The major point in Austrian Business Cycle Theory (ABCT) that Phelps examines is that it is an overinvestment theory. In other words, the economy goes on a boom that causes an overinvestment in the capital structure, which then must collapse with the downturn. As his analysis goes, he paints a convincing argument if you allow a few assumptions. First, the ABCT is really a theory of only overinvestment. Second, capital is homogeneous and evenly distributed through the boom. And finally, the subsequent downturn is proportional to the boom.
Let us take these assumptions one at a time.
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.)
This brings us to the second point of assuming capital to be a homogeneous mass. Phelps, by making this implicit assumption, states that the economy will simply have “to work off some of the excess capital.” Through the process of “wear and tear,” the excess will disappear and we will be back to normal. At this highly aggregated level, Phelps’ logic is correct.
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.
Phelps’ third point on the ABCT, is that there wasn’t enough overinvestment to cause the downturn. As you can see by the analysis of the two preceding points, the size or extent of the boom does not have to correlate with the size of the recession. In the first place, the ABCT emphasizes the problem to be malinvestments which may not show up in a highly aggregated statistic that Phelps examined. Second, the liquidation process, which is the realignment of entrepreneurial expectations and plans, may encounter many price and wage rigidities.
Posted by Paul Cwik
