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Risk and Business Cycles: New and Old Austrian Perspectives (Foundations of the Market Economy), by Tyler Cowen
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Risk and Business Cycles examines the causes of business cycles, a perennial topic of interest within economics. The author argues the case for the revival of an important role for monetary causes in business cycle theory, which challenges the current trend towards favouring purely real theories. The work also presents a critique of the traditional Austrian theory of the trade cycle. This controversial approach will ensure that the book is of interest to all those involved with business cycles, as well as Austrian economics.
- Sales Rank: #4030549 in Books
- Published on: 2010-07-16
- Released on: 2010-07-15
- Original language: English
- Number of items: 1
- Dimensions: 11.69" h x .42" w x 8.26" l, 1.10 pounds
- Binding: Paperback
- 184 pages
Most helpful customer reviews
2 of 2 people found the following review helpful.
A Risky Theory of Business Cycles
By David Chandler Thomas
The 1997 release of Tyler Cowen's book "Risk and Business Cycles" coincided with the efforts of a sharply divided economic profession to come together around a cohesive explanation for business cycles. Cowen, like many others, recognized that the various theories might have something to contribute to the on-going debate, and attempted to perform his own brand of reconciliation by "grafting rational expectations and modern finance theory onto Austrian Theory" (Cowen 1997). It is likely that Cowen's book did not get much attention at the time because mainstream economists did not consider the somewhat obscure Austrian theory of business cycles a good foundation on which to build a consensus. With exuberance forming around the dynamic stochastic general equilibrium theory (DSGE), contributions like Cowen's became moot at best. By the mid 2000's, confidence was high that the DSGE model had finally ended the long debate--so much so, that just a month before the collapse of Lehman Brothers, renowned economist Olivier J. Blanchard wrote, "the state of macroeconomics is good." (Blanchard 2008). But the economic downturn of 2008 threw the newly formed coalition into general stochastic disequilibrium. Still wallowing in the midst of macro-theory chaos, now might be a good time to reevaluate Cowen's contributions. Interestingly, he entered the business cycle fray by incorporating key concepts from new Keynesian and real business cycle theories, while attempting to remain true to his obvious Austrian roots.
The Austrian capital theory of business cycles proposes that significant positive shifts in the money supply lead to systematic errors in the structure of production. The shift from short-run to long-run investment results in an economic boom, followed by a bust when the process reverses. Cowen suggests that shifts in the structure of production are not always problematic, leading, in many cases, to new levels of economic growth when appropriately applied. He proposes that cyclicality is only at play when entrepreneurs make an aggregate error in underestimating the level of risk--generating a boom and then a bust when the expected return never materializes. In other words, significant decreases in real rates of interest can lead to an underassessment of risk and encourage overly risky investments. Cowen proposes that these changes in real interest rates and risk can result from a variety of sources besides monetary policy--government deficits, oil prices, and the forecasting skills of entrepreneurs, to name a few. While Austrian theory suggests that expansionary monetary policy alone will lead to an over-investment in long-run production, Cowen argues that the underestimation of risk is what leads to the various investment errors.
Attempting to incorporate rational expectations into his model, Cowen posits that entrepreneurs do carefully consider those factors deemed significant to their investment decisions, but are unable to foresee future shifts in consumer preferences as well as changes in fiscal policy, savings levels, or monetary policy. This argument attempts to incorporate the theories of new classical economists who assume rational expectations, and Austrian economists who suggest intertemporal discoordination as the primary factor in the emergence of cyclicality.
Cowen makes his case by arguing for the acceptance of six assumptions. The first is that investment has greater inherent risk than consumption. He proposes that the entrepreneur gauges risk more accurately for consumption, which occurs in the short-term, than for the longer-term investments. Second, that declining real interest rates not only increase investment, but also increase the risk of each investment. Cowen argues that because risk aversion diminishes with an increase in wealth, the declining real rates of interest increase the value of portfolios, incentivizing entrepreneurs to make riskier investments. Third, the increased risk at the individual level combines to form economy-wide risk. Here, Cowen argues that the theory of capital complementarity overcomes the subdivision of risk argument. He also argues that as "entrepreneurs try to forecast common variables, ex post deviations of these variables from their population means will cause all entrepreneurs to be wrong at once." (Cowen 1997). Fourth, the higher level of risk will lead to potentially higher returns. Cowen suggests that the shift from consumption to investment will increase the potential return. Fifth, entrepreneurs are more likely to forecast accurately in the short-term than the long-term. Once again referring to rational expectations, Cowen argues that the value of the information used to make the initial investment will decay over time--increasing the risk. Sixth, unforeseen increases in risk will lead to reduced investment once the risk is exposed. Cowen explains that when the market recognizes the true risk of an investment, the price will drop until the return is appropriate for the newly perceived level of risk.
Based on these premises, Cowen builds his case for the boom portion of the business cycle. In contrast to the positive technology shocks explanation of real business cycle theory, Cowen argues that lowered real interest rates increase the commitment to implement existing technology to increase productivity, and do not require the injection of new technology to create growth. Attempting to address the empirical evidence, he spends some time explaining how co-movement in both demand and investment can occur across sectors during an upswing. Dirk Baur defines Co-movement as "the movement of assets that is shared by all assets at time t." (Baur 2003). Cowen argues that although the shift to overly risky investments will lead to a collapse in the end, the short-run increase in the expectation of wealth will increase demand for goods and services. He goes on to suggest that the boom portion of the business cycle will create co-movement as the demand on unemployed or underemployed capital and labor increases. Cowen points out that if entrepreneurs have correctly assessed the level of risk, and the information they use does not decay, the boom will be sustainable and economic growth will rise to a new equilibrium.
Again, Cowen turns to his assumptions to make his case for the bust. He first proposes that the information used to make the initial investment might decay over time and result in diminishing returns. To illustrate this, he reminisces on the fad of moon rocks, implying that many business cycles are a sort of fad wherein the short-run investment brings high returns while the long-run shift in consumer preferences results in a collapse of the market. Next, he explains how investment errors draw away valuable resources and labor from opportunities that are more productive. Finally, he suggests that for those investments that are irreversible and long-term, the length of the bust will increase.
Cowen provides a detailed analysis of monetary policy and the implications for his theory. He proposes two monetary scenarios that can affect his boom-bust cycle. First, substantial increases in the monetary base can result in lower real interest rates igniting a boom, and second, monetary uncertainty can lead to a contraction in economic activity. His treatise on monetary policies is comprehensive and left me expecting some profound recommendation on how to reduce the incidence or severity of his theoretical cyclicality. I was more than disappointed when he concluded that there was no apparent remedy in any of the methods.
The final two chapters of Cowen's book include a detailed critique of Austrian business cycle theory where he offers his eight points of disagreement, and a chapter on the empirical evidence for his theory. I chose not to devote more than a mention of these chapters, as they appear to be included in the book as resource material to support his claims.
My first critique of Cowen's theory is that by incorporating so many components of other business cycle theories into his own, he ends up with a theory that provides virtually no predictive value. The benefit to him is that almost any empirical data will appear to support his theory. An example of this is his argument that a boom is indistinguishable from sustained economic growth until a bust occurs. After all, you cannot determine if entrepreneurs underestimated the risk until the investment has played out. This allows any adherent to his theory to state, after the fact, that the growth that preceded the bust was a boom. We can conclude that if there is no predictability in his model then there can be no monetary or fiscal policy to address the problem. Cowen admits this in his chapter on monetary theory where, after reviewing the range of options, he concludes with "The above survey of policy options indicates no automatic remedy for risk-based business cycles mechanisms." (Cowen 1997)
Secondly, economic theories need the support and research of a large body of economists to flesh out the details. Where would Keynes' General Theory be today if thousands of academics had not written and debated his ideas? Cowen did not make any friends by trying to incorporate so many pieces of other theories into his own. Most Austrians will not seriously consider a theory that incorporates rational expectations and New Keynesians will never consider giving up on demand side shocks as the cause of cyclicality.
Both criticisms aside, I am impressed with some of Cowen's essential arguments. His core premise of entrepreneurial errors in risk assessment is both interesting and credible. While Cowen's style is a bit pedantic, the book is rich in content and certainly worth the read.
WORKS CITED
Baur, Dirk. "What is Co-Movement?" Financial Markets and Portfolio Management. July 2003. [...] (accessed May 18, 2011).
Blanchard, Olivier J. "The State of Macro." NBER Working Paper 14259 (NBER), 2008.
Cowen, Tyler. Risk and Business Cycles: New and Old Austrian Perspectives. New York City: Routledge, 1997.
7 of 11 people found the following review helpful.
No. The variance of a normal (log normal ) prob. dist.does not measure risk
By Michael Emmett Brady
Cowen's thesis is that the present state of Austrian business cycle theory assumes repeated, systematic errors on the part of business men with regard to the information signals that result from changes in real rates of interest.von Mises and von Hayek incorrectly assumed that businessmen automatically increase their investment spending if the real rate of interest falls even if they have negative and/or pessimistic expectations of future profits.This assumes away the standard "safety -first " view of a conservative business investment approach.The von Mises - von Hayek theory is a function of only one independent variable,the real rate of interest, because they assume that businessmen always have positive expectations.There is no learning from experience that would lead to either neutral or negative expectations.This means that ,at best,Austrian business cycle theory is a very special case where businessmen always forecast future ,expected profits correctly.
Cowen is correct to want to improve this highly unsatisfactory ,theoretical position.Unfortunately,Cowen attempts to reformulate Austrian business cycle theory by basing it on rational expectations .Rational Expectations is based on the assumption that price and/or profit changes in all markets are normally (log normally)distributed.Benoit Mandelbrot had already proven in 1963,some 34 years before Cowen wrote this book,that practically all markets are correctly modeled by the Cauchy distribution,not the Normal distribution.Cowen's measure of risk, the variance,does not exist .Both the mean and variance converge to infinity for the Cauchy distribution.This simply means that risk can't be measured by one variable alone .This problem severely impacts both the early Capital Asset Pricing Model's(CAPM)emphasis on the variance ,as well as the later CAPM emphasis on covariance, that Cowen also wants to resort to.
Another major error committed by Cowen is that the importance of the uncertainty of the future,which is independent of risk ,however defined,is eliminated based on Lucas's own clearcut admission that his theory is useless in the face of ignorance or uncertainty.However,Cowen will have to build on J M Keynes's work if he really intends to make progress.Keynes's technical analysis is given in complete form in chapters 15,17,20,22,26, and 29 of the A Treatise on Probability (TP) and incorporated in the elasticity analysis contained on pp.304-306 of the GT when Keynes presents his general theory as a generalization of the Quantity Theory of Money equation.I will append below a brief analysis of Keynes's conventional coefficient of risk and weight ,c,that incorporates the non additive,nonlinear, and sub or super proportional characteristics of Kahneman and Tversky's Prospect Theory model. Cowen needs to integrate this into his book if he is to have any hope of improving on the current,highly unsatisfactory Austrian theory of the Business Cycle.
The Tversky -Kahneman Prospect Theory,of either 1979 or the Cumulative version of 1993,is basically an extension of the analysis provided by Keynes in sections 6,7, and 8 of chapter 26 of his A Treatise on Probability (TP;1921.These sections also appear in the earlier 1907-1908 Fellowship dissertations Keynes did at Cambridge under Bertrand Russell and Alfred North Whitehead).Keynes gets right to the heart of the matter : " The last difficulty concerns the question whether,the former difficulties being waived, the ' mathematical expectation' of different courses of action accurately measures what our preferences ought to be- whether ,that is to say,the undesirability of a given course of action increases in direct proportion to any increase in the uncertainty of attaining its object,or whether some allowance ought to be made for 'risk',its undesirability increasing more in proportion to its uncertainty " (Keynes assumed that a reader could then simply extend the analysis to the other case,which is " decreasing less in proportion to its uncertainty ".See TP,p.313 or p.345 of the CWJMK edition,Volume 8).
Keynes's technical analysis is presented on p.315 and ft.2 on p.315 of the TP(1921).The heart of the T-K Prospect theory is that decision makers use decision weights that are non additive or super additive(sub-proportional or super-proportional), as opposed to the additive probability concept that assumes linearity.Keynes called his decision weight a "conventional coefficient of risk and weight,c ".Keynes presented it as c = 2pw/[(1+q)(1+w),where p is the probability of success ,q is the probability of failure,p+q =1,and w represents the weight of the evidence,w, defined on the interval [0,1].w measures the completeness of the relevant evidence upon which the probability estimates for p and q are based.Keynes defined w in the first paragraph of chapter 6 on p. 71 of the TP.The conventional coefficient of risk and weight is easily rewritten as c = p[1/(1+q)][2w/(1+w)].c consists of the usual linear ,additive p multiplied by two weights-the first weight,[1/(1+q)],deals with the problem of non linear , non-additive risk,while the second weight,[2w/(1+w)],deals with the uncertainty or ambiguity of the evidence w.w is practically the same as D.Ellsberg's rho variable used to deal with ambiguity.K-T assume that there is no uncertainty or ambiguity.Set w = 1 and you obtain a modified Keynesian decision weight,p[1/(1+q)].The other case is obtained simply by using p[1+q].It is a simple case of arithmetic to obtain the same solutions provided by the majority of the K-T experimental subjects in the following categories of decision problem -(a) certainty effects ,(b) reflection effects.
,(c)translation effects,(d)Allais paradox effects and (e) preference reversal effects .The crossover points,relative to the p-axis and the weighting function axis, pi =f(p),where the T-K weighting function,pi, is a function of p, are obtained easily by taking linear combinations of p,p[(1/(1+q)],and p[(1+q)].p[(1/(1+q)] generates a convex curvature.p[(1+q)] generates a concave curvature.Linear combinations of these two different curvatures(first convex then becoming concave or first concave then becoming convex) result in S-shaped curves that cross over the 45 degree line specifying where pi(p) = p.For example,a{p[(1/(1+q)]}+ (1-a){p[(1+q)]},where a and (1-a) sum to one,generates one of many possible different such S-shapes.Three dimensional graphics are easily obtained by using the Mathematica program.
The other part of the K-T theory,the value function,is not theoretically original either.The value function is used to deal with the fact that a large majority of experimental subjects felt that losses of ,say, $500,had a greater negative impact than positive gains of $500.Adam Smith was the first to point this out in his 1759 The Theory of Moral Sentiments.
In summary,there is little that is theoretically new,original,innovative,novel,or creative in the K-T Prospect Theory that was worked out by Tversky and Kahneman in 1979.Keynes and Smith had already provided the theoretical breakthroughs in 1759 and 1921(1907,1908),respectively.What is interesting is the gross ignorance of decision theorists in general when it comes to Keynes's work in the area of decision theory.
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