Lesson 3 of 8
Why they do not cancel
Entrepreneurs are wrong all the time and it usually cancels out. Any theory of the cycle has to say why the errors line up. Here is this one's answer.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Every explanation of a crisis assumes entrepreneurs made errors. The hard part is explaining why they all made the same error at the same time.
- Hayek rejects psychological infection as an answer and offers instead that they were misled by a signal that is usually reliable: the prices they had to decide on.
- The distinction he draws is between errors caused by the price system and errors about external events, and only the first can be simultaneous and general.
Firms are wrong constantly. One misjudges demand and another misjudges it the other way, and the losses of the first are the gains of the second. That is ordinary and it is not a cycle.
What has to be explained
Ordinary error
- Firms are wrong in both directions.
- Losses on one side meet gains on the other.
- Profit and loss corrects each case separately.
- No aggregate needs explaining.
Clustered error
- Firms are wrong in the same direction.
- Losses appear everywhere at once.
- Capital goods industries are hit hardest.
- Something they all consulted was misleading them.
A theory of the cycle earns its keep only on the right column.
Hayek's statement of the problem
He puts it plainly in a lecture given in Copenhagen in December 1933 and published in Profits, Interest and Investment in 1939. Every explanation of economic crises must assume that entrepreneurs have committed errors, but the bare fact that they make errors is not an explanation. Erroneous decisions leading to losses all round are probable only if we can show why entrepreneurs should all simultaneously make mistakes in the same direction.
He then rejects the obvious answer. The explanation that it is a kind of psychological infection, or that most entrepreneurs commit the same avoidable misjudgement for some other reason, does not carry much conviction.
The answer offered
That they were all following guides which as a rule prove reliable. Concretely: the prices existing when they decided, on which they had to base their views of the future, had created expectations that could not be met.
Hayek draws the distinction this gives him. On one side, errors caused by the price system, which he calls justified errors. On the other, sheer errors about the course of external events. Only the first kind can be general and simultaneous, because only the first comes from something everyone consults.
Why an investment is the case where this bites
Hayek's argument is specific. Most investment made over a long period is only part of a process that will be completed by further investment later, so the first instalment succeeds only if capital keeps being available.
Entrepreneurs therefore treat the present supply of capital and the present rate as a symptom that roughly the same conditions will last. Nothing else would justify starting a roundabout process that needs years of further commitment. That assumption is the shared guide, and when it is wrong everybody holding it is wrong together.
Rothbard's version
Rothbard states the same problem at the front of America's Great Depression in 1963, under the heading of the cluster of error, and adds a second fact to be explained: that capital goods industries fluctuate more widely than consumer goods industries, expanding further in the boom and being hit harder in the depression. His answer is that in an unhampered market trained entrepreneurs will not all err at the same time, and that the cycle is generated by bank credit expansion.
That is a strong claim and it is contested. The objection that markets learn, so the signal stops misleading anyone, is one of the four taken at full strength in the course on the case against this theory.
Check yourself
What does Hayek say is not enough as an explanation of a crisis?
- That interest rates changed
- The bare fact that entrepreneurs make errors, since what needs explaining is why they all err in the same direction at once
- That banks lent too much
Show the answer
Answer: B.
He also rejects psychological infection and the idea that most entrepreneurs commit the same avoidable misjudgement for some unspecified reason.What distinction does he draw between kinds of error?
- Large errors against small ones
- Errors caused by the price system, which he calls justified, against sheer errors about external events
- Errors by new firms against errors by established ones
Show the answer
Answer: B.
Only errors traceable to a shared signal can be general and simultaneous, because only those come from something everybody consults.What second fact does Rothbard say a theory of the cycle must explain?
- That unemployment lags output
- That capital goods industries fluctuate more widely, expanding further in the boom and being hit harder in the depression
- That prices always fall in a depression
Show the answer
Answer: B.
He lists it in the first chapter of America's Great Depression alongside the cluster of error and the increase in the quantity of money during a boom.Sources
- Hayek, 'Price Expectations, Monetary Disturbances and Malinvestments', a lecture given in Copenhagen in December 1933 and reprinted as essay IV in Profits, Interest and Investment, 1939, section III, for the statement that error alone is not an explanation, for the rejection of psychological infection, for entrepreneurs being misled by usually reliable guides, for the distinction between justified errors caused by the price system and sheer errors about external events, and for the argument that most long investments assume the continued availability of capital.
- Rothbard, America's Great Depression, 1963, part one, chapter 1, sections on the problem of the cluster of error and on the explanation, for the three facts he says a cycle theory must account for and for his answer.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The two hundred firms are invented and describe nobody.
- The claim that entrepreneurs cannot learn to discount a misleading signal is the sharpest objection to this lesson, and it is not answered here. It is taken at full strength in the course on the case against the theory.