RE: On The Empirical Relevance of Austrian Business Cycle Theory

My friend Grant McDermott, to whom I wrote why I think the empirical relevance of ABCT by Lester/Wolff may produce “mixed” results replied to me in this post. This is a quick one to elaborate my points.

Firstly Grant says he is not convinced by my two arguments. I said that testing an economic theory using at best bad data that to an Austrian measures the wrong things will provide mixed results. Not only that but different National Statistics Offices often construct the same macroeconomic variables differently, so testing the same theory using the different data sets will produce different results, naturally. Russell picked up on the theme of why a PPI or IP data by stage-of-process (which Russ and I discussed at length that day), and explained the challenge of trying to classify a contractor with a short investment horizon that plugs into a property developer with a long-term horizon in the stage-of-process data. My dad’s business, for instance, does multiple short-term contracting projects within long-term property development projects. In the normal production structure distribution his irrigation installations would be classified near the consumer level as it sits very close to final consumption, but he prices projects at the outset of long-term investment projects when the developer begins to plan and commence his project. My dad’s business therefore adjusts prices early in the business cycle at the same time that projects more remote of the consumer do, and will continue to price for projects throughout the period of the long-term project. He adjusts prices early in the cycle even though in the PPI stage-of-process data his business would be classified as less remote to the consumer, producing data results counter to what the traditional ABCT theory would predict. This problem is widespread and in my view impacts the integrity of the PPI and IP macroeconomic data variables significantly, rendering them close to useless for modelling.

So when Grant says that “all that really matters in this case is that these indexes constitute accurate representations of the underlying variables and populations they refer to”, my position is they aren’t accurate representations to the Austrian.

Another initial objection I had was that the monetary variables used in the study fall short of ideal, and that one should also look at credit injection points in the economy – as this measures the primary ABCT intervention, not the secondary intervention that is broad money supply. My take is that the fiduciary media credit injections impact prices more immediately than they do the overall business cycle, and that broad money will impact the business cycle more than they do general prices in the production structure. It is the injection of fiduciary media (fractional credit) into very specific areas of the economy that provide the first users of the money with the purchasing power to bid prices higher and move relative prices. A secondary effect of this credit injection is that broad money supply (as measured by bank deposits) increase, which lowers the market rate of interest (bond yields further out than short-term rates manipulated by the FFR), which then makes longer-term investment projects look more profitable and boosts activity in the sectors more remote from the consumer. It is for this reason that I would say not only the FFR should be looked at when doing this empirical test (although it is instructive to note FFR had the expected results even if not statistically significant – nothing more than instructive), but also other market interest rates. For example the Fed can cut the FFR, but if market interest rates rise for whatever reason, it may not generate the business cycle boom. Of course we have only have had around 5/6 business cycles since 1972 that to my mind can’t produce any statistically significant results either.

ABCT does not claim to be a theory that can explain all observed economic phenomena, which is what Grant thinks it claims to do. ABCT is one aspect to a very rich theory of logical deduction built from the ground up – from the axiom of human action. Austrians know full well that the business cycle will always play out in very different ways depending on the historical data and underlying conditions. It is for this reason that one must engage with the literature and actually read the books I mention to understand how ABCT fits into the overall theory. Trying to test the empirical relevance of ABCT on its own without considering the rest of the theory, will always deliver mixed results. And if it doesn’t produce mixed results and is proven statistically significant, Austrians are still going to question the results. Let me emphasize that the relevance of the Austrian theory can only increase the more one engages and learns about, not only the complexity of the economy, but also the Austrian theory.

Two brief comments on Grant’s concluding statements:

Grant writes: “If empirical methods were truly misleading, then surely the evolutionary dynamics of the market would have brought about their demise long ago?”

Macroeconomic data statistics are mostly produced by government organisations that are certainly not the market, and the econometric fetish is sustained in state-funded academic institutions, largely because central planners need research and data with to justify and use to implement their central plans. I would argue that were the state to leave macroeconomic data to the market, we would likely see more relevant and accurate data produced. Unfortunately the development of this market is crowded out by taxpayer funded government statistics offices.

Grant writes: “I do wonder what evidence would be sufficient for Austrians to reconsider their theories. I detect a remarkable tendency to dismiss any empirical evidence that runs counter to ABCT and its related concepts.”

The Austrian method is the development of economic theory through logical deduction from the axiom of human action. The Austrians see historical data as historical facts of subjective values that existed at the time that imparts no value in economic theorising. Trying to develop economic theories based on conditions and subjective value scales that existed in the past will inevitable lead to continuous revisions of one’s economic theories, which is exactly where the non-Austrian economic approach is and has been in the past. So to Grant’s point, it is more than just a tendency of Austrians to dismiss empirical ‘evidence’ that runs counter to ABCT and related concepts, because their theories are not built on empirical data but on rigorous logical deduction.

But Grant should know, in our professions as economists and in the practice of economic forecasting, we are continuously, nay, every week, refining and enhancing our forecasting methods and theories based on what’s available and recent experience. Economic theory and economic forecasting are, of course, very different things.


About Chris Becker

Chris Becker is Market Strategist and Economist at ETM Analytics. Becker is Co-Founder of the Mises Institute South Africa. Visit his personal blog Follow him on twitter @chrislbecker.
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