3.4.2. The Incorrect and Controversial Aspects of the ABC
What then remains controversial about the ABC - and, as the sequel argues - incorrect? Some of the more important features of the ABC include:
Proposition 3: Monetary expansion distorts the structure of production in an unsustainable way.
Proposition 4: The ABC explains the "sudden general cluster of business errors."
Proposition 5: The ABC provides the best explanation for why downturns hit the capital goods sectors especially hard.
Proposition 6: Only the Austrian theory can explain the existence of inflationary depressions (or "stagflation").
Austrians along with almost all other economists accept that expansionary monetary policy tends to reduce interest rates (definitely real interest rates, and usually nominal rates as well) in the short term.[46] There is no question that this change in interest rates tends to affect the profitability of different investments; as Austrians emphasize, with lower interest rates, more "round-about" investments will become profitable. Projects with returns further in the future previously might have had a negative present discounted value; lower the interest rate, and the PDV quite possibly might become positive. Bohm-Bawerk's capital theory - focusing on the intertemporal coordination of numerous stages of production - does incline Austrians to be particularly aware of the tendency of lower interest rates to stimulate more round-about projects. But modern neoclassicals would surely also accept the claim that lower interest rates alter PDV calculations in favor of investments with more distant returns.[47]
Thus, it is readily conceded that (a) expansionary monetary policy reduces interest rates, and (b) lower interest rates stimulate investment in more round-about projects. Where then does the disagreement emerge? 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.
In short, the Austrians are assuming that entrepreneurs have strange irrational expectations. Rothbard states this fairly explicitly: "[E]ntrepreneurs are trained to estimate changes and avoid error. They can handle irregular fluctuations, and certainly they should be able to cope with the results of an inflow of gold, results which are roughly predictable. They could not forecast the results of a credit expansion, because the credit expansion tampered with all their moorings, distorted interest rates and calculations of capital."[48] Elsewhere, he informs us that: "uccessful entrepreneurs on the market will be precisely those, over the years, who are best equipped to make correct forecasts and use good judgment in analyzing market conditions. Under these conditions, it is absurd to suppose that the entire mass of entrepreneurs will make such errors, unless objective facts of the market are distorted over a considerable period of time. Such distortion will hobble the objective 'signals' of the market and mislead the great bulk of entrepreneurs."[49]
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. Even if simple businessmen just use current market interest rates in a completely robotic way, why doesn't arbitrage by the credit-market insiders make long-term interest rates a reasonable prediction of actual policies? The problem is supposed to be that businessmen just look at current interest rates, figure out the PDV of possible investments, and due to artificially low interest rates (which can't persist forever) they wind up making malinvestments. But why couldn't they just use the credit market's long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates? Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot. Moreover, even if most businesspeople don't understand that low interest rates are only temporary, the long-term interest rate will still be a good forecast so long as the professional interest rate speculators don't make the same mistake.
It should be noted that other Austrians, particularly Roger Garrison, attempt to handle the expectational objection. Garrison astutely notes that "[M]acroeconomic irrationality does not imply individual irrationality. An individual can rationally choose to initiate or perpetuate a chain letter... Similarly, it is possible for the individual to profit by his participation in a market process that is - and is known by that individual to be - an ill-fated process."[50] This is definitely a possible scenario. But does it make sense in this particular case? It does not. Naturally, entrepreneurs will not turn down lower interest rates. Rather, the rational response to artificially low interest rates is to (a) make investments which will be profitable even though interest rates will later rise, and (b) refrain from making investments which would be profitable only on the assumption that interest rates will not later rise. If entrepreneurs followed this rule, then there would be no tendency for policy reversals to produce malinvestments.
The Austrian theory also suffers from serious internal inconsistencies. If, as in the Austrian theory, initial consumption/investment preferences "re-assert themselves," why don't the consumption goods industries enjoy a huge boom during depressions? After all, if the prices of the capital goods factors are too high, are not the prices of the consumption goods factors too low? Wage workers in capital goods industries are unhappy when old time preferences re-assert themselves. But wage workers in consumer goods industries should be overjoyed. The Austrian theory predicts a decline in employment in some sectors, but an increase in others; thus, it does nothing to explain why unemployment is high during the "bust" and low during the "boom."
Even more striking is the Austrian theory's inability to explain why output declines during a depression; instead, it predicts a short-term increase.[51] Bohm-Bawerk's capital theory, on which Rothbard wisely built his work, implies that actually the short-run effect of switching to consumer goods production would be a period of greater production, followed by a period in which production is less than it would otherwise have been if longer period products had been used instead.[52] In short, the Austrian theory all-too-glibly identifies the period of artificially low interest rates with the boom, and the period of re-adjustment with the bust. Without extra assumptions, the theory does not predict an increase in employment during the boom, or a decrease during the bust. Moreover, it predicts an actual increase in current output during the bust. These are puzzling implications, to put it mildly, and they follow from the ABC.
A final supposed merit of the ABC is that it explains why capital goods industries suffer more than consumer goods industries during depressions.[53] Modern neoclassical economics however offers a simple alternative explanation. One interesting business cycle fact is that durable consumer goods production suffers along with the capital goods industries. A simple explanation for both phenomenon is that any durable good purchase, whether durable capital goods or durable consumer goods, is going to be much more sensitive to changes in income or profitability than non-durable purchases. In any period buyers of durable goods both replenish their stock to account for depreciation, plus adjust their desired total stock depending upon new information about profitability (for firms) or permanent income (for individuals). The arrival of a depression causes both forecasts to be adjusted downwards; often this means that there is no point even making up for depreciation, since natural wear-and-tear simply moves you closer to your new, lower total stock. The most basic model of demand for durable goods provides a coherent explanation for why producers' goods industries suffer more during depressions; and unlike the "acceleration" theory that Rothbard properly ridicules, the theory of demand for durable goods follows rigorously from basic microeconomics.
Another interesting argument made in favor of the Austrian theory is that it is the only theory capable of explaining stagflation - the simultaneous presence of high unemployment and high inflation. Rothbard, for example, describes the Austrian theory as "the only proffered explanation" of stagflation.[54] To the contrary, there were numerous theoretically rigorous explanations of stagflation, most of which were well-known to sophisticated academics in 1978 when Rothbard made this claim in favor of the ABC. To name a few:
a. Natural resource shocks, e.g. oil (reduces supply, raising price and reducing output).
b. The rational-expectations explanation: Workers wake up from their real/nominal wage confusion and demand a raise to compensate for inflation (again, reduces supply, raising price and reducing output). Lucas won the last Nobel prize for his work on this idea.
c. Technology shocks (again, reduces supply, raising price and reduces output). The theory which attributes business cycles to technology shocks, known as real business cycle theory, has been a hot topic in macro theory for a decade.
Let me emphasize that all of the arguments in this section have been essentially theoretical, not empirical. The ABC requires bizarre assumptions about entrepreneurial stupidity in order to work: in particular, it must assume that businesspeople blindly use current interest rates to make investment decisions. Even if we accept the ABC, it has important internal inconsistencies: it does not in fact predict changes in employment, and predicts that output will increase during depressions. Moreover, the experience of stagflation is no argument for the ABC, because numerous other theories (most of them developed before stagflation became important) can also account for stagflation.
These objections to the ABC, as mentioned, solely apply to the "controversial" parts of the theory. Austrians were entirely correct to decry the dinosaur Keynesians' neglect of the interaction between wages and employment.[55] Government officials, journalists, the general public, and weaker academics still need to learn this lesson. But the modal academic economist already knows the lesson. If the ABC has anything to contribute, it must add something further - something both original and true - to this lesson. There is little reason to believe that it can.
