Ludwig von Mises et al., The Austrian Theory
of the Business Cycle and Other Essays
Auburn, AL: Ludwig von Mises Institute, 1996, pp. 7-24
Introduction: The Austrian Theory in Perspective
Roger W. Garrison
The four essays
in this volume, each written by a major figure in the Austrian school of
economics, set out and apply a distinctive theory of the business cycle.
The span of years (1932-1970) over which they appeared saw a dramatic waxing
and then waning of the prominence—both inside and outside the economics
profession—of the Austrian theory. Haberler wrote in his 1932 essay that
the theory "is not so well known in this country as it deserves to be"
(pp. 19-20). Although Mises offered no assessment in this regard in his
essay, he remarked in 1943 about the effect of the theory's general acceptance
on the actual course of the cycle. Anticipating a key insight in the modern
literature on "rational expectations," Mises wrote, "The teachings of the
monetary theory of the trade cycle are today so well known even outside
the circle of economists that the naive optimism which inspired the entrepreneurs
in the boom periods has given way to greater skepticism."(1)
Then, in 1969, Rothbard could write—without serious overstatement—that
"a correct theory of depressions and of the business cycle does
exist, even though it is universally neglected in present-day economics"
(p. 50).
What happened over the span
of nearly forty years to account for the rise and fall of this theory of
boom and bust? The simple answer, of course, is: the Keynesian revolution.
John Maynard Keynes' General Theory of Employment, Interest, and Money,
which made its appearance in 1936, produced a major change in the way that
economists deal with macroeconomic issues. A close look at some pre-Keynesian
ideas can show why the Austrian theory was so easily lost in the aftermath
of the Keynesian revolution; a brief survey of the alternatives offered
by modern macroeconomics will show why there is a new-found interest in
this old Austrian theory.
First introduced by Mises
in his Theory of Money and Credit (1912), the theory was originally
billed as the circulation credit theory rather than as a uniquely Austrian
theory. Mises was very much aware of its multinational roots. The notion
that the market process can be systematically affected by a divergence
between the bank rate of interest and the natural rate came from Swedish
economist Knut Wicksell; the understanding that the process so affected
would have a self-reversing quality to it (Mises used the term "counter-movements"
in his earliest exposition) came from the British currency school, whose
analysis featured international gold flows. The uniquely Austrian element
in Mises' formulation is the capital theory introduced by Carl Menger and
developed by Eugen von Böhm-Bawerk. Mises showed that an artificially
low rate of interest, maintained by credit expansion, misallocates capital,
making the production process too time-consuming in relation to the temporal
pattern of consumer demand. As time eventually reveals the discrepancy,
markets for both capital goods and consumer goods react to undo the misallocation.
The initial misallocation and eventual reallocation constitute the microeconomic
market forces that underlie the observed macroeconomic phenomenon of boom
and bust. Mises' theory was superior to its Swedish forerunner in that
Wicksell was concerned almost exclusively with the effect of credit expansion
on the general level of prices. It was superior to its British forerunner
in that the currency school's theory applied only when monetary expansion
in one country outpaced that of its trading partners. Mises' theory was
applicable even to a closed economy and to a world economy in which all
countries are experiencing a credit expansion.
The theory took on a more
predominantly Austrian character in the hands of F. A. Hayek. In the late
1920s and early 1930s, Hayek gave emphasis to the Austrian vision of capital
that underlies the business cycle theory by introducing a simple graphical
representation of the structure of production. He used right triangles
that change in shape to illustrate a change in the economy's capital structure.(2)
Hayek focused the analysis clearly on the relationship between the roundaboutness
of the production process and the value of the corresponding output. The
Hayekian triangles keep track of both time and money as goods-in-process
make their way through the temporally sequenced stages of production. His
notion of a linear production process is highly abstract and overly simple
in the light of a fuller accounting of the fixed and circulating capital
that actually characterize a capital-using economy. However, these triangles
feature an essential but often neglected dimension—the time dimension—in
the account of boom and bust. Alternative theories, in which consumption
and investment appear as two coexisting aggregates, can be seen as even
more simplistic—to the point of being wholly inadequate for analyzing the
boom-bust sequence.
Haberler concludes his essay
with an expression of concern about the complexity of the Austrian theory,
which he saw as a "serious disadvantage" (p. 40). But the complexity, in
his judgment, is inherent in the subject matter and hence is not a fault
of the theory. Complexity is evident in the two early essays (1936 and
1932) in their organization and style of argument. Both Mises and Haberler
defend the theory against its critics and deal with various misunderstandings.
Mises, for instance, identifies Irving Fisher's inflation premium, which
attaches itself to the rate of interest as prices in general rise, only
to say that this is not what he is talking about. He is discussing,
instead, still another aspect of interest-rate dynamics. The real
rate of interest rises at the end of the boom to reflect the increasing
scarcity of circulating capital, after excessive amounts of capital have
been committed to the early stages of production processes (p. 7). Haberler
takes great pains to refocus the reader's attention away from the general
price level and toward the relative prices that govern the "vertical structure
of production" (p. 25). He distinguishes between "absolute deflation" and
"relative deflation," and between "primary and fundamental" phenomena that
characterize the downturn and "secondary and accidental" phenomena that
may also be observed. All these complexities—plus still others involving
such notions as the natural rate of interest and the corresponding degree
of roundaboutness of the production process—are unavoidable in a theory
that features an intertemporal capital structure. The theoretical richness
that stems from the attention to capital has as its negative counterpart
the expositional difficulties and scope for misunderstanding.
Keynes offered the profession
relief from all this by articulating—though cryptically—a capital-free
macroeconomics. As Rothbard's discussion implies, all the thorny issues
of capital theory were simply swept aside. An alternative theory that featured
the playoff between incomes and expenditures left little or no room for
a capital structure. Investment was given special treatment not because
of its link to future consumption but because spending on investment goods
is particularly unstable. Uncertainties, which are perceived to be a deep-seated
feature of market economies, dominate decision making in the business community
and give play to psychological explanations of prosperity and depression.
And the notion that depression may be attributable to pessimism on the
part of the business community suggests a need for central direction and
policy activism. Prosperity seems to depend upon strong and optimistic
leadership in the political arena. Relief from the complexities of capital
theory together with policy implications that were exceedingly attractive
to elected officials gave Keynesianism an advantage over Austrianism. An
easy-to-follow recipe for managing the marcoeconomy won out over a difficult-to-follow
theory that explains why such management is counterproductive.
Tellingly, the two later
essays (1969 and 1970) are as much about Keynesianism as about Austrianism.
Rothbard and Hayek are trying anew to call attention to a theory that had
been buried for decades under the Keynesian avalanche. Rothbard deals with
the Phillips curve, which purports to offer a choice to political leaders
between inflation and unemployment; Hayek deals with the wage-price spiral,
which had captured the attention of journalists and textbook authors for
much of the postwar era. The need for dealing critically with Keynesianism—and
with monetarism—while at the same time reintroducing the key considerations
from capital theory meant that the Austrian theory of the business cycle
was an even harder sell in the 1970s than it had been a half-century earlier.
The offering of these four
separate and distinct essays on the Austrian theory carries the message
that there is no single canonical version of the theory. Our understanding
of boom and bust is not based upon some pat story to be told once and for
all time. Rather, the theory allows for variations on a theme. The market
works; it tailors production decisions to consumption preferences. But
production takes time, and as the economy becomes more capital intensive,
the time element takes on greater significance. The role of the interest
rate in allocating resources over time becomes an increasingly critical
one. Still, if the interest rate is right, that is, if the interplay between
lenders and borrowers is allowed to establish the natural rate, then the
market works right. However, if the interest rate is wrong, possibly because
of central bank policies aimed at "growing the economy," then the market
goes wrong. The particulars of just how it goes wrong, just when the misallocations
are eventually detected, and just what complications the subsequent reallocation
might entail are all dependent on the underlying institutional arrangements
and on the particular actions of policy makers and reactions of market
participants.
The essays leave much scope
for solving puzzles, for refining both theory and exposition, and for applying
the theory in different institutional and political environments. One enduring
puzzle emerges from the writings of several economists, including Haberler,
who once embraced the theory enthusiastically but subsequently rejected
it. The key question underlying the recantations is easily stated: Can
the intertemporal misallocation of capital that occurs during the boom
account for the length and depth of the depression? Haberler provides one
of the best answers to this question—one that is most favorable to the
Austrian theory—in his 1932 essay. The "maladjustment of the vertical structure
of production," to use Haberler's own term, does not, by itself, account
for the length and depth of the depression. Rather, this policy-induced
change in the intertemporal structure of capital is the basis for the claim
that a crisis and downturn are inevitable. The reallocation of resources
that follows the downturn, which largely mirrors—both qualitatively and
quantitatively—the earlier misallocation, involves an abnormally high level
of (structural) unemployment but need not involve a deep and lengthy depression.
However, complications that
may well accompany the market's adjustment to a policy-induced intertemporal
misallocation can cause the depression to be much deeper and longer than
it otherwise would be. The same policy makers who orchestrated the artificial
boom may well behave ineptly when they see that the ultimate consequence
of their policy is a bust. Their failure to stem the monetary contraction
together with interventions by the legislature that prop up prices and
wages and strengthen trade barriers will make a bad situation worse. All
such complications, which play themselves out as a self-aggravating contraction,
are correctly identified by Haberler as "secondary phenomena." This term
is not employed to suggest that these aspects of the depression are negligible
or second-order in importance. "[I]t may very well be," Haberler explains,
"that this secondary wave of depression, which is induced by the more fundamental
maladjustment, will grow to an overwhelming importance" (p. 34). Though
possibly overwhelming, the effects of the complications are still secondary
in the sense of temporal and causal ordering.
The puzzle in all this emerges
when we read Haberler's 1976 recantation of the Austrian theory, which
echoed Lionel Robbins' heartfelt recantation of a few years earlier. Mises
refers to Robbins' 1934 book, The Great Depression, as "the best
analysis of the actual crisis" (p. 3, fn 2). In 1971 Robbins wrote in his
autobiography that this is a book "which [he] would willingly see forgotten."(3)
Drawing on Robbins' recantation, Haberler offers the opinion that the "real
maladjustments, whatever their nature, 'were completely swamped by vast
deflationary forces.'" But rather than suggest, as he had earlier, that
these forces could easily have been "induced by the more fundamental maladjustments,"
he simply attributes them to "institutional weaknesses and policy mistakes."
(4)
The astute reader will see Haberler's 1932 discussion of secondary phenomena
as an insightful and hard-hitting critique of the 1976 Haberler—and would
see a similar relationship between the 1934 Robbins and the 1971 Robbins.
In 1932, Haberler alluded
to the "economic earthquakes" (p. 13) that Western countries had experienced.
He might have put the earthquake metaphor to further use in accounting
for the relationship between primary and secondary issues. During the 1906
earthquake in San Francisco, for instance, fires broke out and caused much
more destruction than had been caused by the actual quaking of the earth.
Even so, the fire was a secondary phenomenon; the quake was the primary
phenomenon. The fact that the length and depth of the Great Depression
are to be accounted for largely in terms of secondary phenomena, then,
does not weigh against our understanding that the primary phenomenon was
the quaking of the capital structure. What accounts, then, for the recantation
of these Austrian theoristsvand of several others, including John R. Hicks,
Nicholas Kaldor, and Abba P. Lerner? This puzzle remains to be solved.
Expositional difficulties
derive largely from the fact that the capital-based macroeconomics of the
Austrian school and particularly the Austrian theory of the business cycle
are foreign to modern economists whose training is exclusively in labor-based
macroeconomics. In today's profession, a given capital stock has become
one of the defining assumptions underlying the conventional macroeconomic
relationships. To allow capital to be a variable rather than a parameter
is to change the subject matter from macroeconomics to the economics of
growth. Further, modern economists tend to think of capital holistically
in terms of stocks and flows, which precludes any consideration of changes—to
say nothing of unsustainable changes—in the capital structure. Gordon Tullock's
bafflement at the Austrian theory is illuminating in this regard. Tullock
takes Rothbard's essay as canonical and explains "Why the Austrians Are
Wrong about Depressions." This article, together with a comment by Joseph
T. Salerno and reply by Tullock, merit careful study.(5)
According to Tullock's understanding of the Austrian theory, the boom is
a period during which the flow of consumer goods is sacrificed so that
the capital stock can be enlarged. At the end of the boom, then, the capital
stock would actually be larger, and the subsequent flow of consumer goods
would be correspondingly greater. Therefore, the period identified by the
Austrians as a depression would, instead, be a period marked by increased
employment (labor is complementary to capital) and a higher standard of
living. The stock-flow construction that underlies this line of reasoning
does not allow for the structural unemployment that characterizes the crisis—much
less for the complications in the form of the secondary depression.(6)
This exchange between Tullock and Salerno gives the modern student of Austrianism
a good feel for the challenge involved in the exposition of Austrian theory
in an academic environment unreceptive to a capital-based macroeconomics.
Capital-based macroeconomics
is simply macroeconomics that incorporates the time element into the basic
construction of the theory. Investment now is aimed at consumption later.
The interval of time that separates this employment of means and the eventual
achievement of ends is as fundamental a variable as are the more conventional
ones of land and labor. The Austrian theory features the time element by
showing what happens when the economy's production time, the degree of
roundaboutness, is thrown out of equilibrium by policies that override
the market process. Beyond this general understanding, as already suggested,
the focus of particular expositions vary in accordance with the historical
and institutional setting. The fact that each of the essays in this volume
reflects its own time and setting does not imply a myopia on the part of
its author. Rather, it suggests the versatility of the theory.
Writing in the early 1930s,
for instance, Mises called attention to the "flight into real values" (p.
6) that characterizes a hyperinflation, such as the one experienced in
Germany in 1923. The lesson, though, transcends the insights into that
particular historical experience. If, over a period of years, capital has
been misallocated by an accelerating credit expansion, there is no policy
that avoids a crisis. In the modern vernacular, there is no possibility
of a "soft landing."(7) Decelerating the
expansion will cause real interest rates to rise dramatically as credit
becomes increasingly scarce; bankruptcies would follow. Further accelerating
the expansion will cause hyperinflation and a collapse of the monetary
system. Mises is telling us, in effect, that the central bank can print
itself into trouble, but it cannot print itself out of trouble. Writing
in 1970, Hayek refers to the central bank's dilemma by suggesting that
on the eve of the crisis the policy makers find themselves "holding a tiger
by the tail." He gives play to the political and economic forces that were
then dominant by relating them to the commonly perceived wage-price spiral
that accompanies a prolonged expansion. The final throes of the boom take
the form of a duel between labor unions, which have the political power
to force wage rates higher, and the central bank, which can bring them
back down (in real terms) by accelerating the rate of inflation. Although
Hayek, above all others, is to be credited with shifting the focus of business
cycle theory from labor markets to capital markets, he offers few clues
in this essay about disequilibrium in the intertemporal structure of production.
Instead, he recognizes that the political and economic dynamics of the
period have given special relevance to the problem—he even calls it the
"central problem" (p. 86)—of wage determination.
The application of the Austrian
theory of the business cycle in today's economy would give little play
to the fear of hyperinflation or to the problem of a wage-price spiral.
The central problem today is chronic and dramatic fiscal imbalance. Budget
deficits rather than credit expansion are bound to be the focus in any
plausible account of the effect of the government's macroeconomic policy
on the economy's performance. Still, the central bank figures importantly
into the story. The very potential for monetizing the Treasury's
debt eliminates the risk of default, and thereby puts the Treasury on a
much longer leash than it would otherwise enjoy. The problem of an artificially
low rate of interest in earlier episodes is overshadowed by the problem
of an artificially low risk premium on government debt. Although risk-free
to the holders of Treasury securities, this black cloud of debt overhangs
the market for private securities, distorting the economy's capital structure
and degrading its performance generally. There are some modern applications
of the Austrian theory that take these considerations into account, but
much remains to be done.(8)
A stocktaking of the modern
alternatives to the Austrian theory suggests that capital-based macroeconomics
may be due for a comeback. Conventional Keynesianism, whether in the guise
of the principles-level Keynesian cross, the intermediate IS-LM, or the
advanced AS/AD is formulated at a level of aggregation too high to bring
the cyclical quality of boom and bust into full view. Worse, the development
of these tools of analysis in the hands of the modern textbook industry
has involved a serious sacrifice of substance in favor of pedagogy. Students
are taught about the supply and demand curves that represent the market
for a particular good or service, such as hamburgers or haircuts. Then
they are led into the macroeconomic issues by the application of similar-looking
supply and demand curves to the economy as a whole. The transition to aggregate
supply and aggregaate demand, which is made to look deceptively simple,
hides all the fundamental differences between microeconomic issues and
macroeconomic issues. While these macroeconomic aggregates continue to
be presented to college undergraduates, they have fallen into disrepute
outside the classroom. One recent reconsideration of the macroeconomic
stories told to students identifies fundamental inconsistencies in AS/AD
analysis.(9)
Conventional monetarism
employs a level of aggregation as high as, if not higher than, that employed
by Keynesianism. While Milton Friedman is to be credited with having persuaded
the economics profession—and much of the general citizenry—of the strong
relationship between the supply of money and the general level of prices,
his monetarism adds little to our understanding of the relationship between
boom and bust. The monetarists have effectively countered the Keynesians
on many fronts, but they share with them the belief that macroeconomics
and even business cycle theory can safely ignore all considerations of
a capital structure. Modern spin-offs of monetarism, which incorporate
the ideas of rational expectations and instantaneous market clearing, have
brought the time element back into play. Overlapping-generations models
and particularly the time-to-build models seem to have some relationship
to Austrian ideas. But the emphasis on the development of modeling techniques
over the application of the theory to actual episodes of boom and bust
has greatly diminished the relevance of this strand of macroeconomic thought.(10)
In recent years, there has
been an increasingly widespread recognition that modern macroeconomics
is in disarray. Today's textbooks and professional journals are replete
with models that, while impressive in their display of technique, are profoundly
implausible and wholly inapplicable to the world as we know it. The inadequacies
of modern macroeconomics have caused some academicians to wonder (if only
facetiously): How far back do we have to go before we can start all over?
The essays in this volume provide a substantive answer to that question.
We have to go back about sixty years to a time when capital theory was
an integral part of macroeconomics. We have to go back to the Austrian
school. A modernized capital-based macroeconomics can compare favorably
with any of the present-day rivals.
Rothbard's essay ends with
an anticipation of the Austrian revival—which actually began, with his
help, in 1974. This volume is offered in the spirit of Rothbard and in
the hope that the Austrians will have an increasing influence in the years
ahead on the development of business cycle theory.
1. Ludwig von Mises, "Elastic Expectations
and the Austrian Theory of the Trade Cycle," Economica, ns. 10 (August),
1943, p. 251.
2. Friedrich A. Hayek, Prices and
Production, 2 nd ed. New York: Augustus M. Kelley, 1935.
3. Lionel Robbins, An Autobiography
of an Economist. London: Macmillan, 1971, p. 154.
4. Gottfried Haberler, The World
Economy, Money, and the Great Depression 1919-1939. Washington, D.C.:
American Enterprise Institute, 1976, p. 26. Also, see Habeler, "Reflections
on Hayek's Business Cycle Theory," Cato Journal, vol. 6, no. 2 (Fall),
1986, pp. 421-435.
5. Gordon Tullock, "Why the Austrians
Are Wrong about Depressions," Review of Austrian Economics,
vol. 2, 1987, pp. 73-78; Joseph T. Salerno, "Comment on
'Why the Austrians Are Wrong about Depressions,'" Review of Austrian
Economics, vol. 3, 1989, pp. 141-45; and Tullock, "Reply to Comment
by Joseph T. Salerno," idem., pp. 147-49.
6. Tullock does make a minor concession
to the Austrian theory: It applies to "those factories and machine tools
that were less than 40 percent completed [at the end of the boom]." But,
"the producer goods industries are always a fairly small part of the economy.
In that small part, however, undeniably a Rothbard, Austrian type of depression
would cause a cutback in production and laying off of personnel."
7. This is not to deny the difference
between a hard landing with no complications and a crash, in which the
complications dominate.
8. Roger W. Garrison, "Hayekian Triangles
and Beyond," in Jack Birner and Rudy van Zijp, eds., Hayek, Coordination
and Evolution, London: Routledge, 1994, pp. 109-125; and Roger W. Garrison,
"The Federal Reserve: Then and Now," Review of Austrian Economics,
vol. 8, no. 1, 1994, pp. 3-19.
9. David Colander, "The Stories We
Tell: A Reconsideration of AS/AD Analysis," Journal of Economic Perspectives,
vol. 9, no. 3 (Summer), 1995, pp. 169-188.
10. On the relationship between new
classical theory and Austrian theory, see Kevin Hoover, "An Austrian Revival?"
in Hoover, The New Classical Macroeconomics: A Skeptical Inquiry,
Cambridge: Basil Blackwell, 1988, pp. 231-257; and Roger W. Garrison, "New
Classical and Old Austrian Economics: Equilibrium Business Cycle Theory
in Perspective," Review of Austrian Economics, vol. 5, no. 1, pp.
91-103.
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