1. Productive consumption:  Consumption which leads to an increase in real wealth.  For example, flour must be consumed to produce bread.  A more mainstream way of putting it is investment.
2. Unproductive consumption: Consumption which does not lead to an increase in real wealth (increase in the supply of economic good), but rather leads to a decrease in real wealth (even if it was meant to satisfy certain desires).
3. Reproductive consumption:  Consumption that leads to the reproduction of the same good.  An example is the consumption of rubber truck tires in the event that a truck is transporting more rubber to a tire plant.

All of this reinforces my belief that the mainstream view of consumption, and especially “national output”, is extremely skewed.  This is because, as implied above, the majority of so-called “consumption” is productive.  When politicians and some economists suggest that the key to economic growth is consumption, however, they neglect the fact that it should be productive consumption, and as such they tend to conflate productive consumption with unproductive consumption (for example, the idea that putting people to work by digging holes can somehow be productive).

When it comes to “national output”, it follows that the cause for our wealth is purely investment (productive consumption), not this concept of “aggregate demand” or aggregated consumption.

I first jotted my thoughts on this topic down yesterday, in response to a post by Dennis Sperduto on the Mises Institute’s website (“The Intellect and Personality of J.M. Keynes“).  Unfortunately, despite having posted the comment twice, it seems as if the blog software was a little glitchy and it failed to go through both times.  My comment also brought into consideration the point brought forth by Jeremiah Dyke in his post, “Keynes, The Intellectual Lightweight“.

It seems to me that the strategy of consistently attempting to discredit Keynes, especially when using the tactic of attacking the persona rather than the theory, covers up a general glut in the presentation of Austrian theory to the mainstream.  In other words, it represents a failure in the ability for Austrians to persuade “non-believers” through the merit of their own theory.  So, instead, they have to discredit the theories of others, and therefore leave “non-believers” no other alternative than to consider the Austrian school.  Obviously, this is not always true—my Austrian sympathies are not a product of any disillusion with the Neoclassical or Keynesian schools, I simply saw Austrian theory are more correct.  I am just suggesting that there is a trend amongst modern Austrians, especially those not involved in academia, of entropy or rot in the development and presentation of Austrian theory.

Many Austrians (again, not all, and mostly non-academia) have perpetuated a myth of victimization, or that the Keynesian school of economics profits off the fact that its theories are in line with government policies.  For example, Sperduto writes,

As Ludwig von Mises observed, the great success of Keynes’s General Theory was due to it providing a pseudo-scientific justification for the policies that virtually all governments of major countries had been pursuing for several years prior to its publication in 1936.

Austrians have a tendency of brushing off their own short-comings, and instead attributing the success of others to intellectual dilution, or a lack of fair play by part of academic rivals (i.e. through the use of government).

In the case of Keynes’s General Theory, its success cannot be placed entirely on the fact that it was published during an era of escalating government interventionism (although, I do think the Great Depression played a big role in its success, albeit for other reasons).  Interventionism, to one degree or another, has always existed.  Indeed, mercantilism became popular during eras of great government intervention in the economy.  However, mercantilism was met with a general free-market movement, to a large degree instigated by “pre-capitalist” economists such as the School of Salamanca and William Petty, and finally solidified by Richard Cantillon, Adam Smith, the Physiocrats and the Classical school of economics.

Keynesian theory, instead, has attracted a growing number of intellectuals, and the anti-Keynesian revolution has been lacking (although, significantly strong and perhaps growing, even if at a very slow rate).  Instead of suggesting that this is a product of government collusion with academia, or a general war against rationalism (a la Ayn Rand and George Reisman), I instead attribute Keynesian success to the solidity they enjoy in marketing their ideas.  In other words, Keynesian theory is attractive.  It is considered theoretically sound by its adherents (and thus I reject the notion that Keynesians only perpetuate Keynesian theory because they are funded by the state).

Did the Great Depression play a role?  I think so.  The Great Depression, if anything, created a great disillusionment with Classical and Neoclassical ideas.  It challenged the then mainstream premise that markets were self-correcting, or that markets were impervious to inherent flaws.  Keynes did not win over economists who prior to The General Theory were completely ignorant of what was to be known as Keynesian economics, rather he knit together concepts which were already floating around and provided a unifying treatise that fellow “believers” could rally around and base further theoretical advancements on.  These economists who thought like Keynes and later fed off Keynes include Joan Robinson and John Hicks.

The overall point was that Keynes’s General Theory appealed to a growing sect of economists who were seriously unconvinced by the then-mainstream narrative.  This could have been a product of the Great Depression, but the state played no direct role.  In other words, The General Theory was not made popular through some mechanism provided by the state which forced Keynesian doctrine down the throat of otherwise non-believers.  The attempt to discredit Keynesian theory by injecting the notion of the corruption of academia and intellectualism by the state is simply unfair.

Equally unfair are the general attacks on Keynes the man, rather than Keynesian theory.  Sperduto quotes Rothbard,

John Maynard Keynes, the man—his character, his writings, and his actions throughout life—was composed of three guiding and interacting elements. The first was his overweening egotism, which assured him that he could handle all intellectual problems quickly and accurately and led him to scorn any general principles that might curb his unbridled ego. The second was his strong sense that he was born into, and destined to be a leader of, Great Britain’s ruling elite. Both of these traits led Keynes to deal with people as well as nations from a self-perceived position of power and dominance. The third element was his deep hatred and contempt for the values and virtues of the bourgeoisie, for conventional morality, for savings and thrift, and for the basic institutions of family life.

Later economists continued to hew a revisionist line, maintaining absurdly that Keynes was merely a benign pioneer of uncertainty theory (Shackle and Lachmann), or that he was a prophet of the idea that search costs were highly important in the labor market (Clower and Leijonhufvud). None of this is true. That Keynes was a Keynesian—of that much derided Keynesian system provided by Hicks, Hansen, Samuelson, and Modigliani—is the only explanation that makes any sense of Keynesian economics. Yet Keynes was much more than a Keynesian. Above all, he was the extraordinarily pernicious and malignant figure that we have examined in this chapter: a charming but power-driven statist Machiavelli, who embodied some of the most malevolent trends and institutions of the twentieth century.

Even accepting that I simply do not know enough about Keynes to judge whether or not Rothbard is right, Rothbard’s criticism is simply irrelevant.  Keynes’s personality or his personal objectives have no direct bearing on the validity of Keynesian theory.  Rothbard’s tactics amount to just poor form; they are an attempt to discredit Keynesianism by making it seem the product of a man with nothing more than power as his objective.

Just the same, Jeremiah Dyke’s post dealing with Keynes’s faulty handle on the German language has no direct bearing on the validity of Keynes’s interpretation of Mises’s The Theory of Money and Credit.  That Keynes’s criticism of Mises was horribly simplistic and a product of the same mistake Austrians make when criticizing Keynes is different altogether (and, perhaps, suggests that Keynes’s criticism is not worth addressing at all).

There needs to be a shift away from rabid anti-Keynesianism (perhaps flamed by the ongoing economic crisis).  Instead of focusing on discrediting Keynesians, Austrians should spend more time making their own theory more attractive.  This means either making the logic easier to see or more attractive to the general audience, and further developing Austrian theory altogether.  Criticizing Keynesians has its uses, but like everything else is subject to diminishing marginal returns.

The problem is that this new “custom” technology requires a second machine.  The doctor who I spoke to yesterday said that the machine was another “half a million dollars”  (I’m not sure if that’s the real cost).  While I am sure that the cost of this second machine does affect prices to some degree, it’s also true that comparatively speaking the cost of the actual custom operation is only marginally higher than that of the standard operation, if you do not include the original cost of the machine.  In other words, my point is that now that the machine has been purchased, it probably doesn’t save much money to commit to the standard operation (the machine will have been bought regardless).

So, I am hoping I can find something between $3,000 and $3,500.

In any case, I was talking to my dad about health care (him being a bleeding heart liberal), and I suggested that the distribution of these LASIK machines much be incredibly limited by the government.  Only certain, accredited ophthalmologists can probably purchase the machines needed to conduct the surgery.

Talking to doctors so far, it doesn’t seem as much effort is put into the operation by the doctor himself.  I am sure that medical knowledge is necessary, but it doesn’t seem as if eight years of medical schooling is.  In the standard operation, the cutting of the flap is manual, and so obviously you want someone who knows what he is doing, but training for this is probably relatively short (doctors don’t spend eight years in medical school learning how to operate a blade to cut the eye’s flap open).

I think that if we had a true free market in health care, other things aside, not only would the cost of these machines go down, but the cost of the operation would go down.  Indeed, I am absolutely certain that if there was a free market in health care, we would see lasik eye surgery being conducted in places like Walmart.  We would literally see eye surgery factories, where clinics would process dozens of people per day (instead of six or seven).  I am convinced that the price of the surgery would be measured in the hundreds of dollars, and would steadily go down.

Surprisingly, my dad agreed with me.

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 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 the wrong lines, i.e.; malinvestment.  The entrepreneurs employ a supply of r + p1 + p2 as uf tget were in a position to employ a supply of r + p1 + p2 + p3 + p4.  They embark upon an expansion of investment on a scale for which the capital goods available do not suffice.  Their projects on unrealizable on account of the insufficient supply of capital goods.  They must fail sooner or later.  The unavoidable end of the credit expansion makes the faults committed visible.  There are plants which cannot be utilized because the plants needed for the production of the complementary factors of production are lacking; plants the products of which cannot be sold because the consumers are more intent upon purchasing other goods which, however, are not produced in sufficient quantities; plants the construction of which cannot be continued and finished because it has become obvious that they will not pay.

This is why I continually stress, not overinvestment, but investment made due to the distortion of the price structure.  Investment made because entrepreneurs were unaware of the true scarcity of capital-goods.   It is a confusion of causality.  Entrepreneurs didn’t invest too much, per sé; their is no abundance of goods.  Rather, there is a lack of goods, caused by malinvestment.

I clarify this in my Krugman contra Hayek Mises Daily,

Despite this notion of disequilibrium, Austrian theory does not argue in favor of blaming “overinvestment,” as the supply of capital goods does not necessarily increase. Instead, it examines price distortion where a price ceiling is effectively installed causing entrepreneurs to not recognize the actual scarcity of the capital goods in question — the adjustment of the price mechanism reveals this scarcity, and entrepreneurs must liquidate their “malinvestments.”

So, for those who continue to claim this overinvestment nonsense as an interpretation of what I write, it is only due to your lack of understanding of Austrian business cycle theory, or an inability to “connect the dots”, so to speak.

I realize I come off as hostile and conceited, but the debate is tiring when it goes in circles.  I don’t accuse non-Austrians of being able to argue in only circles.  My only objection is to move beyond what has already been discussed, or at least disprove that Austrian theory is one of “malinvestment”  not “overinvestment”.  But, don’t debate as if we haven’t addressed these concerns already.

One reason why the bust in the capital-goods sector affects the consumer-good sector is the revelation of the scarcity of capital-goods by the equilibration of the price mechanism (distorted by prior accelerating money creation).  As explained in my previous post on this subject, higher output in one phase of production requires a horizontal expansion of that phase.  In other words, capital-goods are required as inputs to produce these consumer-good outputs, and these capital-goods require other capital-goods to be produced (up until the point where the factors of production are just labor, land, and time).  So, even consumer-goods require a certain number of lower-order capital-goods to be produced.  When the price mechanism is distorted it causes an increase in demand for capital-goods by lengthening and widening the structure of production.  When the price mechanism is restored scarcity doesn’t return to its state prior to the beginning of the boom, but rather capital-goods are now even more scarce because they have been consumed in malinvestment.  This scarcity can effect both higher-order industries and lower-order industries.  It just makes sense that since higher-order industries require a greater input of capital-goods (because the sector is necessarily larger), it will the be most affected by the bust.

A second reason is very similar to the Keynesian “aggregate demand” explanation, although where Austrians differ is in causation.  A drop in productivity in the higher-order capital-goods sector, due to rampant malinvestment and high real-wages, is bound to lead to unemployment (I think this has been agreed upon).  The Austrian case for why this unemployment exists has already been laid out (this was another one of Krugman’s criticisms), but it basically revolves around the idea that unlike during a boom a period of high uncertainty will not produce as much investment, so there is no growth in other sectors that may absorb these newly unemployed (in fact, there is a contraction in the size of all sectors of the economy).  This will limit their ability to purchase certain consumer-goods, which in turns limits the productivity of the consumer-goods sector (it decreases their sales).  This can also be true if wages decrease due to monetary deflation.  It requires a drop in prices in consumer-goods and capital-goods alike (a drop in the price of capital-goods allows the manufacturer of consumer-goods to produce without incurring a loss).  Nevertheless, there is no reason to believe that the capital-goods industry and consumer-goods industry are not interrelated.

Third, and similar to above, industries severely affected by the downturn may not necessarily be those who had originally been involved in the malinvestment.  Indeed, it could be industries that existed before the boom began, and were profitable then.  Previously profitable enterprises will be severely affected by a general drop in productivity.  This includes capital-goods industries directly involved in the production of consumer-goods (that horizontal expansion I was talking about earlier).

Daniel continues with more minor objections of my explanation in general,

This one isn’t quite as clearly sketched out, but I think the point is that if the marginal productivity of the capital good (the nails) falls, because industries are interrelated production in all sectors will fall. Capital goods are substitutable and switchable across industries. But Jonathan fails to even consider any magnitude for the elasticity of substitution between sectors, and implicitly assumes such an elasticity is extremely high. Otherwise productivity shocks couldn’t propagate across sectors. So that’s one implicit assumption of his that he chooses not to share with his readers.

Admittedly, I am not quite sure what Kuehn is talking about.  I didn’t assume any level of elasticity in my explanation.  Elasticity for different capital-goods, along different sectors of production, can be different.  I merely suggested that given the dynamic characteristics of capital-goods they can be used in several different lines of production, which makes different industries interrelated to some extent.  To what extent can vary, but that relationship exists.

Furthermore, he criticizes that “assumption” on account of the Austrians disbelief in the homogeneity of capital.  I am a firm believer in heterogeneity of capital, but it doesn’t mean that certain capital-goods cannot be used for multiple industries.  It is perfectly plausible that the nails used to put together my home are also the same type of nails used to put together a retail store down the block.  Or, the same type of nails used to put together a factory on the other side of the city.  Or, it’s possible that the factory that produced my nails also produces the type of nails for the factory across the city, and when it went under so did the production of nails for that factory.

Kuehn’s criticism seems misplaced and based on a misunderstanding, or exaggerated understanding, of the Austrian concept of heterogeneity of capital.  Just because all capital is not substitutable, doesn’t mean that some capital is in specific industries, or between specific forms of capital-goods.  The Austrian approach, rather than ruling out the interrelation of different industries through the use of similar or the same capital-goods, stresses a microeconomic approach to deciding this interrelation, rather than the macroeconomic blanket approach of homogeneity.

Finally, Kuehn tries to equate my reasoning with Real Business Cycle Theory,

If Jonathan assumes that all capital goods at all stages of production experience a fall in marginal productivity I can certainly accept that as an explanation for widespread unemployment. That’s Real Business Cycle Theory.

This is false.  Two theories can conclude similar consequences, but the causality may differ.  This is true in this case.  While I blame price distortion as the cause of this economy-wide recession, Real Business Cycle Theory (based loosely on rational expectations) blames “real” causes—i.e. supply shocks and similar events.  I agree with Kuehn that Real Business Cycle Theory explains business cycles as a result of a fall in aggregate supply.  But, it is a poor correlation to make that the two are similar, because both predict a fall in “aggregate supply”, and it is a very gross misinterpretation of Austrian theory in general.

Furthermore, Kuehn suggests that no ample explanation for this fall in “marginal productivity” (if those are the words he wants to use), ignoring the fact that the entire basis of this argument is a defense of Austrian business cycle theory (something he previously said he agreed with to some degree, and to that extent he must agree with the conclusions it offers).  The consequence is a very confused criticism put forth by Kuehn, and one that forgets that one of the direct consequences of the boom period is a necessary contraction of the supply of money (strictly speaking, the supply of fiduciary media).  All of this is explained in a prior article of mine: “Krugman contra Hayek“.

Ultimately, I blame the inability , or perhaps the lack of desire, to carry Austrian capital theory to its most logical conclusions, and failing to see the full scope of implications Austrian capital theory has on the structure of production during the necessary post-boom depression.

www.youtube.com/watch?v=EoHJihLaQBw

Christina Jeffrey, here, argues that the 2nd amendment is the constitutional provision which allows for the people’s right to guarantee a “limited government” (although, let’s face it, the 2nd amendment never provided that ability from the very beginning of the union—how many rebellions were put down through the use of brute force?).  I think George Reisman alludes to this as well, in Capitalism; he argues that those who fail to resist to the initiation of force (that which infringes on our rights; he argues that minimal government is necessary to guarantee basic liberties) are slaves and cowards.

Seems to me that this rather proves that the state will always in some way intoxicate society with some level of violence.  The argument here is that violence is necessary to combat the initiation of violence.  A peaceful and free society should never have this as a prerequisite for existence—it is, in fact, a contradiction.  A free society should be built on mutual cooperation.

That is why, theoretically speaking (perhaps, admittedly, not practically speaking), the most peaceful and free society is that which is free from the state.

Krugman makes the point that whatever matching problems are out there, and to whatever extent matching problems and malinvestments may explain unemployment rate differentials (we had a housing bust… the fact that construction workers are out of work after a housing bust is common sense), they do not explain the staggering collapse of employment across all sectors.

Which gets me back to what I continue to ask of Austrians – don’t explain to me ABCT over and over again. I understand ABCT. I even believe ABCT. Give me a reason to believe that is the primary force behind the downturn right now, rather than the secondary or the tertiary force.

I think the final part of the argument is a bit unfair.  Give a good reason why Austrian business cycle theory is not the primary force behind the downturn.  As the person challenging the theory, the burden of proof is not on us (although, of course, it might shift to us out of interest in defending the theory).  “A fall in aggregate demand” is not a good explanation; a fall in aggregate demand can occur for many different reasons.  Austrian business cycle theory suggests that aggregate demand (in the broadest of sense, since Austrians dislike talking about aggregate demand) falls because of a loss in productivity (so, namely, a fall in demand for capital-goods).

In any case, I’d like to comment on the notion that Austrian business cycle theory does not explain why employment falls across sectors other than the housing market.  Fortunately for Daniel Kuehn, the answer is not in Austrian business cycle theory, per sé.  The answer is in Austrian capital theory, and understanding the time structure of production.

Fortunately, I gave a lecture that included an introduction to the structure of production, and so this is all pretty fresh on my mind.  The structure of production can expand in two directions: vertically and horizontally.  The typical depiction of the structure of production is the Hayekian triangle, which is a two-dimensional figure which represents the vertical expansion of the structure of production.  On a basic level, the horizontal expansion of the structure of production would be represented on the z-axis.

From basic Austrian capital theory, we know that as capital accumulation increases, the structure of production becomes more roundabout.  Investment is made in sectors farther away from the consumer.  For example, if the final consumer good is an automobile, then a higher-order phase of production would be the manufacturing of the carburetor, and an even higher-order phase would be designing the carburetor.  If we assume one line of production, this can be represented by the Hayekian triangle (of course, the Hayekian triangle doesn’t really account for what is called “dynamic capital theory”).

However, an increase in demand for a good in a particular stage of production will also tend to expand that stage horizontally.  What is meant, following the example of the carburetor, is that an increase in production of carburetors will necessitate an increase in production of other capital-goods, or factors of production, relevant to the carburetor.  This may not be directly relevant to the final consumer good, in this case the automobile (and there is a caveat here, as well—an automobile, like a house, may not even be a consumer-good in the strictest sense; this is where dynamic capital theory can be brought into play), but represents a lengthening of the structure of production.

The result is that the lengthening of the structure of production relative to one good can have the consequence of lengthening the structure of production relative to a myriad of other goods.  In this fashion, the structure of production tends to expand over multiple sectors of the economy—a basic way of saying this is, different sectors become interdependent.

Only someone with a very poor understanding of Austrian business cycle theory, sorry Daniel, could claim that it only explains unemployment in the housing sector.  This is a gross misunderstanding of the theory, and shows poor understanding of the underlying theories which lead to Austrian business cycle theory (that is, interest theory and capital theory).  For all intents and purposes, Austrian theory predicts unemployment across a wide variety of sectors, and this ultimately affects both lower-order and higher-order industries.

Here it might be useful to describe what I consider a part of dynamic capital theory.  The fact is that an economic-good’s classification in terms of what stage of production it is in can change based on the line of production it is ultimately invested into.  The next good produced can then shift to another line of production, and so whereas the capital-good may have been six stages way from the consumer good at first, is now seven stages away.  That is why in the real world it is not really useful to depict the structure of production using two-dimensional, or even three-dimensional, graphs or illustrations.  There is simply no way of accurately illustrating dynamic capital theory (that I know of).

How is this relevant to the topic at hand?  Well, I’ll offer a very basic illustration.  Let’s say that because the structure of production relevant to the housing industry lengthens, there is an increase in demand and supply for nails.  These nails might be X stages away from whatever stage the actual house represents (like I said with the automobile, I am wary of classifying a house as a strict consumer-good; durable consumer-goods are oftentimes considered capital-goods).  However, if a box of nails is suddenly pitted towards another industry altogether (let us say, the construction of a lumber factory), then the stage it is at suddenly changes, as well.

While the lumber industry, in this case, is relevant to the housing industry, these kinds of switches can occur in industries which may not be directly related (as suggested above).  This, as also mentioned above, causes the structure of production to intensify across multiple sectors.  As a consequence of this interdependence (for lack of a better word), it only makes sense that a fall in productivity would affect several different sectors of an economy, not just the housing sector.

Really, in order to fully grasp Austrian theory, one has to delve into capital theory, as well (which is why most Austrian explanations of Austrian business cycle theory include an elementary explanation of capital theory).  I admit, myself, that I have not spent enough time into capital theory (even though, I agree with Hayek that at a certain point it might not be worthwhile to pursue capital theory in terms of concretely laying down in literature the more complicated dynamics of capital theory).

So, tea partiers, please stop touting the inherent worthlessness of paper money.  The problem is not that our money is made out of paper, but the fact that our money is decided by government fiat.  True, a capitalist society may prefer a metallic commodity over paper (although, more likely than not it seems as if society prefers money substitutes, tied to some specie), but this distracts from the fact that it’s not the paper that’s the problem, it’s the government which disallows through various means the introduction of alternative, freely chosen types of money.

I argue that involuntary unemployment is possible due to two reasons,

1. Knowing that markets are in constant disequilibrium, due to shifting supply and demand, it is fair to assume that at certain points wage-rates will be higher than the market-clearing price.  This creates a surplus of labor, or a shortage of wage-offerings.  Of course, there will be times when it may be the exact opposite; there can be a surplus of wage-offerings, and a shortage of labor.  In a growing economy, the latter may be more likely than the former, but they are both technically possible (I say it’s more likely because the demand for labor is more likely to shift to the right than to the left, and the supply of labor is not likely to be very volatile).
2. There may be imperfect information.  An individual, recently fired from a job, may not find employment in his direct geographical location (such as the city of Chula Vista, for me).  There may be, technically speaking, someone willing to employ him, but he may have to look for a longer amount of time to find this employer.  The amount of time spent looking represents him involuntarily unemployed, traditionally speaking (even if the amount of time he is unemployed is irrelevantly small).  This is actually suggested by Austrian economist Jesús Huerta de Soto.

The debate has really broken down to what really defines unemployment.  If we agree that self-employment is a form of employment, then all individuals can technically become employed.  Indeed, I could just as easily plant tomatoes in my backyard, whether they sell or not (I, effectively, become an entrepreneur).  Every individual has some labor and some capital to pit towards some end (I bring up, in the thread, the example of a homeless man cleaning automobile windows).

To what degree is it practical to talk about self-employment as a form of employment?  How broad is the word employment, in terms of the global population as a whole?  My point is, while it may be technically true that an autarkic individual is employed within his own economy, practically speaking when economists are talking about employment they are talking about employment within a certain economy.

What I mean is that an autarkic individual no longer forms part of the division of labor of the greater economy, and so technically speaking does not form part of the labor force in general (so, for all intents and purposes, he is not unemployed nor employed; he is simply not part of the labor force).  So, when talking about employment (whether it is as a wage-earner or as an entrepreneur), we are talking about individuals employed within a certain division of labor (a certain economy).  If an individual becomes autarkic, he is no longer a part of that division of labor (an individual participating in a division of labor is one who specializes on very few things, and allows the greater portion of his desires to be fulfilled by others).

So, a debate on employment  versus unemployment concentrates on a division of labor economy, where the unemployed are assumed to be individuals who are not earning a wage or gross profits while still looking to be part of that division of labor.

Unfortunately, the discussion has focused on this, rather than my two points (there is some discussion on those two points, but the claim mostly is that my conclusion does not follow my premise).  I am actually surprised that Austrians are hostile to this idea of market disequilibrium, and the possibility of involuntary unemployment.  I am a little let down by the fact that most people in the thread have preferred to call things “praxeologically unsound”(something with very little meaning, unless substantiated), or even dogmatically stick by the words of Ludwig von Mises (who, in Human Action, argues involuntary unemployment to be impossible in a free market).  I don’t mean to suggest that people should simply assume Mises was wrong, but it would be nice if they could apply his argument in their own words and expand it to cover Jesús Huerta de Soto’s case (something which Mises’s words may cover, but don’t directly address [since Mises is dead]).

Caplan lays out his critique with,

Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation.

I do think that entrepreneurs factor in government-induced distortions on the market.  But, the nature of low interest-rates make factoring in the possibility of malinvestment very difficult, although not entirely impossible (especially as the bubble reaches its height).  My defense of Austrian business cycle theory, here, rests on the premise that entrepreneurial activity is unlikely to stop, unless the government provides an absolute disincentive to investment (like squashing the private sector through nationalizations, regulations, et cetera).

An accurate understanding of Austrian business cycle theory is necessary to understand my defense.  A decrease in the interest rate provides an incentive for entrepreneurs to borrow, which Caplan claims is not a disagreement.  Here, there should be a distinction made between borrowing money that is saved, or borrowing money that is created with the sole purpose of lending it.  In the former case, there is no business cycle.  In the latter case, what occurs is that this newly created money causes higher-order goods to only appear more profitable (there is a lesser cost related to interest payment to discount from final profits).  The assumption, of course, is that most newly created money is funneled into the capital-goods sector (consumer credit is taken into consideration, as well, but empirically speaking most newly created loanable funds goes towards investors, not consumers).

This represents a distortion in the price mechanism.  Higher order goods seem less scarce than they actually are, due to their now lower price (again, the lower price is represented by the lower cost to borrow the necessary money to purchase these goods).  In order to maintain this illusion, the supply of loanable funds needs to increase at an accelerating pace.  When this credit expansion decelerates, or stops altogether, then the true scarcity of capital-goods is shown, and some investments prove to be unprofitable (as the cost of capital-goods increase, once again, due to the increase in the rate of interest).

So, why don’t entrepreneurs realize this pattern over a long period of time?  It’s important to remember that not all investment during the boom period is necessarily malinvestment.  Only entrepreneurs who can’t justify the purchase of new capital-goods, due to increased prices, will face the ruin of their enterprises.  So, knowing that not all investment is malinvestment, it doesn’t make sense for entrepreneurs to altogether drop investment.  Rather, entrepreneurs will simply have to estimate whether or not they believe their investment will be profitable over the long-run, even assuming a future rise in the rate of interest.  Also, it’s worth mentioning here that they will also have to plan out the length of their investment, and so this presents itself as an additional difficulty.

The core of my response to Caplan is that with a distorted price mechanism it is effectively incredibly difficult for an entrepreneur to judge whether or not his investment will be profitable over the long-run.  This compounds itself with the fact that entrepreneurs have absolutely no idea for how long central banks will maintain low-interest rates, so that is a factor that cannot be effectively dealt with.

It should be conceded, however, that as a bubble forms and grows, it should become easier to recognize it.  I think that entrepreneurs do begin to recognize bubbles. Furthermore, I do think that certain entrepreneurs do account for the risk of a popping bubbles.  However, I do not think that these entrepreneurs make up the majority of investors in these affected sectors of the market.  Furthermore, it has been shown that governments offer incentives to continue investments in these areas.

Let’s take the housing bubble as an example.  The majority of investors in the housing bubble probably had no real knowledge on any economic theory, let alone Austrian theory.  For all they knew, the increase in the price of housing could have originated simply from an increase in general demand, not due to increases in the supply of money.  Whether or not they could characterize the increase in prices as a bubble depended solely on their knowledge of past bubbles, and whether or not they recognized an unhealthy increase in prices (how many of these investors were knowledgeable on the tech market bubble of the late-1990s?).  Furthermore, the majority of those buying into the housing markets were simply individuals who recognized that if prices were to increase then they would make a profit off the purchase of a house.  Finally, I don’t think anybody really knew exactly when the bubble was going to pop, even if they recognized the existence of a bubble in the first place (not even Austrians!).

Regarding the heavyweight financial companies also involved in the crisis, it’s important to remember that much of the risk they would have otherwise carried was abetted by the government.  This includes the purchase of heavy-risk mortgage bundles by government sponsored enterprises, such as Freddie Mac and Fannie Mae.  Furthermore, big investment banks always operated under an assumed probability of government bail outs and liquidity provision by the Federal Reserve.  So, in many ways the housing bubble was propagated by a diffusion of risk by government.  So, with this considered, it was certainly rational for the big financial players to finance the housing bubble.

So, I don’t think the rational expectations arguments holds much water.  Indeed, could entrepreneurs not account for irrational exuberance?  It would surely be rational of them to do so.