Overview of the Austrian School theories of capital and business cycles and implications for agent-based modeling

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Overview of the Austrian School theories of
capital and business cycles and implications for
agent-based modeling

• Presentation to New School for Social Research
  Seminar in Economic Theory and Modeling
• For more information see cameroneconomics.com
• o

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Background and Motivation The Austrian School
of Economics lost its prominence in the 1930s
with the rise of Keynesian economics. One of the
reasons for this (see Hayek 1995) is that
Austrian School macroeconomic theory could not be
adequately formalized with mathematics, as was
done with John Maynard Keynes's ideas from the
General Theory. When F.A. Hayek won the Nobel
Prize in 1973 this created a resurgence of
interest in the ideas of the Austrian School.
Our research is a further continuation of this
resurgence in Austrian School ideas.
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• Generalized Notes on the Austrian School of
  Economics
• The Austrian School is not an argument for
  laissez-faire capitalism. (Hayek believed in the
  negative income tax, and, that many institutions
  belonged in society because they evolved into
  society, and thus exist for a reason.)
• The Austrian School can be seen as a methodology
  approach which is wary of the unintended
  consequences of government intervention and its
  effect on the price system which is seen as the
  coordinating factor in a societys economy.
• The Austrian School methodology prioritizes
  logical reasoning over empirical relationships
  because it assumes the economy is too complex to
  model causality.
• The Austrian School uses the individual as
  entrepreneur as basis for analytical approach and
  the subjectivity of decision-making. It is thus
  skeptical of the validity of other economic
  schools of thought, especially those using
  generalized aggregations.
• Hayek later in life lost faith in general
  equilibrium theory, thus agent-based modeling
  might be valid method to evaluate some Austrian
  School concepts.

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Hayek uses a triangle to graphical represent an
economy and the disaggregated, simultaneous,
heterogeneous capitals in an economy (the capital
structure of an economy).
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Bohm-Bawerk alone among the Austrians wanted to
aggregate capital into an average period of
production. We have formalized this concept by
making the average period of production as given
by at Capital Index (K),
and
Where i (1, 2, , k), k is equal to the
number of the highest stage of production in the
economy (in our model k 5, where five
represents the mining stage of production) x is
each stage of production, and w is the weight of
the production stages quantity of capital in
relation to the quantity of capital in the
economy as a whole. In this economy, K .4(1)
.25(2) .20(3) .10(4) .05(5) 2.15.
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Austrian School capital theory assumes natural or
normal rates of interest under which an economy
(society as living organism) creates a natural
capital structure, which in turn provides for,
under the animal spirits of human action and
creativity, capital accumulation, economic growth
and increasing standards of living.
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The theory of natural rates of interest (matching
the endogenous preferences of savers and
borrowers) assumes also that an economy
experiences natural business cycles (or colds
in biological terms) the downturns of which are
overcome over time by the animal spirits of
human action. It is only when external bodies
enter the natural economy (in this case monetary
policy interest rate manipulations) that the
natural capital structure is upset, creating
incentives which cause malinvestment in
unsustainable, longer stages of production and,
due to the opportunity costs of scarce resources,
reduced consumption.
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Malinvestment prolongs a natural economic
downturn and associated unemployment because the
sticky over-investment in unproductive sectors
needs to be worked-out (or in biological terms,
cleansed) from the system. This cleansing
process takes longer than if there had not been
unnatural malinvestment. It is when unhealthy
investment is purged from the economy that
healthy investment and (sustainable) economic
development continues based on subjective tastes
and risk preferences of societys individual
entrepreneurial actors.
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Austrian School capital theory is based on
simultaneous, heterogeneous, capitals, each with
a unique level of risk. Note that the alpha risk
measure is actually a proxy for market
uncertainty, the technology, the regulatory
environment, the labor pool, the climate and/or
resource dependency, the competitive factors,
rational expectations based on limited
information, and local knowledge surrounding the
investment in the stage of production as
envisioned by the entrepreneur. Alpha i,
therefore, of course, varies with the subjective
knowledge of each entrepreneur.
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Here is a graphical-analogical model example of
creative destruction. Lets assume a technology
shock which effects alpha 3, what is the result
of productivity, employment and investment in
this and other stages of production?
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• Austrian Capital Theory and Agent-Based Modeling
• The Basic Model Models subjective unique risk
  preferences generalized into three classes, with
  bounded, sticky, investment functions based on
  time lags for investment to move from one stage
  of production to another. Unemployment based on
  investment time-lags, with lay-offs beginning at
  higher stages of production. Economy operates
  over-time showing results on accumulation,
  distribution, growth, employment and population.
• Starts with three classes, 1) rich start with
  2 capital units, earn investment returns only and
  are more risk seeking than middleclass, 2)
  middleclass start with one capital unit, earn
  both wage income and investment returns, and 3)
  poor earn wages only.
• Assumes all wages spent.
• Capital hires wages. Each capital worker unit
  initially allocated in economy according to
  weight of stage of production in capital
  structure of economy.
• Poor moves to middle class after 20 periods of
  work when poor moves to middleclass another poor
  is born. Each agent lives 40 years.
• Middleclass moves to rich after accumulating
  second capital unit.
• Interest rate change takes three periods , moving
  from lower to higher stages of production, before
  fully integrated into investment decisions.
• Model allows for varying endowments , and risk
  preferences, within classes.

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For Further Reference Bohm-Bawerk, Eugen. 1891.
The Positive Theory of Capital. London Macmillan
and Co. Garrison, Roger. 2001. Time and Money
the Macroeconomics of Capital Structure. New
York Routledge. Garrison, Roger. 2007.
Capital-Based Macroeconomics, on-line slide
show, http//www.slideshare.net/fredypariapaza/cap
italbased-macroeconomics, accessed
10/6/07. Hayek, Friedrich A. 1931 1966a.
Prices and Production. New York Augustus M.
Kelley Publishers. Hayek, Friedrich A. 1933
1966b. Monetary Theory and the Trade Cycle. New
York Augustus M. Kelley. Hayek, Friedrich A.
1995. Contra Keynes and Cambridge Essays,
Correspondence. Edited by Bruce Caldwell.
Chicago University of Chicago. Hoppe,
Hans-Hermann. 1993. The Economics and Ethics of
Private Property. Boston Kluwer
Academic. Keynes, John M. 1931. The Pure Theory
of Money. A Reply to Dr. Hayek. Economica (11)
34, 387-397. Kurz, Heinz D. 1990. Capital,
Distribution and Effective Demand Studies in the
Classical Approach to Economic Theory.
Cambridge, UK Polity Press. Kurz, Heinz and
Salvadori, Neri. 1992. Theory of Production I.
Milan Instituto di ricera sulla Dinamica dei
Sistemi Economoci (IDSE). Menger, Carl. 1871
1950. Principles of Economics. Glencoe, IL Free
Press. Mises, Ludwig. 1932 1990. The
Non-Neutrality of Money, in Money, Method and
the Market Process, Richard M. Ebeling, ed., from
lecture given to New York City Economics Club.
Norwell, MA Kluwer Academic Publishers. Mulligan
, Robert F. 2006. An Empirical Examination of
Austrian Business Cycle Theory. Quarterly
Journal of Austrian Economics 9 (2),
69-93. Schumpeter, Joseph R. 1950. Capitalism,
Socialism and Democracy. New York Harper Row.