On Robert Lucas’s Expectations, a Central Feature of Modern Macroeconomics, and On His “Lucas Critique” of Hydraulic Keynesianism

The rational expectations revolution, which led to modern macroeconomics, did further damage to hydraulic Keynesianism. Following Muth (1961), Lucas (1972, 1976) articulated what would become the central feature of modern macroeconomics: expectations are formed as if the representative agent knows the true model, and the ‘true’ model is whatever the theorist says it is. The limits of rational-expectations modelling probably seem more important today than they did before the financial crisis of 2007 and 2008. At the time of the rational-expectations revolution, however, it offered a valuable correction to the more mechanical sort of macroeconomics that had previously dominated policy.

Lucas (1976) pointed out a problem with hydraulic Keynesianism. The theory assumes that the different functions being estimated would not change when policy changed. But those functions reflected the plans and actions of people who are trying to understand the economy in which they act. For that reason, the functions may not have the sort of stability required for the theory to work. In particular, the public will sooner or later catch on to the link between expansionary monetary policy and inflation rates. When they do, inflation will no longer reduce unemployment. Anticipating increases in inflation, workers may not imagine that their higher wages represent more purchasing power, suppliers may not mistake an increase in output prices for an increase in underlying demand for their goods, and so on. The public will protect itself from the expected inflation, thereby eliminating the supposedly beneficial effects. This criticism of hydraulic Keynesianism is the ‘Lucas critique’.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 44-45.

Dynamic Stochastic General Equilibrium (DSGE) Models Are Sometimes Described as “Toy Economies”

Kydland and Prescott (1982) and Long and Plosser (1983) were particularly important in transforming the rational expectations revolution into the rigid orthodoxy of dynamic stochastic general equilibrium (DSGE) models. DSGE models are dynamic because they describe the behaviour of an imaginary economy over time. They are stochastic because some of the key variables of the model such as productivity and labour supply are subject to random shocks. Finally, they are general equilibrium models because all markets are considered at once.

DSGE models are sometimes described as ‘toy economies’ to underline how much they simplify real economies. A modern economy has many people and many goods, each different from the others. It changes continuously with innovations and surprises at every turn. DSGE models boil all this diversity down to a few equations representing, typically, one person, the representative individual, choosing how to distribute one good, labelled ‘consumption’, over time given a production technology that can change only when a random shock alters one or more coefficients of the equation linking a few inputs to the output of the one consumption good. Even the more elaborate DSGE models such as the important model of Smets and Wouters (2003) do not exceed about 30 equations.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 50.

Caballero (2010) Describes the “Dynamic Stochastic General Equilibrium” Model Class as “an Irresistible Snake-Charmer”

The Great Recession seems to be creating a change in the trend of macroeconomic thinking. Prior to the financial crisis of 2008, dynamic stochastic general equilibrium (DSGE) models dominated the macroeconomics literature without any apparent challengers on the horizon. Since then, however, we have seen an increasing interest in macroeconomic models that address the state of confidence (“animal spirits”), complexity, cognition, and radical uncertainty. . . .

Most of the renewed interest in animal spirits, complexity, cognition, and radical uncertainty has come from a more or less “Keynesian” perspective and might alternatively be described as the “return of interventionism.” We note that rejecting the stale theoretical approach of the last few decades could just as well coincide with a greater appreciation of capitalism in general and the market process in particular. Caballero (2010) illustrates the potential to emphasize animal spirits, complexity, cognition, and radical uncertainty from a more “Hayekian” perspective. Indeed, we believe that we may be seeing the revival of old disputes between Keynesian and Hayekian perspectives in macroeconomics. Whether (and to what extent) self-consciously “Austrian” economists will contribute, should these disputes reemerge, may depend on whether they prove themselves able to enter the conversation in a constructive and understandable way. . . . 

__________

Caballero (2010)—who warns against “the pretense of knowledge”—provides support for our claim that macroeconomic thinking is moving in a direction more favorable to Austrian insights. He describes the DSGE model class as “an irresistible snake-charmer” and calls for a radical change in macroeconomics (p. 86). “The root cause of the poor state of affairs in the field of macroeconomics,” according to Caballero (2010, p. 100), “lies in a fundamental tension in academic macroeconomics between the enormous complexity of its subject and the micro-theory-like precision to which we aspire.”

—Roger Koppl and William J. Luther, “Hayek, Keynes, and Modern Macroeconomics,” Review of Austrian Economics 25, no. 3 (September 2012): 224, 235.

Even with Idle Resources, There Is a Misallocation of Resources in the Time Structure of Production when a Keynesian Stimulus is Used

Roger W. Garrison (2001) developed a framework to challenge the efforts of John M. Keynes (1936) and his followers, especially those bound to the IS–LM model. Garrison’s main contribution to this type of macroeconomic modeling is adding the time factor with the aid of the Hayekian triangle to represent a “time structure of production.” Garrison follows Hayek’s insight in pointing out that there can be a disequilibrium in the time structure of production even if the macroeconomic aggregates suggest full employment. Garrison’s model is mostly used to illustrate the effects described by the Austrian business cycle theory (ABCT) and to compare, within this model, the ABCT with other business cycle theories like monetarism and Keynesian theories.

Garrison’s framework, however, can be applied to scenarios other than a monetary policy-induced business cycle. In fact, Garrison (2001, chap. 5) remarks on the expected results of a fiscal, rather than monetary, policy. His model has been extended to different applications like the Phillips curve, equilibrium with unemployment, and open economies (Kollar 2008; Ravier 2011, 2013).

Keynesian policies, however, resort to fiscal policy and not only to monetary policy. The fiscal policy tool has remained largely understudied in Garrison’s framework. In this paper, we contribute to filling this gap in two ways. First, we use Garrison’s model to show the effects of fiscal policy rather than the usual effects of an expansionary monetary policy that derives from the ABCT. Second, we assume the presence of idle resources rather than starting from an assumed equilibrium with full employment. The reason for this is that Keynesian policies are assumed to be useful in the presence of idle resources, not in equilibrium, when the problem that Keynesian policies seek to fix is already solved. We demonstrate that Garrison’s model shows that even with idle resources, there is a misallocation of resources in the time structure of production when a Keynesian stimulus is put in place.

—Adrián O. Ravier and Nicolás Cachanosky, “Fiscal Policy in Capital-Based Macroeconomics with Idle Resources,” Journal of Private Enterprise 30, no. 4 (Winter 2015): 81-82.

The Reswitching Critique Was Perhaps the Main Challenge for Capital Theory in the Twentieth Century

The capital debates dwelt mainly on the neoclassical production function. Apparently well-established conclusions in the profession coming from the Hicksian view of the pricing process were the following: (1) Cobb-Douglas functions, where output is determined by two distinct aggregate variables, labor and capital (in addition to rest, which remained unexplained), exist; (2) both of those factors earn their marginal returns, such that the wage rate depends on the marginal productivity of labor, while the return on capital depends on the marginal productivity of capital; (3) the rate of interest (i.e., profit on capital) is related to the relative scarcity of capital, meaning that its abundance should lead to lower returns, its relative scarcity to higher returns (Pressman 2005, p. 422). From these basic, though at-times-questioned, lines of neoclassical reasoning, many flowers blossomed. If the production-function approach has withstood criticism, the Clarkian task of unifying the theories of capital and capital goods (production on the one hand, and distribution on the other) has been successfully completed (Laibman and Nell 1977, pp. 878–879).

The reswitching debates started off with Joan Robinson’s (1953) famous publication on the production function. Yet perhaps the clearest exposition of the reswitching challenge can be found in the summary by Paul Samuelson, who suggested that the capital structure is an example that validates the “simple story” of William Stanley Jevons, Böhm-Bawerk, and Knut Wicksell—a story of how lower time preference (i.e., greater abstention from consumption) favors more productive and longer processes of production (Samuelson 1966, p. 568).

—Mateusz Machaj, “Challenges Concerning the Structure of Production: Capital-Reswitching Puzzles; What in Production Can Be Measured?” in Money, Interest, and the Structure of Production: Resolving Some Puzzles in the Theory of Capital, Capitalist Thought: Studies in Philosophy, Politics, and Economics (Lanham, MD: Lexington Books, 2017), 37-38.

A Macroeconomic Equilibrium as Captured in the AD-AS Framework CONCEALS Microeconomic Disequilibria

In all of the conventional macroeconomic approaches using the usual macro aggregates, there is only the vaguest of connections to the actual individual consumption and investment decisions responsible for movements of the aggregates usually captured through representative rather than heterogeneous agents. A shortcoming of using a representative agent as a microeconomic foundation is to overlook differences across economic agents. It is not through a representative agent that resources are allocated, but rather through interaction among different individuals and firms. Namely, a macroeconomic equilibrium as captured in the AD-AS framework conceals microeconomic disequilibria. It is not just the level of output that matters, but the composition of relative output and how goods and services are being produced (too much roundaboutness?) that matters for macroeconomic stability.

—Peter Lewin and Nicolas Cachanosky, “A Financial Framework for Understanding Macroeconomic Cycles,” Journal of Financial Economic Policy 8, no. 2 (2016): 273.

The Prominent Explanations of Business Cycles Rely Upon Aggregate Demand (AD) and Aggregate Supply (AS) Constructs

Ever since the advent of Keynesian economics, the prominent explanations of business cycles, including severe crises and bubbles, have proceeded in terms of aggregate demand (AD) and aggregate supply (AS) constructs. Any observed level of aggregate economic activity is perceived to be the result of AD-AS interaction. This has gone through various incarnations, from the simple hydraulic Keynesian model with its totals of consumer and producer spending, C I, and their functional determinants, to more sophisticated, general equilibrium models and dynamic stochastic general equilibrium models. All variants include aggregate measures of spending, prices, real output, total supply of money and total employment. Some models use a measure of the economy’s capital stock from which (together with labor employment) real output is assumed to flow (an aggregate production function).

To explain fluctuations in aggregate production and employment, these models must explain how these aggregates can be made to fluctuate. Broadly, business cycle theories can be divided into three groups, Keynesian (and new Keynesian) theories, monetarist (and later new classical) theories and real business cycle theories (RBC). The first group relies on different versions of what Keynes referred to as “animal spirits” (irrationality). For instance, the propensity of entrepreneurs to invest in production which is very much affected by waves of optimism and pessimism that produce herding behavior. Influential work along these lines was done by the financial economist Minsky (1986) — the turning point toward the boom based on speculative investments was referred in the literature as the “the Minsky moment.” Similarly, Alan Greenspan famously referred to “irrational exuberance” to describe widespread speculative investments on the stock market.

Alternatively, according to the Monetarist and new-classical approaches, fluctuations in the rate of growth of the money–supply produce the illusion of real output and expenditure changes which cause workers to erroneously believe that real wages have risen only to be reversed in the long run when inflationary expectations catch up to the new rate of inflation. Although Keynesian-type explanations emphasize some sort of irrational behavior, monetarist explanations rely on the money illusion produced by an expansionary monetary policy. Because new classical theories assume rational expectations, it is an unexpected monetary shock that produces a crisis.

RBC theories, like new classical theories, also rely on rational expectations but argue that business cycles are produced not by unexpected monetary shocks but by unexpected real shocks. These shocks usually occur to total factor productivity which, through a transmission mechanism that works as an amplifier, produce output fluctuations in the economy.

—Peter Lewin and Nicolas Cachanosky, “A Financial Framework for Understanding Macroeconomic Cycles,” Journal of Financial Economic Policy 8, no. 2 (2016): 272-273.

The First Stock Market — the Amsterdam Bourse — Functioning WITHOUT State Enforced Rules

It is often argued that government rule enforcement is necessary for the development of a stock market (Glaeser, Johnson, & Shleifer, 2001). Work by Boot, Stuart, and Thakor (1993), Klein and Leffler (1981), and Telser (1980), however, suggests that repeated interaction and reputation can create incentives for contracts to be self-enforcing. This paper investigates these claims by examining the first stock market, the Amsterdam Bourse. At a time when many financial contracts were unenforceable in government courts the market developed surprisingly advanced trading instruments. Descriptions by seventeenth-century stockbroker, De la Vega [Confusion de Confusiones], indicate that a reputation mechanism enabled extralegal trading of relatively sophisticated contracts including short sales, forward contracts, and options.

From stock markets in former socialist countries to new electronic trading networks in the West, there is much debate over the proper amount of oversight of financial exchanges (Frye, 2000; Macey & O’Hara, 1999). A market without rules would hardly be conducive to trade (Brennan & Buchanan, 1985) so it is often concluded that government rules and regulations are necessary for a stock market to function (Glaeser, Johnson, & Shleifer, 2001). What happens when a legal system is not equipped to deal with complicated financial transactions? Boot, Stuart, and Thakor (1993), Klein and Leffler (1981), and Telser (1980), give us theories of how contracts can take place even without external enforcement. Among other things they illustrate that repeated interaction and reputation can align incentives such that it pays to abide by one’s contracts. This paper uses evidence from the first stock market to investigate the degree to which financial markets are able to function without state enforced rules.

In the seventeenth century, the Amsterdam Bourse developed surprisingly advanced trading instruments at a time when government courts were unaccustomed and unable to deal with what today would be considered common financial transactions. Much of the dealings that took place were actually prohibited by law, although the law was ineffective and not strictly enforced. This relatively free atmosphere allowed the traders to experiment and devise new trading instruments, even though they were officially proscribed. The development of the instruments on the Amsterdam Bourse was not due to government directive but self-interest of traders who found it profitable to engage in new financial dealings. In contrast to the position that financial markets depend on government rules and regulations, the historical record lends credence to the theories that contracts can be self-enforcing and that market participants can police themselves.

—Edward Stringham, “The Extralegal Development of Securities Trading in Seventeenth-Century Amsterdam,” Quarterly Review of Economics and Finance 43, no. 2 (2003): 321-322.

The Efficient-Markets Hypothesis Is a Good Example of the Neglect of the Entrepreneur in Economic Theory

The entrepreneur is a key figure in the market economy. In a dynamic economy, ideas, products, and services are constantly changing. Entrepreneurship, broadly defined, refers to actions of individuals as they strive to cope with constantly changing market conditions. When viewed in this way, all market participants—consumers, producers, and investors—engage in entrepreneurial activity.

Despite the crucial role of entrepreneurship in the market process, the entrepreneur is often neglected in economic theory. A good example of this neglect is the efficient-markets hypothesis (EMH) of financial investments. This theory holds that the individual investor cannot outwit the market because all available information is already incorporated in stock prices. The efficient-markets approach taken to its logical extreme “means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the expert.” The implication is that a buy-and-hold strategy is as good as any other and that there is no scope for entrepreneurial activity in financial markets.

Insights from the Austrian theory of the competitive market process are used in this article to show that the role of the entrepreneur in investment decisions is similar to that in other spheres of economic activity. Entrepreneurial opportunities exist whenever markets are not perfectly coordinated. Hence, it is argued, there is scope for entrepreneurial activity in financial markets just as there is in other markets. In a world of uncertainty and costly information, the pinpointing of economic inefficiencies is found to be just as difficult in financial markets as it is in all other markets. Since the EMH is a version of the zero-profit theorem of competitive equilibrium in the conventional theory of the firm, it is argued that shortcomings of the EMH are similar to those of other long-run competitive theories that focus exclusively on equilibrium outcomes while ignoring the entrepreneurial market process that generated those outcomes. The conclusion is that neither the dart-throwing monkey nor any other automaton is a good substitute for the entrepreneur in investment markets where relative prospects for different assets are constantly changing. Before specifically considering the role of entrepreneurship in financial markets, the reason for the neglect of the entrepreneur in conventional economic analysis is briefly analyzed.

—E. C. Pasour Jr., “The Efficient-Markets Hypothesis and Entrepreneurship,” Review of Austrian Economics 3, no. 1 (December 1989): 95-96.

A Major Problem with the Efficient Market Hypothesis Is It Assumes Everyone Arrives at a Rational Expectations Forecast

The efficiency of the market means that the individual investor cannot outwit the market by trading on the basis of the available information. The implication of the EMH [efficient market hypothesis] is destructive for fundamental analysis, for this means that analysis of past data is of little help since whatever information this analysis will reveal is already contained in asset prices. Proponents of the EMH argue that if past data contains no information for the prediction of future prices, then it follows that there is no point in paying attention to fundamental analysis. A simple policy of random buying and holding will do the trick. One of the pioneers of the EMH who has popularized this framework is Burton G. Malkiel.

The theory holds that the market appears to adjust so quickly to information about individual stocks and the economy as a whole that no technique of selecting a portfolio — neither technical nor fundamental analysis — can consistently outperform a strategy of simply buying and holding a diversified group of securities. 

Consequently, Malkiel argues that,

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the expert. 

The major problem with the EMH is that it assumes that all market participants arrive at a rational expectations forecast. This, however, means that all market participants have the same expectations about future securities returns. Yet, if participants are alike in the sense of having homogeneous expectations, then why should there be trade? After all, trade implies the existence of heterogeneous expectations. This is what bulls and bears are all about. A buyer expects a rise in the asset price while the seller expects a fall in the price.

—Frank Shostak, “In Defense of Fundamental Analysis: A Critique of the Efficient Market Hypothesis,” Review of Austrian Economics 10, no. 2 (1997): 28-29.

The Efficient-Market Theory Is the Perfect Competition Model of the Financial World

Many economists do not believe that you can beat the market. That is, they believe that investors cannot consistently make big money in stocks, commodities, or any other financial market. I heard this peculiar view when I was an undergraduate, and it is still very much in vogue among academic theorists. It’s called the “efficient-market theory,” and it remains the dominant theory in finance schools. Samuelson and Baumol and Blinder discuss it favorably, and proponents of rational expectations often support it. It is the notion that markets are extremely efficient in the sense that in them all new information is quickly discounted. Therefore, no one can capture consistent profits by trading stocks, commodities, or options. As Samuelson summarizes, “You can’t outguess the market.” I call the efficient-market theory the perfect competition model of the financial world. . . .

The best alternative, say the armchair theorist, is to select stocks on a random basis. This is called the “random walk method” of investing. The most popular book on this subject is A Random Walk Down Wall Street, by Burton G. Malkiel, dean of management at Yale University. Malkiel defines random walk as follows:

A random walk . . . means that short-run changes in stock prices cannot be predicted. Investment advisory services, earnings predictions, and complicated chart patterns are useless. . . . Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts. 

While Wall Street analysts often dismiss the random walk method as academic nonsense, mainstream economists are enamored by it.

—Mark Skousen, “The Economist as Investment Advisor,” in Economics on Trial: Lies, Myths, and Realities (Homewood, IL: Business One Irwin, 1991), 257-258.

The Capital Market Is Utmost Imperfect for Entrepreneurial Businesses Severely Impeding the Use of 3 Valuation Methods

The problems described above lead to severe problems when applying multiples, DCF methods and real option approaches to valuing entrepreneurial businesses. Multiple approaches such as the ‘similar public company approach’ or the ‘recent acquisition approach’ attempt to draw conclusions about the value of the firm by looking at prices that were paid in the past for ‘comparable’ companies either in M&A deals or at the stock exchange. Comparable companies can hardly be found for entrepreneurial firms because of the uniqueness of their business model and the specific managerial expertise and networks of the founder. Therefore, multiples fail when valuing small, innovative firms.

In addition, the several variations of the DCF approach are not convincing for the purpose of valuing small, innovative firms. DCF methods aim to calculate the market value for the firm which is valid in a perfect capital market in equilibrium. However, the premises of a perfect capital market are not met at all in the case of entrepreneurial businesses, as mentioned above. As a consequence, DCF approaches fail when valuing small firms. They are based upon the CAPM and therefore cannot be applied under the assumption of an imperfect capital market.

The real options method computes the value of the firm as the sum of a basic value (calculated by the DCF method) and an option value that is generated, inter alia, according to the models of Black and Scholes or Cox et al. Both basic and option value are therefore calculated assuming a perfect capital market which is not met in the reality of entrepreneurial businesses. Despite this severe weakness, there are surprisingly many proponents of the real options method who claim that the approach is particularly adequate for valuing small, innovative firms.

—Gerrit Brösel, Manfred J. Matschke, and Michael Olbrich, “Valuation of Entrepreneurial Businesses,” International Journal of Entrepreneurial Venturing 4, no. 3 (2012): 241-242.

CAPM’s Assumptions Supplant Heterogeneous Human Persons with an Army of Homogeneous Robots

The current mainstream in investment appraisal relies on input parameters within the income approach that are much different from what investment theory requires. It is based upon neoclassical finance theory and neglects the crucial personal perspective in favor of a questionable “objective” market perspective (Matschke, and Brösel, 2013, pp. 26–27). Though the prevalent mainstream discounted cash flow (DCF) methods are also based upon the income approach, they are inadequate as a decision tool (e.g., Rapp, 2014b, p. 1067). The main reason for this diagnosis is the application of finance-theory based models within current DCF methods (Hering, 2014, p. 263).

In these methods, the discount rate is usually, at least partly, assessed using the capital asset pricing model (CAPM) (Koller, Goedhart, and Wessels, 2010, p. 234). Instead of considering the essential personal endogenous marginal interest rate, the CAPM aims at the determination and application of an “objective” discount rate (Hering, 2015, p. 307). In order to measure an, at least hypothetically, objective discount rate, the CAPM must rely upon several restrictive assumptions (e.g., Perridon, Steiner, and Rathgeber, 2012, p. 546, Hering, 2015, p. 297). These include a perfect capital market (which includes the existence of a single market interest rate for both investments and lending; unlimited access to lending independent of debt ratio, credit-worthiness, credit amount and time pattern; symmetric distribution of information; and the absence of taxes as well as transaction costs) and economic agents with both homogeneous expectations and a standardized risk appetite (µ-σ-principle). Basically, CAPM’s assumptions supplant heterogeneous human persons with an army of homogeneous robots. Because the subjective values of homogeneous robots coincide, the model can generate a (hypothetical) single objective market value (Matschke, and Brösel, 2013, p. 27). The uniformity of economic agents in the CAPM leads finally to the market portfolio which includes every risky asset and which is held by every single investor. In other words, in the CAPM world, everybody owns everything (Hering, 2015, pp. 298–299). The sole ownership of any company is, by definition, impossible. Thus, the purchase or sale of an entire company is excluded as well. Nevertheless, the CAPM is applied for the investment appraisal of entire businesses in preparation of merger and acquisition decisions all over the world every single day.

—Jeffrey M. Herbener and David J. Rapp, “Toward a Subjective Approach to Investment Appraisal in Light of Austrian Value Theory,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 20-22.

Utilizing Neo-Classical Equilibrium Properties, CAPM Explains Pricing on Idealized Capital Markets

In general, an equilibrium theory only has the power to explain a rigid, irrevocable state and is useless to indicate rational resource allocation in a dynamic economy (Herbener 1996, 160; Mises [1949] 1998, 708–9; Morgenstern 1935, 353). As a result, finding an application in a dynamic reality is unlikely. CAPM [Capital Asset Pricing Model] is an equilibrium model that explains pricing in the capital market under idealized assumptions. The application of such restrictive constraints should be carefully considered, especially for the sensitive purpose of calculating a decision value. Caution is advised by neo-classical luminaries. While the CAPM builds on the assumptions of the efficient market hypothesis, which was introduced by Fama (1970, 1965), Fama and French (2004, 43–4) later refute CAPM’s practical applicability and warn of its “seductive simplicity.”

—Michael Olbrich, Tobias Quill, and David J. Rapp, “Business Valuation Inspired by the Austrian School,” Journal of Business Valuation and Economic Loss Analysis 10, no. 1 (2015): 12.

The Austrian “Subjective Business Valuation Theory” As a Rival to the Neoclassical Discounted Cash Flows Valuation Method

The significant failure rates observed in mergers and acquisitions (M&A) indicate structural deficiencies in business transactions. This paper identifies serious weaknesses in common valuation methods that play a key role in poor transaction practice. Common valuation methods are in particular discounted cash flow (DCF) methods. DCF methods are usually based on neoclassical theories that assume the existence of a perfect and complete capital market. As will be demonstrated, the underlying theoretical patchwork is contradictory and lacks utility. Therefore, utilizing DCF methods to value a business and deduce economic decisions from such a valuation is decision-making built on sand. Following a normative-deductive methodology, this paper seeks an alternative theoretical concept to build a business valuation theory on solid ground. Such an alternative is found in the Austrian School of thought. The resulting valuation concept, subjective business valuation theory, is based on the theory of marginal utility proposed by Gossen, which was rediscovered and refined by the scholars of the early Austrian School. Contrary to highly restrictive neo-classical valuation, subjective business valuation approaches reality and is therefore well-suited for practical implementation.

—Michael Olbrich, Tobias Quill, and David J. Rapp, “Business Valuation Inspired by the Austrian School,” abstract, Journal of Business Valuation and Economic Loss Analysis 10, no. 1 (2015): 1.

The 2nd Cantillon Effect from Artificially Low Interest Rates Is Seen in the Wave of Mergers and Acquisitions

The second Cantillon effect from lower rates of interest is the impact on the size of firms. A lower cost of capital encourages firms to grow in size and to take advantage of economies of scale, such as the example of the dairy industry in transition. Here, companies that expand based on artificially low interest rates benefit, at least temporarily, at the expense of companies that do not and exit the industry. As part of this larger-scale, more roundabout production process, firms develop central offices or headquarters for their accounting, management, marketing, human resources, and product-development departments. This increases the demand for office space in central business districts. This demand in turn raises rents and encourages the construction of taller office buildings within the central business district.

The phenomenon of firms growing in size and scope in response to artificially low interest rates can be seen in the history of merger-and-acquisition waves. Mergers between two firms occur when both firms believe they can profit from combining their operations. Acquisitions and takeovers occur when one firm believes it can manage the combined assets of the firms in a more profitable manner. Lower interest rates reduce the cost of the capital to buy out investors of the other firm. Mergers and acquisitions have occurred in clusters or waves during periods of low interest rates and easy credit conditions (the boom), and because they often start operating as a united company during the bust, their record of success has not been great.

Saravia shows that waves of mergers and acquisitions that have been experienced in the past are consistent with Austrian business cycle theory (ABCT). Not only do low interest rates help finance mergers and especially acquisitions, but the demand for such business deals is a reflection of the “resource crunch” of ABCT as shown in the previous example of the expansion of the advanced computer-chip industry. Ekelund, Ford, and Thornton show that when mergers are delayed by government “red tape,” the resulting acquisitions and mergers tend to be unprofitable because they are often completed during an economic downturn. Thornton has furthered the discussion of why so many mergers and acquisitions turn out to be miscalculations.

—Mark Thornton, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century (Auburn, AL: Mises Institute, 2018), 70-71.

High Yield Bonds (a.k.a. “Leveraged Buy-Outs” or “Junk Bonds”) Benefit Everyone Except the Inefficient Old Guard Elites

Mr. Milken was worth it because he has been an extraordinarily creative financial innovator. During the 1960s, the existing corporate power elite, often running their corporations inefficiently—an elite virtually headed by David Rockefeller—saw their positions threatened by takeover bids, in which outside financial interests bid for stockholder support against their own inept managerial elites.

The exiting corporate elites turned—as usual—for aid and bailout to the federal government, which obligingly passed the Williams Act (named for the New Jersey Senator who was later sent to jail in the Abscam affair) in 1967. Before the Williams Act, takeover bids could occur quickly and silently, with little hassle. The 1967 Act, however, gravely crippled takeover bids by decreeing that if a financial group amassed more than 5 percent of the stock of a corporation, it would have to stop, publicly announce its intent to arrange a takeover bid, and then wait for a certain time period before it could proceed on its plans. What Milken did was to resurrect and make flourish the takeover bid concept through the issue of high-yield bonds (the “leveraged buy-out”).

The new takeover process enraged the Rockefeller-type corporate elite, and enriched both Mr. Milken and his employers, who had the sound business sense to hire Milken on commission, and to keep the commission going despite the wrath of the Establishment. In the process Drexel Burnham grew from a small, third-tier investment firm to one of the giants of Wall Street.

The Establishment was bitter for many reasons. The big banks who were tied in with the existing, inefficient corporate elites, found that the upstart takeover groups could make an end run around the banks by floating high-yield bonds on the open market. The competition also proved inconvenient for firms who issue and trade in blue-chip, but low-yield, bonds; these firms soon persuaded their allies in the Establishment media to sneeringly refer to their high-yield competition as “junk” bonds.

People like Michael Milken perform a vitally important economic function for the economy and for consumers, in addition to profiting themselves. One would think that economists and writers allegedly in favor of the free market would readily grasp this fact. In this case, such entrepreneurs aid the process of shifting the ownership and control of capital from inefficient to more efficient and productive hands—a process which is great for everyone, except, of course, for the inefficient Old Guard elites whose proclaimed devotion to the free markets does not stop them from using the coercion of the federal government to try to resist or crush their efficient competitors.

—Murray N. Rothbard, “Michael R. Milken vs. the Power Elite,” in Making Economic Sense, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), 182-184.

Ludwig von Mises on the Role the Capital and Money Market Plays in the Direction of Corporate Business

The illusion that management is the totality of entrepreneurial activities and that management is a perfect substitute for entrepreneurship is the outgrowth of a misinterpretation of the conditions of the corporations, the typical form of present-day business. It is asserted that the corporation is operated by the salaried managers, while the shareholders are merely passive spectators. All the powers are concentrated in the hands of hired employees. The shareholders are idle and useless; they harvest what the managers have sown.

This doctrine disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the “market,” plays in the direction of corporate business. The dealings of this market are branded by popular anticapitalistic bias as a hazardous game, as mere gambling. In fact, the changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation’s business; it creates a state of affairs to which the managers must adjust their operations in detail.

—Ludwig von Mises, Human Action: A Treatise on Economics, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2007), 2:306-307.