Monetary Misperception, Rational Expectations, and the Austrian Theory of the Business Cycle.

Author:Manish, G.P.
  1. Introduction

    Salter and Luther (2016) argue that they can recast the traditional Austrian business cycle theory (ABCT) within a theoretical framework where agents maintain rational expectations during the boom period and where equilibrium always prevails during the bust. In this respect, they build on the pioneering work of Robert Lucas (1972, 1973, 1975) to meet the standard "rational expectations" objection to traditional ABCT, as well as to render ABCT more palatable to neoclassical colleagues.

    Specifically, in Salter and Luther's treatment, the boom commences when a monetary shock misleads agents into making inappropriate investment decisions, which moves the economy along (not beyond, as in Garrison [2001]) the three-dimensional production possibilities frontier (PPF) to an unsustainable point. This mistake by the model's agents is rational once we account for the information constraints they face. However, in the following period, the mix of feasible consumption and investment outputs has contracted (due to the mistaken output mix in the boom period), such that plans must be revised and resources must be reallocated in a costly manner, causing the standard of living to fall--all within an equilibrium framework.

    In this paper, we advance two main criticisms of the model developed by Salter and Luther. First, we argue that by casting the mistakes of the boom purely in an imperfect information context, they ignore what Mises called "the driving force of money" (Mises [1949] 1998, pp. 413-16). We provide quotations from Lucas and Mises to show that their views on the neutrality of money were definitely not compatible. When we consider the important role of appraisement and monetary calculation in the Misesian system, it becomes clearer why monetary injections into the banking system cause a boom. Salter and Luther's model excludes such considerations almost entirely.

    Second, we argue that since Salter and Luther's model lacks a capital structure (or what we may call a time structure of production), it is unclear why, in their framework, the malinvestments in capital goods that characterize the boom will leave the economy permanently poorer. In contrast, in the traditional ABCT, all of this is straightforward.

    The paper is organized as follows: section 2 summarizes Salter and Luther's analysis of the boom and explores a few important implications of their adoption of an equilibrium framework for how increases in the money supply affect the real economy. Section 3 provides our criticism of their claim that monetary misperception causes the boom in the traditional version of the ABCT. Section 4 summarizes their analysis of the bust and includes our criticism of it. Section 5 concludes.

  2. Imperfect Information and Misperception: Salter and Luther on the Boom

    Salter and Luther (2016) envision an economy in which firms produce two types of final goods and services: consumer goods and durable capital goods. The economy is assumed to initially be in a state of general equilibrium, where the plans of firms and households dovetail completely. [Y.sup.*] units of final goods and services are produced by firms, consisting of [C.sup.*] units of consumer goods and [I.sup.*] units of additional durable capital goods. This state leads to a level of wealth [W.sup.*] bequeathed to the next period. The whole process is sustainable.

    Salter and Luther develop a theory of rational behavior in the presence of uncertainty. Theirs is a standard framework in the tradition of Stigler (1961) and Alchian (1969), in which agents may make mistakes in a narrow sense, but broadly speaking, their strategies are rational and optimal after accounting for the costs of acquiring information and the time spent in thinking about strategies.

    This long-run equilibrium is disturbed when the central bank engages in an easy money policy. This disturbance misleads agents into setting current period output higher than their sustainable levels; that is, C > [C.sup.*] and I > [I.sup.*]. As they explain, "Despite having rational expectations, agents will still tend to generate systematic errors ... in response to an unexpected monetary shock" (Salter and Luther 2016, p. 51). It is important, however, that these shocks be unanticipated. Salter and Luther write: "An individual response will reflect the probability that the observed change [in demand, interest rates, etc.] is merely a nominal shock. However, except in the event where it is known with certainty that the shock is purely nominal, agents will still respond to some extent" (Salter and Luther 2016, p. 51).

    Salter and Luther (2016, p. 51) consider their exposition to be superior to the traditional Austrian account:

    We have shown that agents with rational expectations might make errors and, moreover, that these errors can be systematic in the sense that they do not cancel out. However, the magnitude of the errors will be lower than those in the traditional Austrian business cycle theory. Agents in the model discussed herein understand that nominal shocks are possible and weight their responses accordingly. In the traditional view, agents respond naively to such shocks, effectively assuming the probability that the shock is purely nominal equals zero. III. Equilibrium Analysis, Money Neutrality, and Monetary Misperception

    To repeat, Salter and Luther have explicitly relied on Lucas's approach to reconciling the Phillips curve with the long-run neutrality of money: "It is not readily apparent to business owners whether an observed change in demand for their product reflects a change in relative demand or aggregate demand" (Salter and Luther 2016, p. 8). Although this approach has an undeniable theoretical elegance, and it is certain to make the ABCT more palatable to fans of modern, mainstream macroeconomics, we protest that it is a fundamental departure from the traditional ABCT.

    The quickest way to demonstrate the sharp divide between Lucas and Mises is to quote their views on a hypothetical monetary thought experiment. First consider Lucas, from the conclusion of his classic 1972 paper:

    This paper has been at attempt to resolve the paradox posed by Gurley, in his mild but accurate parody of Friedmanian monetary theory: "Money is a veil, but when the veil flutters, real output sputters." The resolution has been effected by postulating economic agents free of money illusion, so that the Ricardian hypothetical experiment of a fully announced, proportional monetary expansion will have no real consequences (that is, so that money is a veil). (p. 121, emphasis added)

    Yet this was not at all the view of Mises. As he wrote in Human Action,

    Is it possible to think of a state of affairs in which changes in the purchasing power of money occur at the same time and to the...

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