In recent posts Chris and Russell have made good points about the relevance of judging Austrian Business Cycle Theory (ABCT) by empirical standards, or better put, by the standards of econometric analysis of data.*
Chris and Russell have also referred to a shortening and lengthening of the capital structure under interest rate manipulations. Keeping track of the ebb and flow of the capital structure in ABCT can be challenging, which is why I highly recommend Roger Garrison’s introductory lecture on capital based macro-economics.
Garrison explains that there are three biases in an artificially low interest rate environment. Together, these three biases cause both an initial expansion, as well as a subsequent contraction, of the capital structure. The biases are:
- A boost to consumption, because the lower interest rate encourages consumers to increase their consumption;
- An over-investment in lower order capital goods to satisfy the increased consumption; and
- A malinvestment in higher order capital goods (those with returns only on a far-off time horizon).
In this view, ABCT actually predicts an initial unsustainable lengthening of the capital structure into higher orders, while simultaneously boosting lower order expenditures (especially consumption, and we could add here capital goods that might be recorded as of a lower order, such as Chris and Russell’s landscaping example). The lengthening is unsustainable because the resource allocations necessary to support the elongated new capital structure exceeds the pool of real resources available, as explained in my fellow bloggers’ posts.
At some future point, the shortage of real resources will be revealed in the form of a bust, prompting capital adjustments.
The capital adjustments of the bust endure for some time, since such adjustments (with capital being sticky and all) takes time to complete. Since all forms of unsuitable capital came at the expense of other forms of capital and since mistaken capital allocation can only be remedied at the expense of additional resources over and above what would have been necessary to form the most appropriate kind of capital in the first place, the new post-bust capital structure indeed ends up shortened.
However, the capital structure shortening results only eventually, and because it was unsustainably extended in the first place.
*Austrians need not concede that their theory is somehow unempirical in the sense that would have Austrian economic theory not rooted in the real world.