20 Sep 2010

Analogies for the Crash in Austrian Business Cycle Theory

Economics 6 Comments

Someone (who may or may not wish to reveal himself in the comments) emailed me and asked for some clarification regarding the Austrian view of the business cycle. In my sushi economy, it’s easy enough to see what the mistake is, and how the capital structure becomes misaligned during the artificial boom (provoked by advice from Paul Krugman).

But in a modern industrial economy, what exactly are the Austrians saying? That people who own trucks forget to have the oil changed? That seems nuts.

Here’s what I said (and you can tell it’s authentic since I didn’t bother with that superfluous SHIFT key):

It’s funny you mention that analogy, because that’s exactly the one I used in my biz cycle class. I said suppose there’s a guy who owns a fleet of 100 tractor trailers. normally he has 95 of them carrying loads, and 5 getting routine maintenance.

but then 5 of his best customers call him up on the same day with emergency orders, and they offer to pay him 50% premium for the short notice. so he redirects the 5 trucks that are headed to maintenance to turn around and go pick up loads.

for a few weeks he can keep this up, and the profits on his books will be astronomical, if he neglects to write down the capital value of his trucks. but of course once a truck breaks down on the road, he realizes how foolish he has been.

now you’re right, no individual trucker is going to be that stupid. but if the ABCT is right, then the economy as a whole does something like this; it’s as if the guy with the invisible hand *is* being that stupid as he guides all the individuals in the market.

i have struggled with trying to figure it out exactly, myself. it might be like a bunch of high-tech factories start gearing up, and then 3 years into it everybody realizes that the guy making ball-bearings went out of business and we just used the last ball bearings. it will take 3 months to get a new batch produced, and everybody has to stop until then.

does this help?

the other thing, with the housing boom years, i think it was more like this: the chinese were happy to crank stuff out, in exchange for a growing asset base from the us. but then when the us real estate market collapsed, the chinese regretted all the hard work and other resources they had shipped to americans, in exchange for claims on their assets and dollar flows.

6 Responses to “Analogies for the Crash in Austrian Business Cycle Theory”

  1. Steven R says:

    Maybe I’m off-base here but I don’t think ABCT requires that the trucker completely ignore maintenance until the truck breaks down. I think a better analogy would be that he, reading the market signals, only slightly neglects maintenance to capitalize on profit opportunities. It’s not that the guy suddenly loses his mind and deliberately begins destroying his property for short-term gain, it’s that he only does the absolute minimum necessary maintenance to keep them rolling. In essence, he makes an asset that would have provided him with 10 years of service only last 8 but doesn’t realize it for a while because the erosion is slow. It’s only when the trucks began to break down early that he is really aware of the scope of the problem. Just as some entrepreneurs – those that save appropriately and get out before the bust – can have spectacular success during the boom-bust cycle, exactly how the trucker makes out will be determined by how quickly he realizes his mistake and the actions he’s taken up to and following that realization. If he realizes in year 4 that he’s only got 4 years left rather than six and acts accordingly then he may come through it just fine.

    The problem for the economy at large is that, while its difficult for a single entrepreneur to fully understand his own situation, its impossible for him to understand that of all of the other entrepreneurs that affect him. The trucker, even if he realizes what he’s doing and acts accordingly, can get hung out to dry by his customer that doesn’t. For the economy as a whole to come through requires most to make the proper recognition and adjustment before their “trucks” begin to break down early. People aren’t dumb, they are just fooled into modifying their behavior and the consequences set in before they can “fix” their mistakes.

    Or did my “A” from your Mises Academy class just become a “C”? 🙂

  2. Mark says:

    Or, the trucker purchases several new trucks (say 5) after a few weeks to make up for those that need maintenance. Several months later, when the additional business goes away, he is left with 100 ready-to-deliver trucks (and 5 in maintenance). Now he has five extra trucks (and some additional drivers?) sitting idle.

  3. Ash says:

    What’s wrong with the simple brick-layer?

    Say, he sees the new (artificially) low price of bricks, and decides to plan his project based on those low prices. Before he’s finished building, though, the price of bricks go up. Now he can’t finish the project he has started, now he either has to stop and wait until the price goes down again, or for someone else to take over his project.

    Or you could just go with Peter Schiff’s circus analogy:


  4. Bob Roddis says:

    I’m not sure analogies are helpful when the truth works just fine. It seems to me that the initial error entrepreneurs make is their obliviousness regarding Austrian theory and the nature of fiat money and credit. No one bothers to understand that when a fiat loan is created, the borrower is spending (stealing) someone else’s purchasing power and savings. That’s the source of the new funds for the artificial boom. I think explaining this surreptitious asset transfer is always essential AND it is easy for a newbie to understand.

    Then the primary error entrepreneurs ultimately make regarding long term projects is over-estimating the affluence of their future customers. Entrepreneurs guesstimate what their future customers will be willing to spend in real goods and services. At the end of the boom cycle, the anticipated customers find themselves much poorer than they earlier believed and the long term investor finds he cannot sell his products derived from his project at a price sufficient to make a profit. Home buyers ultimately do not have $750,000 in real goods and services to trade for a formerly $150,000 house. Everyone has been deluded into thinking that everyone else is getting richer due to wage and price increases when in fact they have been wasting assets in the artificial boom.

    This explanation also ties into what Keynesians believe because, in fact, “aggregate demand” is insufficient to purchase what has been manufactured due to malinvestments. And the Keynesian is now in a quandary trying to explain away his support for stealing purchasing power through fiat borrowing which is truly the essence of the Keynesian scheme.

  5. fundamentalist says:

    I think this shows why Hayek’s Ricardo Effect is necessary. It doesn’t depend upon business people doing stupid things. The change in interest rates changes the relative prices of capital and consumption goods and thereby change profits and investments.

  6. Wonks Anonymous says:

    Did Chinese behavior actually change? It seems like your explanation, with “i have struggled with trying to figure it out exactly, myself”, is actually something of an indictment of the application of ABCT to this recession.