52, NO.1, JANUARY 2002
A Classic Hayekian
By Roger Garrison and Gene Callahan
investment booms followed by busts like drinking binges are followed by
hangovers? Dubbing the idea “The Hangover Theory” (Slate, 12/3/98),
Krugman has attempted to denigrate the business-cycle theory introduced
early last century by Austrian economist Ludwig von Mises and developed
most notably by Nobelist F. A. Hayek.
proponents of the Austrian theory have themselves embraced this apt
And if investment is the intoxicant, then the interest rate is the
drinking age. Set the interest rate too low, and there is bound to be
drinking age is set by—and periodically changed by—the Federal Reserve.
In our Fed-centric mixed economy, the understanding that “the Fed sets
interest rates” has become widely accepted as a simple institutional
But unlike an actual drinking age, which has an inherent degree of
about it, the interest rate cannot simply be “set” by some extra-market
authority. With market forces in play, it has a life of its own.
interest rate is a price. It’s the price that brings into balance our
to consume now and our willingness to save and invest for the future.
more we save, the lower the market rate. Our increased saving makes
investment possible; the lower rate makes investments more future
In this way, the market balances current consumption and economic
fixing foils the market. Government mandated ceilings on apartment
rates, for instance, create housing shortages, as is well known by
who has gone apartment hunting in New York City. Similarly, a
interest-rate ceiling would cause a credit shortage: The volume of
funds demanded would exceed people’s actual willingness to save.
the Fed can do more than simply impose a ceiling on credit markets.
the interest rate below where the market would have it is accomplished
not by decree but by increasing the money supply, temporarily masking
discrepancy between supply and demand. This papering over of the credit
shortage hides a problem that would otherwise be obvious, allowing it
fester beneath a binge of investment spending.
artificially low rate of interest, then, sets the economy off on an
growth path. During the boom, investment spending is excessively
and overly optimistic. Further, high levels of consumer spending draw
resources away from the investment sector, increasing the gap between
resources actually available and the resources needed to see the
and speculative investments through to completion.
more, and we get a market process that plays itself out as economic
Pump new money through credit markets, and we get a market process of a
very different kind: It doesn’t play itself out; it does itself in. The
investment binge is followed by a hangover. This is the Austrian theory
in a nutshell. (Ironically, it is the theory that Alan Greenspan
forty years ago when he lectured for the Nathaniel Branden Institute.)
We believe that there is strong evidence that the United States is now
in the hangover phase of a classic Mises-Hayek business cycle.
recent years money-supply figures have become clouded by institutional
and technological change. But in our view, a tale-telling pattern is
out by the MZM data reported by the Federal Reserve Bank of St. Louis.
ZM standing for “zero maturity,” this monetary aggregate is a better
of credit conditions than are the more narrowly defined M’s.
increasing at a rate of less than 2.5% during the first three years of
the Clinton administration, MZM increased over the next three years
at an annualized rate of over 10%, rising during the last half of 1998
at a binge rate of almost 15%.
Corrigan, a principal in Capital Insight, a UK-based financial
has recently detailed the consequences of the expansion that came in
1998, when the world economy, still racked by the problems of the Asian
credit bust over the preceding year, then had to cope with the Russian
default and the implosion of the mighty Long-Term Capital Management."
Corrigan goes on: "Over the next eighteen months, the Fed added $55
to its portfolio of Treasuries and swelled repos held from $6.5 billion
to $22 billion… [T]his translated into a combined money market mutual
and commercial bank asset increase of $870 billion to the market peak,
of $1.2 trillion to the industrial production peak, and of $1.8
to date—twice the level of real GDP added in the same interval"
party was in full swing, and the Fed kept the good times rolling by
the fed funds rate 100 basis point between June 1998 and January 1999.
The rate on 30-year Treasuries dropped from a high of over 7% to a low
of 5%. Stock markets soared. The NASDAQ composite went from just
over 1000 to over 5000 during the period, rising over 80% in 1999
With abundant credit being freely served to Internet start-ups, hordes
of corporate managers, who had seemed married to their stodgy blue-chip
companies, suddenly were romancing some sexy dot-com that had just
consumer spending stayed strong—with very low (sometimes negative)
rates. Growth was not being fueled by real investment, which would
forgoing current consumption to save for the future, but by the
so often happens at bacchanalia, when the party entered the wee hours,
it became apparent that too many guys had planned on taking the same
home. There were too few resources available for all of their plans to
succeed. The most crucial—and most general—unavailable factor was a
flow of investment funds. There also turned out to be shortages of
network engineers, technical managers, and other factors of production.
The rising prices of these factors exacerbated the ill effects of the
business plans for many of the startups involved negative cash flows
the first 10 or 15 years, while they "built market share." To keep the
atmosphere festive, they needed the host to keep filling the punch
But fears of inflation led to Federal Reserve tightening in late 1999,
which helped bring MZM growth back into the single digits (8.5% for the
1999-2000 period). As the punch bowl emptied, the hangover–and the
bloodbath–began. According to research from Webmergers.com, at least
Internet companies closed their doors between May 2000 and July of this
year. The plunge in share price of many of those still alive has been
wrenching. The NASDAQ retraced two years of gains in a little over a
the first half of 2001, the Fed demonstrated—with its half-dozen
cuts and a near-desperate MZM growth of over 23%—that you can’t
euphoria in the midst of a hangover.
all adds up to the Austrian theory. As a final twist to our story, we
that Krugman, who before could only mock the Austrians, has recently
us an Austrian account of our macroeconomic ills. In his "Delusions of
Prosperity" (New York Times, 8/14/01), Krugman explains how our current
difficulties go beyond those of a simple financial panic:
We are now in the midst
of a financial
panic, and recovery isn't simply a matter of restoring confidence.
excessive confidence [fostered by unduly low interest rates maintained
by rapid monetary growth?–RG & GC] may be part of the problem.
of being the victims of self-fulfilling pessimism, we may be suffering
from self-defeating optimism. The driving force behind the current
is a plunge in business investment. It now seems clear that over the
few years businesses spent too much on equipment and software and that
they will be cautious about further spending until their excess
has been worked off. And the Fed cannot do much to change their minds,
since equipment spending [at least when such spending has already
to be excessive—RG & GC] is not particularly sensitive to interest
on the verge of rediscovering the policy-induced self-reversing process
that we call the Austrian theory of the business cycle, we confidently
claim that current macroeconomic conditions are best described as a
Hayekian hangover. The Austrian theory, of course, gives us no policy
for converting this ongoing hangover into renewed euphoria. But it does
provide us with the best guide for avoiding future ones.
Roger Garrison is Professor
Economics at Auburn University and author of Time and Money: The
of Capital Structure (Routledge, 2001); Gene Callahan is author of
Economics for Real People (Ludwig von Mises Institute, 2001),
"A Classic Hayekian Hangover" was written in August of 2001.