3, 1989, pp. 3-29
The Austrian Theory of the Business Cycle
In the Light of Modern Macroeconomics
Roger W. Garrison*
The Austrian theory of the business cycle has many critics. Some believe
that this part of the Austrian contribution is so misdirected as to constitute
an "embarrassing excrescence" [Yeager, 1986, p. 378]; others simply doubt
that there can be a single theory that provides a general account of cyclical
activity [Leijonhufvud, 1984 and 1986; see also Sirkin, 1977 and Lachmann,
1978]; and still others deny the existence of some of the most salient
features of business cycles.(1) Defending—or
even discussing—the Austrian theory of the business cycle, then, requires
some careful groundwork.
There are a number of expositions
of the Austrian theory in the literature, which for the most part are complementary
[e.g. Hayek, 1967 and 1975b; Mises, 1966, pp. 538-86 and Mises et al.,
1983; O'Driscoll, 1977; Robbins, 1934; and Rothbard, 1975], but because
business cycles remain a live issue inside as well as outside the Austrian
school, there is no—and can be no—canonical version. Gordon Tullock, who
took an exposition by Murray Rothbard to be canonical, has recently identified
perceived shortcomings of the Austrian theory in an article entitled "Why
the Austrians are Wrong about Depressions" [Tullock, 1987].(2)
The present article was initially motivated by Tullock's basic objections
as well as by his "nit picks," as he calls them. But even his title is
evidence of a misunderstanding. The Austrian theory is not primarily about
depressions; it is about artificial booms and about the market process
that brings them to an end. The theory sheds light on the kind of readjustments
needed on the eve of the bust, but the issue of the depth and length of
the ensuing depression as measured by the massive unemployment of labor
are dealt with by the Austrians in ways that are similar to several other
schools of thought.
Though inspired by Tullock's
critique, the present article has an organization of its own—one that is
responsive to other modern critics as well. Section I considers the very
existence of business cycles in order to lay the groundwork for evaluating
the Austrian theorizing about them. Section II identifies essential differences
between allocative distortions caused by legislation and allocative distortions
caused by monetary expansion and links the latter with cyclical characteristics
of resource movements. Section III establishes the significance of capital
theory in theorizing about the business cycle, and Section IV provides
some justification for the Austrian approach by considering how rival schools
theorize in lieu of a theory of capital. Section V offers a summary evaluation.
I. The Existence of Business Cycles
Business cycles as econo-rhythms. There is a sense in
which it can be claimed that business cycles do not exist. If by cycles
we mean continuous rhythmic movements in macroeconomic magnitudes, then
there are no business cycles. The so-called long wave supposedly identified
by Nikolai Kondratieff on the basis of two-and-a-half cycles is the product
of creative empiricism and has no basis whatever in theory [See Rothbard,
1978, who evaluates Shuman and Rosenau, 1972]. Short waves traced out by
chartists, or technicians, are equally baseless. Their triple peaks, triple
troughs, heads and shoulders, and the like are no more real than faces
in the clouds.
Casual inspection of statistical
data for economic aggregates such as total output, employment of labor,
or net investment suggests a lack of cyclical regularity. Apart from obvious
seasonal variations in some sectors of the economy, which require no special
explanation, it is futile to attempt to identify a frequency and amplitude
of some supposed sinusoidal movement. It can be—and has been—argued that
the economy is much too complex for any one particular wave to be readily
observed. Economic activity is characterized, according to Schumpeter ,
for instance, by a number of cyclical movements of different frequencies
and amplitudes. Kondratieff, Juglar, and Kitchin called attention to the
existence of cycles with frequencies of fifty years, nine years, and five
years, respectively. Schumpeter suggested that actual patterns of economic
activity reflect the combined effects of all such cycles.
But theories about a composite
cycle are no more sound than the theory of each of the component waves.
Further, any supposed confirmation on empirical grounds of the Schumpeterian
view is inherently misleading. As a purely mathematical matter, any
single-valued function, such as the time pattern of some economic magnitude,
can be represented by a Fourier Series, which combines an infinite series
of sinusoids of different frequencies and amplitudes. The coefficients
of a specific Fourier series may describe some particular set of macroeconomic
data, but if the economics of business cycles is to be more than descriptive,
cyclical movements must qualify as such on theoretical grounds.
Business cycles as monetary disequilibria. While there
are no built-in econo-rhythms in the market process, there are, from time
to time, economy-wide disturbances of one sort or another. Attempts to
identify rhythmic components in economic activity, according to Sirikin
 and others, are just misguided attempts to understand these macromaladies.
Axel Leijonhufvud  has made headway toward our understanding of macromaladies
and of competing theories about them by creating a useful taxonomy. Basic
categories are defined in terms of (1) the nature of the disturbance and
(2) the nature of the failure of the economy to adjust to the disturbance.
The two "natures" are then categorized as "n" (for nominal)
or "r" (for real).
This approach gives rise
to a two-way taxonomy, which can be symbolized as n/n,
and r/r. To illustrate, suppose that there
is a general, but unanticipated, shift of preferences on the part of wealth
holders to a higher level of real cash balances. This is a real disturbance.
Suppose further that there is some difficulty in the pricing mechanism
for both inputs and outputs, which impedes the necessary decrease in the
general price level. This is a nominal failure. Until the pricing
difficulty is overcome, there will be excess supplies of commodities and
factors of production on an economywide basis. This macromalady belongs
to the r/n category.
that his categories represent the pure cases and that it is possible to
have disturbances and adjustment failures where both are partly nominal
and partly real. He demonstrates, though, that the taxonomy is useful in
sorting out the sequential rounds of debate between Keynesians and Monetarists.
generally speaking, historians of economic thought armed with Leijonhufvud's
categories can readily detect when opposing theorists are simply talking
past one another (theorizing about different sorts of disturbances) and
when they have actual disagreements (about how the market reacts to a particular
sort of disturbance). Leijonhufvud also shows that the historical relevance
of macromaladies of a particular category depends critically upon the nature
of the existing policy regime.
Leland Yeager  draws
attention to a particular sort of disturbance followed by adjustment failure
which, in his judgment, is especially relevant for understanding depressions
and hence for devising institutional reform aimed at avoiding them. A decrease
in the money supply in the face of an unchanged money demand causes the
prices of all commodities and factors of production to be above their market-clearing
levels. While the market can eventually bring prices into line with the
smaller money supply, it cannot achieve a new monetary equilibrium quickly
or painlessly. The theory of "monetary disequilibrium"—a term with which
Yeager ties his own ideas to those of Clark Warburton —focuses on
the difficulties of achieving economywide price adjustments made necessary
by a monetary contraction. Clearly, this focus puts monetary disequilibrium
theory in the n/n category of Leijonhufvud's
The market's inability to
bring about rapid adjustments in prices on an economywide basis guarantees
that quantity adjustments will occur instead. That is, the failure—or sluggishness—of
nominal equilibration brings on real disequilibration. And as is recognized
in almost all macroeconomic theories, a decrease in real output can, through
an income-constrained process, induce further decreases. Keynesians envision
a "spiraling downwards" of income and expenditures. In Yeager's terminology,
"the rot can snowball" [1986, p. 371]. Austrians refer to this same phenomenon
as a "secondary depression" [Hayek, 1975a, p. 44]—a term which reminds
us that the primary maladjustment is something else.
In monetary disequilibrium
theory the problems caused by price level sluggishness are further compounded
by the fact that not all prices are equally sluggish. A gradual and uneven
adjustment in the price level creates a period during which relative prices
are pushed away from their equilibrium levels. (The n/n
malady is contagious and can easily spread to the n/r
category.) By the time the market re-establishes an equilibrium in terms
of both relative and absolute prices, the economy can suffer substantial
losses in terms of both misallocated and unallocated resources.
For those who take their
cue from Warburton, monetary disequilibrium theory is believed to have
broad historical applicability. Any economic downturn involving a monetary
contraction is to be understood in terms of the fundamental difficulties
of price-level adjustment. Such difficulties should dominate, in this view,
any reasonable account of the Great Depression. The theory sheds no light
on the problems inherent in a credit-driven boom such as occurred during
the 1920s, and it does not explain—nor does it purport to explain—why the
money supply began to fall at the end of the 1920s or why there was a prolonged
monetary contraction spanning the years 1929-1933. It does, however, identify
one of the reasons for the economy's poor performance during and immediately
after the contraction.
Business cycles as self-reversing market processes. In
the first view spelled out above, business cycles are an inherent part
of the market process; in the second, they are disruptions of the market
process. That is, both the lower turning point (the upturn) and the upper
turning point (the downturn) are endogenous for those who conceive
of business cycles as econo-rhythms and exogenous for those who
think in terms of monetary disequilibrium. Contrasting econo-rhythms and
monetary disequilibria in this way suggests another, more conventional
taxonomy, in which business-cycle theories are categorized on the basis
of the exogeneity (X) or endogeneity (N) of the lower and upper turning
points [Hansen, 1951, p. 411ff]. The four categories can be symbolized
as X/X, X/N, N/X, and N/N, where X/X is monetary disequilibrium theory
and N/N is econo-rhythm theory. It is difficult to identify any simple
relationship between this taxonomy and the one devised by Leijonhufvud.
However insightful his treatment of market adjustments to monetary disturbances,
Leijonhufvud never explains how—or suggests that—a boom engenders a bust
or vice versa.(3)
The Austrian theory of the
business cycle falls squarely into the X/N category. The exogeneity of
the upturn is a clear recognition that the economywide disturbance is inflicted
on the market process and is not an unavoidable feature of market economies.
The endogeneity of the downturn gives a cyclical quality to the movements
in prices and quantities and to certain macroeconomic magnitudes. The Austrian
business cycle, then, is less of a cycle than the supposed econo-rhythms,
but more of a cycle than sluggish-price monetary disequilibria.
In the broadest terms, the
Austrian theory is a recognition that an extra-market force (the central
bank) can initiate an artificial, or unsustainable, economic boom. The
money-induced boom contains the seeds of its own undoing: the upturn must,
by the logic of the market forces set in motion, be followed by a downturn.
Note that the words "induced" and "unsustainable" are consistent with the
X and N, respectively, that define the X/N category of business-cycle theory.
The Austrian theory also
qualifies, along with monetary disequilibrium theory, as a monetary theory
of the business cycle. "Money matters" in both theories—but for different
reasons. Further, if the Leijonhufvud taxonomy is applied to the entire
sequence of events from the initial upturn to the subsequent downturn,
then the Austrian theory would fall into the n/r
category. As summarized by Fritz Machlup [1976, p. 23], "monetary
factors cause the cycle but real phenomena constitute
it." For Yeager and Leijonhufvud monetary mismanagement precipitates a
bust; for Mises and Hayek monetary expansion engenders a boom, which eventually
leads to a bust.
The Austrian theory is to
be fundamentally distinguished from monetary disequilibrium theory by its
emphasizing that "relative prices matter." The more prevalent claim that
"money matters" derives from considerations of money-induced changes in
the price level and sometimes of changing relative prices as the market
process makes piecemeal adjustments toward monetary equilibrium. But for
the Austrians, relative-price changes form the core of the theory. Money-induced
changes in relative prices cause corresponding changes in the pattern of
resource allocation. The self-reversing character of the market process
set in motion by the injection of newly created money manifests itself
most significantly in that aspect of the process that allocates resources
over time—in the intertemporal structure of capital as governed by the
interest rate. Alternatively stated, the observed cyclical quality of the
market process consists in a temporary disruption of intertemporal
II. Legislated Distortions and Monetary Distortions
The government implements all sorts of policies and programs that cause
the price of some particular good to be above or below its market level.
Interventions in the form of taxes and subsidies, price floors and ceilings,
tariffs and quotas are, from a narrowly economic point of view, permanent
in their effects on resource allocation. A subsidy to home building, for
instance, will result in a larger-than-otherwise investment in housing
so long as the subsidy is in effect. It is possible, of course, that some
regulatory schemes can create a political dynamic that eventually results
in deregulation. Government enforced cartelization of the airlines, for
example, led to an eventual competing away of monopoly profits by the members
of the cartel, which eroded the political support for continued regulation.
The political forces for deregulation eventually prevailed. But apart from
considerations of such political dynamics, non-monetary interventions by
government have a certain permanence about them.
Legislated distortions of
the price system play no direct role in cyclical movements of economic
magnitudes precisely because of their quality of permanence. By contrast,
monetary distortions do play a direct role in business cycles precisely
because—and to the extent that—they are inherently impermanent. The market's
distribution of income, and hence of spending patterns, give rise to a
certain pattern of prices. The pattern can be altered by the spending of
newly created money on some particular good or category of goods. But the
initial price increases brought about by monetary injections, and more
importantly the reallocation of resources associated with those price increases,
do not have the permanence of legislated price supports. Subsequent rounds
of spending of the newly created money reflect not the policy-objectives
of the monetary authority but the preferences of the income earners. Prices
not initially affected by the monetary injection are eventually bid up,
thus causing a reversal in the movement of resources. Apart from one consideration
to be noted below [p. 13], the allocative effects of a monetary disturbance
are necessarily self-reversing.(4)
One of the most common objections
to this aspect of the Austrian theory concerns the movements and subsequent
countermovements of resources. The initial quantity changes would simply
not occur, so the objection goes, if subsequent changes in the opposite
direction were anticipated. Although alternative treatments of expectations
will be discussed in a subsequent section, it may be helpful at this point
to deal in a general way with the problem of expectations in macroeconomic
A business cycle anticipated,
in the view of some macrotheorists, is a business cycle avoided. Employing
the assumption of so-called rational expectations along with other essential
assumptions, such as instantaneous market clearing and costless information,
the New Classicists are able to transform the impermanence of money-induced
distortions as seen by the Austrians into the non-existence of such distortions.
The self-reversing process becomes a self-preventing process. The Austrian
focus on the injection effects of monetary expansion (rather than the price-level
effects) and on the market process set into motion by the monetary injections
warns against adopting the New Classicist view. Several considerations
First, conceiving of monetary
expansion as a process involving sequential rounds of spending suggests
that expectations, even if correct or rational, may not preclude the cyclical
effects of monetary expansion. Whatever their particular expectations,
individuals who receive the newly created money only in later rounds have
less spending power than those involved in early rounds of spending. Although
for any individual the ability to spend is not strictly limited to the
amount of money currently possessed, there are ultimate limits on the individual's
ability to transform expectations into actions. Put bluntly, you can't
spend expectations. While bank credit and trade credit can provide substantial
leeway, spending is not perfectly elastic with respect to unborrowed
money balances [Hayek, 1978, p. 175]. Thus, individuals who correctly and
rationally expect a large injection of newly created money are not necessarily
in a position to act in full accordance with their views—however rational
those views ultimately turn out to be.
Second and more importantly,
individuals who are in possession of increased money balances and who have
correct, or rational, expectations still may not spend in a pattern consistent
with the New Classicist view. A spending pattern that is internally inconsistent
on an economywide basis does not necessarily imply inconsistency for the
individual. That is, macroeconomic irrationality does not imply individual
irrationally. An individual can rationally choose to initiate or perpetuate
a chain letter—sending one dollar to the person on the top of the list,
adding his name to the bottom, and mailing the letter to a dozen other
individuals—even though he knows that the pyramiding is ultimately unsustainable.
Similarly, it is possible for the individual to profit by his participation
in a market process that is—and is known by that individual to be—an ill-fated
process. So long as it is possible to buy in and sell out before the process
reverses itself, rational expectations may exacerbate rather than ameliorate
the misallocation of resources induced by monetary expansion.
Third, apart from the relative-price
changes which are reversed in a subsequent part of the process, there remains
an effect that persists so long as the monetary authority continues to
inject money in some particular way. (If this were the dominant effect,
monetary distortions would be similar to legislated distortions and would
lose their cyclical quality.) To illustrate with an extreme example, suppose
that an aggressive and sustained monetary expansion is accomplished solely
through the purchase of home mortgages. Can anyone doubt that the allocation
of credit among borrowers and of resources among construction projects
would be permanently affected? Hayek clearly recognized the permanence
of this particular effect of monetary injection by using the term "fluid
equilibrium" [Hayek, 1978, p. 173]. So long as the monetary authority maintains
its spending level in real terms, which in view of the resulting inflation
requires an exponentially increasing level of spending measured in nominal
terms, the distortion remains.(5)
Considerations of a possible
fluid equilibrium, of disparities between rationality as applied to the
individual and as imputed to the economy, and of limits to the transformation
of expectations into actions all warn against the New Classicist view.
It is simply not true that full knowledge of a monetary expansion is tantamount
to no expansion at all.(6)
Austrians are sometimes
criticized for assuming static expectations—the clear implication being
that the assumption of rational, or even adaptive, expectations is preferable.
This criticism would have some validity if a change in the assumption about
expectations—from static to adaptive to rational—were to nullify the theory
or cause it to have categorically different implications. But such is not
the case. The assumption of static expectations, when employed, serves
as a heuristic device. The market forces that characterize a money-induced
boom and the subsequent bust can be spelled out first in their simplest
form. Amendments can then be made to account for complications that arise
from other-than-static expectations. The assumption of adaptive expectations
that the arguments be restated replacing monetary injections with rates
of monetary injection and then with accelerations, surges, and so on as
market participants continue to adapt. The assumption of rational expectations,
in its most defensible form, requires that the basic truth in Lincoln's
law (You can't fool all the people all of the time) be recognized—as it
was recognized by Mises [1953, p. 319] long before the birth of New Classicism.
The assumption of rational expectations in its least defensible form (You
can't fool any of the people any of the time), is to be dismissed out of
III. The Significance of Capital in Business-Cycle Theory
The self-reversing market process set into motion by monetary expansion,
described above in general terms, begins to take on a more specific character
when spelled out in the context of some particular market. If the analysis
is to retain its macroeconomic character—that is, if the self reversal
is to have economywide ramifications—then the focus must be on some broadly
defined market such as the market for labor or the market for capital or
the even more broadly conceived market for productive factors. If, however,
the market that serves as the focus of analysis is defined too broadly,
such as the all-inclusive market for goods, then there can be no money-induced
process of any significance and hence no reversal. In a theory where holding
money and buying undifferentiable goods are the only two alternatives,
business cycles would be trivially portrayed—using Irving Fisher's imagery—as
the "dance of the dollar." (This is the fate of business-cycle theory,
for instance, in the four-sector model devised by Patinkin .)
Capital in the Austrian Theory. That the Austrians singled
out the market for capital goods as their focus for business-cycle analysis
is to be accounted for by several considerations. First, it was largely
the observed and widely acknowledged movements in capital-goods markets
that initially motivated a theoretical explanation. Significantly, the
various competing schools of thought—including the Austrians—used the terms
"business cycle" and "industrial fluctuations" synonymously. The idleness
of producers' goods used in heavy industry was perceived to be one of the
most obvious and dramatic characteristics of economic downturns.(7)
Second, as a historical
and institutional matter, monetary injections take the form of credit expansion.
That is, newly created money is put into circulation through credit markets.
In this respect too, the Austrian theory has a stronger empirical content
than rival theories. The conventional assumption that newly created money
is added directly to the cash balances of market participants serves to
abstract from the market process highlighted by the Austrians. Increased
real cash balances of all individuals means an upward pressure on all prices.
But in the Austrian formulation, the spending of newly created money does
not impinge on all prices at once or in some random fashion; it impinges
in the first instance on the interest rate, the price that clears the market
for credit and governs the allocation of capital.
Monetary expansion temporarily
alters the terms of trade between goods now and goods later. This money-induced
alteration has its most direct effect within the market for capital goods.
The capital goods themselves constitute current commitments, some more
binding than others, to particular production processes. In general terms,
a fall in the rate of interest stimulates the creation and use of capital
goods that aid in the production of consumer goods in the relatively remote
future at the expense of those that aid in the production of consumer goods
in the relatively near future. But the movement of resources away from
the production of lower-order capital goods and toward the production of
higher-order capital goods is followed by counter-movements (Mises, 1953,
p. 363). That is, the money-induced restructuring within the market for
capital goods is eventually revealed to be inconsistent with intertemporal
consumer demand and resource availabilities; the process is self-reversing.
Third, it is the temporal
dimension of capital that gives scope and significance to the money-induced
self-reversing process. The essential function of capital, pointed out
early on by Jevons, is "to put an interval between the beginning and the
end of enterprise" [Jevons, 1970, p. 226]. This, in summary terms, is the
interval of time during which a misallocation of capital goods can occur
and after which a reallocation must take place. Alternatively stated, it
is the interval itself that is thrown out of equilibrium by credit conditions
that are at odds with resource availabilities.
The economy's production
process that spans the Jevonian interval consists of a number of separate
stages of production. This vertical segregation, or temporal sequencing,
comes into play in a way that is not always recognized. If all production
processes were characterized by complete vertical integration—such that
the commitment to initiate a process that will eventually result in the
production of a consumer good is, in effect, a commitment to complete it—there
would be little or no scope for a self-reversing process. Many of the arguments
against the Austrian theory based on considerations of expectations would
have greater plausibility. Entrepreneurs who anticipate the ultimate consequences
of easy money—on the basis of either theoretical understanding or historical
experience—would not be eager to participate in a money-induced boom. Those
who continue to produce despite the monetary disturbance would compete
with one another at the outset for lines of credit that would see their
production process through to completion.(8)
Identifying the circumstances
under which expectations would be potentially nullifying helps to explain
why expectations are not actually nullifying in modern industrial economies.
Neither chain letters nor money-induced production processes would be initiated
if their initiators were bound to participate in every subsequent stage
of the respective processes. The absence of complete vertical integration,
however, can create significant opportunities for entrepreneurs to profit
privately from one or more stages of a production process that, taken as
a whole, will result in a social loss. And as in the case of chain letters,
those who make profits in the early stages may or may not hold expectations
that reflect an understanding of the nature of the process; expectations,
rational or otherwise, are in this context a subsidiary issue.
Still again, the Austrian
theory has empirical content that is absent from rival theories. Primitive
societies, whose members live a hand-to-mouth existence, do not experience
business cycles as described by the Austrian theory; they have no capital
structure that can become intertemporally discoordinated. Labor-intensive
agricultural economies, whose intertemporal structure of production is
determined more by the seasons than by credit conditions, are largely immune
to the cyclical disturbances identified by the Austrians. Susceptibility
to money-induced self-reversing market processes increases with the interval
between the beginning and the end of enterprise and with the extent to
which production process are divided into temporally sequenced stages of
production. These propositions conform with the broadly empirical observation
that the boom-bust pattern to which the Austrian theory applies is characteristic
of capital-intensive, market-oriented economies with a centrally directed
That the Austrians were
and continue to be the only school to focus on the market for capital
when theorizing about business cycles is also understandable. They were
the only school that had a well developed capital theory. Menger 
identified the different orders of goods in accordance with their temporal
sequence in the production process and drew attention to the intertemporal
complementarity that influenced the goods' value. Böhm-Bawerk 
dealt with the time element in terms of "roundaboutness" and demonstrated
the inverse relationship between the rate of interest and the degree of
roundaboutness that characterizes the economy's production process. Mises
 integrated monetary theory and value theory by developing Wicksell's
distinction between the bank rate of interest and the so-called natural
rate in the context of Böhm-Bawerk's capital theory. The Austrian
theory of the business cycle was a natural outgrowth of these developments.(9)
Capital in Rival Theories. Rival theories either had no
capital theory at all or had a capital theory that did not integrate well
with monetary theory. In the 1930s Keynes [1964, p. 176] rejected Böhm-Bawerk's
theory out of hand—without providing a serious critique of it or even demonstrating
that he understood just what that theory entailed. But with the Austrian
theory jettisoned, Keynes did not attempt to offer an alternative. As was
made clear in reference to his earlier theorizing, the attempt, instead,
was to press on with the macroeconomic issues in the absence of capital
theory [Keynes, 1931, p. 394f.].
After several decades of
macroeconomics without capital, the Monetarists were able to expose many
of the fallacies and shortcomings of Keynesian theory. But they were unable
to identify those shortcomings that derive from the neglect of capital
theory. Monetarism embraced a theory of capital and interest put forth
by Frank Knight [e.g. 1934], who had engaged in a tedious and protracted
debate with Hayek and other members of the Austrian school. Knight could
make no sense of Jevons' interval or of Böhm-Bawerk's roundaboutness.
Production and consumption, in the Knightian conception, are not temporally
distinct activities. The only relevant distinction, according to Knight,
is that between the economic flows of income or utility and the corresponding
stocks into which such flows can be capitalized. But to conceive, as Knight
did, of capital and interest as nothing but permanent stocks with automatic
flows is to abstract from the intertemporal market processes that captured
the attention of the Austrians and from the monetary disturbances that
may interfere with those processes. Knightian capital theory, in the hands
of the Monetarists, did not provide an alternative basis for integrating
monetary theory and value theory; it provided, instead, a device for keeping
the two theories segregated.
In recent years New Classicism
[Lucas, 1981; Barro, 1981] with its emphasis on rational expectations has
become the most formidable rival to the waning Keynesianism. While the
theoretical constructions of the New Classicists differ in fundamental
ways from those of the older Monetarists [Hoover, 1984], they share in
the neglect of capital theory. These newer constructions highlight the
temporal variation in macroeconomic magnitudes, yet the arguments hinge
almost exclusively on wage rates and the intertemporal allocation
of labor. Interest rates and the intertemporal allocation of capital
are in no fundamental way a part of New Classicism. This incongruity dramatizes
the resolve on the part of contemporary macroeconomists not to grapple
with theories of capital and interest—even when intertemporal relationships
are specifically at issue.
One encouraging development
within the New Classical school, however, deserves mention. The assumption
of rational expectations, coupled with assumptions of costless information
and instantaneous market clearing, implies that a monetary disturbance
should not have any systematic real effects beyond the period in which
the disturbance occurs. Empirical studies, though, reveal a certain persistence
of effects. Some New Classicists [Kydland and Prescott, 1982] attempt to
account for this persistence by incorporating "time-to-build" considerations
into an otherwise capital-free construction. That is, money-induced decisions
to initiate a multi-period production process affect in systematic ways
the decisions to be made in subsequent periods. While time-to-build was
added belatedly and only to resolve a disparity between theory and evidence,
this development could lead to reintroduction of capital theory into macroeconomics.
IV. In Lieu of Capital Theory
The Austrians focus on capital markets in their analysis of business
cycles while rival schools do not. This much is easily established. But
what sort of a macroeconomic construction remains when capital theory is
subtracted from business-cycle theory? Answering this question for each
of the rival schools helps to identify important differences among them.
It also serves further to demonstrate and emphasize the crucial role of
capital in the Austrian theory.
Keynesianism. Although Keynes had sympathy neither for
Austrian capital theory nor for the Austrian theory of the business cycle,
he did not offer alternative theories of his own. Ambitious as his General
Theory was, it contained only "Sundry Observations on the Nature of
Capital" and "Notes on the Trade Cycle," as announced by the titles of
Chapters 16 and 22. Now, more than half of a century after the book's initial
appearance, Keynesian scholars are still debating whether or not the malfunctioning
of capital markets is central to Keynesian theory. The debate gets resolved
as soon as a choice is made between focusing on what Keynes left out of
his book and focusing on what he actually put in it. The consequences of
each choice can be identified in summary terms.
There are no market mechanisms—at
least none identified by Keynes—that can effectively allocate resources
intertemporally. The rate of interest is determined by the supply and demand
for money; the decision to invest is based, in large part, on the groundless
expectations held by the business community, or on animal spirits, to use
Keynes's own terminology. Not surprisingly, booms and busts occur with
the waxing and waning of business confidence. When confidence is on the
wane, the demand for labor falls, resulting in widespread unemployment.
Wage rates either (1) will not fall because of unions or because of wage
rigidities inherent in the market process, or (2) will fall but without
making matters any better and possibly making matters worse because of
the accompanying fall in the price level, or (3) should not be allowed
to fall because of the considerations mentioned in (2).(10)
Macroeconomic problems persist until some set of extra-market forces are
designed to counteract the undirected and misdirected forces of the marketplace.
With this interpretation
of Keynes, the absence of effective markets for capital goods, which derives
by default from the absence of capital theory from Keynes's book, becomes
the central focus [Garrison, 1985]. If there are no coordinating mechanisms
that, even in the best of circumstances, can effectively allocate resources
intertemporally, then intertemporal markets will be discoordinated. The
conclusion follows trivially. There remains nothing more for capital-oriented
Keynesians to do, except for drawing analogies between market economies
and kaleidoscopes [Shackle, 1974] or pondering—on the basis of a highly
selective exegesis—about what Keynes must have had in the back of his mind
As an alternative interpretation,
the fact that Keynes's General Theory contains no general theory
of capital can be taken to imply that his theorizing is based on the assumption
of a fixed capital stock and a fixed capital structure (Keynes, 1964, pp.
40-45). This assumption, stated symbolically in textbooks by the placement
of a bar over the K that symbolizes capital, allows the focus of analysis
to be shifted to other macroeconomic magnitudes, among which Keynes did
posit some definite relationships. Consumption spending rises and falls
with—but not as fast as—income: C = a + bY where b is the marginal propensity
to consume. This short-run consumption function, in which a > 0 and 0 <
b < 1, becomes the keystone of the theory. The remainder of the theory
is specified in terms of interest elasticities: The demand for investment
funds is interest-inelastic; the demand for idle money balances, interest
elastic; both perfectly so in the limit.
Keynesian multipliers, which
are based on such propensities and elasticities, relate changes in employment
to changes in investment spending. The same relationships hold, in this
interpretation, whether the investment is undertaken by the business community
or the government. The will to spend rather than any more fundamental constraint,
such as economic scarcity, is what limits the level of employment and hence
national income. The intertemporal pattern of output is traced out as the
unpredictable forces in the market for investment goods interact with the
largely predictable forces in the market for consumer goods. (Coddington
 finds the significance of Keynesian theory in this interaction between
the stable and the unstable sectors of a market economy.)
Most modern textbooks on
macroeconomics consist of graphs and equations of such relationships gleaned
from the General Theory's treatment of money, interest, and employment,
given the economy's capital stock. The issue of a changing capital stock
is typically relegated to a separate chapter on economic growth, appended
almost as an afterthought to the Keynesian chapters. This interpretation
of Keynes has given rise to a distinction that stands in the way of reintroducing
capital theory into macroeconomics. Macroeconomic theory is implicitly
as all those relationships that can be identified among macroeconomic magnitudes
on the assumption of a fixed capital stock. Theory involving a changing
capital stock is, by definition, growth theory.
Writing three decades after
the publication of the General Theory, John Hicks undertook a telling
of the "Hayek Story." He recalled the "time when the new theories of Hayek
were the principal rival of the new theories of Keynes," [Hicks, 1967,
p. 203] and then he justified his own alliance with Keynes on the basis
of the modern definitional distinction. According to Hicks, we see in retrospect
that Hayek's theories were not relevant to business cycles at all. Monetary
disturbances—money masquerading as savings—could not cause the resource
movements from consumer-goods industries to producer-goods industries as
suggested by Hayek, because those movements involved actual changes in
the capital structure. Actual changes in the capital structure can be brought
about only by actual changes in the rate of savings. Hayek was theorizing
not about business cycles but about economic growth. Not only had Keynesianism
prevailed over Austrianism, it had numbed the ability of at least this
one modern macroeconomist to think in terms of money-induced movements
within the capital structure which constitute an artificial boom and lead—eventually
but inevitably—to a economic bust.(11)
Monetarism. Monetarism has come to be closely identified
with the quantity theory of money—so closely that it is sometimes defined
narrowly in terms of the positive, virtually one-to-one relationship between
the money supply and the general price level. "Inflation is always and
everywhere a monetary phenomenon." The phraseology is uniquely Monetarist,
but the idea itself has long been shared with the Austrians.
Attempts, even by the Monetarists
themselves, to define this school of thought more broadly have been less
than satisfying. At one stage of the debate between the two schools, Friedman
 undertook to differentiate Monetarism from Keynesianism by reference
to the Keynesian-based income-expenditure analysis. In this context the
key differences derive from differences in elasticities. For the Monetarists,
the demand for money is interest-inelastic; the demand for investment funds
is interest-elastic. If debate between the two schools resolved itself
into such a simple empirical question, it could be settled in short order
by consulting the data. If, alternatively, the differences in elasticities
are simply a reflection of the short-run orientation of Keynesians and
the long-run orientation of Monetarists, then Keynesian-based Monetarism
is on weak grounds. The applicability of income-expenditure analysis is
restricted by the assumption of a fixed capital stock—an assumption that
can hold, if at all, only in the short run.(12)
A more general distinction
between the two schools makes reference to underlying beliefs about
the market system [Leijonhufvud, 1981a, p. 297ff]. Monetarists believe
that markets work, that prices and wages are tolerably flexible, that individuals
do not suffer from money illusion, and that market expectations will not
for long be in conflict with reality. The perversities in the Keynesian
vision stem from disbelief on one or more of these counts.
The contrast of underlying
beliefs is especially revealing when applied to a particular market, the
market for capital goods. Both Keynesianism (interpreted as income-expenditure
analysis) and Monetarism leave capital out of account—but for opposite
reasons. For the Keynesians markets for capital goods are so ill-behaved
(references in the General Theory to casinos and musical chairs
are relevant here) that nothing much can be said about them; for
the Monetarists markets for capital goods are so well-behaved (references
to the Knightian vision of synchronous production and consumption are relevant
here) that nothing much need be said about them. It is worth noting
at this point that the Austrians occupy a middle-ground position (as they
do on so many other substantive issues [See Garrison, 1982]). Equilibrating
forces are at work in the market for capital goods but they are particularly
vulnerable to monetary disturbances. Because of the essential time dimension
in the production process, a dimension whose relevance is trivialized by
Keynes and denied by Knight, money-induced disequilibrium originating in
the early stages of production can persist undetected until the production
processes enter their final or near-final stages.(13)
Monetarists and Austrians
do share a common ground, however, in that they each focus on a self-reversing
process triggered by monetary expansion. But with the structure of capital
outside their vision, the Monetarist analysis is focused almost exclusively
on the market for labor [e.g. as in Friedman, 1976]. The analysis of intertemporal
distortions spelled out by the Austrians in terms of the various stages
of production that make up the Hayekian triangle is supplanted by an analysis
of labor-leisure distortions spelled out by the Monetarists in terms of
the short-run and long-run Phillips curve. The self-reversing nature of
the process identified by the Monetarists and hence the analytical kinship
to the Austrians, however, is clearly evident. Money-induced movements
away from the natural rate of unemployment set into motion a market process
in which changes in perceived wage rates and output prices eventually and
inevitably re-establish the natural rate. [Material in the next few paragraphs
is condensed from Bellante and Garrison, 1988.]
The details of the self-reversing
process as described by Monetarists differ categorically from those described
by Austrians precisely because of the absence in the former of any disturbances
within the structure of capital. A time-consuming production process thrown
into intertemporal disequilibrium by a monetary injection is no part of
Monetarism. Instead, the self-reversing process plays itself out within
the market for labor and on the basis of differing perceptions of the effect
that inflation has on the real wage rate. More specifically, northwestward
movements along a short-run Phillips curve are produced by a labor market
in which the worker believes the real wage rate (reckoned in terms of consumer
purchasing power) has risen but in which the employer believes the real
wage rate (reckoned in terms of the price of the firm's output) has fallen.
The inevitable eastward shift of the short-run Phillips curve is brought
about when both workers and employers eventually discover that the real
wage rate has in fact not changed in either direction. In symmetrical fashion,
deflation or even disinflation produces southeastward movements along a
short-run Phillips curve followed eventually and inevitably by a westward
shift of the curve.
The Monetarists' version
of the self-reversing process is less than satisfying on several counts.
First, why should injections of newly created money through credit markets,
which effect, in a very direct way, interest rates and hence markets for
capital goods, have effects of overriding importance on wage rates? Secondly,
how plausible is an account that relies, in one inflationary episode after
another, on chronic and systematic misperceptions of the real wage rate?
(Note here that the temporally sequenced stages of production that make
up the capital structure add a dimension to Austrian theory that has no
direct counterpart in Monetarist theory.) And thirdly, why should it take
so long in any given inflationary episode for workers and employers to
straighten out their misperceptions of the real wage rate?
In addition to lacking plausibility,
the Monetarist account grossly understates the consequences of credit expansion.
If growth in real output prevents the credit expansion from resulting in
an increase in the general level of prices, then there are no misperceptions
of wage rates and hence—in the Monetarists' view—there is no money-induced
self-reversing process. Further, if the account is confined to unskilled
labor, then the misallocations would be short-lived and easily corrected.
Any actual welfare loss would manifest itself as a lament on the part of
workers that they had consumed either too much or too little leisure as
a result of the monetary disturbance. If, alternatively, the misallocation
of skilled labor is be taken into consideration, then the focus is shifted
to human capital and the Austrian analysis comes into play. The time-consuming
development of specific skills and the development of skills complementary
to specific long-term production processes are features of a theory that
involves an intertemporal structure of both human and nonhuman capital.(14)
New Classicism. A brief stocktaking at this point will
help to put post-Monetarist developments into perspective. Keynesian theory
in all its interpretations makes a first-order distinction between markets
for consumer goods, which always perform appropriately in accordance with
the fundamentals of supply and demand, and markets for investment goods,
which never—or only by accident—perform appropriately. The economy's output
as well as the employment of labor in all interpretations of the theory
varies in direct proportion to the spending on (private and public) investment
as Phillips curve analysis, makes a first-order distinction between capital
markets, in which non-human resources are allocated efficiently, and labor
markets, in which inflation-induced misperceptions of the wage rate can
cause temporary but systematic misallocations. The economy's total output
in this analysis varies in direct proportion to the employment of labor.
There is no comparable first-order
distinction in New Classicism between markets that work right and markets
that go wrong. As a first—and sometimes last—approximation, all markets
allocate resources efficiently. In the early and hard-drawn expositions
of New Classicism, the assumption of rational expectations implied trivially
that all markets are governed, in the short run as well as the long run,
by the fundamentals of supply and demand. Stabilization policy as might
be conceived and implemented by the monetary authority is both ineffective
and unnecessary. Thus, rational expectations in its early applications
to macroeconomics did not constitute an alternative to Keynesianism and
Monetarism; it simply denied the phenomenon (cyclical unemployment) that
the Keynesians and the Monetarists were attempting to explain.
To allow the subject matter
back into the analysis of it, the New Classicists had to invent a distinction
that could drive a wedge between some actual price or quantity and the
corresponding equilibrium price or quantity. The distinction that now dominates
in models employing the assumption of rational expectations is that between
local knowledge and global knowledge [Phelps, 1970, Barro, 1976]. A system
of island economies is conceived in which prices can be affected both by
changing supply and demand conditions in each local economy and by money-supply
shocks that have consequences on a global scale. Immediate knowledge about
nominal price changes coupled with belated knowledge about money-supply
changes gives scope for real prices to deviate temporarily from their equilibrium
levels. Monetary disturbances, in this construction, can affect the level
of output in the local economy to the extent that nominal price changes
are mistaken for real price changes.
The critical role of knowledge—of
two kinds of knowledge—allows for an interesting comparison between New
Classicism and Austrianism. The New Classicists' objective, often stated
with unabashed pride, is to theorize about the economy without recourse
to the sort of ad hoc assumptions that characterize other schools
of thought [see e.g. Klamer's conversations with Lucas and Sargent, 1983].
Their conclusions do not turn on some supposed rigidity or inflexibility
of prices or wages or on some expectational scheme that is at odds with
the theory that incorporates it or on some supposed failure of market participants
to take advantage of the knowledge they possess.
The assumption that there
is a first-order distinction between knowledge of movements in the money
supply and knowledge of other economic magnitudes, however, is just such
an ad hoc assumption. What are the relevant constraints and objective
functions that determine the length of this lag? Is the lag constant over
time? And why should this particular lag in the acquisition of knowledge
have significance that overshadows all others—including the one that characterizes
the Monetarists' Phillips curve analysis? While these questions remain
unanswered by the New Classicists, their models must incorporate this or
some similar knowledge lag in order to avoid absurd or trivial conclusions—that
money doesn't matter or that money doesn't matter if market participants
base their actions on real factors only.
The Austrians, too, employ
a knowledge-based distinction but not one that requires island economies
or any other such fictitious construction. Long before the economics of
knowledge was an object of attention, Hayek  made a first-order distinction
between two kinds of knowledge. Theoretical knowledge about how the economic
system works must be treated differently from knowledge of the particular
circumstances of time and place. This distinction does not represent an
hoc assumption but rather reflects important insights of the earliest
political economists. The message conveyed by Adam Smith's "invisible hand"
is that the economic system works without the market participants knowing—or
caring—just how. Referring either in general to the structure of the economy
or in particular to the intertemporal structure of production that serves
as a basis for the Austrian theory of the business cycle, the two kinds
of knowledge can be identified as knowledge of the structure and
knowledge within the structure. Alternatively, the distinction is
between theoretical knowledge and entrepreneurial knowledge. [For a discussion
of the relationship between these two kinds of knowledge and the extent
of the overlap, see Garrison, 1986, p. 444f.]
Market participants possess
enough entrepreneurial knowledge to make the economy work, but they possess
little or no theoretical knowledge. The play-off between knowledge within
and knowledge of the structure has the same analytical significance
for the Austrian formulation as the play-off between local and global information
has for the New Classical formulation. In both, the distinction between
two kinds of knowledge allows for the derivations of results that conform
in some degree to real-world observations. But for the Austrians, the distinction
is not just an abstract modeling device; it is a recognition of one of
the most fundamental features of real-world market economies.
The full dependence in the
rational-expectations models on the time lag between the acquisition of
global relative to local information can be demonstrated by considering
the economic structure typically envisioned by the New Classicists [e.g.
Barro, 1976]. In effect, there is only one commodity being supplied and
demanded. The commodity is conceived to be nondurable in the extreme—a
service indistinguishable from the corresponding labor that renders it.
This construction avoids dealing with any kind of a production process
or even with a choice between consuming a good now or storing it for later
consumption. Also, demanders on any particular island possess the same
information as suppliers. This assumption insures that the only information
difference that matters is the one between global and local information.
At this point we may legitimately
wonder why there would be any trade on such an island? What keeps each
individual from consuming his own labor services? There must be something
in the nature of the service such that one individual must render it to
another. Though several possibilities come to mind, Barro [1976, p. 83]
has suggested that we think in terms of "back-scratching services." Trade
actually does take place. Still there is room for more legitimate wondering.
What need would such an economy have for a medium of exchange? The usually
troubling double coincidence of wants is no coincidence at all: "I'll scratch
your back; you scratch mine." At most, money would serve as an accounting
device used to keep track of the indebtedness of scratchees to scratchers.
The objective of such primitive
models in which individuals live a hand-to-back existence is to facilitate
the investigation of the consequences of a monetary injection. And as is
conventional in such formulations, it is assumed that the injection takes
the form of transfer payments—thus avoiding any interest-rate effects that
might occur in a credit expansion. The only possible consequence, then,
is that the price of back-scratching services is bid up. The key concern
is with how individuals divide their time over the next several periods
between rendering the service and consuming leisure as they guess about
the cause of the price increase and eventually learn that it is attributable
to a monetary shock and not to a change in some real factor—e.g. an increase
in itching. Again, there are grounds for wondering. What relevance could
an answer to such a question possible have for understanding the causes
of industrial fluctuations in modern, market-oriented, capital-intensive
In the face of such wondering
and implied criticism, rational expectations and island economies are defended
not as having direct relevance or as highlighting aspects of the market
process that are actually crucial in real-world business cycles; they are
defended instead simply as modeling techniques for building analogue economies.
If some model, by which is meant a "fully articulated artificial economy,"
turns out to generate time patterns of unemployment and output that mimic
to a first approximation the actual time series for those magnitudes, then
we have attained—by virtue of being able to construct such a model—an understanding
of those patterns [Lucas, 1981, p. 219]. Though the link between building
such economic models and understanding actual economics is often implied
and sometimes asserted, the methodological reasoning that establishes the
link is, to my knowledge, never revealed.(15)
New Classicism might more
palatably be defended by an appeal to instrumentalist methodology. The
models themselves provide no understanding, but they can be instrumental
in our deciding what correlations and time patterns to look for in the
macroeconomic data. By construction, however, the models fail to suggest
that business cycles may have something to do with the capital structure
as affected by movements in the interest rates.
While New Classicists often
claim some affinity to the Austrian school, they reject the Austrian theory
of the business cycle strictly on empirical grounds. The magnitude of the
alleged cause (cyclical changes in the interest rate) is so small compared
to the magnitude of the alleged effect (a crisis in the market for investment
goods) that the Austrian theory cannot seriously be entertained [Lucas
1981, p. 237]. It is tempting simply to ignore this criticism of the Austrian
theory, pointing out that by similar logic a careless smoker could not
possibly cause a forest fire. But because the empirical significance of
interest-rate effects is so often in question, a more serious and considered
response may be in order.
First, a cyclical pattern
in observed interest rates is not essential to the Austrian theory. A money-induced
deviation of the loan rate from the natural rate is the exogenous triggering
device. Further, central-bank policy that maintains constancy in the easily
observed loan rate under conditions in which the not-so-easily observed
natural rate has risen can initiate the self-reversing process within the
market for capital goods as identified by Austrian theorists.
Second, the effects of an
artificially low interest rate are not so much overinvestment as malinvestment.
While the low rate does generally favor investment over consumption, the
validity of the Austrian theory does not hinge on the magnitude of this
effect in aggregate terms. Low interest also favors particular kinds of
investment over others. It favors more durable over less durable capital
goods and capital goods used in more roundabout rather than less roundabout
production processes. These are the effects that are overlooked by simple
calculations showing that the demand for investment funds is interest-inelastic.(16)
Third, the crisis manifests
itself as intertemporal discoordination that requires a systematic reallocation
of capital within the structure of production. Because of the number of
relatively long-term production projects undertaken, resource availabilities
are not quite sufficient to carry them through. That they are merely not
sufficient is what allows the artificial boom to be sustained over a considerable
period without its artificiality being apparent. But that they are not
sufficient is what makes an eventual restructuring inevitable. The realization
that the sustainability of production processes on an economywide basis
may be threatened by small but prolonged distortion of the interest rate
away from its market level confers plausibility on the Austrian theory
of the business cycle.
New Classicism, Monetarism,
and Keynesianism each deal in some indirect way with the intertemporal
allocation of resources. Even a casual survey reveals, however that descriptions
and discussions of market mechanisms supposedly relevant are, in lieu of
a capital theory, contrived. Only by basing such discussions on some coherent
theory of capital is it possible to deal in a direct way with the market
mechanisms that, potentially, can achieve intertemporal coordination and
with policies that may result in intertemporal discoordination.
V. A Summary View
The Austrian theory of the business cycle stands up well to criticism.
The integration of monetary theory with a rich theory of capital involving
temporally sequenced stages of production which are coordinated intertemporally
by market mechanisms provides a theoretically sound and historically relevant
basis for an understanding of the problem of business cycles. Attention
to capital theory gives the Austrians a decided advantage over other schools
in theorizing about cyclical movements in macroeconomic magnitudes—or more
generally, about self-reversing intertemporal market processes.
And as it turns out, the
attention to—or neglect of—capital theory serves as well as a peg on which
to hang some history of economic thought. Fuller understandings of New
Classicism, Monetarism, and of different renditions of Keynesianism are
made possible by noting how they did or why they did not take capital into
account. Except in Keynesian theory, which lacks the very coordinating
mechanisms that the Austrians have for so long illuminated, intertemporal
coordination gets achieved, however well or badly, in some market process.
If the coordinating mechanism does not take the form of an interest rate
that determines the intertemporal allocation of capital, then it must take
some other form—correctly or incorrectly interpreted price changes that
cause individuals to store money or make some adjustment in their consumption
behavior; perceived or possibly misperceived wage rates that allocate the
employment of labor over time; or investment activities that are governed
by the waxing and waning of business confidence.
Austrians are often criticized
for placing too much emphasis on or according too much importance to their
business-cycle theory. Why all the attention to nineteenth-century business
cycles or to the Great Depression, which in so many respects was a unique
historic event? While the Austrian theory does have a direct applicability
to these historical episodes, it has broader significance as well. Austrian
capital theory amounts to a theory of intertemporal coordination; Austrian
business cycle theory—that is, the analysis of the effects of an exogenous
monetary expansion in the light of Austrian capital theory—amounts to a
theory of intertemporal discoordination. And even more broadly, calling
attention to the Austrian theory of the business cycle constitutes an appeal
to the economics profession to put capital theory back into macroeconomics.
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of Austrian Economics. vol. 2, 1987, pp. 73-78.
Wagner, Richard E. "Comment: Politics, Monetary Control,
and Economic Performance," in Mario J. Rizzo, ed., Time, Uncertainty,
and Disequilibrium. Lexington, MA: D. C. Heath and Co., 1979, pp. 177-86.
Warburton, Clark. Depression, Inflation, and Monetary
Policies: Selected Papers, 1945-1953. Baltimore: The Johns Hopkins
Yeager, Leland B., "The Significance of Monetary Disequilibrium,"
Journal. vol. 6, no. 2 (Fall) 1986, pp. 369-99.
1. The concept of involuntary unemployment,
for instance, is found to be meaningless in the context of New Classicism
and its equilibrium models of the business cycle. "In these models the
concepts of excess demands and supplies play no observational role and
are identified with no observed magnitude" [Lucas, 1981, p. 287]. For a
critical survey of this and similar aspects of New Classicism, see Yeager
[1986, pp. 382-86 and Leijonhufvud, 1986, pp. 390-93].
2. Although Rothbard has written extensively
on the Austrian theory of the business cycle, Tullock's critique draws
exclusively from "Economic Depressions: Their Cause and Cure," most readily
accessible in Mises et al. . Tullock references the original publication
by Constitutional Alliance, Inc., which he reports as having no publication
date. My copy is dated 1969.
3. Leijonhufvud's analysis highlights
disturbances and adjustments and downplays the point that the disturbance
of the economy from its natural growth path may be either in the positive
or the negative direction. If we were to focus on this positive/negative
distinction and to divide the adjustment process into an initial phase
and a final phase, we could categorize Leijonhufvud's cycles as X/N or
N/X. The first category would include a positive disturbance caused, say,
by an increase in the money supply, which is eventually rectified as prices
are adjusted upwards to accommodate a higher level of nominal cash balances;
the second category would include a negative disturbance caused, say, by
an increase in money demand, which is eventually rectified as prices are
adjusted downwards so as to produce a higher level of real cash balances.
4. Tullock sees monetary stimulation
as analogous to the stimulation of agriculture brought about by USDA programs
and to the stimulation of industry as might be brought about by a system
of taxes and subsidies. The analogies fail, however, because of the absence
in USDA programs and tax/subsidy schemes of any self-reversal. "Suppose
that the government taxed consumer goods and used the money to subsidize
investment. Suppose further that after a while it stopped the subsidy"
[Tullock, 1987, p. 77]. The "Suppose..." followed by "Suppose further..."
is a characteristic of disturbances in the X/X category. Hence, distortions
caused by such a sequence of fiscal policies are categorically different
from distortions caused by monetary stimulation.
5. In defending his own account of
the boom-bust sequence against a challenge by John Hicks, Hayek 
drew attention to the first and third consideration spelled out here, the
first in terms of the absence of perfectly competitive conditions in the
market for loanable funds and the third in terms of "fluid equilibria."
Though responsive to Hicks, whose objections where based on comparative-statics
analysis, Hayek overlooked the potentially exacerbating effects of rational
expectations that are revealed by comparing the dynamics of the production
process to the dynamics a chain letter.
6. As an alternative illustration of
all three considerations, note that when the government discovers a counterfeiting
ring, it immediately shuts it down. Does the New Classicist view imply
that accurate and timely publication of the total money supply inclusive
of the ring's contribution would be an equally effective policy?
7. It is ironic, in view of these empirical
roots, that the Austrians are so often accused of having no empirical foundation
for their business-cycle theory. What is true is that the Austrians have
always rejected the modern positivists' strategy of fabricating wholly
abstract models and then mining the available statistical data to determine
whether such models may be related in any way to real-world events. For
the Austrians, history, which includes but is not limited to statistical
data, and theory, which helps to make history intelligible, are complementary
disciplines [Mises, 1969].
8. Though concerned with chronic resource
idleness rather than with an unsustainable boom, Keynes lamented the loss
of commitment brought about by the emergence of organized capital markets.
"The spectacle of modern investment markets has sometimes moved me towards
the conclusion that to make the purchase of an investment permanent and
indissoluble, like marriage, except by reason of death or other grave causes,
might be a useful remedy for our contemporary evils" [1964, p. 160].
9. Tullock [1987, p. 78, fn 8] objects
to Rothbard's account of the business cycle on the grounds that roundaboutness
in investment occurs in the depreciation of plant and equipment rather
than in some more narrowly conceived production process. As an empirical
matter, this claim may well be correct. In the earliest modeling attempt
by Hayek , the focus was confined to a continuous-input/point-output
production process. This construction allowed the highlighting of the time
element in the production process without involving the complications of
durable capital. Applications of the theory, of course, require that the
time element in all its manifestations be taken into account. Tullock is
suggesting, in effect, that a model involving depreciating capital goods
would be more realistic and hence more directly applicable to actual production
processes. Tullock's claim [p. 76] that "the producer goods industries
are always a fairly small part of the economy" is puzzling. Surely, industrial
economies are to be distinguished from primitive economies in terms of
the size—fairly large and fairly small, respectively—of their producer
goods industries. In any case, the problem of intertemporal coordination
can be incorporated into economic theory by distinguishing between relatively
more time-consuming and relatively less time-consuming production processess.
10. Keynes appears to be adopting
a strategy usually confined to the legal profession: "My client didn't
borrow your urn; it was in perfect condition when he returned it; and it
was already broken when you lent it to him." Keynes was "arguing like a
lawyer" that the profession's attention should be directed away from wage
rates and toward interest rates. This view of Keynes is consistent with
11. An alternative interpretation
is that opponents of the Austrian view have pursued, in effect, a divide-and-conquer
strategy: Sort out that part of the Austrian theory that looks like fixed-capital
macroeconomics and pit it against Keynesian theory; sort out that part
that looks like the economics of capital accumulation and pit it against
Neoclassical growth theory. Neither part fares well on its own. The key
to the divide-and-conquer strategy is the working hypothesis that capital
is homogeneous. Lachmann identified this battle ground and recognized the
significance of the battle more than thirty years ago: "Once the homogeneity
postulate has been abandoned the distinction between growth and fluctuations
loses its meaning. The distinction finds a place in a theory which confines
itself to asking whether and to what extent existing resources are being
used, whether, and perhaps at what speed, such resources can be augmented,
and what are the circumstances in which such augmentation is likely to
take place. Once we have learnt how to ask how, and in what order, existing
resources are being used, and what are the implications of such multiple
use, once we have begun to understand the importance of the concrete form
of resources in limiting the scope of multiple use, we can easily dispense
with the all too simple distinction between economic growth and cyclical
fluctuations" [Lachmann, 1978, p. 112].
12. Leijonhufvud [1981, p. 140 ff]
rejects the elasticity-based distinction between Keynesianism and Monetarism:
Demands for liquid assets and for investment funds are not always
characterized by some particular elasticity. Each is sometimes elastic,
sometimes inelastic—depending on the state of expectations and the circumstances
created by the particular policy regime. From an Austrian viewpoint, Leijonhufvud
can be faulted only for a sin of omission. Isn't it more instructive to
call attention first to the intertemporal structure of capital, which is
ignored by both the Keynesians and the Monetarists, and then to expectations
and policies that influence the allocation of resources within that structure?
13. Some Keynesian scholars will undoubtedly
object to the claim that Keynes trivialized the time dimension of the production
process. Yet in his discussion of the nature of capital, he suggested that
a given process has all sorts of attributes—which include "smelliness"
as well as "roundaboutness." No single such attribute, according to Keynes
[1964, p. 215], has any special claim on our attention. Keynes's deep-felt
concern about "the dark forces of time and ignorance that envelop our future"
[p. 155] is expressed several chapters earlier in a discussion of long-term
expectations. The order of the two discussions is revealing: Keynes deals
with expectations about long-term rates of profit without having brought
into view the proximate objects of those expectations—the capital goods
that give concreteness to the structure of production.
14. The social losses attributable
to monetary disruptions are not at all accurately measured by unemployed
labor [Wagner, 1979]. Some distortions of the capital structure may involve
no unemployed labor at all. Conversely, labor employed to undo such distortions
can hardly be counted—in a broader context—as social gains. Tullock's claim
[1987, p. 77] that money-induced distortions of the capital structure should,
according to his understanding of the Austrian theory, give rise to higher
living standards simply ignores the intertemporal discoordination identified
by the Austrians. It is true that if we reinterpret the theory in the context
of a Knightian stock-flow conception of capital, then we can argue that
monetary expansion forces individuals to forgo part of the consumption
flow in order to add to the capital stock, after which the flow is permanently
higher. But such an intertemporal distortion of the flow of output cannot,
on the whole, be considered welfare enhancing.
15. Assertions by Lucas [1981, p.
219] are explicit: "One exhibits understanding of business cycles by constructing
a model in the most literal sense: a fully articulated artificial
economy which behaves through time so as to imitate closely the time series
behavior of actual economies. The Keynesian macroeconomic models were the
first to attain this level of explicitness and empirical accuracy; by doing
so, they altered the meaning of the term "theory" to such an extent that
the older business cycle theories could not really be viewed as "theories"
16. Leijonhufvud [1986, p. 417], who
claims to have been overexposed to the Austrian theory, rejects that theory
on the basis of such simple calculations involving high levels of aggregation:
"My trouble with ABC [Austrian business cycle theory] is that its ... falsifiable
content has been falsified. According to ABC, inflation should produce
an overinvestment boom. The stagnation decade of the 1970s does not fit:
it gave us inflation but no acceleration of capital accumulation...." But
see Leijonhufvud  for a more thoughtful discussion of the relationship
between theory and evidence.