The Austrian theory of the business cycle is among the most interesting and distinctly “Austrian” ideas in the school of thought. The basic story is a simple one: Manipulation of interest rates distorts investment. In particular, by artificially depressing them, government creates an artificial business boom in which firms undertake more long-term investment than is truly profitable. When interest rates are allowed to return to their “natural” levels, firms realize their malinvestment and the bust ensues.
This theory is so ingenious, why limit it to business cycles? What else might the basic ABC insight help us explain?
In a recent paper (“Balkanization and Assimilation: Examining the Effects of State-Created Homogeneity”), I try and apply the same basic framework to the problem of ethnic balkanization. I argue that state-directed attempts to create homogeneity over important dimensions, such as language, money, or even the methods of dispute resolution one follows, balkanize social groups. These dimensions of homogeneity are important signaling devices for facilitating inter-group interaction where government does not manipulate them.
For instance, what type of contractual dispute resolution methods I use (as well as the adjudicator’s identity) signal something about my type as a trader, and individuals look to these social signals to for information about outsiders–particularly when they are from social groups one is not closely tied to. Absent government involvement, individuals voluntarily adopt certain practices, customs, etc., of outsiders to signal their credibility and these signals accurately reflect the sender’s underlying type.
When government formalizes these things, however, and legally requires them (or in some other way alters the price of adopting them), a signal extraction problem is created. Do I use the same money as you because the state requires me to, or would I have anyway in the absence of this requirement? In the short run, because it looks like we share more in common than we really do, state manipulation may actually increase the amount of interaction and exchange. But soon individuals learn that observed commonality is not real. On the basis of artificially high observed commonality, they interact with untrustworthy actors and are defrauded. Having been defrauded, they reduce their interactions with others but by how much they should curtail these interactions is unclear.
With a newly-reduced ability to determine the credibility of others, interaction becomes more uncertain, reducing actors’ willingness to exchange. This is especially true for members of distant social groups, who rely more on such signals to facilitate interaction and are therefore more sensitive to signal noise. The result is balkanization.
In a recent article in the Journal of Institutional Economics, I also try to use this framework to understand Africa’s fractionalization problem. Chris, Tony Carilli and I are working on a paper that applies this idea in the context of social capital as well.