Cowen (1997) offers a version of the traditional Austrian theory that focuses on “risk” as distinct from “roundaboutness”. However this poses several problems. Firstly it runs the risk of misstating the original Austrian position – “roundaboutness” can not be easily summised as “chronological time”, and is really best thought of as whether a capital structure is more or less “elaborate”[1]. Cowen defines riskiness as “long-term, costly to reverse, high-yielding, and having returns highly sensitive to the arrival of new information” (Cowen 1997) and this also poses problems. It might seem reasonable to use basic finance theory to define risk as the inverse of returns, but when Cowen talks about “aggregate macroeconomic risk” the concept becomes highly dubious. Surely risk cannot be aggregated? Indeed instead of deciding upon the extent of their exposure to risk, entrepreneurs can only determine their exposure to different types of risk[2]. This begs the question: What sorts of risk do entrepreneurs engage in when credit conditions are loose? My suggestion is those that involve a more elaborate capital structure.
Moreover, we want to move away from characteristics of individual agents (such as risk preference) when trying to explain the so-called “cluster of errors” that arise during a cycle. Evans & Baxendale (2008a) highlights the heterogeneity of entrepreneurship, and we draw attention to the fact that an array of entrepreneurial plans will always exist[3]. If we assume reasonably efficient financial markets it is sensible to expect that the most profitable plans have a propensity to receive funding. Consequently during an inflationary boom there will be a systematic tendency for less profitable plans to find funding, and to come into fruition. Evans and Baxendale (2008a) therefore move away from representative agents to focus on marginal plans. Rather than deal with psychological explanations there are institutional reasons why the marginal plans will be prone to error.[4]
[1] Robert Miller has made an important discussion of buffer stocks. These might be defined as “resilience”. Indeed if we also label capital consumption as “extravagance” we have a three dimensional model to observe the Austrian cycle – resilience, elaborateness, and extravagance.
See Miller, R.C.B., 2010, “The role of ‘buffer stocks’ and commodities in an Austrian interpretation of the crisis” Paper presented at the Austrian Scholars Conference
[2] As a corollary an economic agent cannot be “risk averse”, they can only be “averse” to certain kinds of risk, but must also by definition have a corresponding penchant for other kinds of risk.
[3] This point is later echoed by Callahan & Horwitz (2010) “the ABC can be understood as assuming that actors have expectations that are to some degree heterogeneous”.
[4] Note that our knowledge assumptions here occupy a middle ground between omniscience and stupidity (see Evans 2014). This may seem sensible, but many economic studies imply that any deviations from the former leads to the latter.