Austrian Business Cycle Theory And Rational Expectations
Yet there are two fatal flaws in Caplan's argument, each of which by itself is fatal to his argument. The first flaw is that in order for entrepreneurs to correctly anticipate the future downturn created by central bank policy they must be aware of and believe in the Austrian theories. If they don't believe in it, then they will not see that investments based on artificially lowered interest rates will turn out to be malinvestments. And since the Austrian business cycle theory is unfortunately only known and accepted by a small minority, the vast majority is not going to foresee the problems arising in the future.
Secondly, and perhaps even more importantly, even if the Austrian Business Cycle Theory became generally known and accepted among entrepreneurs, it would still make sense for profit maximizing entrepreneurs to act upon lower interest rates. The reason is simple. Because the central bank subsidizes interest rates during the initial boom phase, the economic gains for entrepreneurs during the boom will exceed the economic gains for the overall economy. Moreover, because the central bank generally tends to bail out failed investors during the bust phase of the business cycle, this means that the loss for investors during the bust will be smaller than the losses for the overall economy. A recent concrete example of this is the case of Bear Stearns.
Interestingly, Caplan notes that Austrian economist Roger Garrison has already put forth a version of that counter-argument, but Caplan's reply is simply to note that entrepreneurs will make investments that are profitable to them, while abstaining to make investments that aren't profitable to them. This is of course not an answer at all to the argument that there exists a distinction as to what is profitable for the entrepreneur and what is profitable for the overall economy, and that it might therefore be profitable to create malinvestments.
Finally, given the more realistic assumption that some investors will believe in the Austrian business cycle theory, while most won't and given the fact that investments in the form of both equities and bonds can be sold off, an additional incentive is created for investors aware of the Austrian business cycle theory to create malinvestments during the boom, enjoy the profits of it as long as the boom last, and then sell of the stakes in that investments to more clueless investors during the end of the boom.
UPDATE: I see on Wille Faler's blog a good illustration of how central banks bailout actions make it profitable for investors to create malinvestments.