The Macroeconomics of Captial Structure
Roger W. Garrison
The Long and the Short of It
In early 1997 a small group of world-class economists, serving as panelists
in a session of the American Economics Association meetings, addressed
themselves to the question "Is there a core of practical macroeconomics
that we should all believe?" We could hardly imagine that a second group
of economists were gathered across the hall to answer a similar question
about microeconomics. Dating from the marginalist revolution of the 1870s,
microeconomics has had a readily recognizable core-and one that has grown
increasingly solid over the past century. By contrast, the Keynesian revolution
that began in the 1930s ushered in a macroeconomics that was-at least from
one important point of view-essentially coreless. The capital theory that
underlay the macroeconomics being developed by the Austrian school was
no part of Keynesian theory.
"One major weakness in the
core of macroeconomics," as identified by AEA panelist Robert Solow (1997,
p. 231f), "is the lack of real coupling between the short-run picture and
the long-run picture. Since the long run and the short run merge into one
another [sic], one feels that they cannot be completely independent."
Ironically, when the same Robert Solow (1997b, p. 594) contributed an entry
on Trevor Swan to An Encyclopedia of Keynesian Economics, he took
a much more sanguine view: [Swan's writings serve] as a reminder that one
can be a Keynesian for the short run and a neoclassical for the long run,
and that this combination of commitments may be the right one."
The present volume takes
Solow's more critical assessment to be the more cogent. The weakness, or
lacking, in modern macroeconomic theorizing can most easily be seen by
contrasting Keynes's macroeconomics with Solow's own economics of growth.
In the short run, the investment and consumption magnitudes move in the
same direction-both downward into recession or both upward toward full
employment and even beyond in an inflationary spiral. The economics of
growth, which also allows investment and consumption to increase together
over time, features the fundamental trade-off faced in each period between
current consumption and investment. We can increase investment (and hence
increase future consumption) if and to the extent we are willing to forgo
current consumption. For a given period and with a given technology, any
change in the economy's growth rate must entail consumption and investment
magnitudes that move, initially, in opposite directions.
So, can we accept or find
practical use for a macroeconomics (1) in which consumption and investment
always move together in the short run, (2) in which these two magnitudes
must move in opposition to change the economy's rate of growth, and (3)
for which the long run emerges as a seamless sequence of short runs?
Keynes (1936, p. 378), whose
demand-dominated theory offered us nothing in the way of a "real coupling,"
simply refocused the profession's attention on the short-run movements
in macroeconomic magnitudes while paying lip service to the fundamental
truths of classical economics: "if our central controls succeed in establishing
an aggregate volume of output corresponding to full employment as nearly
as is practicable, the classical theory comes into its own again from this
point onward." This statement comes immediately after his claim that the
"tacit assumptions [of the classical theory] are seldom or never satisfied."
The classical economists,
if we are to accept Keynes's caricature of them, focused their attention
exclusively on the long-run relationships, as governed by binding supply-side
constraints, and relied on Say's Law ("Supply creates its own Demand,"
in Keynes's rendering) to keep the Keynesian short run out of the picture.
If Keynes focused on the
short-run picture, and the classical economists focused on the long-run
picture, then the Austrian economists, and particularly Friedrich. A. Hayek,
focused on the "real coupling" between the two pictures. The Hayekian coupling
took the form of capital theory-the theory of a time-consuming, multi-stage
capital structure envisioned by Carl Menger and developed by Eugen von
Böhm-Bawerk. Decades before macroeconomics emerged as a recognized
subdiscipline, Böhm-Bawerk had molded the fundamental Mengerian insight
into a macroeconomic theory to account for the distribution of income among
the factors of production. Dating from the late 1920s, Hayek, following
a lead provided by Ludwig von Mises, infused the theory with monetary considerations.
He showed that policy activism practiced by the monetary authority can
be a source of economywide distortions in the intertemporal allocation
of resources and hence an important cause of business cycles.
Tellingly, Robert Solow,
as revealed in an interview with Jack Birner (1990, p. 28n.) found Hayek's
work to be "completely incomprehensible." A major claim in the present
book is that Hayek's work-and the work of modern Austrian macroeconomists-can
be comprehended as an effort to reinstate the capital-theory "core" that
allows for a "real coupling" of short-run and long-run aspects of the market
process. Hayek, in effect, anticipated and heeded a warning issued by Mises
(1949, p. 284): "[W]e must guard ourselves against the popular fallacy
of drawing a sharp line between short-run and long-run effects. What happens
in the short run is precisely the first stages of a chain of successive
transformations which tend to bring about the long-run effects."
The question addressed by
the AEA panelists in 1997 is but an echo of a lingering question about
the nature of macroeconomic problems posed by John Hicks (1967, p. 203)
three decades earlier: "[Who] was right, Keynes or Hayek?" The most recent
answer to Hicks' question is offered by Bruce Caldwell in his introduction
to Contra Keynes and Cambridge, (Volume 9 of the Collected Works
of F. A. Hayek). According to Caldwell (1995, p. 46), "neither was right.
Both purported to be supplying a general theory of the cycle, and in this,
neither was successful." This verdict can be called into question on two
counts. First, Chapter 22 of Keynes's General Theory, "Notes on
the Trade Cycle," is not advertized as a general theory of the cycle, and
the remainder of Keynes's book is concerned primarily with secular unemployment
and only secondarily if at all with cyclical variations. Second, although
Hayek's Prices and Production and related writings were concerned
primarily with cyclical variation, applicability took priority over generality.
Hayek's focus (1967, p. 54) on a money-induced artificial boom reflects
the fact that, as an institutional matter and as an historical matter,
money enters the economy through credit markets. Hence, it impinges, in
the first instance, on interest rates and affects the intertemporal allocation
of resources. He recognized that a fully general theory would have to encompass
other institutional arrangements and allow for other possible boom-bust
scenarios.
But there is a greater point
that challenges Caldwell's answer. The major weakness that Solow saw in
modern macroeconomics has as its counterpart in Austrian macroeconomics
a major strength. There is a real coupling between the short run
and the long run in the Austrian theory. The fact that the Austrian economists
feature this coupling is the basis for an alternative answer to Hicks'
question: Hayek was right. Or, more substantively, identifying the relative-price
effects (and the corresponding quantity adjustments) of a monetary disturbance,
as compared to tracking the movements in macroeconomic aggregates that
conceal those relative-price effects, gives us a superior understanding
of the nature of cyclical variation in the economy and points the way to
a more thoroughgoing capital-based macroeconomics.
What's in a Name?
The subtitle of this book, The Macroeconomics
of Capital Structure, is intended to suggest that the macroeconomic
relationships identified and explored here are, to a large extent, complementary
to the relationships that have dominated the thinking of macroeconomists
for the past half century. Arguably, the macroeconomics of labor, which
is the focus of modern income-expenditure analysis, and the macroeconomics
of money, which gets emphasis in the quantity-theory tradition, have each
been pushed well into the range of diminishing marginal returns. If further
pushing toward a fuller macroeconomic understanding is to pay, it may well
involve paying attention to the economy's intertemporal capital structure.
In a
more comprehensive and balanced treatment of the issues, we might want
to present a macroeconomics of labor, capital, and money. This trilogy
is sequenced so as to parallel the title chosen by Keynes: The General
Theory of Employment, Interest, and Money. Capital does not appear
in his trilogy, but its shadow, interest, does. The lack of conformability
in Keynes's identification of the objects of study-employment (of labor),
capital's shadow, and money-should alert us at the outset to the enduring
perplexities that theorizing about capital and interest entails. Classical
economists saw the rate of interest, also known as the rate of profit,
as the price of capital. Keynes, who clearly rejected this view, would
have us believe that the shadow is actually being cast by money. Keynes's
critics, particularly the members of the Austrian school, took the rate
of interest to be a systematic discounting of future values-whether or
not capital was involved in creating them or money was involved in facilitating
their exchange. Decades of controversy have demonstrated that the interest
rate's relationship to capital and to money is not a simple one. In the
present study, capital-or, more pointedly, the intertemporal structure
of capital-is the primary focus. The centrality of the interest rate derives
from its role in allocating resources-and sometimes in misallocating them-within
the economy's capital structure.
Undeniably,
claims can be made to justify each of the three candidates (labor, capital
and money) as an appropriate basis, or primary focal point, for macroeconomic
theorizing. The rationale for labor-based macroeconomics and for money-based
macroeconomics are more often assumed than actually spelled out. The case
for capital-based macroeconomics, however, is, at least, an equally compelling
one.
Labor-Based Macroeconomics The employment
of labor is logically and temporally prior to the creation of capital.
Capital goods, after all, are produced by labor. Even the macroeconomic
theorists who have devoted the most attention to capital have typically
identified labor, together with natural resources, as the "original" means
of production. And although the employment of labor in modern economies
is facilitated by a commonly accepted medium of exchange, the use of money
is not fundamentally a prerequisite to employment. The employment of labor
can take place in a barter economy, and self-employment in a Crusoe economy.
Employee
compensation accounts for a large portion-more than seventy percent-of
national income even in the most capital-intensive economies. The earning
and spending by workers, then, dominates in any circular-flow construction.
The occasional widespread unemployment in modern economies is the most
salient manifestation of a macroeconomic problem. And cyclical variation
in economic activity is conventionally charted in terms of changes in the
unemployment rate. The pricing of labor even in markets that may otherwise
be characterized by flexibility can be affected by attitudes about fairness,
implications for worker morale, and considerations of firm-specific human
capital. Hence, changes in labor-market conditions can result in quantity
adjustments and/or price adjustments not fully accounted for by simply
supply-and-demand analysis. All these considerations give employment a
strong claim to being the primary focus for macroeconomic theorizing.
Money-Based Macroeconomics It is the use of money, arguably, that puts the macro in macroeconomics. In the context of a barter system, it is difficult even to imagine-unless we think of a widespread natural disaster-that the economy might experience variations in market conditions that have systematic economywide repercussions. But, with trivial exceptions, money is on one side of every transaction in modern economies. Unavoidably, however, the medium of exchange is also a medium through which difficulties in any sector of the economy-or difficulties with money itself-get transmitted to all other sectors. Further, the provision of money even in the most decentralized economies is-not to say must be-the business of a central authority. This institutionalized centrality translates directly into a central concern of macroeconomists. Money comes into play both as a source of difficulties and as a transmission of those difficulties. Using terminology first introduced by Ragnar Frisch, we can say that money matters both as "impulse" and as "propagation mechanism." So involved is money that macroeconomics and monetary theory have, in some quarters, come to be thought as two names for the same set of ideas. Monetarism, broadly conceived, is simply money-based macroeconomics.
Capital-Based Macroeconomics What, then, is
the case for capital-based macroeconomics? Considerations of capital structure
allow the time element to enter the theory in a fundamental yet concrete
way. If labor and land can be thought of as original means of production
and consumer goods as the ultimate end toward which production is directed,
then capital occupies a position that is both logically and temporally
intermediate between original means and ultimate ends. The goods-in-process
conception of capital has a long and honorable history. And even forms
of capital that do not fit neatly into a simple linear means-ends framework,
such as fixed capital, human capital, and consumer durables, occupy an
intermediate position between some relevant production decisions and the
corresponding consumption utilities.
This
temporally intermediate status of capital is not in serious dispute, but
its significance for macroeconomic theorizing is rarely recognized. Alfred
Marshall taught us that the time element is central to almost every economic
problem. The critical time element manifests itself in the Austrian theory
as an intertemporal capital structure. The scope and limits to structural
modifications give increased significance to monetary disturbances. Simply
put, capital gives money time to cause trouble. In a barter economy, there
is no money to cause any trouble; in a pure exchange economy, there is
not much trouble that money can cause. But in a modern capital-intensive
economy,....
The macroeconomic
significance of the fact that production takes time suggests that, for
business-cycle theory, capital and money should get equal billing. The
nature and significance of money-induced price distortions in the context
of a time-consuming production processes was the basis for my early article
"Time and Money: the Universals of Macroeconomic Theorizing" (1984)-and
for the title of the present book. Macroeconomic theorizing, so conceived,
is a story about how things can go wrong-how the economy's production process
that transforms resources into consumable output can get derailed. Sometime
subsequent to the committing of resources but prior to the emergence of
output, the production process can be at war with itself; different aspects
of the market process that governs production can working against one another.
Thus, the troubles that characterize modern capital-intensive economies,
particularly the episodes of boom and bust, may best be analyzed with the
aid of a capital-based macroeconomics.
An Exercise in Comparative Frameworks
This book was originally conceived as a graphical
exposition of boom and bust as understood by the Austrian school. In its
writing, however, the horizon was extended in two directions. First, a
theory of boom and bust became capital-based macroeconomics. The relationships
identified in pursuit of the narrower subject matter proved to be a sound
basis for a more encompassing theory, one that sheds light upon such topics
as deficit spending, credit controls, and tax reform. The general analytical
framework that emerges from the insights of the Austrian school qualifies
as a full-fledged Austrian macroeconomics. Chapter 3 sets out the capital-based
framework; Chapter 4 employs it to depict the Austrian perspective on economic
growth and cyclical variation; Chapter 5 extends the analysis from monetary
matters to fiscal matters and develops still other applications; Chapter
6 offers a variation on the Austrian theme by introducing risk and uncertainty
and making a distinction-in connection with the distribution of risk and
exposure to uncertainty-between preference-based choices and policy-induced
choices.
Second,
the task of setting out and defending a capital-based (Austrian) macroeconomics
requires a conformable labor-based (Keynesian) macroeconomics with which
to compare and contrast it. The comparison was not well facilitated by
the existing renditions of conventional macroeconomics-the Keynesian cross,
ISLM, and Aggregate-Supply/Aggregate-Demand. Fortunately, it was possible
to create a labor-based macroeconomic framework that remains true to Keynes
(truer, arguably, than the more conventional constructions) and that contains
important elements common to both (Keynesian and Austrian) frameworks.
The resulting exercise in comparative frameworks requires a second set
of core chapters. Chapter 7 sets out the labor-based framework; Chapter
8 employs it to depict the Keynesian view of cyclical variation and of
counter-cyclical policies; Chapter 9 shifts the focus from stabilization
policy to social reform.
As it
turns out, money-based macroeconomics is virtually framework-independent.
Any framework that tracks the quantity of money, the economy's total output,
and the price level can be used to express the essential propositions of
Monetarism. However, two separate strands of Monetarism can be identified-one
that offers a theory of boom and bust and one that denies, on empirical
grounds, that the boom-bust sequence has any claim on our attention. Both
strands can be set out with the aid of either the labor-based framework
(We're all Keynesians, now) or the capital-based framework (A close reading
of Milton Friedman reveals elements of Austrianism). Chapters 10 deals
with the Monetarists' view of boom and bust; Chapter 11 deals with depression
as monetary disequilibrium.
The intertemporal
structure of capital gets a strong emphasis throughout the book-an emphasis
that some might judge to be unwarranted. But this book emphasizes the structure
of capital in the same sense and in the same spirit that Friedman's work
emphasizes the quantity of money or that the New Classical economists emphasize
expectations. We tend to emphasize what we judge to have been unduly neglected
in earlier writings. Chapter 12 summarizes and puts capital-based macroeconomics
into perspective.
The emphasis
in macroeconomics during the final quarter of the twentieth century has
clearly been-not on labor, not on capital, not on money-but on expectations,
so much so that theories tend to be categorized and judged primarily in
terms of their treatment of expectations. Static expectations are wholly
inadequate; adaptive expectations are only marginally less so; the assumption
of rational expectations has become a virtual prerequisite for having any
other aspect of a macroeconomic construction taken seriously. There is
something troubling, however, about the notion of an expectations-based
macroeconomics. Readers of Lewis Carrol and Dennis Robertson will sense
a certain grin-without-the-cat flavor to modern treatments of expectations.
Chapter 2 deals head on with the issue of expectations in the context of
the development of macroeconomics over the last three-quarters of a century
and argues that there has been an overemphasis on expectations in modern
theory which is ultimately attributable to the corelessness of modern macroeconomics,
to the lack of "real coupling," as identified by Solow, between short-run
and long-run macroeconomic relationships, or-more concretely-to the failure
to give due attention to the economy's intertemporal capital structure.
Point of Departure and Style of Argument
F. A. Hayek's contribution to the development of
capital theory is commonly regarded as his most fundamental and path-breaking
achievement (Machlup, 1976). His early attention to "Intertemporal Price
Equilibrium and Movements in the Value of Money" (1928; English translation
in Hayek, 1984) provided both the basis and inspiration for many subsequent
contributions. The widely recognized but rarely understood Hayekian triangle,
introduced in his 1931 lectures at the University of London, were subsequently
published (in 1931 with a second edition in 1935) as Prices and Production.
The triangle, as described in the second lecture (Hayek, 1967, pp. 36-47),
is a heuristic device that gives analytical legs to a theory of business
cycles first offered by Ludwig von Mises (1953, pp. 339-366). Triangles
of different shapes provide a convenient but highly stylized way of describing
changes in the intertemporal pattern of the economy's capital structure.
In retrospect
we see that the timing of Hayek's invitation to lecture at the University
of London takes on a special significance. We learn from the preface of
the subsequent book that had the invitation come earlier, he couldn't have
delivered those lectures; had it come later, he probably wouldn't have
delivered them. "[The invitation] came at a time when I had arrived at
a clear view of the outlines of a theory of industrial fluctuations but
before I had elaborated it in full detail or even realized all the difficulties
which such an elaboration presented" (Hayek, 1967, p. vii). Hayek
mentions plans for a more complete exposition and indicates that his capital
theory would have to be developed in much greater detail and adapted to
the complexities of the real world before it could serve as a satisfactory
basis for theorizing about cyclical fluctuations.
A decade
after the London lectures the more complete exposition took form as The
Pure Theory of Capital (1941). In this book Hayek fleshed out the earlier
formulations and emphasized the centrality of the "capital problem" in
questions about the market's ability to coordinate economic activities
over time. The "pure" in the title meant "preliminary to the introduction
of monetary considerations." Though some 450 pages in length, the book
achieved only the first half of the original objective. The final sixty
pages of the book did contain a "condensed and sketchy" (p. viii)
treatment of the rate of interest in a money economy, but the task of retelling
the story in Prices and Production in the context of the Pure
Theory of Capital was put off and ultimately abandoned. The onset of
the war was the proximate reason for cutting the project short; Hayek's
exhaustion and waning interest in the business-cycle issues-and his heightened
interest in the broader issues of political philosophy-account for his
never returning to the task. In later years he acknowledged that Austrian
capital theory effectively ended with his 1941 book and lamented that no
one else has taken up the task that he had originally set for himself (White,
20?? drawing from Hayek, 1994, p. 96).
More
fully developing the Austrian theory of the business cycle came to be synonymous
with writing the follow-on volume to Hayek's Pure Theory. Many a
graduate student has imagined himself undertaking that very project, only
to abandon the idea even before the enormity of the task was fully comprehended.
Thus, while the comparatively simple relationships of capital-free Keynesian
theory captured the attention of the economics profession, the inherently
complex relationships of Austrian theory languished.
Time
and Money is not the follow-on volume to Hayek's Pure Theory.
Rather, the ideas and graphical constructions in the present volume take
the original Hayekian triangle of Prices and Production to be the
more appropriate point of departure for creating a capital-based macroeconomics.
The trade-off between simplicity and realism is struck in favor of simplicity.
Hayek's triangles allow us to make a graphical statement that there is
a capital structure and that its intertemporal profile can change. This
statement enables the Austrian theory to make a quantum leap beyond the
competing theories that ignore capital altogether or that treat capital
as a one-dimensional magnitude.
It is
true, of course, that the triangles leave much out of account, but so too-despite
their complexity-do the Pure Theory's warped pie-slice figures
that are intended to make some allowance for durable capital (Hayek, 1941,
pp. 208 and 211). Degrees of realism range from K (for capital) to an aerial
photograph of the Rust Belt. K is too simple; everything from the Pure
Theory to the aerial photograph is too realistic for use in a macroeconomic
framework. The Hayekian triangle is just right. It is comparable-in terms
of the simplicity/realism trade-off-to the Keynesian cross; and it is comparable
in this same regard to other graphical devices (the production-possibilities
frontier, the market for loanable funds, and markets for labor) that make
up the capital-based framework. Sophomores in their first economics course
sometimes complain about all the considerations that the a simple Marshallian
demand curve fails to capture. As they reel off a list of particulars,
the professor waits patiently to deliver the news: "What's remarkable about
demand curves is not that they leave so much out of account but that they
account for so much on the basis of so little." The same point is an appropriate
response to those critical of Hayekian triangulation.
The style
of argument in Time and Money may appear to some as strangely anachronistic-as
theory from the 1930s and pedagogy from the 1960s. This appearance is not
without significance. The theory is from the 1930s because it was during
that period that capital theory was dropped out of macroeconomics. The
pedagogy is reminiscent of the 1960s because Austrian macroeconomics is
missing the stage of development that the alternative (Keynesian) macroeconomics
was pacing through during that decade. The sequence of frameworks from
the Keynesian cross to ISLM to Aggregate-Supply/Aggregate-Demand has no
counterpart in Austrian macroeconomcis. Instead, we have the Hayekian triangle
accompanied by critical assessments and apologetic defenses, followed in
time with the Pure Theory, which was and unfinished task and strategic
miscue, followed by years of neglect. In recent years there has been a
scatter of restatements of the Austrian theory, many of which are contorted
by the near-obligatory attention to the current concerns of mainstream
macroeconomics, such as expectations and lag structure. Not surprisingly,
there can be only limited success in reintroducing the old Austrian insights
into a macroeconomics whose development over the past half-century has
followed an alternative course. Accordingly, if the constructions and argumentation
in Time and Money are throwbacks and partially remedial in nature,
they are unapologetically so.
Modern
Austrian theory is not some hardened set of ideas or even an generally
agreed upon set of agenda items. There are members of the school who have
long turned a blind eye to the issues of business cycles and of macroeconomics
more broadly conceived. Classics in Austrian Economics: A Sampling in
the History of a Tradition, edited by Israel Kirzner (1994), gives
little or no hint that the Austrian economists ever asked a macroeconomic
question, let alone offered answers that show great insight and much promise
for development. And while Kirzner himself has contributed importantly
to the development of capital theory, primarily in his Essays on Captial
and Interest: An Austrian Perspective (1996), he has steered clear
of macroeconomics. His introductory essay includes a brief assessment of
the progress on this front: "[R]ecent Austrian work on Hayekian cycle theory
[and presumably on Austrian macroeconomics generally] seems, on the whole,
to fail to draw on the subjectivist, Misesian, tradition which the contemporary
Austrian resurgence has done so much to revive" (p. 2). Karen Vaughn's
Austrian Economics in America: The Migration of a Tradition leaves
the impression that macroeconomics never reached-or possibly shouldn't
have reached-the American shore. And in her recent reflections on the development
of the Austrian tradition (1999, p. ??), she hints that progress is to
be measured in part by the school's distancing itself from the issues of
business cycles and the gold standard.
The capital-based
macroeconomics offered in this volume is bolstered by the judgment of Machlup
that Hayek's contribution to capital theory was both fundamental and path-breaking
and by the belief that a macroeconomic framework that features the Austrian
theory of capital can compare favorably to the alternative frameworks of
mainstream macroeconomics.