5, no. 1, 1991, pp. 93-103
New Classical and Old Austrian
Equilibrium Business Cycle Theory
Roger W. Garrison*
recent flourishing of New Classical economics, and especially its Equilibrium
Business Cycle Theory, has given a fresh hearing to the Old—but still developing—Austrian
Business Cycle Theory (ABCT). While the New and the Old differ radically
in both substance and methods, they exhibit a certain formal congruency
that has captured the attention of both schools. The formal similarities
between EBCT and ABCT invites a point-by-point comparison, but the comparison
itself dramatizes differences between the two views in a way that adds
to the integrity and plausibility of the Austrian theory.
modern macroeconomic literature, the label EBCT is applied sometimes so
broadly as to include New Keynesian as well as New Classical constructions
and sometimes so narrowly as to preclude the very developments within the
New Classical school that are most closely related to ABCT. So-called Real
Business Cycle Theory, in which cyclical movements of macroeconomic variables
are characterized by both market clearing and Pareto optimality, is sometimes
designated as the only true equilibrium construction. The comparison of
New Classical and Old Austrian theories is best facilitated by letting
EBCT refer to those theories in which (a) individuals make the best use
of the information available to them and (b) an informational deficiency
temporarily masks the interventions of the monetary authority. As exposited
by Robert Lucas (1981), Robert Barro (1981) and others, EBCT so conceived
accounts for business cycles in terms of the actions of market participants
confronted with what has come to be known as a signal-extraction problem.
Difficulties in interpreting price signals during a monetary expansion
also lie at the root of ABCT as introduced by Ludwig von Mises (1953) and
developed by Friedrich A. Hayek (1967).
Lucas's EBCT with Hayek's ABCT, R. W. van Zijp (1990) argues that Lucas
is not a Hayekian on the grounds of the differing goals of the two theorists.
Hayek sought to explain the business cycle in terms of a multitude of partially
conflicting individual plans; Lucas seeks to predict the behavior of the
"representative individual" during the course of the business cycle (p.
20). Kim Kyun (1988) provides an historical perspective by finding links
between modern EBCT and business cycle theories of the interwar period.
He concludes that the New Classical economists have so revolutionized the
style of argument that their ability to challenge old views and deal with
key issues is seriously restricted (pp. 112-14). William Butos (1985) assesses
the claims that Hayek pioneered modern EBCT and finds them misleading.
While Hayek took the equilibrium relationships established by price theory
as the point of departure for his business cycle theory, the technique-bound
EBC theorists take those same relationships to be effective constraints
throughout the course of the business cycle (pp. 337 and 341). These treatments
of the relationship between EBCT and ABCT are mutually reinforcing and
are consistent with my own Austrian perspective on New Classicism (Garrison,
1986, pp 443-45, and 1989, pp. 19-23).
Substance and Method
It is possible to describe a business cycle in
such general terms that the description is consistent with both EBCT and
ABCT yet distinct from, say, Keynesian and Marxian theories. The common
ground can most easily be identified in terms of the reactions of market
participants to a price change whose origins are possibly real, possibly
monetary, or possibly both. Similarities between EBCT and ABCT reveal themselves
despite the fact that the particular price featured in the two theories
is the price of output (in EBCT) and the price of credit (in ABCT).(1)
Points of congruency derive from the fact, emphasized in each theory, that
market participants cannot easily (or costlessly) distinguish between the
real and the monetary component of the change.
appropriateness of the response to the price change clearly depends upon
the origin, or cause, of the change. An alteration in in the underlying
economic realities requires accommodation in real terms; monetary manipulation
does not. Until the true nature of the price change is known, market participants
will respond, at least in part, as if its causes were real. If the price
change is, in fact, purely of monetary origins, then market participants
will eventually readjust their activities in recognition of the actual,
and pre-existing, economic realities. Thus, both EBCT and ABCT allow for
a certain non-trivial and systematic non-neutrality of money during the
period the economy is adjusting to an increased money supply.(2)
EBC models could be taken at face value, the substantive differences between
these models and Austrian theory would be easy to identify. In their most
basic formulations (e.g. Barro, 1981, pp. 80-83 and Hayek, 1967, pp. 69-100),
the initial response by market participants take the form of an increase
in labor services in response to nominally high output prices (in the EBC
model); of an inherently unsustainable capital restructuring in response
to an artificially low interest rate (in ABC theory). The subsequent response
takes the form of a reversion to the initial level of labor services (in
the EBC model), of a time-consuming liquidation of malinvested capital
(in ABC theory). If these differences were the essential ones separating
EBCT and ABCT, then the two theories could rightly be viewed as variations
on a theme. And there is even some overlap in the variations as evidenced
by discussions in the Austrian literature (e.g. Hayek, 1967 and 1975) of
the misdirection of labor and by developments within New Classicism which
incorporate a capital stock variable (e.g. Lucas, 1981, p. 179ff.) and
even "time-to-build" considerations (Kydland and Prescott, 1982, as discussed
by Lucas, 1987). Seemingly, EBCT and ABCT have much common ground.
EBC models are not to be taken at face value. An EBC model is not offered
as a theoretical account of some actual or possible historical episode.
Rather, EBCT is only a modeling technique designed to demonstrate that
a model economy can exhibit cyclical patterns in macroeconomic variables
without violating the constraints imposed by general equilibrium theory.
Equilibrium conditions hold for the model economy throughout the course
of the cycle. In the New Classical view, the constraint imposed by the
logic of general equilibrium confers theoretical respectability on the
model; econometric testing as suggested by exercising the model economy
and performed on extended time-series data descriptive of the real-world
economy establish the model's empirical relevance.
New Classical technique is foreign to ABCT, which treats the business cycle
as an instance of systematic intertemporal disequilibrium. In the
Austrian formulation, the very language used to describe the course of
the cycle is the language of disequilibrium: Credit expansion suppresses
the rate of interest below its natural level; the artificially low interest
rate results in forced saving, which unduly restricts consumption; capital
is malinvested; the boom is unsustainable; entrepreneurial errors are revealed
in the inevitable bust. These notions cannot be described in the language
of equilibrium without doing violence to their meaning.
Old and New Uses of Equilibrium.
The Austrians, particularly Hayek, have made
explicit but limited use of the concept of equilibrium in the exposition
of their business cycle theory. But, as van Zijp, Kim, and Butos have noted
or implied, the limited use made does not qualify ABCT as a specific instance
of EBCT. For the Austrians, the appropriate role for some suitable equilibrium
construct is mandated by a self-evident methodological consideration: Any
account of the origins of phenomena characteristic of business cycles,
such as an uncoordinated capital structure, massive unemployment of labor,
and other instances of widespread resource idleness, cannot assume those
phenomena to exist at the beginning of the account. Theory, in short, is
logically incapable of explaining what it assumes. Hayek (1948, p. 34)
undoubtedly had Keynes in mind when he insisted that before we can even
ask how things can go wrong, we need to understand how things could ever
very meaning of disequilibrium in the context of business cycle theory
derives from its being compared to some relevant equilibrium. That is,
adopting a suitable equilibrium concept establishes the initial conditions
and facilitates the analysis of an ensuing disequilibrium caused, say,
by the central bank's cheap-credit policy. It allows our understanding
of the particular kind of disequilibrium associated with the business cycle
to be dovetailed with our understanding of the equilibrium that would have
prevailed in the absence of the monetary disturbance.
essential but limited role for an equilibrium concept is not at all what
the New Classical economists have in mind. For them (e.g., Lucas, 1981,
pp. 287 and passim), the concept of disequilibrium is of no use
in understanding business cycles. The phrase "equilibrium theory" is pleonastic
and means, simply, "theory"; "disequilibrium theory" is self-contradictory
and can only mean "non-theory." The methodological precept that underlies
EBCT is that each phase of the business cycle can be understood as an equilibrium
set of prices and quantities, or it cannot be understood at all.
all-inclusiveness of the equilibrium concept in New Classicism warns against
comparisons of EBCT and ABCT that ignore the radically different methodological
contexts. For instance, the inevitable bust that figures importantly in
ABCT cannot easily be translated into the language of EBCT. For the Austrians,
"equilibrium bust" is a term at war with itself; for the New Classicists,
"disequilibrium bust" can only mean an unexplainable downturn (cf. Lucas,
1981, pp. 225 and 231).
The ERE and the FAAE.
Criticism of even the limited use of equilibrium
made by the Austrian theorists can help to assess the fruitfulness of "equilibrium
theorizing" in each context. Cowen and Fink (1985) find a contradiction
between ABCT and the assumed initial conditions that link business cycle
theory with established price theory. They base their case on the most
thorough-going concept of equilibrium in the Austrian literature, the Evenly
Rotating Economy (ERE) so designated by Mises (1966, pp. 244-50). The complete
coordination of all economic activities, which defines the ERE, precludes
disequilibrium of any sort. The ERE allows for no uncertainty and hence
has no role for the real-world institutions that help market participants
deal with uncertainty. Monetary institutions and even money itself are
no part of the ERE—hence the contradiction between a theory of money-induced
disequilibrium grafted onto a concept of moneyless general equilibrium.
Cowen and Fink have shown, however, is that Mises's ERE is not the appropriate
equilibrium concept to serve as the initial conditions for ABCT. It is
not necessary for the initial conditions to preclude all kinds of disequilibria
but only to preclude systematic intertemporal disequilibrium—the kind of
disequilibrium for which the theory itself accounts. This limited equilibrium
construct complies fully with both the logic and the spirit of ABCT.
view of the differing uses of equilibrium constructs in EBCT and in ABCT,
contradictions of the sort identified by Cowen and Fink are much more telling
against EBCT. The equilibrium construct that underlies both the initial
conditions and all subsequent phases of the business cycle is a clear rival
for the ERE in terms of its severity and other-worldliness. The cyclical
variations that mimic the ups and downs in a real world economy play themselves
out in the context of a "Fully Articulated Artificial Economy" (FAAE),
in which all markets continuously clear (as in Lucas, 1981, pp 271 and
and in Barro, 1981, p. 81-83).
order that full articulation be possible, the FAAE must assume away virtually
all the features that give economics its subject matter. The FAAE disallows
diversity among market participants in terms of knowledge and entrepreneurial
ability. Output typically takes the form of a single service indistinguishable
from the labor that renders it. The price system is non-existent except
in the trivial sense of the ratio of output to leisure. And except in some
similarly trivial sense, there is no role in the FAAE for a monetary institution
or even for money itself. Yet, a monetary impulse is what triggers the
cyclical variation of output and prices. Money is injected into an artificial
economy that has no non-trivial use for money.(3)
attempt to articulate the process through which a hypothetical monetary
injection affects output and prices in the artificial economy inevitably
draws on our understanding of how actual monetary injections affect the
real-world economy. The characteristic effects of an actual monetary injection
derive largely from the nature and limitations of the price system. Broadly
conceived, the price system serves as a communications network, but any
individual price signal, by itself, may be ambiguous. This limitation in
the ability of the price system to communicate real changes in economic
conditions underlies monetary theory from Richard Cantillon to David Hume
to Friedrich Hayek. Hayek's "The Use of Knowledge in Society," (in Hayek,
1948) virtually redefines the economic problem as a communications problem
inherent in a society in which knowledge is widely dispersed among market
underlying EBCT is the fact that market participants have no timely and
failsafe method of distinguishing between real and monetary components
of a price change. But a FAAE in which there is no dispersion of knowledge
and only one output has little need for communications and even less scope
for ambiguity. The communications network exists, if at all, in its most
for ambiguity of a price change is incorporated into EBC models by a technique
originated by Edmund Phelps (1970, pp. 6-7). A global economy consists
of numerous local, or island, economies, such that inter-island communication
lags intra-island communication. Such models allow economic agents to observe
price changes on their own island instantly and price changes on other
islands belatedly. Ambiguity about the true meaning of price changes characterizes
the period marked by the instantly perceived and the belatedly received
agents would react one way if a particular price change is attributable
to monetary expansion, which is presumed to affect all islands equally,
and another way if the change is attributable to underlying economic conditions,
which is presumed to affect only the one island. But during the wait for
the inter-island information, which will clarify the meaning of the local
price change, economic agents must react in some way. Possible reactions
during the period of partial information is constrained by the assumptions
of optimizing behavior and continuous market clearing. The supposed behavior
of the model's agents, however, depends upon whether the implicit reasoning
has a supply or a demand orientation (Friedman, 1978, p.76). That is, a
supply-side adjustment plus assumed market clearing and a demand-side adjustment
plus assumed market clearing imply different behavior and different outcomes.
While the virtue of the FAAE is believed to lie in its being fully articulated,
the behavior of its inhabitants varies substantially from one model to
another and invariably leaves much to the imagination.
in understanding why agents in the FAAE would use money at all are transformed
into difficulties in understanding how (or why) these agents would react
to monetary expansion. Accounts of their supposed behavior derive their
plausibility from—rather confer their plausibility upon—our understanding
of the effects of monetary expansion in real-world economies. The FAAE,
then, which contains just the sort of contradiction identified by Cowen
and Fink, cannot help us understand the real world. Rather, it is the implicit
and intuitive understanding of the effects of actual monetary expansions
that has rescued the EBC models from their own contradictory construction.
The Wicksell Connection.
Except for Marxian theories, nearly all modern
theories of the business cycle have essential elements that trace back
to Knut Wicksell's turn-of-the-century writings on interest and prices.
Austrians, New Classicists, Monetarists, and even Keynesians can legitimately
claim a kinship on this basis. Accordingly, the recognition that both the
Austrians and the New Classicists have a Swedish ancestry does not translate
into a meaningful claim that the two schools are essentially similar. To
the contrary, identifying their particular relationships to Wicksellian
ideas, like comparing the two formally similar business cycle theories
themselves, reveals more differences than similarities.
to Wicksell's treatment of the relationship between prices and interest
was the distinction between the natural rate of interest and bank rate
of interest and the recognition that the bank rate can diverge from the
natural rate. These are the ideas that directly influenced Mises and subsequent
Austrian theorists. The institutional setting in which the interest rate
reflects both the intertemporal preferences of market participants and
the actions of policy makers, then, figures importantly in the Austrian
account of the artificial boom and inevitable bust. Fritz Machlup (1976,
p. 23) accurately summarized the Austrian view with the statement that
"monetary factors cause the cycle but real phenomena
it." But to establish the essential difference between the Austrians and
the New Classicists, it needs to be added that the focus of the Austrian
theory is on the actual market process that translates the monetary cause
into the real phenomena and hence on the institutional setting in which
this process plays itself out.
New Classicists deliberately abstract from institutional considerations
and specifically deny, on the basis of empirical evidence, that the interest
rate plays a significant role in cyclical fluctuations (Lucas, 1981, p.
237, n15). Thus, Wicksell's
Interest and Prices is at best only
half relevant to EBCT. More relevant, in establishing the Wicksell connection,
is Ragnar Frisch's (1933) work on "impulse and propagation." This separation
of issues in Frisch's writing formally parallels Machlup's characterization
of the Austrian view, but the difference in the extent of the separation
translates into a fundamental difference between EBCT and ABCT.
(1933, p. 198) took as his inspiration a metaphor that he attributed to
Wicksell. Cyclical fluctuations in economic activity is mimicked by the
motion of a child's rocking horse. The metaphor is intended to suggest
that understanding the horse's rocking, or even its propensity to rock,
requires an analysis of its structure. Further, the questions What sets
the horse to rocking? and What are the structural parameters that underlie
its rocking motion? are completely separate. The impulse that causes the
motion need not have any particular relationship to the activated propagation
mechanism that constitutes the motion. Taking the Wicksellian metaphor
as their cue, the New Classicists are led away from the preeminent Austrian
concern about the actual market process that transforms cause into effect
and towards the belief that a full specification of the economy's structure,
which is possible only in the context of an artificial economy, can shed
light on an effect whose nature is fundamentally independent of the cause.(4)
the analysis as it relates either to questions about the impulse that initiates
cyclical movements or to questions about the economic structure in which
cyclical movements can occur has allowed for developments within New Classicism
that transcend the traditional categories of business-cycle theories. Theories
traditionally categorized as "monetary" and "non-monetary" can now belong
to the same category. Within the context of New Classicism, Real Business
Cycle Theory is distinguished mainly in terms of the nature of the impulse
that is thought to set the economic structure into its cyclical motion.
In RBCT, business cycles are initiated by real supply shocks rather than
by monetary shocks. And while the hard-drawn version of RBCT's propagation
mechanism (Long and Plosser, 1983), assigns no role at all to money, more
accommodating accounts (King and Plosser, 1984) allow for money and credit
to become involved through "reverse causation."
or agnosticism about the true nature of the impulse has only a minimal
effect on the empirical research inspired by the monetary EBCT or the non-monetary
RBCT. Lucas (1987, p. 70-71), for instance, favors the former over the
latter on the basis of the comparison of the amplitude of cyclical fluctuations
with the magnitude of nineteenth- and twentieth-century supply shocks.
The fact that monetary considerations can be ruled in or ruled out on such
grounds suggests that money and monetary institutions are not nearly so
central to New Classical theory as they are to Wicksellian and Old Austrian
Broadly Historical or Narrowly Empirical Analysis.
Fundamental differences between the process analysis
of ABCT and the structural analysis of EBCT imply corresponding differences
in the respective historical, or empirical, treatments of cyclical fluctuations.
The Austrian theory finds empirical expression in actual historical episodes
in which a credit-driven boom is followed by an economywide bust. The policies
of the Federal Reserve System during the 1920s in the light of the subsequent
crash in 1929, for example, provide primary raw materials for an historical
study. The theory establishes the causal connection between the boom and
the bust and explains many of the features of both, such as the movements
of capital-good prices relative to consumer-good prices during the boom,
the high real interest rate immediately preceding the bust, and the disproportionately
low value of long-term capital goods during the depression.
the spirit of Mises (1969), theory and history are shown to yield complementary
accounts of a particular instance of boom and bust, an instance that is
understood to have occurred independent of our theoretical understanding
of it. And the process analysis that provides the theoretical understanding
requires, as its empirical complement, an economic history that gives full
play to monetary institutions, policy goals, and beliefs held by opinion
makers, public officials and key Federal Reserve operatives, as well as
to the more narrowly conceived macroeconomic data.
structural approach of EBCT leads to a fundamentally different kind of
empirical research. Wicksell's rocking horse can help to explain. The motion
of the rocking horse can be understood and predicted exclusively on the
basis of knowledge of its structure. And in principle, as applied literally
to a rocking horse, knowledge of the structure can be acquired without
the horse rocking at all. Values of a few structural parameters, such as
weight, center of gravity, and curvature of the runners, are enough to
fully specify the parameters of the horse's motion.
properties of the economy, however, cannot be measured independent of relative
movements of economic variables. But the relative movements needed for
the identification of the economic structure need not be movements that
any contemporary historian has identified as a boom-bust cycle in the sense
of ABCT. All that is required is that there be enough variation in the
independent variables to allow for statistically significant estimates
of the system's parametric values. In other words, the metaphorical rocking
horse cannot be observed directly by econometricians. Available data consist
only of the points of contact between runners and floor. Thus, inferring
the structure from the data requires that there be some movement in these
points of contact.
the needed variation in the independent variables falls as the sample size
increases, the prospects for identifying the economic structure increase
with the length of the period that serves as the basis for the empirical
research. The typical data base used is the time series of macroeconomic
variables from the end of World War II to the latest quarter for which
data are available. Parameter estimates, then, are based upon data for
the entire period whether or not the constituent subperiods were part of
a noticeable or a not-so-noticeable cyclical episode. Revealingly, the
most noticeable of all cyclical episodes, the Great Depression, is viewed
by New Classicists as an outlier that defies explanation by existing economic
analysis (Lucas, 1981, p. 284).
examples of Austrian-based historical research and New Classicist-based
empirical research are easily identified. Lionel Robbins' The Great
Depression (1934) and Murray Rothbard's America's Great Depression
(1975) clearly exemplify the analysis of a particular historical episode
as the empirical counterpart of ABCT. The econometric testing of hypotheses
consistent with EBCT is exemplified by Robert Barro's "Unanticipated Money
Growth and Economic Activity in the United States" (in Barro, 1981) and
Thomas Sargent's "A Classical Model for the United States" (1976), both
of which test an extended time series for relative movements in macroeconomic
variables thought to be characteristic of cyclical activity. An interesting
hybrid is Charles Wainhouse's "Empirical Evidence for Hayek's Theory of
Economic Fluctuations," in which a number of hypotheses derived from ABCT
are tested on the basis of monthly data for the period January 1959 through
June 1981. There seems to be no hybrid of the other sort, in which EBCT
is shown to illuminate some historical account of a particular cyclical
EBCT in its Lucas and Barro formulations and
ABCT as spelled out by Mises and Hayek have a certain formal similarity.
The two theories owe something—though something different—to Knut Wicksell.
Policy implications of the two theories, not discussed in this article,
are clearly similar. Yet, in terms of the well recognized methodological
distinctions that sepatate the Austrian school from the modern orthodoxy,
EBCT and ABCT are worlds apart. Theorists who are more at home with ABCT
than with EBCT will do well, though, to monitor developments of EBCT. These
New Classical models continue to provide a forum for Old Austrian ideas.
* Helpful comments on an earlier
draft of this paper from Parth Shah, Sven Thommesen, and an anonymous referee
are gratefully acknowledged.
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1. The difference
in terms of the particular price featured in the two theories accounts
for an anonymous referee's observation that in EBCT the cycle is initiated
by a rise in the interest rate [in the sense of a greater spread between
input and output prices], while in ABCT the cycle is initiated by a fall
in the interest rate [in the sense of cheaper credit].
the comparison to encompass Monetarism would involve too great a detour.
In general, the qualifier "non-trivial" distinguishes this general description
from the Monetarist view, which characteristically trivializes all short-run
monetary non-neutralities with the label "first-round effects." Otherwise,
the Friedman-Phelps treatment of short-run and long-run Phillips curves
identifies a market process similar to the ones identified by EBCT and
ABCT. This similarity is the focus of Bellante and Garrison (1988). But
for an argument that the Friedman-Phelps dynamics is not an integral part
of Monetarism, see Garrison (1991).
3. Garrison (1989,
p. 21) discusses what, in effect, is the Cowen-and-Fink contradiction in
the context of Barro's back-scratching economy. Lucas (1987) attempts to
"motivate the use of money" (p. 74) by introducing the concept of "cash
goods," which—for reasons plausible enough to participants in the real-world
economy—can be purchased only with cash.
4. In his historical
perspective Kim (1988) gives some play to Frisch and the rocking horse
as a link between Wicksell and EBCT and argues that EBCT is a "child of
the Cowles Commission method," which was the method pioneered by Frisch.