Confirmation Bias And Austrian Business Cycle Theory

I’ve been picking on Matt Yglesias lately. Partly because he often makes bad arguments, but also because I find it distasteful when people refuse to take their opponents’ arguments seriously. The other day I was browsing the econ blogs and someone linked to an old blog post of his where he criticized Austrian Business Cycle Theory. The amazing thing about the post is that he dismisses it based solely on second-hand accounts of the theory by other economists — namely Paul Krugman, Tyler Cowen, and Bryan Caplan.

I’ve written on this before, but all three of these economists have misinterpreted the theory (at least in the works Yglesias links to. If they’ve offered more accruate accounts of the theory elsewhere, I’d be happy to read them). Rather than critiquing ABCT, they end up critiquing some garden variety theory of sectoral shifts. Consider these examples:

Bryan Caplan:

Even more striking is the Austrian theory’s inability to explain why output declines during a depression; instead, it predicts a short-term increase.[51] Bohm-Bawerk’s capital theory, on which Rothbard wisely built his work, implies that actually the short-run effect of switching to consumer goods production would be a period of greater production, followed by a period in which production is less than it would otherwise have been if longer period products had been used instead.[52] In short, the Austrian theory all-too-glibly identifies the period of artificially low interest rates with the boom, and the period of re-adjustment with the bust. Without extra assumptions, the theory does not predict an increase in employment during the boom, or a decrease during the bust. Moreover, it predicts an actual increase in current output during the bust. These are puzzling implications, to put it mildly, and they follow from the ABC.

Paul Krugman:

Here’s the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don’t even realize this is a problem for their story.

Tyler Cowen:

But I think the point is more effective in reverse.  Why should the boom be a boom in the first place?  The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages.  In other words, the Austrian theory doesn’t generate the very high degree of comovement found in the data.

And finally Yglesias from last year parroting the others:

If investment spending in general declines, you would expect spending on consumer goods to rise to offset it. In practice, this doesn’t always happen and you get a recession. It’s this anomalous collapse in overall spending that needs explaining, and describing some of the past spending as “malinvestment” doesn’t help you understand it.

As you can see, all of these accounts portray ABCT as a theory of sectoral shifts. The new money bids resources away from consumers towards long term capital investment. Then when the inflation kicks in, the resources have to revert back to where they came from. Caplan, Cowen, and Krugman (correctly) suggest this implies a decrease in consumption during the “boom” phase of the cycle and an increase in consumption during the “bust”. Obviously this is manifestly different from what actually happens. Here’s a visualization of their interpretation using the production possibilities frontier and Hayekian triangle:

Figure 1

The problem here is this is not Austrian Business Cycle Theory. The actually theory presupposes a simultaneous increase in long term capital investment and an increase in consumer demand both driven by artificially low interest rates. The distortion temporarily (and unsustainably) pushes the economy beyond the production possibilities frontier, not along it. The PPF and Hayekian triangle actually look like this:

Figure 2

Notice this theory is fundamentally different from the one critiqued by Caplan, Cowen, and Krugman ― and the theory that Yglesias glibly dismisses as being relevant only in “crank” circles.

Bob Murphy responded up on Tyler Cowen’s misinterpretation and offered an example using sushi production to illustrate how a misallocation of resources can lead to a temporary boom financed by capital consumption in the intermediate stages.

Krugman picked up on the article and rather surprisingly wrote that it “is the best exposition I’ve seen yet of the Austrian view that’s sweeping the GOP — and I mean that sincerely.” He also suggested that it may explain China’s great leap forward. That was last of his foray into Austrian economics, however, before returning to his usual criticism of Republicans.

Now I’m not suggesting that Caplan and Cowen misinterpreted ABCT because of confirmation bias. Both of them are very strong thinkers and supporters of free markets (Krugman is another story). Most likely they got their understanding of ABCT from Murray Rothbard who portrayed the theory the in the manner they described throughout his popular writings. Neither does this imply that ABCT is correct. It very well could be wrong. But it at least isn’t wrong for the reasons they suggest.

So what happened here is that Yglesias got his understanding of ABCT entirely from second-hand sources who portrayed the theory in a factually inaccurate manner… then felt comfortable enough with it to fire off a blog post. Had he actually went and read say, Hayek or even a modern interpretation such as Roger Garrison’s Time and Money, he would have realized that ABCT is an intellectually serious theory worth of study. Instead he stopped after he read these three critiques, I suspect, because they confirmed his political bias.

While I’m singling out Yglesias, you could substitute his name for any one of bloggers/commentators on the internet, left-wing and libertarian alike. Confirmation bias is extremely pervasive. The only way to guard against it is to be vigilant, recognize that everyone suffers from it, and try to be as fair and objective as possible when analyzing theories. Unfortunately that isn’t something bloggers like Yglesias are good at.


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