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Monday
Apr282014

Roundaboutness

The term "roundaboutness" is often used in Austrian business cycle theory, and I'm not sure if it's a simple term being consistently applied, or something more complex. At the recent APEE meetings Nicholas Cachanosky presented a paper arguing that it isn't a mysterious concept (co authored with Peter Lewin), but I'm not sure I'm convinced. My basic understanding, stemming from Bohm-Bawerk is the following:

Roundaboutness = capital intensity. 

Cachanosky & Lewin define roundaboutness as the "average period of production", and use net present value formulae and the concept of EVA to measure it. This is a great way to operationalise the concept, but is it "roundaboutness" that is straight forward, or their method?

One of the reasons I find Tyler Cowen's "Risk and Business Cycles" unsatisfying is because he doesn't really allow for different types of risk. In his treatment "risk" does all the work, and there's no need to talk about roundaboutness. I can't help feel that this fails to do justice to the Austrian story. Hence I am always wary of the following characterisation:

Roundaboutness = Time = Risk.

We can think of the interest rate as a measure of our time preference (or the ratio of the value of present goods to future goods), or a market generates risk assesment. Must they be the same thing? All else equal the longer the production process the greater the risk, but we can conceive of production plans that are risky but immediate (e.g. fashion) and those that are not so risky but distant (e.g. oil wells). In other words risk and roundaboutness are conceptually distinct.

Consider a standard Hayekian triangle:

Now, whilst playing around with these diagrams can go too far, I think they're a good way to illustrate my point. Consider these two alternative ways of treating roundaboutness. Firstly, aa an increase in the production period:

Alternatively, roundaboutness could mean that there's more stages of production:

In the example above the final value of the consumer goods being generated is the same, but the value at all stages of production has increased. We could also show this where there's a change in the composition of the value from late stage to early stage:

And so on. It would be interesting to assign some possible applications to show that this is empirically relevant. 

When sketching out these triangles I have in mind Lachmann's notion of reserve assets, which has recently been utilised by Robert Miller with his treatment of "buffer stocks" (here and here). It's hard to measure buffer stocks, and it's tempting to use inventories as a starting point. Here's what's happened to inventories in the UK over the last few years:

What we (sort of) see here is a steady decline in inventories from 1997 - 2007, which point to two things. Firstly, they get run down because excessive optimism means that entrepreneurs don't feel that they need them. And secondly, the utilisation of inventories as a means to generate unsustainable production (i.e. go beyond the PPF). Then during the crisis there's a dramatic reduction in inventories, and the "recovery" involves rebuilding. We need to be careful though, since inventories are just one source of buffer stock (and indeed one that is particularly close to consumer goods or final stage production). Some examples of buffer stocks include:

  • Inventories
  • Cash balances and other liquid assets
  • Commodities (not only as aproduction input but also as a speculative hedge)
  • Labour
  • Any goods that are relatively less heterogeneuous that others and thus adept at fitting into an array of alternative production plans

Finally, consider a Hayekian triangle and what's supposed to happen when interest rates fall. For simplicity, let's go use a 3-stage version.

If lower interest rates induce entrepreneurs to move towards more roundabout methods we would expect resources to move from stage iii back to stage i. But stage iii is substantially larger than the early stages. Let's say we shift around 30% of the value in stage iii to stage ii, and likewise from stage ii to stage i. Here's (roughly) what we might see (original is dashed):

Is it not conceivable that the reduction in stage ii (as a result of activities being shifted to stage i) is offset by the shifted production from stage iii? In other words lower interest rates will cause unambiguous reductions in late stage production, increases in early stage production, but may also swell mid stage production? The stylised facts would be an increase in stage ii.

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Reader Comments (4)

The reason that "roundaboutness" is confusing is because it's not well defined in some cases. Take the following example that Gene Callahan gave to me last year:

"Well, no, you've missed Hayek's point here. Process A make take 12 months, but with few inputs invested in months 1-11 and then quite a few in month 12. Process B make take six months, with almost all of the inputs invested in the first month. Which is a "lengthier" production process?"

There is no obviously correct answer to this question. Gene Callahan and I discussed this quite a bit. There are different problems with "roundaboutness", "average period of production" and total time taken for a particular process. But, the problems for each of them aren't readily solved. Some of this is discussed in PToC and some in P&P.

See the following links and notice that I was wrong and Gene was right.
1: http://gene-callahan.blogspot.ie/2013/03/hayek-too-abandoned-lengthening-of.html
2: http://gene-callahan.blogspot.ie/2013/04/hayeks-got-my-back-on-this-one.html

April 29, 2014 | Unregistered CommenterCurrent

Thanks Anthony for stopping at the panel and putting up this comment.

The way I think of roundaboutness (in the traditional use of the term) is as a complicated concept that conflates two different "variables": capital intensity (K) and period of production (time).

One can, in theory, think of a capital intense project that produces faster than a lower capital intense alternative project (a turnpike versus a road). Related and no less of a problem is to define when should we define that production "starts."

In our paper we want to show that once we think of "roundaboutness" as a forward looking (rather than backward looking) concept then financial duration allows to: (1) separate the two dimensions of capital and time (thanks to the EVA literature) and (2) capture the insights that longer-value projects are more sensitive to changes in interest rates.

If roundaboutness is related to time, then a definition of stages of production is not necessary. It is a measure of time (duration) and (financial) capital intensity what defines the degree of roundaboutness regardless of how we (subjectivley) want to define stages of production.

If the period of production is not measured in units of time, but in time-value (how many dollars are locked-up for how much time), then it seems that the concept is not too far away from that of Macaulay and modified duration. Hicks develops the concept of duration trying to solve this problem (but wasn't taken by the economics profession) and it may be an argument to sustain that Hayek's triangle, by having value (the vertical axis) can be interpreted as a particular case of a duration calculation.

Admittedly, risk is not something we have talked (yet) as much as would be of interest to expand the ABCT story.

Thanks again.
Please share any thoughts, there is no much literature on this "financial approach" and all insights are very useful to us.

May 1, 2014 | Unregistered CommenterNicolas Cachanosky

Yes, my thanks to Anthony too.

I endorse exactly what Nicoloas said. I post only to emphasize two things.

1. the focus is on the effect of interest rate changes on the incentive to invest being different for projects with different duration. Fascinatingly, what Hicks showed is that his measure of the Average Period (not Bohm-Bawerk's; Hicks is in terms of value, not labor) is also the elasticity of the (expected) present value of the project wrt the interest (discount) factor (f = 1/1+r, where r is the interest rate). We show that modified duration is this same idea wrt to absolute changes in r. So, for the same change in r it may plausibly be argued that there will be significantly different changes in incentive to invest depending on the duration of the project.

2. We are talking about investment prospects - mental images in the minds of the appraising entrepreneurs - forward looking, non-equilibrium constructs. They may be wrong, but how will they act? That is the key.

May 1, 2014 | Unregistered CommenterPeter Lewin

Thank you for both making a contribution. The emphasis on being forward looking is really important and it definitely seems that you are on to something. I need to read up on the Hicks side of things but everything you've said makes sense.

May 6, 2014 | Registered CommenterAnthony J. Evans

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