals regarding the profitability of investment projects. Projects that
were previous sub-marginal are, at the lower market interest rate, now profitable to
undertake. Resources, guided by the false interest rate signal, are misallocated towards
investment projects that, because there has been no increase in real savings, are
unsustainable. These Bmalinvestments,^ while expected to be profitable, are ultimately
untenable. The boom—the expansion of projects brought about by the wedge between
the market and natural rate—thus necessarily gives way to the bust—the costly
reallocation process whereby malinvestments are liquidated and the economy restruc-
tures to once again reconcile consumer demand with producer supply. This is the heart
of the Btoo low for too long^ claims discussed in the previous section.
3.2 The ABCT is a theory on unsustainable booms, not of crisis recovery
Not all the statements made by the above authors concerning ABCT are correct. Hume and
Sentance (2009, Chapter 1443) improperly indict ABCT for not being able to explain the
duration of the boom or the slowness of post-bust output growth. ABCT is, properly
understood, a theory of the unsustainable boom and not a theory about the subsequent
crisis. Although it predicts that an artificial boom will inevitably give way to bust, there is
9
In this way ABCT foresaw the Bsignal extraction^ problem of Lucas (1972).
no concrete statement in the theory as to how to predict the length of the boom.10 This is in
part because the length of the boom is endogenous to policymakers’ response. Since this
inherently involves a calculus of non-market decision making, this aspect is properly
exogenous to ABCT. In particular, it would be required to predict the behavior of Big
Players, whose behavior defy predictive theory (R. G. Koppl 2002). A similar explanation
details why ABCT need not explain the rate of output growth following the crisis. The
speed and accuracy with which resources are directed away from unprofitable projects and
are once again allocated to their highest-valued uses depends crucially on policymakers’
response to the crisis, to the cost associated to the misallocation of resources during the
artificial boom, and to the state of confidence of economic agents (Higgs 2009; Rothbard
1963, Chapters 19–23). Hume and Sentance (2009) are correct in insisting that the length
and recovery from a crisis are important and demand an explanation. But that explanatory
burden starts where the ABCT story ends.
3.3 Rationality and expectations
As Calvo (2013, p. 15) recognizes, the unsustainable boom is consistent with individual
rationality due to the faulty information signals sent by the price mechanism in an
environment where the central bank is acting to drive the natural rate below the market
interest rate. In more familiar language, because it is costly to acquire information
concerning the degree to which the price system will be distorted, individuals can be
thought of as facing Stigler’s (1961) search problem, in the sense that they acquire
information up to the point where the equimarginal conditions are satisfied. This still
leaves room for a boom-bust cycle while showing that, ex ante, agents are optimizing
and thus irrationality is not needed to explain the cycle.11
The problem of rationality and expectations is not absent in the ABCT. Both Hayek
(1931, pp. 83–85) and Mises (1943) recognized the importance of expectations in their
business cycle theory. In fact, ABCT is built upon a loose sense of rational expectations
where Lincoln’s law holds: You can fool some people all the time, and all people some
of the time, but you cannot fool all the people all the time. What ABCT rejects is the
position that it is not possible to fool any of the economic agents anytime (Garrison
1989). For better or for worst, the ABCT uses a broader conception of expectations
than strict rational expectations. As Caballero (2010) illustrates, rational expectations in
modern macroeconomic seems to suffer from the similar problems that rational expec-
tation critics charge on the ABCT: an unclear link to the behavior of actual economic
actors. The literature reviewed in this paper suggests that when rational expectations
models failed, the attention was turned, at least in part, to ABCT in search of answers.12
10
Larger booms are associated with larger busts, all else being equal, in the sense that more malinvestments
made during the boom requires more malinvestments to be liquidated during the bust. But whithout specifying
additional institutional details, e.g., the ease of resource reallocation via the entrepreneurial market process
following the bust, we cannot make any stronger claims.
11
The problem of sheer ignorance, namely, not knowing what is unknown, is also emphasized in some strands
of ABCT. These Bunknown unknowns^ cannot be subject to a rational price calculation because of its radical
character. However, to not know what is unknown is not irrational, but arational (Evans and Friedman 2011;
Garrison 1986). This arational presence in all economic agent behavior can explain why they may not behave
as strict rationality predicts but at the same time such behavior is not irrational.
12
For recent BAustrian^ literature dealing with the problem of rational expecations see Cachanosky (2015);
Callahan and Horwitz (2010); Carilli and Dempster (2001) and Evans and Baxendale (2008).
3.4 Capital theory
Surprisingly, none of the above papers explicitly mention the role that capital
goods play in ABCT. Since Hayek’s (1931, 1935) lectures, the necessity of
coordinating consumers’ demands with producers’ supply by adjusting the
economy’s heterogeneous capital stock has been an important part of the ABCT
narrative. The divergence between the market rate and natural rate of interest
results in an increase not just in investment projects in general, but in investment
projects more Bdistant^ from final consumption. In Hayek’s conception, this
distorts the economy’s structure of production is the main reason why the
increased capital investment, classified as malinvestment rather than mere over-
investment, is unsustainable.13 Whether the authors would agree with the impor-
tance of capital theory or not, the fact that it is not brought up given its
importance to ABCT is conspicuous. To clarify, the distortions or imbalances
emphasized in the ABCT story occur across different stages of production, an
emphasis not usually mentioned when the problem of imbalances is brought up.
An exception is Calvo (2013, p. 16), who uses a an analogy to refer to the
relevance of capital theory:
Whatever one thinks of the power of the Hayek/Mises mix as a positive theory of
the business cycle, an insight from the theory is that once credit over-expansion
hits the real sector, rolling back credit is unlikely to be able to put BHumpty-
Dumpty together again.^ Inflation may subside but the credit contraction is likely
to have severe real effects. No hard proof is offered, but their conjecture is not
easy to reject.
3.5 Modern treatments of the ABCT
Perhaps even more important than the absent discussion of capital theory is the
omission on any modern reference to ABCT since its early development. This
overlooks work that has been done developing the microfoundations of ABCT
and linking it to monetary disequilibrium theory (Horwitz 2000). Horwitz does
not only work on the microfoundations of ABCT, he also connects the theory to
the problem of monetary equilibrium and the literature on free banking (Dowd
1988, 1992, 1993; Sechrest 1993; Selgin 1988, 1996, 1997; L. H. White 1984,
2011).
Garrison (2001) embodies the ABCT in a graphical model that connects the market
of loanable funds, the production possibilities frontier and the Hayekian triangle. 14
Garrison’s model, however, is not just a pedagogical exercise to explain the ABCT, but
is also a simple framework to put the ABCT next to other business cycle theories like
13
For empirical studies see Bismans and Mougeot (2009); Cachanosky (2014b); Carilli and Dempster (2008);
Hoffmann (2010); Keeler (2001); Lester and Wolff (2013); Luther and Cohen (2014); Mulligan (2002, 2005,
2006, 2013); Murphy et al. (2009); Ravier and Lewin (2012); and Young (2012).
14
A fourth member of Garrison’s model, usually set aside for simplification purposes, is the Bconsumer
triangle^ which differentiates between more and less durable goods. A house, for instance, has a larger
Bconsumer triangle^ than dinner a restaurant.
the Keynesian and the monetarist. Garrison’s work has become a central reference that
sets the ABCT in the context of modern macroeconomics that the non-Austrian
references have mostly overlooked. Thus Garrison (2001) and Horwitz (2000) are the
most important modern theoretical expositions of ABCT.
4 The case for ABCT
There are a few insights that make it reasonable to pay attention to ABCT as business
cycle theory with significant explanatory power. The theory points to economic insights
that are worth exploring and hard to ignore once a few realistic and plausible assump-
tions are accepted.
4.1 The ABCT belongs to the credit cycle family
To accept the idea that an expansionary credit policy can produce an unsustainable
boom is to accept, even if credit expansion is not the distinctive unique aspect of
ABCT, the general thesis of ABCT. 15 If there is a distinctive aspect of ABCT,
agreement would probably be on the effects produced on the time structure of produc-
tion. In fact, as Sechrest (1997) and Shah (1997) show, other business cycle theories,
like the monetarist, make use of similar arguments to those of ABCT. Without ignoring
the differences, there are clear parallels as well. For instance, the ABCT links monetary
policy, financial markets, capital goods; and the monetarist business cycle theory links
monetary policy, financial markets, and the labor market (Garrison 2014). Once human
capital is recognized as an important factor, then this parallel becomes clear. ABCT is a
theory that illustrates on one of the different mechanisms through which an excess of
credit can produce a misallocation of resources.
There is no reason to consider ABCT and other business cycle theories as always
incompatible with each other. Nor is there reason to think a choice has to be made
between the ABCT and other business cycle theories. A business cycle theory may
apply in some crises but not on others, and different phases of a crisis might be
explained with different business cycle theories. For instance, in the context of the
Great Depression, ABCT focuses on the unsustainable boom that led to Great Depres-
sion, whereas Friedman and Schwartz’s (1963) monetary explanation becomes impor-
tant in explaining the unfolding crisis, and Higgs’ (2009) regime uncertainty theory
explains why the crisis lasted for so long.16 Different theories focus on different
mechanisms. This is why, for instance, Austrians usually look at what happens before
the crisis and monetarists at what happens when the crisis triggers. As already men-
tioned, ABCT is a theory of unsustainable booms, not of the particulars of the
15
For a review of other monetary business cycle theories that evolved contemporaneously to the ABCT see
Haberler (1937). Mises (1943, p. 252) saw the ABCT as contintation of credit-cycle theories: BI wish,
however, to stress one more point. Why call this monetary or credit expansion theory of the trade cycle the
BAustrian^ or the BAustro-Wicksellian^ theory? Of course, I am very grateful for the honour paid in this way
to me and to my country. But why forget that his theory is a continuation, perfection and generalisation of the
Currency theory? Neither Wicksell nor I myself nor Professor Hayek have ever forgotten to emphasise this
point.^
16
For a review on the effects of the New Deal see Anderson (1949); Reed (1981) and Rothbard (1963).
unfolding crisis. Even if a monetarist theory has nothing to say either way about an
unsustainable boom before a crisis, the presence of an unsustainable boom is still
consistent with a monetarist explanation where the severity of the crisis is increased by
the mishandling of monetary policy.
It should be noted that the ABCT does not in itself propose a full liquidation of
the economy during the bust as is sometimes wrongly but persistently associated
with the ABCT. Hayek (1931, Chapter IV) argues that the role of the monetary
authority is to keep monetary equilibrium by keeping nominal income per capita
(NGDP) stable. Hayek makes a distinction between primary and secondary con-
traction to differentiate between the monetary contraction in a gold standard
required to avoid a depletion of gold reserves (primary contraction) by issuers
banks and a deflation that goes beyond this (secondary contraction). Hayek
opposed to the secondary contraction because it would impose a monetary defla-
tionary pressure on the economy. The same problem associated to the monetarist
explanation of business cycles (L. H. White 2008a). Hayek was hardly the only
one at his time arguing for stabilization of nominal income (Selgin 1996, Chapter
8). This was a common position before the Keynesian revolution shifted interest
toward the now-familiar macroaggregates. Today, a similar argument to Hayek’s
can be seen in the recent arguments that NGDP targeting and a productivity norm
can be a superior monetary policy than price level stabilization for central banks
(Cachanosky 2014a; Salter 2013; Selgin et al. 2015; Selgin 1996, Chapter 7, 1997;
Sumner 2012; L. H. White 2007). The important issue is that ABCT allows for an
artificial boom that does not require above-trend inflation, as in the years prior to
the 2008 crisis.
4.2 Production takes time
The ABCT focuses on the fact that production takes time and examines the effects
of a policy-induced change in interest rates on the allocation of resources in the
process of production, what Austrians call the Btime structure of production.^ If
the interest rate reflects the time preference of economic agents, then the interest
rate is the price of time. It is to be expected, then, that by setting the price of time
outside the equilibrium level, disequilibrium in the production process arises.
ABCT can be thought as a theory that studies the effects of a monetary policy
that artificially changes the relative price of time with respect to the price of goods
and services. To assume that production is timeless does away with the insights of
ABCT, but this is a rather heroic abstraction that ignores, rather than grapples
with, the problem of coordinating the economy’s structure of production.17
In addition, if production takes time, then it follows that one can envision stages of
production as an analytical framework of how monetary policy affects the production
process at different times. For instance, mining occurs before refining, which in turn
occurs before manufacturing, which in turn occurs before distribution, which occurs
before the final step before consumption: retailing. This is, in fact, how Garrison (2001)
and Hayek (1931) illustrate the effects of monetary policy on the structure of
17
There is a crucial difference between an assumption that simplifies the economic problem under study and
an assumption that changes or eliminates the problem being studied.
production.18 If production takes time, then allocation of resources along the stages of
production needs to be sustainable and consistent with consumer preferences. The how
to produce final goods becomes as important as the what final goods to produce.
An economic analysis that recognizes that production takes time must also
recognize that time has a price too, and this requires considering the effects
produced by a policy that moves the price of time outside its equilibrium level.
In essence, recognizing that production takes time implies acceptance of the
problem ABCT was designed to solve. In contrast, to assume a timeless produc-
tion technology shifts our attention away from the role that interest rates play in
coordinating production in time, which assumes, rather than argue away, the
substance of ABCT.
4.3 BRoundaboutness^ is not a mysterious concept
The concept of Broundaboutness^ plays a central role in ABCT and is a key aspect
of Austrian capital theory. Roundaboutness is usually associated to the average
period of production, which goes through unavoidable interpretation problems. It
is not the same, however, to argue that the Baverage period of production^ is a
difficult term as it is to take the position that production does not take time. But
this does not mean the concept cannot be meaningfully discussed. A straightfor-
ward meaning of roundaboutness comes to surface by acknowledging, like Kirzner
(2010), that investment is forward-looking and, at the margin, are interest-
sensitive; hence the wedge between market and natural rates captured by ABCT
is important in this context. Investment decisions are driven by the present value
of the expected free-cash-flow of a project. Two projects with equal present value
but different time horizon have a different sensitivity to changes in the interest rate
used to discount the expected cash-flow. A reduction in the discount rate increases
the present value of the longer constant cash flow more than the increase in the
shorter constant cash flow. The modified duration is the upfront financial repre-
sentation of Broundaboutness.^ The modified duration represents the semi-
elasticity of the present value against the discount rate. And the macaulay duration
represents the weighted average period of the cash-flow. Modified and macaulay
duration are equal if the return of the cash-flow is continuously compounded.
Duration, then, captures precisely the two central concepts associated to round-
aboutness: average period of production and interest rate sensitivity. There is no
need, then, to associate Broundaboutness^ with a mysterious meaning that only
Austrians use (Cachanosky and Lewin 2014b). The interpretation of roundabout-
ness as duration was first exposed by Hicks (Lewin and Cachanosky 2014). With
this modification, ABCT can be rephrased in financial terms and calculations
(Cachanosky and Lewin forthcoming).
An entrepreneur that is facing projects with different modified duration will see the
value of the more roundabout (i.e., more time-sensitive) project increase more than the
less roundabout project when there is a fall in the interest rate used to discount the cash-
flow. It is even possible that a project with negative present value becomes profitable at
18
Even though the graphical exposition of stages of production is mentioned in contemporary work as the
BHayekian triangle,^ it was first proposed by Jevons (1871, pp. 229–236).
the lowered discount rate. Due to this change in relative value, investments are
allocated into more roundabout projects. Eventually, when the central bank raises
interest rates, the more roundabout projects are now the ones that face a higher loss
in value. The unsustainability of the more roundabout projects becomes evident when
the market interest rates move towards the Wicksellian values. The irreversibility of
investments and labor adjustment costs makes the correction of the unsustainable
investments a costly process that is seen as the bust (Dixit 1991).19
5 Contemporary treatment and contributions to ABCT
5.1 Risk
Young (2015) argues that the canonical version of the ABCT as represented in
Garrison’s model is ill-suited to offer a good fit to the 2008 financial crisis. The
housing market, Young argues, cannot be counted as typical roundabout industry.
According to the canonical version of the theory, a boom should be expected in
more roundabout industries than housing. This in itself does not pose a challenge
to the abstract or unapplied ABCT theory. As Callahan and Horwitz (2010)
explain, ABCT is built with ideal types and assumptions of differing generality
levels. At the moment of applying ABCT, like with any theory, empirical assump-
tions particular to the case under study need to be appended to the theory. L. H
(White 2008b), for instance, explains how the excess of credit was channeled to
the housing market producing the boom in that particular market and not in other
industries. However, Young is right in pointing out that the canonical version of
the ABCT is not well suited to deal with financial risk exposure, a distinctive issue
of the 2008 financial crisis.
While Cowen (1997) offers a critical assessment of the ABCT by arguing that
risk, not roundaboutness, is what matters in contemporary economics, Young
(2012) extends Garrison’s model to explicitly account for risk next to roundabout-
ness and applies the modified model to the 2008 crisis. Given that ABCT assumes
that production takes time, and that time implies risk, Young’s model makes
explicit what was already implicit in Garrison’s model. This allows Young to
work with changes in risk exposure, holding constant other parameters. In other
words, Garrison’s model implicitly assumes an invariant risk while Young’s
version allows for risk to change. Young’s model allows, then, to show how
monetary policy and market regulation can affect, under certain conditions, the
level of risk exposure more than the average period of production offering a new
variation on the ABCT general theme.
19
The fact that longer and more capital intensive projects are more sensitive to changes in the discount rate is a
well-established financial principle. A theory that depicts the effects of monetary policy on the present value of
the cash-flow of potential investments is not working with a model that describes an Bas if^ economy, but a
theory that works on how investment decisions are actually made in the market. To reject the insights of
ABCT is to reject the relationship between discount rates and present value of cash-flows as described by the
modified duration.
5.2 Fiat currencies and international business cycles
The development of ABCT by Hayek (1931) and Mises (1912) was done in the context
of a gold standard regime. Obviously, monetary regimes have changed significantly
since these writings. L. H. White and Selgin (2010) discuss how the ABCT story
changes when fiat currencies replace the gold standard. In the original version of
ABCT, an expansionary monetary policy cannot continue endlessly as the loss of
reserves will constraint the central bank’s policy.20 L. H. White and Selgin (2010, p.
18) argue that the Bongoing expansion no longer creates an excess aggregate demand
for output^ because the Bbuldge in real output fades and goes negative due to
malinvestment during the boom.^
The trigger that results in a revision of monetary policy is different under a gold
standard than under fiat currency. In the case of gold standard it is the loss of reserves.
L. H. White and Selgin (2010) offer a long-run neutrality argument for the case of fiat
money, that as price and expectations adjust, the liquidity effect on interest rates fades
even of money growth does not slow. The market rate returns to the natural rate despite
a permanent increase in the rate of monetary expansion. Finally, White and Selgin also
point out that because there is no gold convertibility anymore, there is no distinction to
be made between primary and secondary deflation. This point connects to the NGDP
targeting and productivity norm as rules to keep monetary equilibrium and against the
claim that the ABCT is in favor of liquidating any economic activity, and not only those
that consume rather than create economic value.
Bilo (The international business cycle as a coordination failure, unpublished man-
uscript) and Cachanosky (2014c) also offer a version of the ABCT with fiat currencies
but focuses on different issues than White and Selgin. Bilo and Cachanosky brings into
the theory exchange rates between fiat currencies and argues that this is another
transmission mechanism to be added to the canonical version of the ABCT. While L.
H. White and Selgin (2010) deal with a close economy,
5.3 International business cycles
According to Calvo and Mishkin (2003) exchange rates play an important role in the
transmission of shocks to small open economics. In the case of a monetary shock,
conventional theory suggests that a fixed exchange rate will avoid affecting the relative
price between tradables and non-tradables, stopping the monetary shock from having real
effects. In contrast, in the case of a real or productivity shock, conventional theory suggests
that a flexible exchange rate can help relative prices to adjust if necessary. Following this
logic, the output of small open economies with a different exchange rate regime should
react differently when facing a similar shock. However, studies find that this is not always
so. Latin America, a region particularly sensitive to U.S. monetary policy, is such a case
(Bengoa and Sanchez-Robles 2003; Calvo et al. 1993; Canova 2005).
An international application of ABCT that pays attention to the costs associated with
the misallocation of resources can help to understand why small open economies see
their output cycle looks similar even when using different exchange rate regimes. Both
20
This is a response to Hummel (1979), who argues that under fiat currencies a central banks does not need to
stop an expansionary policy as described by the ABCT.
the interest rate and the exchange rate can become transmission mechanism of resource
misallocation (Cachanosky 2014c). Cachanosky (2014b), for instance, finds that two
countries with different exchange rate regimes, Colombia and Panama, went through
similar type of distortions as predicted by the ABCT as a reaction to U.S. monetary
policy. In a nutshell, the reason is access to international credit markets where major
central banks are increasing the supply of loanable funds.
In addition, Hoffmann and Schnabl (2011) and Hoffmann (2010, 2012) extend the
ABCT to the problems of transmission of business cycle from a center (Europe) to a
periphery (Eastern European Countries), the feedback effects between countries pro-
duced by buoyant excess of liquidity in the international markets and effects of
accommodative monetary policy after the 2008 crisis.
5.4 Phillips curve with a positive slope
Ravier (2010a, 2013) uses ABCT to build on Friedman’s (1976) idea of a Phillips
Curve with a positive slope. According to Friedman’s lecture, a third stage in the
Phillips Curve research should account for this dilemma and draw on political behavior
and research being done, at that moment, by scholars like Arrow, Buchanan and
Tullock. Ravier follows a different path. His argument is that, because capital goods
are heterogeneous and costly to reallocate, an expansionary monetary policy produces
capital losses that negatively affects labor productivity. Wage stickiness and the loss of
labor productivity can produce a higher rate of unemployment when nominal wages are
sticky. If nominal wages do not adjust downward in when labor productivity falls,
unemployment may rise resulting in an upward sloping Phillips curve. The advantage
of Ravier’s approach is that his results are endogenous to the dynamics of the Phillips
Curve and does not need to resort to exogenous explanations like political behavior.
5.5 Monetary shocks with non-neutral effects
Campbell and Mankiw (1987a, b) tackle the question of why the effects on output of a
shock to aggregate demand (i.e. a monetary shock) sometimes take quite long to
vanish. If output is forced away from trend because of a monetary shock, it should
promptly return to trend; in statistical terms, the problem is whether GPD is a trend-
stationary or a unit root process. Cochrane (2012); Cushman (2012); DeLong (2009,
2011); Hosseinkouchack and Wolters (2013); Krugman (2009) and Mankiw (2009a, b)
discuss this problem in the context of the 2008 crisis.
Perron and Wada (2005) offer an alternative interpretation. Their argument is not
that output takes too long to return to trend, but that there is a break in the trend of U.S.
GDP beginning in 1973. This suggests that output takes Btoo long^ to return to trend
because it is returning to a different point. Perron and Wada (2005) offer statistical
reasons of why there is break in the trend in 1973, but give no economic explanation for
why this happened. 1973 is, however, an important one. After Nixon closes the gold
window in 1971, the countries in the Group of Ten agreed to keep their exchange rates
stable and let their currencies appreciate against the USD. In early 1973, this agreement
is broken and countries let their currencies freely float.
ABCT insights, especially those that focus on efficient allocation of capital goods,
can contribute to understand either a slow return to trend or a break in the trend. In the
former, the emphasis that ABCT puts on capital goods and heterogeneity and the cost of
resource reallocation implies that after an unsustainable boom the burden of economic
correction can slow the reversion of GDP to trend. Economic policy and new regulations
after a crisis can make things worse, as during the New Deal. But ABCT, by assuming
capital heterogeneity sets the stage to understand why revert to trend can be sluggish and
not as automatic as the aggregate demand-aggregate supply model seems to imply. This
is a case of short-term money non-neutrality, resulting in resource misallocation and
reallocation. In the latter case, a change in trend implies a non-neutral effect of monetary
policy even in the long run. The Austrian literature is characterized for the emphasis in
the fact that money neutrality is an assumption that does not hold necessarily in the real
world.21 An artificial boom that affects the determinants of equilibrium (resources are
wasted or preferences change in a different way than monetary policy should not
happen) has non neutral effects in the long-run. The composition of the equilibrium
can be affected, and one of those components could be time preference, which is
important in determining the long-run growth rate. It might not be an accident that the
change in trend found by Perron and Wada (2005) after a major monetary institutional
change was followed by a decade of high inflation that ended in an economic crisis.
6 Conclusions
The 2008 financial crisis has shaken the state of macroeconomics to the point that some
scholars have turned to the once-forgotten business cycle theory of Mises and Hayek
for answers. For this enterprise to be productive, it is necessary to know what aspects of
the theory have been correctly captured, what has been misapplied or misunderstood,
what important aspects that can contribute have been overlooked, and what advance-
ments have occurred since the days of Mises and Hayek that make the theory more
compatible with contemporary economics. We delineate the treatment of ABCT
distinguishing between what has been said right, what has been said wrong and what
has been overlooked.
We also suggest how the modern treatment of the ABCT can contribute to different
contemporary economic puzzles, like the Phillips Curve with a positive slope, output
comovement in small open economies with different exchange rate regimes and the
problem of GDP as a trend-reverting or a unit root series. Certainly further research in
all these areas is needed. We think that the treatment and layout we present in this paper
shows that there are gains of trade to be gained between BAustrians^ and Bnon-
Austrians.^ This intellectual arbitrage has the potential to expand significantly the
explanatory power of modern economics, and should be embraced by all economists,
regardless of how they self-identify.
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21
For a discussion in monetary non-neutrality in the long run see Ravier (2010b).
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Cachanosky, Salter - 2017 - The View From Vienna An Analysis of The Renewed Interest in The Mises-Hayek Theory of The Business Cycle

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Rev Austrian Econ (2017) 30:169–192

The view from Vienna: An analysis of the renewed

Nicolás Cachanosky 1 & Alexander W. Salter 2

Published online: 22 February 2016

Keywords 2008 crisis . Subprime crisis . Austrian business cycle theory

Jel Codes . B53 . E32 . E52

2.1 ABCT-type explanations with reference to the ABCT

[…] the Austrian School offered valuable insights – disregarded by mainstream

Leijonhufvud’s (2009) critique of pre-crisis macroeconomic theory seems a strange

2.2 ABCT-type explanations without reference

3 Assessment of the literature

3.1 Mistreatment of money and the ABCT in a nutshell

3.2 The ABCT is a theory on unsustainable booms, not of crisis recovery

3.3 Rationality and expectations

3.4 Capital theory

3.5 Modern treatments of the ABCT

4 The case for ABCT

4.1 The ABCT belongs to the credit cycle family

4.2 Production takes time

4.3 BRoundaboutness^ is not a mysterious concept

5 Contemporary treatment and contributions to ABCT

5.2 Fiat currencies and international business cycles

5.3 International business cycles

5.4 Phillips curve with a positive slope

5.5 Monetary shocks with non-neutral effects

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