The Importance of the Demand Shock

Why does Austrian business cycle theory predict a spike in unemployment when boom turns to bust, but not during the boom itself? Because the former involves a demand shock and the latter doesn’t.

ABCT predicts that fiduciary overexpansion will cause a distortion of relative prices that will bias capital intensive changes to the structure of production. The changes are price, or profit, driven, and these profits are created by fiduciary overexpansion. When credit growth slows or ceases, these profits begin to dry up and non-random malinvestment is revealed. What is malinvestment? Imagine a capital structure prior to the boom, which we’ll call ‘A,’  and a new capital structure at the height of the boom, ‘B.’ This A→B transition represents a change in the type of capital goods produced, because changes in the distribution of profits also change the imputed values attached to each good. When the source of “false profits” (profits caused by credit expansion) dries, the various capital goods that gained value from these profits lose that value; this is a capital consumption shock, where a large chunk of the capital stock loses value, because of a demand shock.

To make the point clearer, let’s think about how something similar could occur if it were to be completely consumption-driven. That is, suppose we’re at structure of production ‘A’ — no boom —, where the values of the means of production are imputed from the demand for their final product (the consumer good). Suppose there is a sudden shock to consumption, because there is a dramatic society-wide change in time preference, in favor of an immediate doubling of savings. Let’s assume that this shock is large enough to make a noticeable downward impact on the prices of the different consumers’ goods. The prices of the relevant means of production will also change, because this scenario presents an immediate halving of revenue for the consumer good industry. The structure of production will have to change (becoming more capital intensive), but since these changes take time there will be a period of heightened unemployment. In any case, note that this is also a case of a capital consumption shock, since those capital goods once valued for their final product are no longer as highly valued (because demand for their final product falls).

There may be secondary features that differentiate the two cases (a credit induced boom–bust v. a dramatic change in time preference). For example, our hypothetical “consumption shock” will probably not lead to significant “debt deflation,” where bad loans are revealed and liquidated. The financial malinvestment that characterizes real world business cycles is a byproduct of the fact that banks, or financial intermediaries, are key players in the extension of credit — they finance the malinvestment. There may be some monetary disequilibrium, due to any increase in uncertainty, but this wouldn’t be the primary cause (or perhaps not even a major cause) of the unemployment spike. But, the two cases are similar where it matters: the relationship between imputed profits/prices, changes in these, and capital consumption.

Of course, these kinds of wild swings in consumption patterns aren’t likely to occur in the real world (it would be a black swan event). I only bring it up to show the relevance of the demand shock to the business cycle. Changes to a more capital intensive structure of production are gradual; the Austrian business cycle, at least where boom turns to bust, is not a theory of gradual change, but of the need for immediate transition — to avoid the spike in unemployment the capital structure has to immediately change. Because immediate change is unrealistic, we have a temporary period of increased idleness.

This discussion, by the way, reminds me of a paper by Hoffmann and Urbansky, “Order, Displacements and Recurring Financial Crises.” It’s been over a year since I read it, and I vaguely remember some areas of disagreement, but I think it more-or-less captures what I write here and presents it in the more sophisticated framework of order.

7 thoughts on “The Importance of the Demand Shock

  1. Zack

    So what you are saying Jonathan, in other words, is Austrians argue that these “demand shocks” happen in response to a recession, caused by fiduciary over-expansion and malinvestment, but are not necesarily the cause of the recession in the first place? Like many Keynesians would argue? Am I wrong here?

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    1. JCatalan

      Yea, credit expansion causes a restructuring of the allocation of expenditure (agg. demand) and when the credit expansion slows/ceases the allocation of AD changes to what it was originally, requiring an immediate restructuring of output. To speak more directly to your question, whereas AD shocks in the Keynesian/Monetarist framework are almost random, here the AD shock is caused by the policies which also caused the boom.

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      1. Zack

        right- MM’s and Keynesians would attribute AD shocks, to what, animal spirits? Basically, there is no casual reason as to why these demand shocks happen, its that they just “happen?” correct?

        That never made sense to me, even before I discovered what Austrian economics was.

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        1. JCatalan

          I don’t know what they see as the catalyst for the recession. There was a resurgence of Minsky after the crisis, which seems to suggest that most “Keynesians” will point at the bad loans being made — but rather than malinvestment, they see it as a foolish disregard for the underlying risk (as well as fraud). As for market monetarists, I’m not really sure, because I don’t know what “falling NGDP expectations” really means (surely, NGDP expectations fell because of bad economic performance, as opposed to bad economic performance caused by falling NGDP expectations).

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  2. Rob Rawlings

    Stated simplistically ABCT is a theory that explains how the economy can be induced (by an inappropriate monetary regime) to move away from a structure that optimally matches the underlying preferences of market participants. At the end of the boom the economy has to go thru a process to adjust back to the optimal structure.

    You correctly point out that that this is the same challenge that would be faced by an economy that had a sudden change in time preference-where the economy would likewise have to go thru a process from a sub-optimal to an optimal structure.

    Comparing and contrasting these situations makes for an interesting thought experiment.

    I’m interested in your statement “There may be some monetary disequilibrium, due to any increase in uncertainty, but this wouldn’t be the primary cause (or perhaps not even a major cause) of the unemployment spike”. I’m not sure I agree with this.

    Even if prices and wages were perfectly flexible and there was no change in uncertainty then there may be unemployment during the transition. Because productive capacity is (in both cases) misaligned with actual demand schedules there will be some “structural” unemployment (unemployed workers in some shrinking industries with the wrong skill-set or in the wrong location for the growing industries, or perhaps bottlenecks caused by some “stages” of production unable to produce at capacity because of missing inputs).

    But in both cases it seems to me that an increase in uncertainty would very likely occur and induce a “demand shock”. If prices and wages are sticky and if appropriate monetary policy wasn’t conducted this could eaily lead to a recession that would be much more significant than the structural unemployment described above.

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    1. JCatalan

      You may be right. I suppose it’s an empirical question. I’m interested in what skill-levels most of the unemployment is in, because the lower the skill level, the less relevant sticky wages should be, I’d think (lower productivity workers, the efficiency wage argument should be less relevant — none of my minimum wage employers cared about efficiency wages, at least). My guess is that sticky wages is not a major driver of unemployment (although it is a driver), and that it’s that in conjunction with other issues that are holding back productivity. The way I see it is that, even with a fall in wages, it makes sense to hire only a maximum number of workers per firm, because at some point the additional employee will bring about negative productivity. If competition between firms is reduced because of deficient restructuring, then there will be some level of unemployment. I think some of my “transaction cost” issues that I talk about a lot (although, to be honest, I haven’t really developed what these are exactly all too well) are relevant here.

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