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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.Read more ›
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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 .Read more ›