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You Have to be Plucking Kidding Me

February 07, 2012 – Comments (12)

An analysis of Milton Friedman's Plucking Model and Critique of Austrian Business Cycle Theory.

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In free market circles it is generally bad form to criticize Milton Friedman. After all, his eloquent defenses of capitalism against crocodile tear shedding socialists (e.g. Phil Donahue) have inspired many. While reading this blog, keep in mind that Milton inspired me long before I could define inter-temporal disequilibrium.

It was argued recently in an economics forum I troll that Milton Friedman, with his wizardry of Positivist econometrics and data mining, had long ago proven that the Austrian Theory of the Business Cycle is false. Being familiar with Friedman's methods and mistakes, I decided to take a closer look at his Plucking Model to see if it had shed any light on business cycles, or the lack thereof in his opinion. What I discovered is how simplistic Friedman's macroeconomic view compares to the rich nature of Austrian School theory.

Understanding Austrian Theory

My attempts to explain Austrian Business Cycle Theory have taught me that I'm no David Gordon, but I can give you the broad strokes. Austrians view the economy as processes of production that occur over time, with these production stages being arranged from higher order goods furthest away from the consumer to lower order goods, like your iPad. Think of the processes involved in assembling and building the parts for the iPad. Those would be intermediate stages - higher than the stage at which the final product is assembled. Now step back again, to the stages where the materials are assembled for the parts. We can continue to step back all the way to the natural resources being pulled from the ground (mining, for example.) If we walked back forward we could count from highest stage to 2nd stage to nth stage of production down to the moment the device is boxed and sent to your home for your birthday.

From the Austrian point of view, this incredible lattice work of stages of production, with parts and goods being created and assembled for myriads of different lower stage goods, on and on, is coordinated by the rate of interest. A higher rate of interest means that consumers are spending more, leaving less funds available for loan. This causes entrepreneurs to abandon plans that require a great deal of time and money, as they are no longer feasible at high rates. However, in a very low interest rate environment, when society is displaying a desire to save (funds becoming available), entrepreneurs can make investment in higher stages, lengthening the structure of production (think again of the iPad and how many stages are required to produce the final product. This cannot happen in a society with limited structures of production.)

The problem according to Austrians occurs when an expansion of credit occurs, not from a condition of society expressing a desire to save, but rather from an unnatural process, causes a disequilibrium in the capital structure, shifting resources from lower to higher stage production without a corresponding desire to save in society. That process can be government-sponsored fractional reserve banking, where suspension of payment or bailouts from the Treasury are implicitly guaranteed. It can also occur when that fractional reserve system is anchored by a central bank, like the Federal Reserve, whose sole purpose is to keep the expansion of credit constant at all costs. (Yes, I am aware of the dual mandate but any noob can see that it is easier for the Federal Reserve to expand the supply of credit than to increase employment, hence, the road always traveled.)

What occurs next is predictable and many times predicted. The expansion of credit pushes down the rate of interest, enticing entrepreneurs to borrow more as they expand their investment in higher order goods. However, the real resources to complete those projects. For example, houses are built and built and built with no consideration given to whether there actually exists people who can purchase them. When the inevitable grasping for resources reveals that price signals were lies, a final desperate push for panic borrowing accelerates the demise. A wave of bankruptcies (and in our latest crash, foreclosures) sweeps the nation. The longer the unsustainable boom is propped up, the worse will be the dislocations in the economy. In the real estate boom, how many talented people interrupted productive careers to chase the house flipping dream or become agents and brokers, mortgage lenders and appraisers? Just as those individuals need to restructure after the crash (we don't pay anyone to flip houses just to “have the house flipping industry stimulated”), so too do unproductive businesses and overzealous banks. This process, called a recession, is necessary to clear the malinvestment of the previous unsustainable boom and replace it with sustainable investment that matches consumer preferences.

In a nutshell, that's Austrian Business Cycle Theory. Still awake? Hehe, good. I'll stop here and you can hit the discussion for more explanation. If I can't get to your questions in time, plenty of smart people on this board can help you out. Now let's turn to Milton.

Friedman on Business Cycles

Milton Friedman did not attempt to prove Mises' theory was false. He set out to discredit all business cycle theories. In his view, general business fluctuation (not to be confused with specific lines of business rising or falling through changes in preference) was random. The economy moves toward full employment and its productive ceiling, only to be pulled back, or plucked, from its path. Usually, Friedman argued, the cause was an error in central bank policy, e.g. foolishly tightening credit when more funds were being demanded.

Using a high level of aggregation and working without capital theory or an analysis of the structure of production, Friedman measured the amplitudes of expansions and contractions in the United States from 1879-1961. His finding was that rather than a boom being followed by a bust, the opposite is true. The economy, in his view, tends to become depressed and then boom back to its proper path. Friedman was far more cautious in the assessment of his findings than critics of Austrian School theory believe. It was not a proof, but rather an interesting finding that confirmed his suspicions and needed further investigation.

“This phenomenon, should it be confirmed by a fuller analysis of the data for the United States and other countries, would have important implications for the analysis of the business cycle in general, not solely for our monetary studies. For one thing, it would cast grave doubt on those theories that see as the source of the deep depression the excesses of the prior expansion [the Mises cycle theory is a clear example.]” (“The Plucking Model of Business Fluctuations Revisited” Milton Friedman, Dec 1988).

Here is a representation Friedman's famous plucking model. The y axis is output, income, and employment. The x axis is time. The black solid line is something called the Hypothetical Maximum, the theoretical point at which the economy is supposed to operating at full capacity. But what is this Hypothetical Maximum based upon? It's based upon the amplitudes of the economy during the time period measured. In other words, from Friedman's point of view, those rates of growth are healthy and sustainable, and any deviation below must be the economy being pulled back, or plucked from its natural trend. But what if your view differed? What if you saw those periods, through a deeper analysis of the inter-temporal structure of the economy, as unsustainable?

Hypothetical vs Reality

It turns out, Friedman's findings are broadly consistent with ABCT, but his analysis of a health economy differs from that of the Austrians. In reality, not all growth is sustainable. Furthermore, the further you move depart from (or intervene with) the pricing structure that is developed through the market process of subjective values and exchange, the less sustainable that growth becomes. The interest rate is a price. It is a real thing. When an intervening authority distorts the value of money, unsustainable expansion becomes the norm, while sustainable growth becomes rare. The real question then is, which view of the economy can discern between sustainable and unsustainable growth? Certainly the Austrian School makes an excellent case, based on a logical chain of reasoning, that long term growth must match consumer preferences for consumption with higher order investment.

Milton Friedman's approach to economics is vastly different. He views the economy through the aggregation of statistics, with the answers to be found if one only correlates enough data with historical events. Yet, since plenty of data and studies exist that correlate with the Austrian Businesses Cycle Theory (see here and here for many examples), how do we know which data is correct, which theory is correct?

For more on Friedman vs. Mises on the Business Cycle, see here, here, here, and here.

And for fun, if you made it this far, here's the Ultimate Keynesian Stimulus Project. (I can't go a whole econ post without making fun of them at least once).

In follow up posts, I will continue this discussion. We'll look at Rothbard vs. Friedman on The Great Depression and Mises vs. Fisher on economic methodology. I'll also address any questions in the discussion that do not receive adequate attention.

David in Liberty

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