Austrian Business Cycle Theory on the CFA Exam

Austrian Business Cycle Theory on the CFA Exam

Monday,November 12th,  2012

A friend informs me that the mainstream and prestigious CFA Institute now features Austrian economics in the study materials for the Level 1 CFA Exam. The section “Theories of the Business Cycle” includes several pages on Mises and Hayek (as well as Schumpeter), and they’re pretty good. “As a result of manipulating interest rates, the economy exhibits fluctuations that would not have happened otherwise. Therefore, Austrian economists advocate limited government intervention in the economy, lest the government cause a boom-and-bust cycle. The best thing to do in the recession phase is to allow the necessary market adjustment to take place as quickly as possible.” About 100,000 people take this exam each year, and now they are all being exposed to Austrian teaching.

A quick search of the CFA Institute website turns up several Austrian-friendly items, including a chapter from the 2011 book Boombustology that opens with a quote from Mises.

Just remember that Wall Street will be in a shrinkage mode for many years. The low interest rates, miniscule spreads on bonds, the tiny commissions on stocks all bode ill for employment.

Market Inefficiency:

…… As marvelous as the market economy is at problem solving, in a sense the real genius of the market process is in how it brings problems to people’s attention in the first place.  Before you can solve a problem, you have to be aware that there is a problem.  This, I believe, is the great insight that Israel M. Kirzner, beginning in the 1970s, contributed to our understanding of the market—in particular, that it is a process of entrepreneurial discovery of error.

One implication of this insight is that government policies that undermine the (admittedly imperfect) reliability of money prices also make the discovery of inefficiencies profoundly problematic: Undermining prices casts doubt on the very meaning of inefficiency.

Strictly speaking, an inefficiency exists when, for a given person at a given time and place, the cost of an action outweighs the benefit.  We’ve seen that to rationally calculate costs and benefits you need money prices of inputs and outputs, of steel and bridges.  So when government erodes private property rights, interferes with trade, distorts prices, and manipulates money, it doesn’t just make it harder to be efficient; it also pulls the rug out from under anyone trying to spot inefficiencies at all.

Using the rules of arithmetic, for example, it’s easy to see that the statement 1 + 2 = 4 is wrong, but what about  _ + _ = _ ?  What’s the solution to this “problem”?  Is there even a problem here?  Money prices fill in the blanks; they “create errors”—i.e., reveal mistakes that no one could see without them—that alert entrepreneurs might then perceive and correct. If mistakes and inefficiencies remain invisible, the search for better ways of doing things could never get off the ground.

An economy without inefficiencies is either one where knowledge is so perfect that no one ever makes a mistake, or it’s one in which government policy has effectively foreclosed the very possibility of inefficiency.  In a world of surprise and discovery, of experiment and innovation, the former is impossible; the latter sort of economy, as Mises showed almost 100 years ago, is impossible as well as intolerable.

So a living economy needs to “create” inefficiencies, and lots of them, to set the stage for greater efficiency and ongoing innovation.  And that’s just what the market process does all the time—thank goodness!

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