Academic journal article Atlantic Economic Journal

An Empirical Analysis of the Austrian Business Cycle Theory

Academic journal article Atlantic Economic Journal

An Empirical Analysis of the Austrian Business Cycle Theory

Article excerpt

Building on the work of Knut Wicksell, the Austrian economists Ludwig von Mises and Friedrich A. Hayek developed a unique theory of the business cycle. In their view, an unsustainable boom ensues when the rate of interest prevailing in the market falls below the natural rate. Mistaking the easy credit for a genuine increase in savings, entrepreneurs are led to take on more capital-intensive projects. According to the Austrians, the boom is characterized not only by an increase in aggregate production but also by a distortion of the structure of production. Once the errors are realized, a recession follows: aggregate production declines as the structure of production is repaired. Hence, the Austrian account of macroeconomic fluctuation stresses the misallocation and reallocation of resources in addition to the overproduction and underproduction of more conventional business cycle theories.

Lacking a measure of the structure of production, modern economists working in the Austrian tradition have struggled to assess the empirical relevance of the Mises-Hayek theory in such a way that other economists find satisfactory. (1) In a recent article, however, Lester and Wolff (2013) argue that the available stage-of-process data accurately capture the Austrian notion of a structure of production. They measure industrial production in early, middle, and late stages with indexes of industrial production for crude, primary, and finished goods. They measure the average prices of goods produced in early, middle, and late stages with producer price indexes of crude, intermediate, and finished goods. With these measures, they use a structural vector auto regression to estimate the change in the structure of production immediately following a monetary shock. If the Austrian view is empirically relevant, the authors surmise, a positive monetary shock should increase the production and prices of goods at early and late stages relative to the production and prices of goods at middle stages. Their results call into question the Austrian view. Although monetary shocks are followed by changes in aggregate production, the magnitude of changes in the structure of production and prices at the various stages are small, statistically insignificant, and often of the opposite sign as that predicted by theory.

We support the efforts of Lester and Wolff (2013) to consider the Austrian business cycle theory empirically. (2) However, we take issue with their use of the federal funds rate (FFR) as an indicator of monetary policy. As Lester and Wolff (2013: 442) acknowledge, the boom-bust cycle postulated by the Austrians does not result from mere fluctuations in the market interest rate. Rather, it is brought about when the market interest rate deviates from the natural rate. The authors make no effort to estimate the natural rate and in using the FFR fail to distinguish a low market interest rate from a market interest rate that is low relative to the natural rate. For this reason, their approach does not constitute an accurate assessment of the Austrian business cycle theory.

In what follows, we attempt to improve upon the analysis offered by Lester and Wolff by considering deviations from the natural rate. After reviewing the Austrian business cycle theory, we describe the data and approach. Our approach differs from the earlier study only in that, rather than using innovations in the FFR as an indicator of monetary policy, we use innovations in the difference in FFR and the natural rate as estimated by Selgin et al. (2011). After presenting our initial results, we use more common estimates of neutral policy rates to check the robustness of these results. In general, our results are consistent with those offered by Lester and Wolff.

The Austrian Business Cycle Theory

Ludwig von Mises was the first to articulate a distinctly Austrian business cycle theory in his 1912 work, The Theory of Money and Credit. (3) He based his view on the Wicksellian distinction between the natural rate of interest (naturlicher Kapitalzins), determined by the supply and demand of loanable funds in equilibrium, and the money rate of interest (Geldzins) prevailing in the market at a particular point in time. …

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