The Role of Capital Structure in Austrian Business Cycle Theory.

Author:Cachanosky, Nicolas
 
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  1. Introduction

    Recent years have seen an interesting turn in the Austrian business cycle theory (ABCT) literature. On the one hand, there has been an increased interest in and endorsement of the ABCT from non-Austrians as a valid theory to explain crises such as the one that occurred in 2007-08 (Cachanosky and Salter 2016). On the other hand, Austrians have raised questions about the soundness and even necessity of using the structure of production construct in the ABCT. For instance, Salter and Luther (2016, p. 52) suggest that whether "these malinvestments [induced by a credit expansion] conform to the specific distortions of the time structure of production discussed in the traditional ABCT is irrelevant in our view. Any investment in inappropriate projects will do" (emphasis added).

    In our view, the ABCT not only sheds light on the events building up to the 2007-08 financial crisis, but the structure of production can also be reframed in a way that (1) solves theoretical problems and (2) provides the change in relative prices that produces the specific distortions of the time structure of production discussed in the traditional ABCT. We develop these issues in more detail in our previous work. (1) For the purposes of this symposium, we emphasize points related to the role of capital structure in the ABCT.

    In the next section, we discuss the distinctive characteristic of the ABCT. In section 3, we review the challenges surrounding the average period of production and its role in the ABCT. In section 4, we explain how the structure of production can be saved and the implications of our approach. Section 5 concludes.

  2. What Distinguishes the ABCT?

    The ABCT is not just a theory about any distortion produced by credit expansion. It is a theory positing that a specific distortion pattern takes place when easy monetary policy pushes interest rates below their equilibrium (sustainable) levels. These specific distortions occur in the so-called structure of production, the time structure of production, roundaboutness, or average period of production (APP). To question the specific distortions that would take place in the structure of production is to question the theory itself. To renounce the role of the structure of production in the ABCT is to renounce the theory's identity. (2)

    The structure of production is not only the distinctive characteristic of the ABCT, it is also the most obscure and objectionable component of the theory. This is because of the complexities of capital theory, of which the structure of production is a key element. Capital-theory difficulties survived the three well-known capital-theory controversies during the twentieth century. (3)

    Note that in the first paragraph of this section we use four different terms to refer to the same component of the ABCT: how production is structured in time. The existence of these different terms, some more obscure than others, to refer to the same phenomenon indicates how intricate capital theory can be. One reason for this is that the structure of production implies multiple dimensions or variables that are confounded in a single term. First, taken to refer to a given structural method of production or technology, a different amount of time can be allocated. For instance, in this sense, the same capital structure can produce a twelve-year-old or a twenty-one-year-old whisky; it is the time invested that differentiates one product from the other. Second, for a given period, different capital goods and labor skills with a similar capital intensity can be used to produce the same good. Finally, the same good can be produced with different technologies that imply different capital intensity. The problem is that all these different dimensions or scenarios need to be analytically separated, but they are blended in terms not very self-descriptive such as roundaboutness or average period of production.

    But besides these difficulties, the core argument of the ABCT is that if the interest rate is the price of time, then a relative fall in the price of time would increase the consumption of time in the production of goods and services. This is why, for consistency, the ABCT cannot be stripped from the structure of production and interest-rate movements. However, different from other "resources," time cannot be stored; time works with other factors of production. It is more accurately a separate dimension of production. In the next two sections, we discuss three issues with capital theory that are central to our argument.

  3. The ABCT and the Structure of Production: The Challenge

    A crucial issue with Menger and Bohm-Bawerk's capital theory is the concept of the average period of production. The intuition behind a period of production (average, total, or otherwise) is straightforward. As long as it recognized that production takes time, then it would appear that there has to be a total, and therefore also an average, period of production. But, how to measure this period of production is a separate issue. And misspecifying how to measure the period of production is a different issue than saying the there is no such thing as a period of production.

    1. An Old Problem: What Does "Average Period of Production" Mean?

      The old problem surrounding the conceptual consistency of the APP starts with a misspecification in Bohm-Bawerk's formula. Bohm-Bawerk offers, more as an illustration than as a definite measurement, a formula based on units of physical labor inputs, not based on the market value of those labor inputs. In addition, Bohm-Bawerk's presentation invites a backward-looking interpretation of the period of production. Bohm-Bawerk presents us, then, with two problems. The first concerns difficulties related to the heterogeneity of labor (and other factors of production). The second concerns the period of production as backward looking--there is either no starting point or it becomes an arbitrary decision. This issue had a significant presence in the capital controversy debates. (4)

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