Vol. 20, No. 4, Winter 2000
Q: What was it that prompted you to believe that we need a graphical exposition of Austrian macroeconomics?
A: While I was in graduate school, I was
constantly being subjected to the ISLM version of Keynesianism. I vividly
remember a discussion I had with my brother, in which I explained how the
Keynesians had this extended, interlocking model that dominated the textbooks.
The students all learned it and then had a vested interest in its being
right. That bothered me. My brother, himself a graphic designer, asked
whether the Austrians had some alternative model, and I had to say no.
Q: And how was your paper received?
A: The response from the Austrians was
mixed. Murray Rothbard loved it because he saw it as beating the Keynesians
at their own game. The main value, he thought, was its polemical value:
here is a diagrammatical exposition that competes effectively with the
mainstream. Murray invited me to New York to discuss it. There was a small
gathering at his apartment and we all went through the paper page-by-page
into the wee hours of the morning.
Q: Can you give your rendering of the business cycle in a nutshell?
A: The Austrian theory is sometimes called
an overinvestment theory, or, to capture the uniquely Austrian insight,
a malinvestment theory. The idea is that during a credit expansion too
many resources are allocated to the early stages of production, leaving
too few for the late stages. In my graphical exposition, production is
actually pushed beyond the production possibilities frontier, which helps
to explain what would otherwise be unexplainable: the lag between the initiation
of the boom and the subsequent market correction that constitutes the bust.
But the intertemporal mismatch between consumption preferences and investment
plans, brought about by artificial manipulation of the interest rate, is
what necessitates the downturn.
Q: And the advantages of your graphical framework do go beyond exposition and pedagogy.
A: Yes, but the pedagogy is very important. To have the ability to explain the theory to students and colleagues shouldn't be underestimated. And I've found that my new framework in Time and Money is very teachable at all levels. And it is not at all limited to the issues of the business cycle. But graphics serve another function: they impose certain constraints on your theorizing. This helps answer Paul Krugman's objection that the Austrian theory does not comply with the "adding up" test, by which he means that everything has to fit together. Typically, economists meet the adding up test by some system of equations. Well, graphics can serve the same purpose. They help you get your story straight by keeping track of all the general interdependencies among markets.
Q: What began, then, as an effort to explain the business cycle turned into a larger project.
A: Right. My ambition is not just to construct
a graphical story of the business cycle only, but to provide a full-fledge
macroeconomic framework that allows us to look at a large variety of theoretical
and applied topics. For instance, it deals with the problems of converting
from an income tax to a consumption tax: the model shows that the transition
alone will create unexpected dilemmas and perversities.
Q: Have you thought about putting your graphics into equations?
A: Yes, I did that sometime ago with my
earlier model. I wasn't quite satisfied with the results. What warns against
it is that the equations attract undo attention to the possible states
of equilibrium and aren't much of a help in discussing the market process,
which is what the Austrian theory is really all about. You can't write
out a series of equations that give you an equilibrium theory of the business
cycle because business cycles involve disequilibria in an essential way.
Q: How does your new book fit into the Austrian tradition in particular?
A: Well, I hope it will be seen as a follow-up
to Hayek's Prices and Production. That book, which was based on
lectures first delivered in 1931, gave us a key element of an Austrian
framework for macroeconomics, namely, the Hayekian triangle. I have attempted
to avoid getting tangled up in the issues the consumed Hayek in his Pure
Theory of Capital (1941), even though the overarching goal of my work
has been to put capital theory back into macroeconomics.
Q: You are not, then, attempting to contribute to a capital theory per se.
A: Once we understand that capital is heterogenous,
that production takes place in stages, that resources can be allocated
among the stages in different ways, you have the core of the theory. Then
you can make use of Hayek's triangles to construct a viable framework.
Hayek's Pure Theory
lays out the whole problem we need to address
in the first hundred pages: the problem of intertemporal coordination.
And dealing with that problem, it turns out, helps keep the theory anchored
to real-world issues.
Q: Sometimes Austrians are said to be too theoretical. Do you suppose your more real-world approach is somewhat more marketable to the mainstream?
A: I would like to think so, but I fear
that the more accurate comparison is just the reverse. Most mainstream
macroeconomists are not real-world oriented. They are sometimes put off
by theorists who insist that we need to examine practical considerations
in light of simple theories. They are more interested in the consistency
and rigor of their theorizing and the mathematical elegance of their models
than they are in questions of application. For that reason, they may see
my macro model as pretty low-tech and not worthy of much attention.
Q: At the same time, you are very critical of, for example, Friedman for having no theory of causation.
A: In his "plucking model" of the business
cycle he just looks at the Keynesian-based National Income Statistics and
describes what he sees as a revealing pattern they follow over time. But
this pattern is based upon such a high level of aggregation, it is impossible
to make any sense of it without a theory that operates on a lower level
of aggregation. That's what the Austrian theory does. I've had correspondence
with Friedman on this issue. Not surprisingly, he remains unreceptive to
the Austrian view.
Q: Why didn't Friedman recognize his theory as Austrian?
A: Because Friedman has never seen the
significance of Hayek's
Prices and Production. In personal conversation
he has offer this book along with Dennis Robertson's Banking Policy
and the Price Level as examples of books that are virtually impossible
to understand. But if you do understand Hayek, you see that he is explaining
how policy can set the market process off on a wrong course and how subsequent
"distress borrowing" characterizes the particular phase of the process
just before market forces win out over the effects of credit manipulation.
Q: And that's why you claim that Friedman is himself a Keynesian.
A: Friedman himself said so, and the reason
is that he bought into the Keynesian framework of a macroeconomic theory
that made no reference to the structure of capital. In a New York Times
[date] article last year, Friedman expressed some regrets about setting
out monetarist ideas in a Keynesian ISLM framework. He said it was a strategic
mistake. Over the years, the differences between Keynesianism and Monetarism
devolved into dispute about elasticities and the shape of curves, and the
relative adjustments speeds of prices and wages. Not that Friedman now
thinks he would have been better off expressing monetarist ideas in a Hayekian
framework. He simply thinks that there is a more fundamental distinction
between his views and Keynes's: Monetarists believe markets work and the
Keynesians believe they don't.
Q: In support of the Austrian theory and your exposition of it, you cite Lord Robbins's 1933 book on the depression. What happened to Robbins?
A: His work on the Great Depression is
excellent. He sets out the Austrian theory and provides empirical evidence
for it. But he eventually became persuaded that Keynesian demand-management
policies are the right medicine for a depressed economy. That is, schemes
for getting out of the depression should take precedence over concerns
about how we got into it. This particular ranking of priorities, of course,
is very unHayekian. Robbins saw the economywide deflationary forces during
the 1930 as "swamping" all considerations of possible vertical maladjustments
during the 1920s. He eventually became hostile to the Austrian theory to
the point of refusing to autograph his book, and he said in his autobiography
that he never should have written it.
Q: How do you employ Keynes's theory in your model?
A: I use his theoretical framework as a
contrast with the Austrian framework, and I do it in a way that is more
faithful to the General Theory than are most modern renditions of
Keynesianism. I feature one aspect of Keynes that tends to get glossed
over, especially in discussion of Keynes's theory of the business cycle.
He starts with an economy that is plagued by the perversities I've mentioned
but one in which (somehow) the wage rate is at the right level. The labor
market clears. But the pattern of business expectations is house of cards,
and hence the economy is prone to collapse. When the "animal spirits" that
drive the investment community are dimmed and pessimistic investors pull
the economy into a depression, unemployment becomes widespread. But contrary
to most textbook accounts, Keynes does not lament that the wage rate is
sticky downwards. There is nothing wrong with the wage rate in his judgment.
It shouldn't be allowed to fall because it is—or would be, could be—the
market-clearing wage rate. Axel Leijonhufvud emphasizes this point in his
1968 book on Keynes: in the Keynesian vision, the wage rate is not stuck
too high; it is stuck just right.
Q: Is it your view that wages are not stickier than prices?
A: There are a variety of reasons why they
could be, some of which are due to government intervention. But a the important
point is that at the downturn of a business cycle, what is crucial is not
an overall change in the wage rate but a relative change among wage rates
that will reallocate labor. Labor needs to shift from early stages of production
into late stages of production.
Q: For years, you have had your students read The General Theory. Why is that?
A: Here you find the roots of macroeconomics.
If you are to understand what macro is all about, you have to understand
this book. It also helps students see the fallacies of Keynesianism, because
they're much more transparent in the General Theory than in the
cleaned-up versions that came out years later.
Q: Do you think that your use of Keynes as foil to the Austrian view might be considered anachronistic, since Keynes is so out of favor with the mainstream?
A: The development of Austrian economics missed out on an important phase—the translation of the macro theory into a graphical framework and the creation of what is sometimes called a "positive heuristic." So, the point isn't just to provide a contrast but to make a positive restatement of the Austrian theory. Also, on the level of policy, Keynesianism is far from being out of favor, despite it's not being on the cutting edge in the mainstream journals. If you keep track of policy matters by reading the Wall Street Journal, you find that the newer, allegedly more rigorous theories have virtually no role to play in driving debate. What drives the thinking of policy makers is 1960s style Keynesian thinking, and we have never had a wholly effective counter to it.
Q: So how does your book fit into the policy world?
A: There's a book by Sherly Kasper coming
out next year called
The Revival of Laissez-Faire in American Macroeconomic
Theory [subsequently reviewed for EH.NET].
I look forward to reading it, but I'm not sure the title allows for the
kind of revival needed in the Austrian school. Mainstream macroeconomists,
at least those who are actually interested in matters of policy, tend to
be interventionist. It would be good to see them moving toward a laissez-faire
position. Austrian economists tend to be laissez-fairists through and through,
but what needs reviving for them is their interest in macroeconomic issues.
Q: Do you worry that the structure of your model might tempt policymakers to use it for countercyclical purposes?
A: No, not really, because of the sheer
complexity of the capital structure, and the implications about the needed
reallocation of labor resources during a downturn. No conceivable pro-active
macroeconomic policy could orchestrate a recovery.
Q: Your taxonomy at the end of your book has tremendous explanatory power.
A: I originally had that matrix at the
front of my book. But then I realized that this was really a pretty good
way of summing up. I tried to explain why the debate among Austrians and
Monetarists and Keynesians has been so protracted. I came up with the answer
that debaters are trying to deal with two separate issues at the same time.
One issue is whether or not markets work. The other issue whether, in resolving
the first issue, the focus should be on labor or on capital. That is, what
are the key features of the market's mechanisms (those involving capital
or those involving labor) for assessing the ability of the market to work
in the macroeconomically relevant sense?
Q: What are the most common myths about Austrian business cycle theory?
A: One common myth is that the Austrians believe that all ups and downs in the economy necessarily involve intertemporal disequilibrium that was caused by monetary expansion. This simply isn't true. The theory goes the other way. According to the Austrian theory, artificial booms that are caused by credit expansion are unsustainable. The theory doesn't try to explain every downturn. One notable episode that didn't directly involve an artificial boom was the downturn in the late 1930s—when the Federal Reserve bone-headedly raised reserve requirements just when the economy was in the process of recovery. That caused a collapse in the money supply and extended the depression for two more years.
Q: Would you cite Japan as a case of attempting to print itself out of recession?
A: Yes, I would—also some of the so-called
"emerging nations." Many of those booms were caused by artificially cheap
credit. And some were caused by artificially secure loans—where the risk
is borne not by the borrower but by the lender, and ultimately by the government.
Paul Krugman has emphasized this troublesome discrepancy between risk-taking
and risk-bearing, but he doesn't see the strong family resemblance of his
own his own theory to the Austrian theory.
Q: Krugman seemed to pick up some anti-Austrian arguments from Gottfried Haberler's later work.
A: Yes, he says that the Austrians need
some sort of symmetry in their boom-and-bust story. The bust involves a
reallocation of capital from early stages to late stages and this can involve
heavy doses of unemployment. So Haberler asks: why don't you get the same
unemployment while capital is reallocated during the boom from late stages
to early stages?
Q: Do you want to address any of Tyler Cowen's arguments in his book criticizing Austrian cycle theory?
A: Well, Cowen makes long lists of arguments,
but let me address one in particular. He claims that according to the Austrians,
rates must be subject to frequent and dramatic change. Otherwise, entrepreneurs
wouldn't take a credit expansion for an increase in saving. This argument
confuses pedagogy with historical application. The Austrians make no claim
that savings rates are volatile; they need only recognize is that saving
rates can change and do change. The idea is that the interest rate must
reflect even the small and gradual changes if the economy is not to be
set off on an unsustainable growth path.
Q: Another objection often raised is that consumer credit markets dramatically change the Austrian story. Is that correct?
A: It's certainly true that when Hayek first developed the theory, there simply wasn't much in the way of consumer credit. The lion's share of loans went to the business community. This circumstance made for a straightforward application of the theory. But even with a large volume of consumer loans in play, the theory still holds, though the particulars are different. Most consumer loans are for buying consumer durables—appliances, automobiles, and swimming pools. These kinds of goods, though, have many of the characteristics of capital. Harry Browne once wrote about one of his clients who had splurged on a swimming pool during a period of low interest rates and then later found that he couldn't afford to maintain the pool. Here, the Austrian business cycle theory plays itself out entirely within the consumer credit market.
Q: How does the Austrian story fit with the so-called political business cycle?
A: It's a nice fit: The Austrian theory explains the mechanics but not the timing of the boom or the length of the period between booms. It just explains how artificial booms lead into busts. Early on, Mises accepted Knut Wicksell's explanation—that technological factors cause the natural rate of interest to rise and that the banking system only belatedly adjusted the bank rate. But by the 1920s, Mises had come to blame the boom not on technology but on "inflationist ideology." It wasn't until 1960 that Hayek explained—in his Constitution of Liberty—that the credit-driven boom is politically motivated. He used an explicit public-choice argument—two years before the publication of Buchanan an Tullock's Calculus of Consent—to explain the political benefits of expanding credit before an election.
Q: How does the internationalization of capital markets affect the model?
A: With international capital markets in full play, changes in the interest rate are less pronounced. Instead, we get changes in capital flows, as foreign investors take advantage of even a small increase in the interest rate. So, interest rates aren't quite so high on the eve of the downturn, but capital inflows are large—and export markets are weakened. In effect, the access to world capital markets allows the boom to continue longer than it otherwise would. We should remember, though, that Mises originally devised his business cycle theory by borrowing an idea from the British Currency School. That school had set out the self reversing process strictly in terms of changing patterns of trade between nations. Mises showed that, even in a closed economy, there is still a self-reversing process—one that plays itself out as interest-rate changes and capital reallocations.
Q: All the while you have been working on this book, the economy has been on an upswing and conventional macro problems like unemployment and deficits have become less of a problem. Did you ever get discouraged that you are dealing with issues that are no longer relevant?
A: No, my greater objective is to put together
a capital-based macroeconomics that can deal with many different issues
in many different circumstances. But I don't believe for minute, as the
profession periodically seems to believe, that the business cycle is dead.
In fact, it's probably fair to say that the popularity of business cycle
theory is at low ebb on the eve of the bust. We've heard a lot lately about
the "new economy"—the internet, the digital revolution, and just-in-time
inventory management. I don't deny that things have changed, but I doubt
the changes somehow add up to perpetual prosperity. Just before the Bush
recession in the early 1990s, the unemployment rate was 5.5%. Nobody suggested
that this rate was unacceptably high. It was seen instead as the "natural
rate," the hallmark of macroeconomic health. Are we now to believe that
over the period of a single cycle, the natural rate has fallen from 5.5%