Collected responses to Phelps and McTeer

As a convenience for myself, I have been hunting down the links of responses to Phelps' mischaracterization of Austrian Business Cycle Theory (ABCT), for future reference. As one would expect, the Mises Institute's blog has been commenting both extensively and excellently, and PrestoPundit has also mined some nuggets from the Hayek-L list (to which I need to subscribe, judging from the quality of the excerpts). In the process I also collected some responses to "Sideshow Bob" McTeer (tm Sean Corrigan), which complement Jonathan's analysis below.

The bottom line in all of this, is that Phelps argued against the ABCT based on a fundamental misunderstanding of what it was about. ABCT is a malinvestment theory, not an overconsumption theory (although Roger Garrison, who develops Austrian Macroeconomics, says overconsumption is a part of it, required but not sufficient). Its not that people overconsume, its that producers are misaligned with the needs of the population due to a credit expansion- and when the bubble pops (the credit is pulled back), the error is revealed, and since capital has structure (and is not simply an amorphous and uniform aggregate pool), it takes time to re-align production to meet current needs (the recession). That's it in a nutshell (or, rather, the downside aspect of ABCT in a nutshell).

As for McTeer, Jonathan skewers him rightly on both buying the Keynesian fallacy and completely misunderstanding the 'broken window fallacy', and the responses I've collected make similar points. So, for everyone's viewing convenience, the list:

The original Phelp's piece (reproduced on PrestoPundit)

Sam Bostaph on Phelps on US economy

Phelps' critical paragraph on Austrian "overinvestment" theory does not seem to acknowledge that the market process takes place in real time, not in a diagram, nor does it address consumer time preference. It seems a pure production-oriented critique that leaves out the teleological purpose of production--consumption.

Casey Khan on overinvestment or malinvestment

Mises: It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. [Human Action, p. 560]

Paul Cwik on assumptions

In the ABCT, there is some controversy whether there is any actual overinvestment. Depending on how one constructs definitions, Austrians can legitimately claim that there cannot be an overinvestment (Hayek and Mises) and others can claim that overinvestment does happen (Garrison). Both sides of the debate are making the same point; it's simply a difference in definitions of the production possibilities frontier curve. Nevertheless, what every ABCT theoretician does support is that during the boom, firms engage in malinvestments. The structure of production can be distorted from a stable state, while aggregate figures seem relatively unchanged. (The sea has mighty currents below the calm surface.)

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However, Phelps misses the main point of the ABCT, which is the process of liquidation of malinvestments is not as simple as waiting for some excess capital to wear out. During the boom, entrepreneurs engaged in the process of investment hoping to make a profit. They received false price signaling through a distorted interest rate. Once the error of the price signal is made plain, the entrepreneurs must change their lines of production to meet the demands of the consumers. They must drop and liquidate their malinvestments and reorganize the structure of production in alignment with the time preferences of the consumers. This process is the realignment of malinvested capital. If the capital cannot be absorbed into existing lines of production, it will have to be scrapped?thrown away. Therefore, the size of the boom and the subsequent contraction should not be proportional.

Jeffrey Herbener's response to Phelps

Mr. Phelps and Mr. Friedman claim that unemployment cannot be held below its "natural" rate by increasing aggregate demand through monetary and fiscal policy. While in the short run, they argue, production may be artificially stimulated and unemployment lowered by such policies, in the long run, the market adjusts to the additional spending by pushing up all prices commensurate to the artificial increases in aggregate demand and thereby, removing the stimulus. The normal functioning of the market returns production and unemployment to their "natural" rates.

In a similar way, the Austrian theory of the cycle argues that an investment boom cannot be forever sustained by central-bank monetary inflation and credit expansion. For a time, artificial credit expansion can push the interest rate below its "natural" level and stimulate a build up of some capital projects, but only at the expense of others. Credit expansion results in malinvestment, not in overinvestment. The market reacts to the distorted capital structure by restoring the "natural" rate of interest and setting in motion a reversal of the capital boom by which the capital structure of the market is returned to one that can be sustained by normal demands. Given his belief in the self-correcting nature of the market, it is odd that Mr. Phelps rejects this conclusion and holds that the "high performance of the boom" can become the "norm rather than the exception."

John Cochran on Phelps

The Austrian cycle theory is a theory of the misdirection of production-malinvestments-which may be accompanied by overinvestment and overconsumption. Most 'Austrians' would agree with Phelps that "world markets would react to the addition of capital with a sharp drop of interest, a skyward jump of capital goods prices, and immediate lift of real wages and jobs."
But Phelps, unlike the Austrian, fails to realize that a sudden addition of capital is not heaped on the world; it comes from increased saving. The boom-bust cycle develops because credit creation through central bank intervention in the economy causes markets to respond as if more 'capital' was available when in fact it is not. The bust and necessary readjustments develop when the misdirections of production of the economy and the relative scarcity and possible consumption of capital are discovered.

(Via PrestoPundit)

Fiona writes: But, on another issue, I wonder why the great aversion to the term "overinvestment" if Austrians regard I/GDP increasing out of sync with consumers' preferences as a part of their story?

The aversion stems from the popular misinterpretation of the Austrian theory as a theory that's all about overinvestment, a characterization that overlooks the malinvestment emphasized by the Austrians. The malinvestment is the first phase of the self-reversing process. In my own view, the Austians need not deny--and in fact should affirm--that there is overinvestment during the boom. What they should deny is that overinvestment is the whole story As understood in the context of a macroeconomy, it would seem that while malinvestment is unique to the Austrian theory, both malinvestment and overinvestment (along with overconsumption) are essential to it. Malinvestment without overinvestment would allow the counter-movements to set in early, nipping the boom in the bud. Overinvestment (along with overconsumption) without malinvestment would allow the economy to experience a temporarily high growth rate, moving first beyond and then back to the PPF but without there being any intertemporal misallocations requiring painful adjustments that can send the economy inside the frontier. Only with both prefixes (mal- and over-) in play do we have (1) a problem of intertemporal misallocation and (2) time for that problem to fester before the internal conflict of market forces eventually turns boom into bust.

Thornton to Wanniski, re: Phelps

Austrian economists rarely speak favorably in terms of aggregates, or like an accountant or historian might. They speak and write in terms of prices, economic decisions, and resource allocation--real life "price theory." They are concerned about the structure of production (the economy from natural resources to consumer goods) and the structure of production was completely out-of-whack in 1999 despite rosy statistics and record breaking stock markets. You don't need much "extra" investment to change the structure of production and entrepreneurs were doing just that--radically changing the structure of production--under the influence of Alan Greenspan's monetary policy.
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By the way, do you know of any mainstream economists who accurately predicted the "boom" and "bust" in the stock market and economy? For most orthodox economists, "science is prediction" and yet I don't know of many who made accurate predictions in print. Shiller is one, but he doesn't buy into the rational-scientific version of economics. Please let me know.

Mark Thornton on McTeer, Keynes, and Bastiat

McTeer?s endorsement of Keynes?s concept of the Paradox of Thrift is most troubling and a setback to economic education. Economy wide saving is not bad for the economy; it is the engine of economic growth. Saving does not cause recessions, it is a cure-all for economic ills.

The economic problem is that Americans have not saved enough, largely because the Fed has kept rates too low, driving savers into the stock market where they were clobbered. Some have tried to refill their savings and to protect themselves from the recession, but by and large Americans continue to spend like a drunken Congress.

President McTeer implores us to avoid the Luddite fallacy of keeping jobs for jobs sake?a good point. However, he has long advocated the Fed driving interest rates down to keep consumers buying more than they can afford, businesses investing in sub-marginal projects, and the propping up of businesses and investments that need to be liquidated before a real recovery can begin.

John Cochran's latest on Phelps & McTeer

At the heart of Phelps?s misrepresentation or misinterpretation of Austrian business cycle theory is his capital theory and a lack of an appreciation for the important role of saving in the wealth creation process. Robert D. McTeer, ?The Dismal Science? Hardly! (WSJ, June 4, 2003) makes a similar error in his defense of Keynes?s paradox of thrift, which he uses as an example of the fallacy of composition, ?Individually, most consumers need to save more. But if all or many consumers start trying to save more, the economy will be in deep trouble.? McTeer, President of the Federal Reserve Bank of Dallas, fails to recognize that the paradox of thrift is just the broken window fallacy, which he does an excellent job of explaining, in a more subtle guise.

Jeffrey Herbener on the nature of 'unintended consequences'

Robert McTeer?s inclination to "define economics as the study of how to anticipate unintended consequences" ("The Dismal Science? Hardly!" June 4) is a tendency we should expect of economists who make their careers in government. Economics was, after all, slandered with the moniker, "dismal science," because economists were continuously pointing out the infeasibility of schemes for improving society by government coercion.

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Mr. McTeer invokes the "broken window fallacy" without mentioning that it was popularized by the great Henry Hazlitt in his best selling, Economics in One Lesson. Mr. Hazlitt speaks not of unintended consequences, but of secondary consequences. "The art of economics," Mr. Hazlitt wrote, "consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists of tracing the consequences of that policy not merely for one group but for all groups." Because secondary consequences are hard to perceive, they can be ignored in policy decisions. The task of economists is not to promote such ignorance, but to dispel it.

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Anarchists have long been

Anarchists have long been aware of the importance of child rearing and education. As such, we are aware that child rearing should aim to develop "a well-rounded individuality" and not "a patient work slave, professional automaton, tax-paying citizen, or righteous moralist." [Emma Goldman, Red Emma Speaks, p. 108] In this section of the FAQ we will discuss anarchist approaches to child rearing bearing in mind "that it is through the channel of the child that the development of the mature man must go, and that the present ideas of. . . educating or training. . . are such as to stifle the natural growth of the child." [Ibid., p. 107]

If one accepts the thesis that the authoritarian family is the breeding ground for both individual psychological problems and political reaction, it follows that anarchists should try to develop ways of raising children that will not psychologically cripple them but instead enable them to accept freedom and responsibility while developing natural self-regulation. We will refer to children raised in such a way as "free children."

Work in this field is still in its infancy (no pun intended). Wilhelm Reich is again the main pioneer in this field (an excellent, short introduction to his ideas can be found in Maurice Brinton's The Irrational in Politics). In Children of the Future, Reich made numerous suggestions, based on his research and clinical experience, for parents, psychologists, and educators striving to develop libertarian methods of child rearing. (He did not use the term "libertarian," but that is what his methods are.)

Hence, in this and the following sections we will summarise Reich's main ideas as well as those of other libertarian psychologists and educators who have been influenced by him, such as A.S. Neill and Alexander Lowen. Section J.6.1 will examine the theoretical principles involved in raising free children, while subsequent sections will illustrate their practical application with concrete examples. Finally, in section J.6.8, we will examine the anarchist approach to the problems of adolescence.

Such an approach to child rearing is based upon the insight that children "do not constitute anyone's property: they are neither the property of the parents nor even of society. They belong only to their own future freedom." [Michael Bakunin, The Political Philosophy of Bakunin, p. 327] As such, what happens to a child when it is growing up shapes the person they become and the society they live in. The key question for people interested in freedom is whether "the child [is] to be considered as an individuality, or as an object to be moulded according to the whims and fancies of those about it?" [Emma Goldman, Op. Cit., p. 107] Libertarian child rearing is the means by which the individuality of the child is respected and developed.