An Austrian View of Expectations and the Business Cycles

Abstract

Austrian economists have contributed several important concepts to business cycle theory including: inter-temporal coordination of production and consumption, heterogeneous specificity of capital, nonneutrality of money, and the capital structure of production. Noticeably lacking, however, is a clear theory of expectations. Austrians should develop such a theory, one where expectations are endogenous to the market process and market institutions, because it will improve our understanding of business cycles. An endogenous theory of expectations explores how people adapt their expectations to changing market phenomena based upon their perceived costs and benefits of doing so. It supplants, to some extent, recent Austrian responses to rational expectations critiques such as positing a prisoner's dilemma, heterogeneous entrepreneurs, and adverse selection. This paper sketches a framework for thinking about endogenous expectations and uses it to examine the 2008 financial crisis.