Q1: In your book (Time and Money, 2001) you present a graphical framework that captures the essence of Austrian Macroeconomics. The first impression is that this project is something that the Austrians should welcome, either to explain the business cycle theory in a simpler way (traditional Austrian literature is not an easy reading) or to facilitate a critical debate about the use of graphics in economics. How did you become involved with this idea?
I was led to a graphical approach in graduate school where I was confronted with the Keynesian ISLM analysis and realized that Austrians didn’t have a viable alternative to it. There was no way to put Keynesian macro head-to-head with Austrian macro. So even at that early stage, one of my objectives was to create an Austrian graphical framework that could compare favorably with mainstream constructions. The general idea was that it takes a set of graphics to beat a set of graphics, so I pursued it on that basis.
In the early 1970s, I wrote my first graphical piece, which was eventually published by the Institute for Humane Studies (in 1978) as a monograph titled Austrian Macroeconomics. It was based on Mises’s classical rendition of the relationships, so it was hard for modern students to understand—because it wasn’t in their analytical language. That piece was welcomed many Austrian economists, even those who weren’t particularly fond of graphical analysis per se. Murray Rothbard, for instance, who was not known for his analytics, loved the graphics. He simply saw the piece as “the Keynesians being beaten at their own game.”
But I think the technique goes well beyond that. Adopting a graphical form is a good way to get a coherent exposition of the theory. The graphs impose a certain discipline on your thinking. You have to line up the diagrams and sometimes make adjustments to the theory to make it all work. Yet, these adjustments, it usually turns out, have a basis in the Austrian literature—for instance, the business of pushing beyond the production possibilities frontier as a way to represent an “overheated” economy. If you put the theory in a graphical form you can see this aspect of the policy-induced boom; you see that people are investing more and consuming more. That means pushing beyond the frontier. It’s something that has rarely been noticed in the Austrian literature, but it’s there and it’s a logical necessity. The interlocking graphs have a way of flushing out almost all of the critical aspects of the Austrian argument.
Q2: Graphics imposing discipline recalls an engineering approach...
My undergraduate degree is in electrical engineering. After graduation I ended up in the Air Force, spending my time in upstate New York in a Research and Development Laboratory as a systems engineer specializing in electronic countermeasures. The Vietnam war ended about the same time I was released from the military, and there was a glut in the market for engineering. My options were to stay in warfare electronics, which I didn’t want to do, or get out from engineering, which I also didn’t want to do…but that’s what I did and I got into economics. My engineering degree was from a school in Missouri, which required students to take one class covering both microeconomics and macroeconomics. I did a Masters in Economics at the University of Missouri-Kansas City. Then I worked for 3 years at the Federal Reserve before continuing my graduate studies at the University of Virginia.
Q3: Is Austrian macroeconomics a contradiction in terms? In your book, you ask Austrians to accept that the market processes have consequences for macroeconomic aggregates. What was the reaction to this approach?
The reaction was really mixed. As I already mentioned, Rothbard liked my Austrian Macroeconomics, but I also got some hate mail from people who said that it was a sacrilege to Mises to represent his ideas with macroeconomic graphs; it was just unacceptable.
That was my first indication of a strong visceral attitude against graphical expositions. But I haven’t spent much time defending the approach—because I’m more interested in dealing with people who find the graphs helpful than confronting people who simply say that graphs are inappropriate and walk away. I had a student in my office, for instance, who told me: “you can show me the graphs if you want, but you might as well show me a head of cabbage; they mean about the same thing to me.”
Even micro involves aggregation. If you have the supply and demand for apples, you treat apples as if they are all alike, you build up the total, or aggregate, demand for apples, and so on. You would have to disaggregate the apples if you’re trying to account for the price differences among different varieties of apples. The point is that you need your level of aggregation to be consistent with the theory in which it is employed, but this is true for micro no less than for macro. There’s nothing unique about using macroeconomic aggregates.
Q4: You introduced a new key phrase: “capital-based macroeconomics.” Could you tell us about the advance in the field facilitated by this new vision?
I’m gratified to see the phrase “capital-based macroeconomics” catch on. Not long after I started using it, I began to see it appear in quotation marks or with a “so-called” attached. Now, it’s frequently used as a generic term and with no special reference to my work. That’s good. The idea, of course, is to use a name that’s based on the substance of the theory rather than on its national origins.
There’s room for advancement mainly in the form of empirical studies, or better, historical studies, which is the Austrians’ understanding of empirical anyway. Ben Powell, a GMU graduate who is now on the faculty at San Jose State in California, has pushed forward in this direction. He wrote a very good article explaining Japan’s recession using the Austrian theory. He took Japan as a case study that fits nicely into the capital-based framework. The piece was published in the Quarterly Journal of Austrian Economics. He recently he told me that the article was inspired by my Time and Money.
Also, there is a working paper at the International Monetary Fund that wonders out loud if the Austrian theory might have current applicability. That piece, by Stefan Oppers, is essentially a review article based on my book. Though the paper’s conclusions are mixed and weak, I’m encouraged to see the IMF pay attention to the Austrian theory of the business cycle.
Q5: In your view, does Capital-based macroeconomics have any point where it could be improved or that needs further researches?
I think the improvements are mainly at the empirical stage—looking in detail at historical events interpreted in light of the Austrian theory. The objective is to find historical aspects that allow clear distinctions among the Austrian view, the Monetarist view, and the Keynesian view. There’s an often-cited paper by Charles Wainhouse (“Emperical Evidence for Hayek's Theory of Economic Fluctuations,” in Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform, Barry N. Siegel ed., Cambridge, MA: Ballinger Publishing Co., 1984), showing that in the post-war period, movements of the aggregates were consistent with the Austrian theory. Fine, I think they were, but those movements could also have been consistent with Monetarism and Keynesianism, too. So we need something that more convincingly discriminates.
Also, it is hard to come up with data that track the separate aspects of a diseggregated capital structure. For two reasons: one is that postwar macroeconomic data were collected with no regard for the Austrian theory. Simon Kuznets designed the US data-collection system with the Keynesian theory in mind; Richard Stone did the same thing for the UK data-collection system.
A second reason is that capital has no natural unit of account. Data on capital investment, even if disaggregated into early-, middle-, and late-stage capital, are recorded in value terms. And those capital values reflect the then-prevailing rate of interest. It is essential to the Austrian theory that interest rates are artificially low during the boom. Hence, capital creation discounted on the basis of artificially low interest rates would be artificially high just as a matter of measurement.
You always get tangled up in these thorny issues of the capital theory. Back in 1930s a lot of the debates were about capital theory (Robinson, Sraffa, etc.). One of the reasons that Keynes’s theory had so much appeal is that it pushed forward on the issues of unemployment and stabilization policy while leaving the thorny issues of capital behind.
For modern Hayekians, it is tempting to go back and find the evidence of those movements of capital among the different stages of production. But the notion of stages, as conceived by Hayek, is essentially a pedagogical tool. The stages have no unambiguous real-world counterparts. That’s why we need some innovative empirical research—to get a handle on the temporal dimension of the structure of production.
Q6: Do you have any interesting anecdote about your relation with neoclassical economists?
I have had communications with Milton Friedman in regard of his “plucking model” that I discuss in Chapter 11 of my book. There’s a revealing story about this particular face of Monetarism that hasn’t been told. Back in the late 1980s, Walter Block, then coeditor of the Review of Austrian Economics, asked Friedman to write an article outlining his objections to the Austrian theory of the business cycle. Friedman declined, claiming that he had already done that, and didn’t have anything more to say about it. Block, being as persistent as is usual for him, wrote back saying he didn’t know about this contra-Austrian article.
Friedman then indicated that it was all in a preliminary report he wrote while at the NBER (National Bureau of Economics Research) in 1964 (which turned out to be the first time and possibly the only time he had mentioned his “plucking model”). He qualified his earlier claim, saying that he hadn’t actually mentioned the Austrian school or any of the Austrian economists by name but that the Austrians should have recognized that it was their theories being criticized. In a short section of the report Friedman indicated that it was not so much that the Austrians were wrong with their logic, but rather that their theory had no empirical counterpart. To Friedman, the aggregate data cast a grave doubt on those theories that see as a source of a deep depression the excesses of the prior expansion. What you find empirically are not “boom-bust” episodes but rather “bust-boom” episodes, the later being described by his “plucking model”: The macroeconomic aggregates are plucked below trend at various times and to various extents.
So, this was supposed to be a critique of the Austrian theory. Walter sent the correspondence to me just as I was preparing a conference paper with the title “Is Milton Friedman a Keynesian”? I included only a short section on this business of “plucking” because I thought it was a little inappropriate to saddle Friedman with a position he took in some preliminary report back in ’64. After all, the short-run/long-run Phillips curve analysis, which stands in contradiction to plucking, came out in the late 1960s. I’d never before seen the plucking model, but there he was, and so I included an assessment, focusing on Friedman’s high level of aggregation, and suggested that the data are not at odds with a theory—the Austrian theory—that works at a lower level of aggregation.
That was that, or so I thought. But as things developed, Friedman, who had not been active in monetary economics for years, was asked to appear on a panel at the Western Economic Association meetings, where he would be honored on the occasion of his eightieth birthday. So, with plucking on his mind, he took that section from the old 1964 report and reformatted it as a conference paper to be presented anew in 1992.
Though about ninety percent of the paper was excerpted from the old report, the Western Economic Association’s journal, Economic Inquiry, ran it as the lead article. That was in April of 1993. One of the few amendments he made was the identification of the intended target of the criticism. He inserted in brackets the statement that “the Mises cycle theory is a clear example.” That is, Mises has a boom-bust theory, which is immediately suspect because Friedman’s aggregated data suggest a bust-boom sequence.
Well, the important thing to me was that Friedman had given currency to the argument and had pointed a finger at the Austrians. That gave me an opportunity to write a comment defending the Austrians against this monetarist critique. In the process I had some correspondence with Friedman. The focus soon turned to the movements in interest rates during the 1920s—with Friedman claiming that they were not low by historical standards. This was supposed to be further evidence against the Austrian theory. But, of course, the 1920s were years of rapid innovation—in automobiles, home appliances, and processed foods. So, we would expect to see a high demand for investment funds and a relatively high rate of interest. The “artificial” component of the boom came from the Federal Reserve’s credit expansion, which kept interest rates below the true scarcity value of capital. By the way, this was Hayek’s position at the time. He watched the Fed pump money through credit markets to keep prices from falling in this period of increasing output and labeled that policy “artificial price-level stabilization.”
I argued in my comment that Friedman had misidentified economic recoveries as booms and had failed to identify any credit-driven booms because of his excessively high level of aggregation. Artificially low interest rates affect the relative movements among the different stages of production—an effect that is concealed by combining the output of all the stages into aggregate output. And I showed that the Austrians’ boom-bust sequence identified at one level of aggregation leaves a trail of bust-boom data at a higher level of aggregation.
For a time, I thought that Economic Inquiry was not going to publish my comment. One referee vehemently argued against its publication—on the grounds that Friedman’s article should never have been published! Fortunately, the journal’s editor took a different view and accepted the comment. It came out three and half years after Friedman’s article (in October 1996).
In Time and Money I gave myself more space to deal with these issues. I dealt with a few Friedman-inspired papers that tried to test for plucking using post-1964 data from various countries. And I actually drew for the first time—Friedman never drew it—this infamous plucking model.
Q7: Those who are familiar with the Mises Institute and regard Roger Garrison as one of the pillars of the new wave of academic research it supports consider your visit to LSE as a Hayek Fellow as a big event. This is the place were Hayek presented his Nobel-prize winning theories. But it is also the most important neoclassic academic institution in Europe, so this is a big thing for Austrians. How did it happen?
This visit was arranged by Toby Baxendale, an LSE alum and a very successful businessman in London. He follows the Austrians in his own reading and has a special interest in Mises and Hayek. Toby is also a supporter of the Ludwig von Mises Institute, which is located in Auburn, Alabama (USA) and is associated with Auburn University. The five-week visit, then, was spondored by the Mises Institute in cooperation with LSE. The host for the visit is STICERD (Suntory and Toyota Centers for Economics and Related Disciplines), which is located here on the top floor of the Lionel Robbins Building. If things work out, there will be other Hayek Visiting Fellows in future years.
I might mention that, for a few years now, LSE’s economics department has had a Lachmann Chair—named for Ludwig M. Lachmann, who was a student of Hayek’s and who spent most of his career at the University of the Witwatersrand in South Africa. During the academic year 2001-2002, that chair was held by Bruce Caldwell, who is now the general editor of the Collected Works of F. A. Hayek, an ongoing project of the University of Chicago Press.
Q8: What are the priorities in the research field of the Capital-based macroeconomics?
In Time and Money, the exposition is all about a closed economy. That’s where you have to start, I think. I didn’t try to factor the international sector into the graphics. But I’ve already seen some of my students trying to apply my graphics to a multiple-economy setting. It would be possible—and I believe it would be good thing—to create an open-economy version of the graphics. Also, John Cochran of Metropolitan State in Denver, Colorado, has been putting the basic graphics through their paces to deal with combinations of preference changes and policy reactions that I didn’t deal with in my book. I think that’s good, too.
Q9: In US they are in a big time credit expansion…what’s going on?
The Federal Reserve and the Bush administration are simply fighting the market’s attempt to adjust to the excesses of the prior boom. But by fighting the market, they’re making things worse. The exceedingly low interest rates give no incentive for businesses to liquidate malinvested capital. Some capital has been committed to projects that are now not panning out. But why liquidate if you can carry the capital forward at low interest rates, hoping for better times? Also, the low interest rates are stimulating consumption. People are refinancing their mortgages and spending the windfall. The policy-induced spurt in consumption is even being seen as a sign of a new economic expansion. But, of course, it’s just the Federal Reserve trying to keep the market for recovering from the earlier expansion.
Q10: Professor Huerta de Soto thinks that the Fed is going to print whatever is needed, indefinitely. Does it imply a change in the monetary system? Should we be worried of a coming apocalyptic financial crisis? Someone speaks of Japanization…
The Fed seems to be totally preoccupied with preventing deflation. One of the newer Federal Reserve Governors, Ben Bernanke, adopts the old Irving Fisher view known as debt-deflation—which just means that if prices fall when debt levels are high, the economy is in trouble. Well, prices did fall in the 1930s when Irving Fisher was deeply in debt, and he was in trouble. Randall Parker has recently published a book titled Reflections on the Great Depression. Parker interviewed all the old economists who lived through the depression and asked them why it happened. Bernake wrote the foreword. It’s a revealing and—though not so intended—a comical account of the thinking at the time. Parker totally misunderstands the Austrian view. I wrote a review article for The Independent Review.
I see the Federal Reserve as fighting a market correction and, in effect, trading depth for duration. In other words, by keeping malinvested capital from being liquidated on a timely basis, the Fed simply prolongs the period of liquidation. And, of course, this is more or less what the Bank of Japan has done.
So, what should the Federal Reserve do? The work Hayek did here at LSE in the 1930s suggests that the once the bust comes, the central bank should allow interest rates to rise enough to get the needed liquidation but not so much as to send the economy spiraling into a self-reinforcing contraction. Of course, actually implementing that policy may push the so-called art of central banking to its limits and even beyond. And, making matters worse, short-run political considerations all weigh on the side of keeping interest rates low. These are the considerations that cause modern Austrians—Hayek, too, starting in the 1970s—to prefer reform in the direction of a decentralized banking system: Let competitive forces of the marketplace keep the supply of money—and of credit—in line with demands.
Thank you Professor Garrison
Massimiliano Neri is a PhD student in Economics at the University of Madrid, studying with Professor Jesus Huerta de Soto.
This interview was originally prepared for:
and the Liberanimus Institute
An Italian translation of selected portions of the interveiw will appear in Enclave.