ABCT and the Price Level

I remember my monetary theory professor using an aggregate demand/supply graph to illustrate supply-side theories of the business cycle, where a supply shock shifts the supply curve to the left. All else equal, a negative supply shock will lead to an increase in the price level — the same amount of money chasing less goods. This is how some people interpret Austrian business cycle theory (ABCT): there is a negative supply-side shock to the capital stock. It follows that the price level for capital goods rises. But, the evidence suggests the exact opposite, falling prices in the capital (intermediate) goods sector. That interpretation is wrong. ABCT is a demand-side theory, and it predicts just what the evidence shows, a falling price level for capital goods.

I also discuss what predictions ABCT makes regarding the general price level. The simple answer: none. This is why the ABCT cannot explain the depth of a recession on its own. I make my case in the second part of the post.

If you think that Hayek’s theory is about a supply-shock, read “The Maintenance of Capital.” The article presents a theory of the value of the heterogeneous capital stock. It’s related to Hayek’s business cycle research, in that it clearly frames the issue in the context of aggregate demand. Note his discussion of “capital consumption.” Capital consumption is not the same thing as a supply-side shock to the capital stock. Remember, the value of the capital stock is imputed (derived) from the final product. A rise in the price of an input is caused by an increase in demand for that input’s output. A fall in the demand for the final product, leads to a fall in the value of those inputs — capital consumption. This is important to keep in mind, because this is one of the basic parts to ABCT.

Let’s call an economy “neutral” when the allocation is optimal (don’t worry about frictions and imperfections). Picture an economy as a production possibilities frontier (PPF), with capital goods on one axis and consumer goods on the other. The PPF represents potential mixtures of output, given some given amount of resources. Not all points on the PPF are equally valuable. The neutral economy produces where the opportunity cost is lowest, which is a specific point on the PPF. Essentially, ABCT predicts that an excess supply of money will cause an economy to become non-neutral, by producing on some other point along (or inside) the PPF. This is shown in the graphic below, where the PPF is on the right — consumer goods on the y-axis and capital (or producer) goods on the x-axis. There are two marked places on the PPF; the uppermost circle is the original mix of output, and the lower circle is the new mix of output.

Output Combinations and the Hayekian Triangle

(Don’t worry about the Hayekian triangle on the left panel.)

Forget about central banks and interest rates, and focus on an excess supply of money. Hayek and Mises believed excess supplies of money to be non-neutral. Specifically, they thought excess supplies of money changed the prices of capital goods relative to those of consumer goods. The stylized process by which this happens is that new money is introduced through the loanable funds market, as banks extend loans. That borrowed money is used to buy certain inputs, raising the price of those inputs, and thus the profitability of producing them. The economy moves towards producing somewhere lower on our PPF curve, above (the second point on the curve). This means less consumer good output, since more resources are being used to manufacture intermediate (capital) goods. But, the level of consumption remains the same, so as the supply of consumers’ good falls, their price increases. This sets off a process of reversion, where the structure of production has to re-adapt to society’s time preference (intertemporal equilibrium).

Where is the shock to the capital stock? As amount of current inputs going into the production of future inputs increases, it changes the nature of capital. If the value of capital is imputed from the final product, and the final product capital is being used for changes, then the value of the capital stock will change. The excess supply of money, by raising the price of inputs, creates “false” profits. To keep it simple, “false” profits are non-neutral. These profits will make the new structure of production seem of high value. But, the reversion process corrects this, and there is a change in the pattern of demand. The investment during the boom is “malinvestment,” and the capital stock loses much of its value (it’s consumed), by virtue of the fact that the “false” demand for its output collapses.

Note that the prediction is a fall in the value of the capital stock. The physical stock of capital remains the same. The prices of capital goods, however, collapse. The type of inputs produced by the boom-time structure of production are not as useful as they first seemed. The range of productive uses narrows, and if the capital is highly specific it might become completely useless (Hayek makes this point explicitly in Prices and Production, and references the debate on idle resources).

To put the same point differently, imagine a supply/demand graph. The price of a capital good is decided at the margin at which the supply and demand curves meet. ABCT predicts that the demand curve will shift to the right during the boom, and then to the left during the process of reversion. Thus, the bust coincides with a falling price level for capital goods. The supply-side shock, just to be able to compare and contrast, predicts that the bust coincides with a leftward shift of the supply curve, or an increase in the price level for capital goods. The intuition behind that process is that as the amount of a type of capital decreases, the least valuable end that last input is useful towards increases in value (since there is less capital, there are less ends that can be satisfied — and, optimally, the most valued ends are satisfied first). This is not what ABCT predicts. Rather, ABCT says that, during the bust, the least valued end will decrease in value, because, as it turns out, what producers thought were highly valued ends were just distorted profit signals, caused by an excess supply of money.

The theory fits the empirical evidence, at least in this respect,

PPI Intermediate Materials 2001-2012

What about the general price level (consumers’ + producers’ goods)? ABCT is somewhat indeterminate in this regard, because capital consumption occurs while the price of consumers’ goods increases. It’s also ambiguous whether the excess supply of money will end through a rise in the price level, or through some kind of aggregate reflux mechanism. What brings about the primary effects of the ABCT are not changes in the money stock, but changes in relative prices. To explain a decline in the general price level, Austrians usually employ another theory, typically referred to as “secondary deflation.” Because this is no longer really within the scope of the ABCT, Austrians are somewhat vague on this point. But, I think this point is worth discussing, because it shows that ABCT most likely cannot explain a major business cycle on its own.

Rothbard provides an entire section (pp. 14–19) to explaining secondary deflation in America’s Great Depression. He employs a very strict quantity theorist definition of inflation/deflation: an increase/decrease in the money supply (although, I’m not sure this is consistent with some of the causes of deflation he discusses). Some of the causes he gives assume a gold standard, relevant then, but not now. Still, I think they can be generalized. He cites an outflow of gold (or, more broadly, let’s call it capital), forcing banks to contract their balance sheets. He also cites debt liquidation, where credit simply cannot be repaid. Finally, a third force is the increase in the demand for money. The deflationary process is, strictly speaking, separate from the process described by ABCT; related to it, but not directly. Rothbard considers the deflationary process beneficial. In the preface to “Monetary Theory and the Trade Cycle,” Hayek also distinguishes deflation from the process described by ABCT, but writes that “an indefinite continuation of that deflation would do inestimable harm.”

There are multiple margins to judge deflation on. Rothbard’s point, which is valid, is that what matters are relative prices, not general prices, so that deflation doesn’t necessarily cut into profits — especially if capital good prices fall faster than consumer good prices (which is empirically true). I will come back to this shortly. Other channels through which deflation may not be beneficial include those akin to Fisher’s theory of debt deflation. A New Keynesian model will also tell you that a non-inflationary environment forgoes the benefit of inflation to reduce the demand for money, if we are in a liquidity trap, where interest-bearing assets and money are equally attractive, because of low interest rates. I’m not going to comment on the validity of these theories. They are nevertheless worth considering, and I will say why that is below.

Debt deflation and liquidity traps aside, knowing why Rothbard is somewhat wrong is important. Note a claim he makes on the height of unemployment caused by an Austrian business cycle,

Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary.

America’s Great Depression, p. 14.

This is, by the way, the exact claim Paul Krugman makes in his criticism of ABCT, what he calls the “hangover theory.” The initial boom period requires substantial capital readjustment, as well, but during this period the unemployment rate is relatively low — either around its “natural” level (~4–5 percent), or below. I think the critique is not as strong as some make it out to be, because the bust is a sudden change in relative demand, with significant capital consumption. During the boom, there is competing demand for consumer and capital goods, so one sector doesn’t necessarily suddenly become unprofitable. The shift in the allocation of labor is much less painful during the boom. Still, Krugman (and Rothbard) have a point: ABCT cannot explain the depth of unemployment very well.1 You need an additional story, and the scapegoat many Austrians like is government, bad supply-side policy and regime uncertainty. But, blaming government is not always right.2

Explaining the direction the general price level moves in is relevant to explaining the depth of unemployment. Putting debt deflation and liquidity traps aside, deflation is good if it’s neutral. If the demand for money increases and deflation is non-neutral, the unemployment rate and the output gap will grow. Assume the money stock at time t is M1, but the demand for money at time t+1 calls for a stock equal to M2. If the supply of money doesn’t increase, there will be a demand shortage. There will be people who want to increase their cash balances by selling non-money assets, including labor and goods/services. But, there isn’t enough money to meet their demand for it. If deflation is neutral, a falling price level will cause a falling demand for money. If deflation is not neutral, the demand for money remains the same there is a shortage of money, and therefore of demand, and trade that would have taken place does not — output falls. Deflation can be non-neutral if some key prices don’t fall to clear the market, including the price of labor and, perhaps, other capital goods that are heavily complimentary to labor. This is monetary (dis)equilibrium theory. You need this theory to explain the depth of the recession.3

Austrian business cycle theory does not offer us ideas on the direction the general price level takes during a bust. Empirically, deflation is the norm. ABCT cannot explain this deflation, except through use of alternative theories. Further, while the ABCT explains the boom and the direct causes of the bust, it cannot explain other elements of the bust that are caused by confounding factors. But, ABCT definitely does not predict an increase in the price level of capital goods, which is what would happen in a supply-side shock. Rather, it predicts declining capital good prices, which fits the evidence.



1. I discussed a similar criticism in an August 2011 article, “Rethinking Depression Economics.” I think that much of my insight is valuable, but, at the time, I had not considered the role of monetary equilibrium to the extent I should have.

2. Bad supply-side policy can explain a lot of unemployment. The high unemployment of the Great Depression is explained in large part by bad supply-side policy. Alternative theories should be seen as complimentary. Look at the difference in unemployment between Spain and the United States, both of which have similar output gaps. Spain is an example of bad supply-side policy. The U.S., however, is an example of bad demand-side policy. As the unemployment rate falls, the output gap remaining equal, supply-side theories of unemployment have less explanatory power.

3. Hayek understood this. Apart from his comments on the negative effects of deflation, see “The Gold Problem” (published in Good Money, Part I) and “Monetary Nationalism and Monetary Stability.” I think he realized the power of Hawtreyian (?) explanations of the Great Depression, which focused on international gold flows and reserve hoarding by part of central banks. He wanted to synthesize these theories with his own.

6 thoughts on “ABCT and the Price Level

  1. Bernardo Versiani

    Excelent post, Jonathan.

    I also think that explanations about the size and intesity of the boom could be enriched by applying a bit of the FIY from Minsky.

    But just one question. On the first paragraph you say that the usual supply-side theory happens when “a supply shock shifts the supply curve to the left – all else
    equal, a negative supply shock will lead to an increase in the price
    However, a little further on the text, when you use de AS/AD diagram to compare the two theories, you say “the supply-side shock (…) predicts
    that the bust coincides with a rightward shift of the supply curve, or
    an increase in the price level for capital goods”. Am I missing something here?

    1. JCatalan

      Thanks, I think that was a mistake on my part. I mean a leftward shift.

      My problem with Minskyite explanations is that it explains bad investments by banks, and other financial organizations, as a product of excessive risk-taking, or something similar. I don’t think that’s the case, empirically. It’s easy to say that bankers were taking excessive risks after the fact; it’s not to easy before the fact.

  2. Roman P.

    There is some merit in ABCT, I think. There is a great deal of holes in it, though: from the lack of the natural interest rate to the loanable funds model it employes. I believe that makes causality in ABCT wrong: it’s not credit boom that leads to the unwise investments, it is the general optimism about investments that must lead to credits and the increase of money supply. Business doesn’t care much about interest rates when it decides on capital investments anyway (and that’s an empirical fact). Maybe ABCT future is in being mated with endogenous monetary theories?

    Overall, I think that FIH and ABCT describe different kinds of recessions. FIH is about Ponzi schemes and high leverage leading to chain reactions of financial failure. ABCT is about disillusionment and previously booming industries turning out to be not so hot anymore. So FIH is 1929 and 2009, ABCT is Dotcom bubble or Videogame market crash of 80’s.

    There probably are other types and mechanisms of recessions. ABCT, suitably modified, could be a very nice description of a certain kind of historical occurrences. But overall FIH is probably more relevant because, as history shows, financial collapses it describes are the most dangerous kinds of system-wide failures.

    1. M.H.

      Interest rate is not necessarily the key concept in ABCT. Hayek himself in (Profits, Interest, and Investment, pg.64) focused more on the rate of profit in his later work. Also, Mises in Human Action noted the following :

      “If a bank does not expand circulation credit by issuing additional fiduciary media (either in the form of banknotes or in the form of deposit currency), it cannot generate a boom even if it lowers the amount of interest charged below the rate of the unhampered market. It merely makes a gift to debtors. The inference to be drawn from the monetary cycle theory by those who want to prevent the recurrence of booms and of the subsequent depressions is not that the banks should not lower the rate of interest, but that they should abstain from credit expansion.”

      Even if you don’t truly like the “natural interest rate” concept, note that when econometricians use proxy (e.g., long-term interest rate, or the Rothbard’s savings-consumption ratio) to approximate the natural interest rate(s) they usually find empirical support for ABCT prediction. There is more support in favor of ABCT than against it. The only problem I see with all these empirical works is that they rely on the interest rate, whereas the rate of profit would have been surely a much better proxy variable.

      “it is the general optimism about investments that must lead to credits and the increase of money supply”

      Without monetary injection, the increase in interest rate would stop credit inflation. Optimism does not generate credit inflation. Or, to cite Fritz Machlup :

      “If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, the boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted.”

      Empirical works by Carilli & Dempster (Is Austrian Business Cycle Theory Still Relevant?) also refute your claim here. They found evidence that the interest rate gap leads to an artificial expansion followed by a contraction of GDP. In other words, boom-bust cycle is endogenous to interest rate distortion. That couldn’t be the case if it was due to some other phenomenons, such as over-optimism.

      Regarding this sentence, “ABCT, suitably modified, could be a very nice description of a certain kind of historical occurrences.” it seems odd to me, because it sounds like you think the ABCT is aimed to describe what has occurred during the boom-bust cycle, which is mischaracterization. ABCT says only that credit inflation create the boom-bust cycle, but not where the credit goes first or which sectors had inflated within each of these cycles.

      1. Roman P.

        There is a certain problem that the understanding of how banks work was pretty dim back then (not that it’s a crystal clear topic even now). Even Keynes was ambivalent whether money supply was exogenous. Austrian school, as demonstrated by this quote from Machlup, lies on a hidden assumption of a loanable funds theory. The reality (readily verified in any book on bank accounting) is that it’s not how real banks work. We live in a world with an endogenously determined money supply, for better or worse.

        Concerning the blog post about Empirical Evidence for the ABCT, many thanks, I’ll have to read it in depth. I have to say that I like how it starts right away with a truistic analysis of RGDP/smoothed RGDP ratio in recessions.

        Regarding your last paragraph, I don’t really understand what’s your point there. I didn’t imply that ABCT is useful for ex ante predictions of exact booming industries. Hindsight is fifty-fifty, in the end.


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