Just when I was about to finish my reswitching streak (2 posts, barely) before a commenter on my last post sent Meng Hu’s terrible piece on reswitching. Austrians have a general tendency to either assert a metaphysical aspect to reswitching and other capital paradoxes or simply claim they are empirically non-existent or negligible, such as Garrison (2006). Meng Hu, somehow, manages to group them all and make an incredibly ignorant piece on reswitching and its implications for the Austrian business cycle theory, along with simply just spewing quote vomit absolutely everywhere.
“And it doesn’t appear to be a very common phenomenon and casts doubt on its relevance in the real world. Young (2012) found evidence that the more roundabout industries have seen their industrial prices increased by more than the less roundabout, on the onset of the subprime episode. Besides, Roger Garrison expresses his doubts about the plausibility of the reswitching hypothetical example, as follows:”
Meng Hu, being the “go to” empiricist for the internet Austrians, of course first attacks reswitching on an empirical rather than theoretical ground as most vulgar Neoclassical and Austrian economists have attempted to do in the past, e.g., Ferguson (1969) and Garrison (2006). This entire argument, as I’ve pointed out in my last post, is incredibly ignorant of the main point demonstrated by the existence of reswitching and reverse capital deepening is that there is no possible argument to be made that there lies an inverse linear relationship between capital intensity and interest rates, if such an argument is demonstrated to have paradoxical results. On a methodological point, it is not necessary to invalidate the Austrian business cycle theory by positing an empirical relationship/likelihood of reswitching occurring with production processes, meaning the percentage of reverse capital deepening and reswitching occurring within production processes in the economy (economies?) drawn from NIPAs is irrelevant to the general validity/invalidity of the Austrian business cycle theory. What the Sraffians in the CCC demonstrated was that there was no inverse relationship between the quantity of capital and rates of profit, and extended to reverse capital deepening, there is no inverse relationship between capital intensity and the rate of interest. With reverse capital deepening, the Sraffians demonstrated, the entire relationship between capital and the interest rate simply does not follow a monotonic decreasing relationship, with reswitching it is indeterminate and with reverse capital deepening the relationships is not an inverse deepening relationship, it’s an relationship with the quantity of capital moving “up” as the rate of interest moves “up”. The demonstration of an existence of a paradox does not need empirical data to refute the existence of theories which depend upon the paradox generating theory, the demonstration of a paradox means the entire relationship cannot exist as posited by the Austrian theory. The same follows for the excerpt from Garrison’s paper on reswitching, it doesn’t matter about the cost differences inasmuch as a paradox has been demonstrated in which unless the paradox itself does not exist, the theory is bankrupt. Garrison did not demonstrate that the middle technique on the w-r frontier could be readopted, he demonstrated that the cost difference is smaller than expected which is not sufficient to refute the demonstration of the existence of reswitching or reverse capital deepening. This all stems from a general methodological error by the Austrians and Neoclassicals, that it needs to be empirically demonstrated that the existence of reswitching is frequent to refute the marginal productivity theory of distribution and the aggregate production function or the Austrian theory of the business cycle. Another point, on Young (2012), is that Young’s regression did not incorporate the capital paradoxes into his regression, meaning there could be many misspecifications for Young’s model and other Austrian macro models caused by reswitching and reverse capital deepening’s effects, causal indeterminacy, among others.
“Meng Hu” then proceeds to cite Rothbard on the theoretical dependence of capital intensity by the Austrian business cycle theory:
“Credit expansion always generates the business cycle process, even when other tendencies cloak its workings. Thus, many people believe that all is well if prices do not rise or if the actually recorded interest rate does not fall. But prices may well not rise because of some counteracting force – such as an increase in the supply of goods or a rise in the demand for money. But this does not mean that the boom-depression cycle fails to occur. The essential processes of the boom – distorted interest rates, malinvestments, bankruptcies, etc. – continue unchecked. This is one of the reasons why those who approach business cycles from a statistical point of view and try in that way to arrive at a theory are in hopeless error. Any historical-statistical fact is a complex resultant of many causal influences and cannot be used as a simple element with which to construct a causal theory. The point is that credit expansion raises prices beyond what they would have been in the free market and thereby creates the business cycle. Similarly, credit expansion does not necessarily lower the interest rate below the rate previously recorded; it lowers the rate below what it would have been in the free market and thus creates distortion and malinvestment. Recorded interest rates in the boom will generally rise, in fact, because of the purchasing-power component in the market interest rate. An increase in prices, as we have seen, generates a positive purchasing-power component in the natural interest rate, i.e., the rate of return earned by businessmen on the market.”
Rothbard’s claim in this excerpt is extremely illogical because it takes the unhampered market rate of interest as a given, and furthermore, that the market rate of interest itself is determined by non-monetary subjective temporal preferential factors, i.e., “time preference”. Unless the theorist himself is aware of the state of prices, including the interest rate, in an unhampered market without an interventionist central bank or “State”, the theorist himself is in a state of causal indeterminacy. Aside from the major empirical issues of the inability to properly theorize about the ABCT when the statistical empirical analysis necessarily requires, in Rothbard’s own words, an unhampered standard to theorize off of. Until such a state is satiated, it’s impossible for anyone to take the Austrian theory seriously as it posits some sort of metaphysical relationship, taking for granted the necessity to prove the theory using an existent standard of measurement. Another ignorant argument by Rothbard is that the problem with historical-statistical data is that it is impossible to isolate a single causal factor. This is true in a very crude sense, i.e., while it’s impossible to find a general singular causal factor it is definitely possible to find a general trend which through a line of causal events leads to a final conclusion of the phenomena analyzed statistically. The same argument follows for Huerta De Soto’s argument of the non-necessity for the interest rate to actually decline, it assumes an unhampered standard to theorize from, which cannot exist due to the immense of causal factors the theorist must analyze before attempting to even start predicting the various prices in the market economy.
“And Ludwig Von Mises (1940, p. 50; 1949 [1996] pp. 558-559, 795) himself focuses on the credit (over)expansion, not the interest rate as such. When the amount of credit supply diverges from individuals’ time preference, with more credit than people’s willingness to wait, the entrepreneurs are left to believe there is more savings than what is actually available. Even an increase in the interest rate will not necessarily stop speculation and malinvestments to be accumulated if the borrowers are determined to complete the new capital goods stages begun and which they begin to see threatened. Mises uses this example to say that the origins and end of the boom were not to be found in the interest rates but credit expansion.”
A very common occurrence, I’ve found with reading on the Austrians, is that their claims generally follow an institutionally backward non-credit based economy. The Misesian theory posits a general divergence from the rate of savings and the amount of loans in the economy, i.e., that savings rates in an unhampered market economy itself would drive loans and the monetary overexpansion driven by the central bank or government through fiscal policy causes more loans to be expanded than there is real savings. If real savings are in a disconnect with the amount of loans, then there is not enough “real resources” in the economy to complete projects which necessarily results in liquidation of the malinvested projects. This may hold true for a commodity based economy or a fiat economy, but this is not true for a credit based economy in which the amount of loans and the amount of savings don’t ever matter. Real resources are not purchased by savings expanded through loans, they’re purchased using credit administered from banks in a circuit like manner, i.e., a financial provision is first expanded to the firms which transfers itself into means of production purchases and finally discharged into profits and wages, which make their ways back to the banks. The incredibly important thing to note is that banks are not ever savings constrained and that real resources are barely ever purchased by savings and by a transitive property, a lack of savings caused by monetary overexpansion would cause a shortage of real resources; banks are always lending out of line with savings and will continue to do so in an advanced credit economy, real resources are purchased through credit and a shortage of savings does not imply, in most general cases, a shortage of real resources as credit in the economy is not reserve constrained at all. The “monetary overexpansion” and a lack of real savings causing a shortage of real resources itself ignores the logical possibility of idle resources & that savings purchase very little consequential things in the business world compared to credit.
Citing De Soto:
“An increase in saving (and thus a decrease in the interest rate, other things being equal) may result in the replacement of a certain technique (the Roman plow, for instance) by a more capital-intensive one (the tractor). Even so, a subsequent drop in the interest rate may permit the reintroduction of the Roman plow in new production processes formerly prevented by a lack of saving (in other words, the established processes are not affected and still involve the use of tractors). Indeed a new lengthening of production processes may give rise to new stages in agriculture or gardening that incorporate techniques which, even assuming that production processes are effectively lengthened, may appear less capital-intensive when considered separately in a comparative static equilibrium analysis.
What De Soto (And in effect Meng Hu) is attempting to claim is that regardless of the adoption of techniques by economic actors, the structure of production will increase a priori. This approach itself has multiple flaws, starting from the argument that an increase in the rate of saving has anything to do with the rate of interest. Austrians who make this claim (And Neoclassicals) assume the loanable funds theory of interest, i.e., an increase in the amount of loanable funds caused by increased savings triggered by “time preference” will cause a general decrease in the rate of interest. This approach, however, is sorely mistaken by assuming a general property of savings immediately being turned into loanable funds without regards for liquidity preference. Liquidity preference ensures that there is no direct relationship with the quantity of savings and the amount of loans in the economy, as a hedge against uncertainty individual economic actors will invest in liquid assets. This means that any increase in saving does not lead to an equivalent increase in the supply of loanable funds, which by the principle of supply and demand, lowers the rate of interest. Another important thing to consider is what was pointed out in the paragraph above, that the level of savings in the economy has nothing to do with the amount of real resources or amount of loanable funds in a credit based economy. De Soto also takes for granted that any increase in the stages of production (Better termed, complexity) will cause the business cycle. An adoption of less capital intensive processes implies that the entire structure of production does not need to move towards “Earlier” or “Higher” stages of production, they can remain in a stage of production that is near the “middle”; which means that the phenomena of stretching of the stages of production in the ABCT does not exist at all. De Soto, like other Austrian others, takes the theory as true a priori and then simply claims that any increase in savings lengthens the structure of production despiste an adoption of techniques which lie along a “middle” stage of production”. In effect, De Soto completely isolates the structure of production from its own composition, the techniques of production and economic actors. Something must be wrong here!
The same argument applies for Rizzo and O’Driscoll point on the increased roundaboutness even though there’s a decline in consumption per head and the amount of capital employed, i.e., they posit some sort of independence between the structure of production itself and the techniques which consist of the structure of production, a foolish notion to anyone who understands how very basic complex composition works. Another thing is that, as pointed out, time preference is not a satisfactory cause for the rate of interest’s determination at it supposes, very importantly, loanable funds for the theory to cause a fall in the rate of interest. If loanable funds were to be non-existent in the Austrian interest rate determination model, then the entire argument falls apart as there is no proper causal factor which can cause a decline in the rate of interest caused by supply and demand mechanisms:
“… In the Cambridge formulation the rate of interest is treated as an exogenous variable. The changes in the interest rate that supposedly induce technique reswitching are themselves unaccounted for. This simply makes for bad theory – theory in which changes in the level of savings are neither a cause nor a consequence of changes in the rate of interest. In the reswitching models, the only change in production activities allowed for is a change in the technique employed. A change in the rate of interest either has no effect whatever or provokes a change in the production technique. The relevance of such a model – even to Böhm-Bawerk’s formulation of Austrian capital theory – is questionable. And the particular way in which the analysis is carried out raises still further questions. Despite claims to the contrary, the fundamental distinction between the comparison of alternative equilibrium states and the description of the process by which the economy is moved from one state to another is hopelessly blurred. This is a virtually inevitable consequence of the failure to specify what particular preference or policy change caused the initial change in the rate of interest. While these aspects of Cambridge capital theory are grounds for dissatisfaction with the theory itself, they have been largely overlooked in the present treatment in order that the thematic distinction between subjectivist and objectivist views of a capital-using economy could be emphasized.”
Accounting for the determination of the rate of interest, aside from being an exogenous entity as pointed out by Basil J. Moore[1], is relatively inconsequential for the demonstration of the phenomena of reswitching. As has been pointed out, the argument that the rate of interest is determined by time preference is logically invalid, which means another causal factor must be attributed. Adopting an either horizontalist or structuralist conception of endogenous money, i.e., exogenous short-long run interest rates or exogenous short term and endogenous long term rates, still doesn’t change the conclusion of reswitching for the ABCT. It isn’t a bad theory, considering exogenous rates or liquidity preference determination of the interest rate means very little for the theory itself, the Austrians are grasping at straws from a fallacious theory of interest rates. Rizzo and O’Driscoll’s arguments of “subjectivism” or “objectivism” are inconsequential for the theory as they again suppose independence of the structure of production from the techniques of production. Adoption of reswitching does not cause increased stages of production, it rather leads to a decline or indeterminate relationship about the level of complexity and the rate of interest. For these projects to be unsustainable, what is necessary is that savings must be equated to loans, which is not true for a credit based economy.
“At this point, however, one particular misunderstanding of the theorem that roundabout processes of production are more productive may be mentioned, as it is due to a confusion between these two concepts. It has sometimes been argued that an increase of capital is more likely to shorten than to lengthen the time during which we have to wait for the product. And this is quite true when we speak of the time interval which will elapse before a given quantity of output will emerge. But this is quite compatible with a simultaneous increase in the periods for which we have to wait for the product of particular units of input.”
For most of the rest of the post, Meng Hu presupposes there is a fundamental non equivalence between the structure of production and composition of the production techniques. What must result is causal indeterminacy, one is completely unable to draw any reasonable conclusions about the Austrian theory if one posits indeterminacy of the relationships between composition of the production structure and the structure itself. To prove the Austrian theory, it is near impossible to draw a relationship between over-roundaboutness, the interest rate, and money supply as the independence means that there cannot be any relationship between the composition of the structure of production and its “roundaboutness”! Mateusz Machaj, an Austrian I do like a great deal on capital and interest theory, expresses the ridiculous nature of De Soto et al. on reswitching:
“The one argument that supports those conclusions is that with every shift and change of circumstances, the system resets. All factors have a new life with every switch, so Huerta de Soto would not allow us to compare various ways of producing goods. Such a statement may be doubtful, but let us assume it is true. Taking a future-oriented perspective, we can still show a potential reswitching between two ways of producing a particular good, depending on the interest rate. We do not have to rely on bygones and include past costs in any way. The reswitching challenge can be presented in a forward-looking manner. Moreover, the more we look into Huerta de Soto’s statements, the more questionable they become. In a sense, he tries to completely separate the notions of “technique” and “length of production.” But why? What if by “technique” we also mean length of production, as in the reswitching debate? A contradiction appears since, in Huerta de Soto’s terms, we would have to state that the productive structure lengthens regardless of whether we choose a shorter production technique—even if all sequences of techniques are in sum taking shorter time! Put differently, we would have to state “savings always causes, in prospective terms, a ‘lengthening’ of the productive structure, irrespective of whether techniques are shorter.”Obviously there is something missing here.”[2]
On the presentation of reswitching in a forward looking manner, blogger Robert Vienneau and Saverio M. Fratini[3] have both reframed the argument in a forward looking manner, Vienneau taking the argument even further by demonstrating around switchpoints entrepreneurs are indifferent to production processes and need not even adopt a project with more capital intensity and a higher NPV, which again refutes the Neo-Austrian notion based off of the “Rehabilitated” “Average Period” measure of the structure of production.
“One result of the recent discussion on “reswitching” is to the advantage of the Austrian school. As long as all capital is regarded as homogeneous, managers may respond to a marginal fall in the rate of interest by a marginal act of substitution of capital for labor. But heterogeneity of capital entails a regrouping of the existing capital combination; some capital goods may have to be discarded, others acquired. It is no longer a marginal adjustment that is called for but entrepreneurial choice and decision. As Pasinetti pointed out, “Two techniques may well be as near as one likes on the scale of variation of the rate of profit and yet the physical capital goods they require may be completely different.” In a world of disequilibrium, entrepreneurs continually have to regroup their capital combinations in response to changes of all kinds, present and expected, on the cost side as well as on the market side. A change in the mode of income distribution is merely one special case of a very large class of cases to which the entrepreneur has to give constant attention. No matter whether switching or reswitching is to be undertaken, or any other response to market change, expectations play a part, and the individuality of each firm finds its expression in its own way. Yet only “reswitching” has of late attracted the interest of theoreticians. There is more in the world of capital and markets than is dreamt of in their philosophy.”
I am quite unaware of the manner of which this is to attempt to refute the Sraffians on reswitching, it’d help if Meng Hu could explain this quote more clearly as it does in no possible way refute the Sraffian notions of reswitching! Yes, entrepreneurs are forced to consider other phenomena occurring in the economy and plan ex ante to adjust to these expected changes, which include income distribution. Even presuming that for some reason a firm will not choose the cost minimizing less capital intensive process due to expected ex ante plans, it still does no good for the Austrian theory as Lachmann ends up accepting that there is no monotonic relationship between the structure of production, interest rates, and capital intensity and adds on to the Sraffians. I do enjoy Lachmann’s work a great deal, being incredibly interested in his heterogenous theory of capital and analysis of the kaleidic world and consequent ex ante planning in a kaleidic world, and this insight offered by him does not refute the Sraffian theory at all, merely adds on a more “subjectivist” angle to entrepreneurial decisions in a kaleidic market economy.
“This premise is that each technique of production involves a simple, unidimensional ‘quantity’ of time, such that different techniques can be unambiguously ‘objectively’ ranked as involving greater or lesser quantities of time (or waiting). In fact, there is no reason at all to accept this premise. The cases that yield the capital-reversing paradoxes all arise from production processes involving more or less complex dating patterns for inputs and outputs. (In a stylized example made by Samuelson (1966), a given quantity of output can be obtained in year 4 from one technique that calls for the input of two units of labour in year 1, and six units of labour in year 3; or alternatively by a second technique of production calling only for the input of seven units of labour in year 2.) It appears obviously mistaken (or at least to involve an arbitrary and possibly misleading oversimplification) to wish to collapse the possibly incommensurable quantities of time associated with individually dated input components of a given complex production technique into a single simple unidimensional quantity of time.”
It’s worth briefly mentioning the erroneous argument made by Kirzner that reswitching models are hyper-aggregated and consequently cannot explain choice of technique or other phenomena satisfactorily. Aside from the ability for reswitching to analyze disequilibrium situations[4] such as being existent in types of structural instabilities like cusp catastrophes, which necessarily entail non-equilibrium disaggregated structural instabilities by virtue of its own nature, reswitching can also be formalized in a forward looking disaggregated manner as pointed out above. Kirzner’s comment is out of line and has little knowledge of Sraffian literature outside of the very barely Sraffian argument made by the Neoclassical Synthesis Keynesian Paul Samuelson, as most Austrians discussing reswitching. The rest of Meng Hu’s blogpost is just a vomit of quotes, all of which repeats itself and would be inconsequential to repeat here as it has already been covered.
“The reswitching paradox appears crystal clear now. The error was to consider the interest rate as being the fundamental cause behind the technique reswitching while, in reality, the relative prices were really what mattered most. The distortion of those relative prices through money expansion can indeed predict the technique reswitching. This reveals those attacks on the ABCT to be misleading and completely outside the point.”
Aside from the heterogeneity in the “ABCT” itself, i.e., differences between the Misesian/Rothbardian and Hayekian theory of the business cycle, it has been demonstrated throughout this blogpost that the alternative views cannot be sustained on account of taking given unhampered market price benchmarks, assuming independence of the structure of production and its composition leading to causal indeterminacy, or primarily as a cornerstone assuming loanable funds. All of the arguments raised by Meng Hu simply do not stand in light of the vast Sraffian literature on differential types of reswitching or are simply erroneous.
References:
1. Moore, B. J. (1988). Horizontalists and verticalists: The macroeconomics of credit money. Cambridge [England: Cambridge University Press]
2. Machaj, M. (2017). Money, Interest, and the Structure of Production: Resolving Some Puzzles in the Theory of Capital (Capitalist Thought: Studies in Philosophy, Politics, and Economics). Lexington Books.
3. Saverio M. Fratini, 2019. "A note on re-switching, the average period of production and the Austrian business-cycle theory," The Review of Austrian Economics, Springer;Society for the Development of Austrian Economics, vol. 324, pages 363-374, December.
4. Rosser, J. Barkley, Jr. 1983. “Reswitching as a Cusp Catastrophe,” Journal of Economic Theory 31:1, 182-193.
